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Most economists believe that a growing economy requires a growing
money stock, on grounds that growth gives rise to a greater demand for money
which must be accommodated. Failing to do so, it is maintained, will lead to
a decline in the prices of goods and services, which in turn will destabilize
the economy and lead to an economic recession-or, even worse, depression.
Since growth in money supply is of such importance, it is not
surprising that economists are continuously searching for the right
percentage growth, or the optimum rate of growth in money supply. The most
vocal economists on this issue are the followers of Milton Friedman-also
known as monetarists-who want the central bank to target the money supply at
a fixed percentage. They hold that if this percentage is maintained over a
prolonged period of time, it will usher in an era of economic stability.
The whole idea that money must grow in order to sustain economic
growth gives the impression that money somehow sustains economic activity. If
this were the case, then most Third World economies by now would
have eliminated poverty through printing large quantities of
money.
According to Rothbard,
Money, per se,
cannot be consumed and cannot be used directly as a producers' good in the
productive process. Money per
se is therefore unproductive; it is dead stock and produces
nothing. Land or capital is always in the form of some specific good, some
specific productive instrument. Money always remains in someone's cash
balance.[1]
Money's main job is simply to fulfill the
role of the medium of exchange. Money doesn't sustain or fund real economic
activity. The means of sustenance, or funding, is provided by saved real
goods and services. By fulfilling its role of the medium of exchange, money
just facilitates the flow of goods and services.
Historically, many different goods have been used as the medium of
exchange. On this, Mises observed that, over time,
. . . there would be an inevitable tendency for the less marketable of
the series of goods used as media of exchange to be one by one rejected until
at last only a single commodity remained, which was universally employed as a
medium of exchange; in a word, money.[2]
Through the ongoing process of selection
over thousands of years, people settled on gold as the general medium of
exchange. Most mainstream economists, while accepting this historical
evolution, cast doubt that gold can fulfill the
role of money in the modern world. It is held that, relative to the growing
demand for money as a result of growing economies, the supply of gold is not
adequate.
Furthermore, if one takes into the account that a large portion of
gold mined is used for jewelry, this leaves the
stock of money almost unchanged over the period of time. In short, it is held
that the free market, by failing to provide enough gold, will cause money
supply shortages. This, in turn, runs the risk of destabilizing the economy.
It is for this reason that most economists, even those who express sympathy
toward the idea of a free market, endorse the view that the money supply must
be controlled by the government.
But does this make sense?
When we talk about demand for money, what we really mean is the demand
for money's purchasing power. After all, people don't want a greater amount
of money in their pockets so much as they want greater purchasing power in
their possession.
On this Mises wrote,
The services money renders are conditioned by the height of its
purchasing power. Nobody wants to have in his cash holding a definite number
of pieces of money or a definite weight of money; he wants to keep a cash
holding of a definite amount of purchasing power.[3]
In a free market, in similarity to other goods, the price of money is
determined by supply and demand. Consequently, if there is less money, its
exchange value will increase. Conversely, the exchange value will fall when
there is more money. In short, within the framework of a free market, there
cannot be such thing as "too little" or "too much" money.
As long as the market is allowed to clear, no shortage of money can
emerge.
Consequently, once the market has chosen a particular commodity as
money, the given stock of this commodity will always be sufficient to secure
the services that money provides. Hence, in a free market, the whole idea of
the optimum rate of growth of money is absurd.
According to Mises:
As the operation of the market tends to determine the final state of
money's purchasing power at a height at which the supply of and the demand
for money coincide, there can never be an excess or deficiency of money. Each
individual and all individuals together always enjoy fully the advantages
which they can derive from indirect exchange and the use of money, no matter
whether the total quantity of money is great, or small. . . . the services which money renders can be neither improved
nor repaired by changing the supply of money. . . . The quantity of money
available in the whole economy is always sufficient to secure for everybody
all that money does and can do.[4]
But how can we be sure that the supply of a selected commodity as
money will not start to rapidly expand on account of unforeseen events? Would
it not undermine people's well-being? If this were to happen, then people
would probably abandon this commodity and settle on some other commodity.
Individuals who are striving to preserve their life and well-being will not
choose a commodity that is subject to a steady decline in its purchasing
power as money.
This is the essence of the market selection process and the reason why
it took several thousands years for gold to be
selected as the most marketable commodity. In short, the prolonged market
selection process raises the likelihood that gold is the most suitable
commodity to fulfill the role of money.
But even if we were to agree that the world under the gold standard
would have been a much better place to live than under the present monetary
system, surely we must be practical and come up with solutions that are in
tune with contemporary reality. Namely, that in the world in which we
presently live, we do have central banks, and we are not on the gold
standard. Given these facts of reality, what then must be the
correct money supply rate of growth?
It is not possible, however, to devise a scheme for a
"correct" money rate of growth while central authorities have
coercively displaced the market-selected money with paper money. Here is why.
Originally, paper money was not regarded as money but merely as a
representation of gold. Various paper certificates represented claims on gold
stored with the banks. Holders of paper certificates could convert them into
gold whenever they deemed necessary. Because people found it more convenient
to use paper certificates to exchange for goods and services, these
certificates came to be regarded as money.
Paper certificates that are accepted as the medium of exchange open
the scope for fraudulent practice. Banks could now be tempted to boost their
profits by lending certificates that were not covered by gold. In a
free-market economy, a bank that over-issues paper certificates will quickly
find out that the exchange value of its certificates in terms of goods and
services will fall.
To protect their purchasing power, holders of the over-issued
certificates naturally attempt to convert them back to gold. If all of them
were to demand gold back at the same time, this would bankrupt the bank. In a
free market then, the threat of bankruptcy would restrain banks from issuing
paper certificates unbacked by gold. On this Mises wrote,
People often refer to the dictum of an anonymous American quoted by Tooke:
"Free trade in banking is free trade in swindling." However,
freedom in the issuance of banknotes would have narrowed down the use of
banknotes considerably if it had not entirely suppressed it. It was this idea
which Cernuschi advanced in the hearings of the
French Banking Inquiry on October 24, 1865: "I believe that what is
called freedom of banking would result in a total suppression of banknotes in
France. I want to give everybody the right to issue banknotes so that nobody
should take any banknotes any longer."[5]
This means that in a free-market economy, paper money cannot assume a
"life of its own" and become independent of commodity money.
The government can, however, bypass the free-market discipline. It can
issue a decree that makes it legal for the over-issued bank not to redeem
paper certificates into gold. Once banks are not obliged to redeem paper
certificates into gold, opportunities for large profits are created that set
incentives to pursue an unrestrained expansion of the supply of paper certificates[6]. The uncurbed
expansion of paper certificates raises the likelihood of setting off a
galloping rise in the prices of goods and services that can lead to the
breakdown of the market economy.
To prevent such a breakdown, the supply of the paper money must be
managed. The main purpose of managing the supply is to prevent various
competing banks from over-issuing paper certificates and from bankrupting
each other. This can be achieved by establishing a monopoly bank-i.e., a
central bank-that manages the expansion of paper money.
According to Hoppe, "If one is to succeed in replacing commodity
money by fiat money, then, an additional requirement must be fulfilled: Free
entry into the note-production business must be restricted, and a money monopoly must be
established."[7]
To assert its authority, the central bank introduces its paper
certificates, which replace the certificates of various banks. (The central
bank's money purchasing power is established on account of the fact that
various paper certificates, which carry purchasing power, are exchanged for
the central bank money at a fixed rate. In short, the central bank paper
certificates are fully backed by banks certificates, which have the
historical link to gold.)
The central bank paper money, which is declared as the legal tender,
also serves as a reserve asset for banks. This enables the central bank to
set a limit on the credit expansion by the banking system.
It would appear that the central bank can manage and stabilize the
monetary system. The truth, however, is the exact opposite. To manage the
system, the central bank must constantly create money "out of thin
air" to prevent banks from bankrupting each other. This leads to
persistent declines in money's purchasing power, which destabilizes the
entire monetary system. This tendency to destabilize the system is also
reinforced by the fact that a money monopolist naturally has the incentive to
look after his own interest.
According to Hoppe,
He can print notes at practically zero cost and then turn around and
purchase real assets
(consumer or producer goods) or use them for the repayment of real debts. The real wealth
of the non-bank public will be reduced-they own less goods and more money of
lower purchasing power. However, the monopolist's real wealth will
increase-he owns more non-money goods (and he always has as much money as he
wants). Who, in this situation, except angels, would not engage in a steady
expansion of the money supply and hence in a continuous depreciation of the
currency? [8]
Observe that while, in the free market, people will not accept a
commodity as money if its purchasing power is subject to a persistent
decline, in the present environment, central authorities are coercively
imposing money that suffers from a steady decline in its purchasing
power.
Since the present monetary system is fundamentally unstable, the
central bank is compelled to print money out of thin air to prevent the
collapse of the system. It doesn't really matter what scheme the central bank
adopts as far as monetary injections are concerned. Regardless of the mode of
monetary injections, the boom-bust cycles will become more ferocious as time
goes by.
Even Milton Friedman's scheme to fix the money rate growth at a given
percentage won't do the trick. After all a fixed percentage growth is still money growth, which leads to the exchange of
nothing for something-i.e., economic impoverishment and the boom-bust cycle.
What about removing the central bank altogether and keeping the
current stock of paper money unchanged? Would that not do the trick? No, it
would not. An unchanged money stock will cause an almost immediate breakdown
of the present monetary system. After all, the present system survives because
the central bank, by means of monetary injections, prevents the
fractional reserve banks from going bankrupt.
It is therefore not surprising that the central bank must always
resort to large monetary injections when there is a threat from various political
or economic shocks. For instance, to prevent possible disruptions to the
monetary system due to the September 11 terrorist attack, the Fed pumped
out over $100 billion in one week.
Observe that the same fate is likely with other schemes. The only difference,
of course, is that in other schemes it will take some time before the
final breakdown will occur. How long the central bank can keep the present
system going is dependent upon the state of the real pool of funding. As long
as this pool is still growing, the central bank is likely to succeed in
keeping the system alive. Once the real pool of funding begins to
stagnate-or, worse, shrink-however, then no monetary pumping will be able to
prevent the plunge of the system.
In a true free market, if people raised their demand for gold as a
result of a major upheaval, this would lift money's purchasing power, and
that would be about it; no further disruptions would emerge. The monetary
system would remain intact. Also, as opposed to the present
monetary system, money can't disappear in a true free market and set in
motion the menace of the boom-bust cycles.
In fractional reserve banking, when money is repaid and the bank
doesn't renew the loan, money evaporates. Because the loan has originated out
of nothing, it obviously couldn't have had an owner. In a free market, in
contrast, when the gold is repaid, it is passed back to the original
lender; the money stock stays intact.
Conclusion
Since the present monetary system is fundamentally unstable, there
cannot be a "correct" money supply rate of growth. Whether the
central bank injects money in accordance with economic activity or fixes the
rate of growth, it further destabilizes the system. The only way to make the
system truly stable is to permit the free market to take over.
In a truly free market, there is no need to be concerned with the
issue of the "correct" rate of money supply growth. No institution
is required to regulate the supply of money in a free market. Furthermore,
while the free-market money is associated with rising real wealth, the
present monetary system is inherently inflationary and leads to economic
impoverishment.
[1] Murray
N. Rothbard, Man,
Economy, and State (Los Angeles: Nash Publishing, 1970), p. 670.
[2] Ludwig
von Mises, The Theory of Money and Credit (Irvington-on-Hudson,
N.Y.: The Foundation for Economic Education, 1971), pp. 32-33
[3] Ludwig
von Mises, Human Action, 3rd rev. ed. (Chicago:
Contemporary Books, 1966), p. 421.
[4] Ibid.
[5] Ibid., p. 446
[6] Hans-Hermann
Hoppe, "How is Fiat Money Possible?-or,
The Devolution of Money and Credit," The Review of Austrian Economics 7,
no. 2 (1994), pp.49-74.
[7] Ibid., p. 59.
[8] Ibid., p. 62.
Frank Shostak
Frank Shostak is a former
professor of economics and M. F. Global's
chief economist.
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