What Is Up With Fiat Money?

by Dmitry Chernikov
by Dmitry Chernikov

Inflation and the business cycle are as much parts of our lives as death and taxes. But it need not be this way. Commodity money such as gold can stop both in their tracks. Before we get to that, however, let us first get right some of the basics of money.

Money

First, notice that the purchasing power of money varies inversely with supply and directly with demand for money. (PPM = 1/Price.) That is, the more (less) money is in the hands of the public the higher (the lower) the prices will be and the less (the greater) the PPM be. And the greater the demand for money, the more people will save in their cash balances, which means that the prices will fall (in order to give an incentive to people to spend again), and the PPM will rise. Similarly, the lower the demand for money, the more people will want to spend their money on goods and services, which will cause prices to rise and the PPM to drop. Of course, higher or lower demand for money cannot cause supply to change, so by spending more or less people will not affect the total amount of money in the aggregate, but they will change the PPM by changing the price level.

What should the supply of money be? Notice that money is different from all other commodities. Unlike all the sundry consumer or capital goods, an increase of money does not confer any social benefit. It merely dilutes the PPM. To be sure, if we magically doubled one person's bank balance, he would benefit, but everyone else would lose, since some of the prices will rise in response to his greater spending power. Society as a whole is no better off than before, since real resources, labor, capital, consumer goods, natural resources, productivity, have not changed at all. All that happens is that existing goods are redistributed toward the person with the higher bank balance and away from everyone else. In short then, because no additional money is socially useful, any money supply is "optimal," given, of course, a sufficient amount of gold in the hands of the public to facilitate daily transactions. (Is mining gold therefore wasteful? Only partially so, because gold has non-monetary uses. At any rate, even if mining were in this sense wasteful, a gold standard could still be defended as being preferable to any of its alternatives.)

What affects the demand for money? A number of things, such as:

1. The supply of goods and services. If economic growth is taking place, then this supply increases, which causes the demand for money (for use in exchange) to rise and prices to fall. Hence the same total amount of money in a progressing economy will command ever greater purchasing power. This is the "deflation" of whose allegedly evil consequences we are constantly warned. But in fact, deflation is a natural and benign process of ever lower prices due to economic progress in a free society.
   
   
2. Frequency of payment. The less frequent the payment of wages to a worker, the higher the average cash balance he has to keep, and therefore the greater the demand for money.
   
   
3. Devices to economize on cash, such as credit cards. Carrying a credit card enables a person to carry much less cash, for he can instantly borrow any amount of cash he wants. This causes the demand for money to drop and prices to rise. (It is true that credit cards–issuing banks now have to keep more cash, but insofar as the merchant is a member of the same bank as the customer, there is no need to physically move money from one bank to another. There is just a transfer of ownership from one account to another within the same bank. Even if interbank transfers are necessary, still the receiving bank can expand the money supply by the same amount that the sending bank must contract it. Since, as we shall see below, lower demand for cash entails higher money supply, widespread credit card use increases the latter.)
   
   
4. Confidence in money. The greater the confidence, given competing currencies, the greater the demand for a particular currency will be.
   
   
5. Inflationary of deflationary expectations. These speed up future price reactions. In other words, if people expect that prices will rise, they spend money now (for why wait until things get more expensive?) and thereby cause prices to rise even before inflation does it on it own. If, on the other hand, they think that prices will fall, they will curtail their spending in anticipation of lower prices in the future, thereby lowering them even more in the present.

Debasement of money was widely practiced in the ancient world. A king would issue coins that would by decree be equal in value to existing coins but would actually contain less gold (or silver) than they. For example, such coins could consist of gold mixed with silver. Thus the king would make a profit from artificial lightening of the currency. This was an early form of inflation. (The more sophisticated form had to await the invention of unbacked paper money.) Gresham's law states that artificially overvalued currency will drive out the artificially undervalued currency, as people hoard the "good" money and use the "bad" in its place (for why spend more gold when one can spend less, if both types of coins can purchase exactly the same things?). Those who receive the new money first benefit, because they can spend it before the inevitable rise in prices, which occurs as the new money propagates throughout the economy. People such as those on fixed income are harmed because the purchasing power of their money will eventually have decreased.

Why do governments love inflation? Because it is a hidden tax. Overt taxation is unpopular and can even sometimes cause a revolution, but inflating the money supply can fool the public for centuries.

Banking

There are two distinct types of banking: loan banking and deposit banking. The former is concerned with channeling money brought to the bank into loans for productive or consumptive activities, such as starting a business or buying a car. The bank loans the money at a higher interest rate than what the person who gives money to the bank for this purpose is paid. Deposit banking, on the contrary, is more like putting one's money for safekeeping. Now it is the bank's customer who pays the bank for guarding his property in a money warehouse. The crucial difference is that in loan banking it is the bank that becomes the owner of the money, which it promises to repay the customer with interest at some specified later date; whereas in deposit banking the money is due to the customer at any time on demand. Neither type of banking in its pure form is inflationary.

What is inflationary, however, is when deposits are treated as loans to the bank. There is indeed a great temptation of a bank (warehouse) owner to treat them as such. If he correctly estimates the amount of gold that will be redeemed, then he can print a number of fake warehouse receipts for the rest of the gold in his storage and lend them out. In so doing he will be creating money essentially out of thin air by letting these fake receipts circulate equivalent to cash. This is how banks pyramid credit on top of deposits. Instead of keeping 100% reserve (the amount of cash in the bank's vaults ready for instant redemption), he will be keeping less, thereby engaging in fractional-reserve banking. This is the standard way of how banks today operate, notwithstanding the fact that fractional-reserve banking is inherently fraudulent and is a type of embezzlement, precisely because there is not enough cash in the bank to satisfy the legal rights of all of its customers. A bank's assets are due to it at some later dates, whereas its liabilities are instantaneous. Hence every single bank in the United States is insolvent and therefore bankrupt.

Under free banking are there any limits on bank credit expansion? First, there is the famous bank run. It occurs when there is a loss of confidence in a bank that has overextended its credit. As people line up to get their money (which is not simply there), the bank can become bankrupt in a matter of hours. But, of course, bank runs, though a wonderful tool of keeping banks in check, are rare events that happen only when the public has reasons to suspect that a bank is in trouble. The more permanent and day-to-day limit to the expansion of credit is the limited customer base of each bank. The point is that the borrowers, being very likely clients of other banks than the one that loaned them money, will have those banks call upon the loan bank to redeem the receipts. Money (real gold) will have to be transferred into the vaults of those other banks. The now smaller reserve in the loan bank will then ensure a money supply contraction. It is true that the reserves of the other banks will increase, but those banks, too, will have the same difficulty with their own loans. There is always a danger that the loans will be cashed in elsewhere. The smaller the customer base of each bank, the greater the accompanying threat of bankruptcy and the better the check on inflation, because it is more likely that any given note-holder will be a client of a different bank. As Henri Cernuschi proclaimed in 1865, "I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer."

Central Banking

The Central Bank is the banker's bank. It alone has the right to issue banknotes. Just as the banks' customers have deposit accounts in their banks, so the banks, too, have deposit accounts in the Central Bank. They draw on these accounts whenever they need cash to redeem the deposits of their clients. The accounts are necessary also in order to satisfy the banks' reserve requirements. (According to the Federal Reserve, "The difference between an institution's reserve requirement and the vault cash used to meet that requirement is called the required reserve balance" to be kept at the Fed.) Whenever cash is handed out, the bank's reserve dwindles which necessitates a contraction of the money supply. This the bank does by selling its assets, paying off its loans, etc. Whenever new deposits are brought to the bank, its reserve increases, the banks checking account at the Central Bank grows, and consequently the bank will expand the money supply (because that is how it makes money under fractional-reserve banking). Hence the supply of money is inversely related to the demand for cash.

The bank runs are now checked by the Central Bank which is to its member banks a "lender of last resort": it will lend cash to the bank or purchase its assets at any time. The establishment of FDIC has further reduced the probability of a bank run by "insuring" every deposit up to a certain maximum through the government's power to tax and print new money. And with the Central Bank in the picture, there is little danger to any particular bank from the demands for redemption from other banks. All banks can now expand together at the same time on the top of the reserves supplied by the Central Bank. How it is done? In a system of many competitive banks, no bank can expand all the way up to its money multiplier (that is, <NOBR>1 / reserve requirement</NOBR>), because of the threat of redemption by other banks. The maximum that it can expand is <NOBR>1 �?reserve requirement</NOBR>. If the reserve requirement is 20%, then the first bank can expand by 80%. This way, when this cash is transferred to its customer's bank, it will still keep enough to satisfy the legal reserve requirement, i.e., 100 �?80 = 20%. But the next bank will, too, expand by 80% of the money that it received; so will the third bank; and so on. The total expansion will be equal to <NOBR>&Sigma(1 �?p)ⁱ x n</NOBR> which converges to <NOBR>n / (1 �?(1 �?p))</NOBR> = <NOBR>n / p</NOBR>. Thus the total expansion will be set to the money multiplier even though no individual expansion is.

The Central Bank can control this expansion in two ways: either by lowering or raising the reserve requirements or by manipulating the total reserves. Since the reserve requirements are fairly steady and, whenever they are changed, are changed only slightly, the question is, How does the Central Bank control the total reserves? One such way is by extending short-term loans to banks through what is known as the discount window. Although supposedly these loans are the "last resort" and should command a higher than normal interest rate, the rate was, at least until recently, set to be below the prime rate, which is inflationary, because it encourages banks to take loan money from the Fed and then re-lend it. There is also the very active "federal funds market," which is "the market in which banks can borrow or lend reserves, allowing banks temporarily short of their required reserves to borrow reserves from banks that have excess reserves." Here it is the banks themselves rather than the Fed that lend money to their fellow banks.

The Fed also fixes the money supply by engaging in open market operations. By purchasing securities, such as government bonds, it increases the total reserves, because the commercial banks that cash the checks that the Fed writes on itself for its purchases will have their demand deposits at the Fed increased by the amounts on the checks, which permits them to pyramid credit on top of the new reserves; by selling them, it decreases the total reserves through a similar mechanism. (What if the Central Bank decides to buy up the whole country in this way? It can certainly try, but then the resulting hyperinflation will probably derail this plan.) In other words, according to the Fed,

Purchasing securities or arranging a repurchase agreement increases the quantity of balances because the Federal Reserve creates balances when it credits the account of the seller's depository institution at the Federal Reserve for the amount of the transaction; there is no corresponding offset in another institution's account. [Since the seller of the securities bought by the Fed must go to his bank in order to deposit the cash received.] Conversely, selling securities or conducting a reverse repurchase agreement decreases the quantity of Federal Reserve balances because the Federal Reserve extinguishes balances when it debits the account of the purchaser's depository institution at the Federal Reserve; there is no corresponding increase in another institution's account. [Again, the buyer gives the Fed a check drawn on his account in his bank; when the Fed receives the money, it debits the bank's account and retires the cash.]

The Trade Cycle

According to Greenspan, "since the late '70s, central bankers generally have behaved as though we were on the gold standard." Not so fast, Maestro. The point is that central banking cannot, in principle, replace the automatic mechanism of the market.

Because the interest rate set by the Fed does not reflect the real rate as determined by the consumers, entrepreneurs are deceived into thinking that the consumers prefer them to focus on the production of goods that take longer time to be brought into existence. Their belief is that the consumers prefer future goods to the present goods to a greater extent that they in fact do. Hence the wrong signals cause a misallocation of resources into ultimately unsustainable projects. They are unsustainable because the pool of real savings is unable to support all the projects being undertaken. Thus the seeds of a bust are sown in the preceding boom.

Gold Standard Once More

So here's what I find odd. People worry about all sorts of things. They worry about their families, their 401Ks, the declining morals, and so on and so forth. What they don't worry about is that their money is backed by nothing at all. So great is their faith in the power, wisdom, and virtue of the federal government that they think that our money is in good hands. Fellas, the situation is actually very precarious. The whole thing is unstable and unsafe. You know it, and that's why you've bought shares of that precious metals mutual fund. You also sense that the government guys are not as good as gold. It is very important that they be restrained so that our money becomes gold-solid and not paper-thin and not subject to unpredictable manipulation by the secular gnostics of the Federal Reserve who think that the rules do not apply to them. Let's start worrying about this, because it's worth worrying about!

Further, I tell you, you've been had. You are a dupe, a sucker, a sap. The banksters are laughing at you all the way to the bank. Look, they print their own money at the expense of your savings! They are the official counterfeiters. Honestly, I can't believe you fell for the oldest trick in the state's book. Doesn't that bother you? For how long are you going to keep being the loser? The eggheads at the Federal Reserve are frauds. So wise up and let's do something about it!

Further, if the lifeblood of the economy, our medium of exchange, store of value, and unit of account that allows our most important social institution, the market, to operate, is dishonest �?poisoned �?by the corrupt authorities who sold their souls for riches, how can we expect all other aspects of life to remain honest? Paper currency that can be inflated at will by a mysterious cabal exudes chaos and perversion. The corruption then spreads throughout society, affecting everyone. Fiat money, in short, is an abomination unto the Lord. So praise the Lord and let gold be king once more.

Finally, the fiat monetary regime is outrageously inefficient. The exhausting boom and bust cycles and global economic instability are due to the large extent to unsound currencies. After decades of Keynes have economists finally lost their minds? Are they senile and incompetent old men whose only skill is putting cheap magic shows of turning stones into bread? Get back to school, fellas, and then help to force sound money onto the state.

Conclusion

Gold is not a "barbarous relic" as Lord Keynes famously called it. Nor do the proponents of the gold standard suffer from any "gold fetish." They simply realize that gold and silver have usually been chosen as money for such qualities as being already in heavy demand, scarce, highly divisible, portable, and durable, and having high value per unit of weight that make them ideal as media of exchange.

The fiat dollar standard is probably the most intractable problem in the U.S. and the world, simply because there is no debate going on about the pros and cons of its alternatives. It may take a crisis or hyperinflation to prompt Americans to realize the virtues of commodity money. Fortunately, no matter how exalted and surrounded in mystery the Federal Reserve is, it is always in danger, for if only the public knew how cleverly they are swindled of their savings through inflation and how much wealth they lose due to economic inefficiencies, they would not permit it to continue.

December 26, 2005

Dmitry Chernikov [send him mail] is a graduate student in philosophy at Kent State University.

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