PART III MONEY AND BANKING CHAPTER 15 THE BUSINESS OF BANKING Summary

A banker is one who lends out other people’s money; a capitalist lends out his or her own money. The business of banking falls into two distinct categories: (1) the negotiation of credit through the loan of other people’s money and (2) the granting of credit through the issue of fiduciary media.

In their role as negotiator of credit (or credit intermediaries), banks borrow from lenders at a certain rate of interest and then lend it to borrowers at (what promises to be) a higher rate of interest.

Credit transactions involve the exchange of present for future goods. Credit transactions can be divided into two groups: (1) Those in which one party has the benefit of obtaining a good in the present while the other party has the disadvantage of providing a good in the present, and (2) those in which one party has the benefit of obtaining a good in the present while the other party does not suffer any corresponding disadvantage. Loans of the first type (in which the lender actually renounces the use of his money) involve commodity credit while loans of the second type (in which the bank issues fiduciary media) involve circulation credit.

The crucial feature in loans of fiduciary media is that the original depositor is not engaged in a credit transaction. He retains the full use of his money, even as the bank lends it to someone else. This process increases the total amount of money in the broader sense.

Only by recognizing the fundamental distinction between notes and current accounts that are either (a) backed versus (b) unbacked by money, can the economist hope to understand the broader role that fiduciary media play in economic cycles.

Chapter Outline

1. Types of Banking Activity

A banker is one who lends out other people’s money; a capitalist lends out his or her own money. The business of banking falls into two distinct categories: (1) the negotiation of credit through the loan of other people’s money and (2) the granting of credit through the issue of fiduciary media. (Recall that fiduciary media are notes and bank balances—claims on money—that are not actually covered by money in reserve.)

2. The Banks as Negotiators of Credit

In their role as negotiator of credit (or credit intermediaries), banks borrow from lenders at a certain rate of interest and then lend it to borrowers at (what promises to be) a higher rate of interest. In this activity, prudent banks will obey the golden rule by which their liabilities will not mature earlier than their assets. In other words, the banks should not “borrow short to lend long,” if they want to avoid the risk of insolvency. Following the golden rule, by matching the maturities of assets and liabilities, will not eliminate all risks of course, because any investment could go sour and the borrower default on the loan from the bank.

3. The Banks as Issuers of Fiduciary Media

Credit transactions involve the exchange of present for future goods. Credit transactions can be divided into two groups: (1) Those in which one party has the benefit of obtaining a good in the present while the other party has the disadvantage of providing a good in the present, and (2) those in which one party has the benefit of obtaining a good in the present while the other party does not suffer any corresponding disadvantage. This second class of credit transactions is possible when a creditor issues fiduciary media; this person lends without really giving anything up. Loans of the first type (in which the lender actually renounces the use of his money) involve commodity credit while loans of fiduciary media involve circulation credit.

For all goods, an absolutely secure and immediately redeemable claim will inherit the market value of the good itself. However, what makes fiduciary media special is that they can indefinitely function as money substitutes, since (unlike all other goods) nobody ever is the final “consumer” of money proper. Therefore, claims to it can circulate in the community without ever being redeemed, which allows the banks to issue fiduciary media in the first place.

4. Deposits as the Origin of Circulation Credit

The issue of fiduciary media is intimately connected with the deposit system. A customer will deposit actual money with the bank, which then is the basis upon which fiduciary media (i.e., unbacked claims to money) are issued. The crucial feature in these operations is that economically speaking, the original depositor is not engaged in a credit transaction. He is not lending the bank his money, but is merely depositing it, because he still retains the full economic use of his money in the present. Therefore by granting new loans on top of such deposits, the banks increase the total amount of money in the broader sense. They are not mere credit intermediaries, but instead are granting the economic use of money to a new group, without taking it away from the original group.

5. The Granting of Circulation Credit

The specific method of issuance of fiduciary media is irrelevant for its effects on the value of money. The bank might (1) literally lend out the original depositor’s money (while the original depositor still believes he has full and immediate claim to it), (2) issue other bank clients banknotes which may be redeemed with the depositor’s money, or (3) grant new loans in the form of checkbook accounts, with the depositor’s money serving as part of the reserves behind the new loan. [NOTE: A full description of the accounting of fractional-reserve banking is available in the lecture, “The Theory of Central Banking,” at: http://www.youtube.com/watch?v=6HAEPSt_12U]

Some writers treat the expansion of banks’ note-issue as akin to an increase in the community’s demand for credit. But if the community tries to borrow more, perhaps by issuing more bills of exchange, then the interest rate tends to go up. In contrast, the bank supplies credit: when it issues more notes, the rate of interest (at least initially) goes down.

6. Fiduciary Media and the Nature of Indirect Exchange

Only by recognizing the fundamental distinction between notes and current accounts that are either (a) backed versus (b) unbacked by money, can the economist hope to understand the broader role that fiduciary media play in economic cycles. On the other hand, it is also a mistake to deny fiduciary media’s ability to facilitate indirect exchanges. When someone sells a commodity for a banknote, and then uses the banknote to purchase another commodity, this is an indirect exchange just as surely as if the person had used money proper.

Important Contributions

• In the beginning of this chapter, Mises divides banking into two categories: the negotiation of credit through the loan of other people’s money, and the issue of fiduciary media. (Murray Rothbard, in his work on banking, classifies the two activities as loan banking versus deposit banking.) Although other writers are familiar with these concepts, Mises shone a spotlight on the distinction and will go on to point out the problems with the issue of fiduciary media (i.e., deposit banking) that some earlier economists had discovered.

• Continuing with the previous note, Mises explains his settling on the terms commodity credit and circulation credit on pages 264–65. Precisely because he believes the issuance of fiduciary media play such a crucial role in the boom-bust cycle in market economies, Mises is designing his theoretical edifice to highlight the phenomenon.

New Terminology

Banker: A person who lends out other people’s money.

Capitalist: A person who lends out his or her own money.

Credit intermediaries: Institutions that act as “middlemen” between lenders and borrowers.

Golden rule (of bank lending): Matching the maturities of assets and liabilities, so that the bank is not dependent on the ability to “roll over” maturing debt. If a bank does not follow the golden rule, increases in short-term interest rates can lead to disaster, when the bank must pay its own creditors while its assets are not yet due.

Commodity Credit: A loan granted through the renunciation of the use of present goods by the lender. Commodity credit may involve money certificates but not fiduciary media.

Circulation Credit: A loan granted even though the lender does not sacrifice the use of present goods. Circulation credit involves the use of fiduciary media.

Bill of exchange: A non-interest-bearing written order that binds one party to a pay a fixed sum of money to another party at a specified future date or upon demand. A bill of exchange is generally transferable through endorsement.

Current accounts (in banking): Accounts held with a bank, giving the owner the ability to write drafts or withdraw money upon demand. (Today a standard “checking account” would be an example.)

Loan banking: Banking through the use of commodity credit, where the bank receives loans from one group of savers in order to itself make loans to another group of borrowers. The savers do not consider this money as part of their cash balances during the term of the loan to the bank.

Deposit banking: Banking through the use of circulation credit, where the bank receives deposits into current accounts from one group of clients in order to make loans to another group of borrowers. The depositors consider this money to be part of their cash balances, even though much of it has been lent out to others.

Study Questions

1. Does Mises realize that modern banks perform other operations besides the two types of banking he mentions? (pp. 261–62)

2. Explain: “A person who has a thousand loaves of bread at his immediate disposal will not dare to issue more than a thousand tickets each of which gives its holder the right to demand at any time the delivery of a loaf of bread. It is otherwise with money.” (p. 267)

3. Why does Mises say that fiduciary media “can therefore be created only by banks and bankers”? (p. 269)

4. How does the issue of fiduciary media affect the objective exchange value of money? (p. 268)

5. Explain: “[Credit circulation] loans are granted out of a fund that did not exist before the loans were granted.” (p. 271)

CHAPTER 16

THE EVOLUTION OF FIDUCIARY MEDIA

Chapter Outline

1. The Two Ways of Issuing Fiduciary Media

Fiduciary media may be issued by banks or by non-banks (primarily the government). Banks can issue fiduciary media either through banknotes or by granting deposits in a current account (i.e., a modern-day checking account). Banks treat their outstanding fiduciary media as liabilities on their balance sheets, and must loan or directly invest them wisely.

Governments may also issue fiduciary media such as convertible Treasury notes and token coins. Governments often do not set aside a credit fund out of their capital to “cover” the increased obligations. Instead governments will pocket the seigniorage as income just as surely as tax revenue.

2. Fiduciary Media and the Clearing System

The use of fiduciary media can reduce the demand for money in the narrower sense. For example, in the modern United States, the demand to hold actual Federal Reserve notes (green pieces of paper with pictures of dead presidents) is much lower, because people can open checking accounts with commercial banks and write checks or use debit cards (where these deposits are partly fiduciary media, because they are not fully backed up by cash in the vault).

However, an entirely different phenomenon is the reduction in the demand for money in the broader sense—including money proper and even money substitutes (including fiduciary media)—brought about by the development of credit and the clearing system. If one party to a transaction is willing to defer receiving payment, he has thus granted credit. If the other party later delivers goods or performs services such that the original debt is partially or fully offset, only the difference needs to be settled by actual money or money substitutes. As more such transactions are incorporated into such arrangements, the community’s demand for money in the broader sense falls below what it otherwise would have been.

3. Fiduciary Media in Domestic Trade

So long as a country has a stable legal framework that permits the building of trust in issuers, the use of clearing operations and fiduciary media can grow to dominate transactions and almost completely displace the use of money in the narrower sense.

4. Fiduciary Media in International Trade

The practice of using claims and counter-claims in clearing operations to reduce the need to transport money was of particular benefit in international trade, because of the longer distances and time involved. However, fiduciary media themselves are still limited by national boundaries. For example, a particular supplier in the United States might grant credit to a merchant in France, but the claim on the French merchant would not circulate from hand to hand in the same way that a banknote in the United States (or in France) could. Only with the development of a world bank, with clientele drawn from every country, could fiduciary media transcend national boundaries.

Technical Notes

• On page 278 Mises writes, “[Bank fiduciary media] are entered as liabilities, and the issuing body does not regard the sum issued as an increase of its income or capital, but as an increase on the debit side of its account, which must be balanced by a corresponding increase on the credit side if the whole transaction is not to figure as a loss. This way of dealing with fiduciary media makes it necessary for the issuing body to regard them as part of its trading capital and never to spend them on consumption but always to invest them in business.” This is a crucial point that newcomers to fractional-reserve banking often miss. Even though such bankers in a sense “create money out of thin air,” they can’t simply open up a new account for $100,000 and then write checks to buy themselves sports cars and designer clothes. The reason is that the merchants in the community would then have $100,000 in claims on the actual cash reserves of the bank, and ultimately the bank’s vault would run out of the genuine money. What fractional bankers do instead is loan out the $100,000 to a productive business at (say) 5 percent interest. When the $105,000 is repaid in a year, the $100,000 that was initially created can be “destroyed” (through bookkeeping) and the $5,000 in interest income can be safely spent without draining the bank’s cash reserves. Thus fractional-reserve bankers create money out of thin air not to directly spend it—which would be incredibly reckless and short-lived—but instead to earn interest income from it.

•On page 291 Mises rejects the claim that India and other Asiatic countries used gold as a “measure of prices” while retaining silver as a medium of exchange. For one thing, the modern subjective value theory explodes the very notion of money as a measure, since value is not an objective property like length or weight that can be measured. Yet of more relevance to this passage, Mises is pointing out that even in the classical gold standard countries, people rarely used actual gold when buying goods and services. Instead, they employed claims to gold. But this is precisely what happened in India, which retained silver coins in circulation that could be redeemed for the official money, gold, at a certain exchange rate.

New Terminology

Convertible Treasury notes: Paper notes issued by the government that entitle the bearer to redemption in money upon demand.

Seigniorage: The difference between the market value of money and the cost to produce it.

Credit: The ability to receive present goods in exchange for the promise of delivering (typically a greater number of) future goods.

Study Questions

1. Explain: “To complete [a] transaction ... by full or partial cancellation of counter-claims offers important advantages in comparison with direct exchange: all the freedom connected with the use of money is combined with the technical simplicity that characterizes direct exchange transactions.” (p. 282)

2. What does Mises think is the importance of credit for the monetary system? (p. 282)

3. Explain: “Money in these cases [of international clearing operations] is still a medium of exchange, but its employment in this capacity is independent of its physical existence. Use is made of money, but not physical use of actually existing money or money substitutes. Money which is not present performs an economic function; it has its effect solely by reason of the possibility of its being able to be present.” (p. 283)

4. Does Mises classify bills of exchange as fiduciary media? (pp. 285-86)

5. If a hypothetical world bank had deposits and notes that were backed up 100 percent by money on reserve, could it economize on money payments? (p. 294)

CHAPTER 17

FIDUCIARY MEDIA AND THE DEMAND FOR MONEY

Summary

If labor and other resources are used to extract more gold from mines, and this additional gold goes into the cash balances of people in the community, then from a social point of view the labor and other resources have been wasted. The quantity of “real output” (pounds of steak, barrels of crude oil, etc.) produced per person doesn’t rise, but merely the prices of these items quoted in gold or silver.

The development of fiduciary media kept the objective exchange value of money lower than it otherwise would have been, and thereby avoided a large diversion of resources into mining more of the precious metals for cash holdings.

Some writers argue that the payment system in an advanced market economy is “elastic” and responds to the “needs of commerce,” rather than the actual stock of money in the narrower sense. Although the extension of the clearing system does reduce the demand for money in the broader sense, there is no reason that its development should be related to the demand for money. It is an independent phenomenon that may either strengthen or counterbalance changes in the demand for money originating from other causes.

Many writers (such as those of the Banking School) argue that the banks do not have the power to independently increase the quantity of fiduciary media. What these writers fail to understand is that the demand for loans depends on the rate of interest. It makes no sense to speak of how much money the banks’ customers wish to borrow, without specifying a rate of interest. If the banks want to issue fiduciary media, they must lower the market rate below the natural rate of interest.

Businesses seek loans from the banks because they desire capital; they simply want capital in the form of money, so that they can conveniently acquire the physical capital goods that they ultimately desire for their operations. Of course, the mere issuance of fiduciary media does not increase the amount of tractors, fertilizer, or power tools. The only way the banks can provide these goods to their clients is through redistribution of purchasing power away from members of the community who do not receive the influx of the newly created money.

Chapter Outline

1. The Influence of Fiduciary Media on the Demand for Money in the Narrower Sense

In one sense, the employment of the precious metals (or any other useful commodity) to enlarge the stock of money is wasteful. If labor and other resources are used to extract more gold from mines, and this additional gold goes not into industrial or commercial uses (such as for dental fillings or jewelry), but instead increases the cash balances of people in the community, then from a social point of view the labor and other resources have been wasted. Increasing the quantity of money may redistribute existing wealth to make some individuals richer, but only at the expense of making others (who are last to receive the new money) poorer. The community as a whole doesn’t achieve a higher standard of living, simply because people hold more gold or silver in their cash balances. The quantity of “real output” (pounds of steak, barrels of crude oil, etc.) produced per person doesn’t rise, but merely the prices of these items quoted in gold or silver.

The development of fiduciary media reduces the demand to hold money in the narrower sense. In a community using gold as commodity money, a person who holds (airtight and instantly redeemable) claims to gold, which are accepted in commerce by everyone in the community, doesn’t need to carry as much actual gold on a day-to-day basis. In this sense the widespread use of fiduciary media “economizes” on the amount of metal that must be allocated into the function of serving as the medium of exchange; more gold is freed up to be used in jewelry or industrial applications.

Were it not for the simultaneous development of fiduciary media, the intensification of the division of labor as the world became one giant integrated market would have led to a sharp increase in the objective exchange value of money. In other words, as more people around the world became part of the global market which used gold as the international money, more people would have tried to obtain gold as part of their cash holdings. If actual gold had to satisfy this huge growth in demand, prices (quoted in gold) would have fallen and the owners of gold mines would have intensified their extraction efforts. But the simultaneous development of fiduciary media counterbalanced this tendency, so that the purchasing power of a unit of gold did not rise as much as it otherwise would have.

2. The Fluctuations in the Demand for Money

Some of the fluctuations in the demand for money are quite predictable. An increase in population and the spread of the money economy increase the demand for money. The demand for money changes during boom and bust periods. And even in a typical year, there are cyclical patterns based on agriculture and the payment of workers.

3. The Elasticity of the System of Reciprocal Cancellation

Some writers argue that the payment system in an advanced market economy is “elastic” and responds to the “needs of commerce,” rather than the actual stock of money in the narrower sense. The quantity of money is said to have little influence on the objective exchange value of money, because (say) an increase in the demand for money will automatically be counterbalanced by other forces. These claims are often difficult to evaluate because they fail to make the crucial distinction between the extension of the clearing system, versus the increased use of fiduciary media. Although the extension of the clearing system does reduce the demand for money in the broader sense, there is no reason that its development should be related to the demand for money. It is an independent phenomenon that may either strengthen or counterbalance changes in the demand for money originating from other causes.

4. The Elasticity of a Credit Circulation Based on Bills, Especially on Commodity Bills

Many writers (such as those of the Banking School) argue that the banks do not have the power to independently increase the quantity of fiduciary media. If business needs require more transactions, then somehow or other, business will get it—either from banks issuing more fiduciary media, or from businesses developing techniques to economize on the use of money. On the other hand (so the argument continues), if the banks try to issue more fiduciary media than the business community desires, these excess notes will come flowing back to the banks.

What these writers fail to understand is that the demand for loans depends on the rate of interest. It makes no sense to speak of how much money the banks’ customers wish to borrow, without specifying a rate of interest. If the banks want to issue fiduciary media, they must lower the market rate below the natural rate of interest.

5. The Significance of the Exclusive Employment of Bills as Cover for Fiduciary Media

The German Bank Act of 1875 followed the famous Peel’s Act in imposing requirements on the cover that banks could accept when issuing new loans in excess of their gold deposits. The requirement was significant not because it somehow tied the expansion of credit to the desire of the community for more money. Rather, it was significant because it placed an obstacle in the issuance of fiduciary media, keeping the quantity of money in the broader sense lower than it otherwise would have been.

6. The Periodical Rise and Fall in the Extent to Which Bank Credit is Requisitioned

Businesses seek loans from the banks because they desire capital; they simply want capital in the form of money, so that they can conveniently acquire the physical capital goods that they ultimately desire for their operations. Of course, the mere issuance of fiduciary media does not increase the amount of tractors, fertilizer, or power tools. The only way the banks can provide these goods to their clients is through redistribution of purchasing power away from members of the community who do not receive the influx of the newly created money.

7. The Influence of Fiduciary Media on Fluctuations in the Objective Exchange Value of Money

As with the extension of clearing operations, there is no reason that the expansion or contraction of fiduciary media should mirror changes in the demand to hold money; there is no “automatic” mechanism by which the objective exchange value of money is stabilized. Thus the insights of the quantity theory are upheld.

Technical Notes

• An example will clarify the terminology and arguments running throughout this and earlier chapters. Suppose a man asks his bartender if he can “run a tab,” meaning that he will obtain drinks in the present but will pay money for them later (perhaps at the end of the month). The bartender agrees, saying the man can have up to $100 in drinks without having to pay for them upfront. By doing so, the bartender has extended credit to the man. However, the quantity of money in the man’s possession hasn’t increased, because the man doesn’t have any transferrable claim (issued by the bartender) that others in the community would accept. In contrast, if the man goes to his local bank and applies for a $100 loan (to be paid back at the end of the month), then in this case too the man receives an extension of credit, but he also receives an addition to his cash balances. Whether the bank loan consists of a new checking account (with $100 as the initial balance), actual money, or notes issued by the bank, these would all be classified as money in the broader sense. The man could use them to buy anything he wanted, including drinks at the bar. Finally, to see the limited role of clearing systems, revert to the original assumption, where the man’s credit consists of a “tab” issued by the bartender with a limit of $100. If the man wanted to use this credit not to buy alcoholic drinks, but rather to buy (say) a pair of shoes, he would have to find a shoe seller who also wanted to buy drinks from the particular bar in question. Then it might be possible to arrange a deal whereby the man acquires the shoes, in exchange for telling the bartender to put the shoe seller’s drinks on his own tab (rather than charging the shoe seller for them).

• Mises concludes his discussion of section 4 on page 312 by saying, “[A]ll of this is true only under the assumption that all banks issue fiduciary media according to uniform principles, or that there is only one bank that issues fiduciary media.” In the section, Mises had criticized the writers of the Banking School who argued that the banks couldn’t get the community to accept extra issues of fiduciary media, if the community didn’t want to hold them. Mises objected that the demand for the additional loans could be influenced by the rate of interest the banks charged, and hence the Banking School’s views were mistaken. So long as they are willing to sufficiently lower the rate of interest below the natural rate, the banks can convince the community to accept any amount of new fiduciary media. However, Mises does not mean that an individual bank has no checks on its issue. If any single bank unilaterally lowers its interest rate and issues more fiduciary media (compared to the policies of its competitors), then eventually those notes will fall into the hands of people who are not clients of the expanding bank. When these people deposit the bank’s newly issued notes with their own banks (which are competitors), these notes will be presented for redemption in money in the narrower sense. Thus the lone bank engaged in an expansionary policy will soon see its reserves of money proper dwindle, and will have to abandon its experiment. Yet this mechanism is not what the Banking School theorists had in mind when they said banks couldn’t issue more notes than the needs of the community warranted.

New Terminology

Banking School: An English school of thought which argued that the banks were incapable of independently altering the rate of interest or the purchasing power of money, because the market would use clearing operations, bills of exchange, and other techniques to receive the credit it demanded for business purposes.

Currency School: An English school of thought which argued that the banks caused economic crises through the expansion and contraction of credit. However, the Currency School thought the suppression of the issue of fiduciary media in the form of banknotes (which was codified in Peel’s Act) would solve the problem, because its members erroneously excluded demand (or current account) deposits from their analysis.

(Wicksellian) natural rate of interest: Developed by economist Knut Wicksell, the hypothetical rate of interest that would occur if goods were traded directly against each other without the use of money.

Peel’s Act [Bank Charter Act 1844]: An important legislative act that took the power of issuing new notes away from private banks and vested it completely with the Bank of England, which itself was required to maintain 100 percent metallic backing for any new notes that it issued. However, the Act crucially did not impose such a restriction on the extension of deposits, meaning that private banks could create more fiduciary media by granting loans (not backed by gold) to their customers.

Cover (of note issue): Assets backing the issue of new banknotes. Depending on the regulations, a bank might issue fiduciary media not backed by money itself, but backed by another asset such as a commodity bill.

Working capital: Current assets minus current liabilities. More generally, a measure of a firm’s ability to quickly turn some of its assets into cash in order to finance an expansion.

Fixed capital: Assets embodied in durable investments such as factories and specialized equipment that will be used over a long period.

Study Questions

1. What was Adam Smith’s analogy to explain the drawback of using the precious metals as money? (p. 298)

2. If fiat or credit money is employed, does it still make sense to use fiduciary media to economize on the use of money in the narrower sense? (pp. 299–300)

3. Why would population growth influence the demand to hold money? (pp. 300–01)

4. Explain: “The demand for money and money substitutes that is expressed on the loan market is in the last resort a demand for capital goods or, when consumption credit is involved, for consumption goods.” (p. 307)

5. Who bears the “cost of creating capital for borrowers of loans granted in fiduciary media”? (p. 314)

CHAPTER 18

THE REDEMPTION OF FIDUCIARY MEDIA

Summary

The confidence in a bank’s ability to redeem its fiduciary media is an all-or-nothing proposition: if a portion of the community panics and rushes to redeem their claims, then everyone does. By their very nature, fiduciary media cannot all be honored by the bank at once. Consequently, some writers suggest an outright prohibition on the practice. However, historically this requirement would have led to a much larger diversion of resources into the production of the precious metals as the demand for money increased.

A bank operating in a competitive environment can only issue as much fiduciary media as its own customers wish to hold, for transactions among themselves. Whenever a bank’s customer seeks to do business with someone outside the clientele of the bank, the customer must convert his claims into money in the narrower sense, because the other person will not wish to accept the bank’s promises to pay.

Solvency means that an institution (such as a bank) could shut down, sell off all of its assets, and raise at least enough money to pay off all of its creditors. Liquidity is a stronger condition, meaning that the institution’s assets deliver a cash flow allowing it to pay its liabilities on time. If a firm is liquid, it is solvent, but it might be solvent while illiquid. Banks issuing fiduciary media are always illiquid.

Sometimes legislation, but always public opinion, compels the banks to give preference to short-term rather than long-term loans. This is a quite valid preference, backed up by centuries of experience, simply because it limits a bank’s ability to issue fiduciary media.

Chapter Outline

1. The Necessity for Complete Equivalence Between Money and Money Substitutes

So long as some people believe that a claim to money issued by a particular institution is absolutely reliable and can be redeemed upon demand, these people may pass such claims among themselves as if they were money. This is what makes them money substitutes. However, the issuing institution must always keep a reserve fund of money in the narrower sense to redeem the claims whenever they are presented, in order to maintain this trust. Such redemptions will be requested whenever the bank’s own clientele wish to use their claims to do business with someone outside the clientele, i.e., a person who does not consider the claim to be a substitute for money in the narrower sense.

2. The Return of Fiduciary Media to the Issuer on Account of Lack of Confidence on the Part of the Holders

The confidence in a bank’s ability to redeem its fiduciary media is an all-or-nothing proposition: if a portion of the community panics and rushes to redeem their claims, then everyone does. By their very nature, fiduciary media cannot all be honored by the bank at once. No matter how wisely a bank manages its assets, it will not be able to pay out money in the narrower sense for all of its outstanding claims, if customers show up en masse and demand redemption—assuming the bank has been issuing fiduciary media.

3. The Case Against the Issue of Fiduciary Media

Because of the internal contradiction of the nature of fiduciary media—which renders every issuing institution liable to ruin—some writers suggest an outright prohibition on the practice. However, historically this requirement would have led to a much larger diversion of resources into the production of the precious metals as the demand for money increased. The banks could survive even if they were legally required to maintain 100 percent reserves covering all note issues and deposits; it is not consideration for the practice of banking that led legislators to tolerate fiduciary media. Rather, it was the desire to avoid a large increase in the objective exchange value of money (i.e., a general fall in prices of goods and services).

4. The Redemption Fund

A bank operating in a competitive environment—where its rivals may pursue different policies and where its own clientele is only a fraction of the whole community using the same money—can only issue as much fiduciary media as its own customers wish to hold, for transactions among themselves. Whenever a bank’s customer seeks to do business with someone outside the clientele of the bank, the customer must convert his claims (whether in the form of notes or a checkbook deposit) into money in the narrower sense, because the other person will not wish to accept the bank’s promises to pay.

5. The So-called “Banking” Type of Cover for Fiduciary Media

Solvency means that an institution (such as a bank) could shut down, sell off all of its assets, and raise at least enough money to pay off all of its creditors. Liquidity is a stronger condition, meaning that the institution’s assets deliver a cash flow allowing it to pay its liabilities on time. If a firm is liquid, it is solvent, but it might be solvent while illiquid.

Some writers suggest that “prudent” banks will invest in short-term assets, in order to remain liquid. Yet by their very nature, banks issuing fiduciary media are illiquid: their liabilities are immediately due if presented, while their assets are necessarily of longer duration. The best such banks can strive for is solvency.

6. The Significance of Short-Term Cover

Sometimes legislation, but always public opinion, compels the banks to give preference to short-term rather than long-term loans. This is a quite valid preference, backed up by centuries of experience. However, the explanation for its wisdom is not that it allows the banks to redeem fiduciary media in the event of a panic—the bank’s asset maturities are irrelevant if everyone shows up, demanding redemption. The actual benefit from focusing bank loans on short-term investments is simply that the constraint checks the bank’s ability to issue fiduciary media.

7. The Security of the Investments of the Credit-Issuing Banks

There is similar confusion when it comes to proposals seeking to guarantee the (eventual) redemption of all fiduciary media by means of reserve funds consisting of illiquid assets (such as mortgages). Even if the public is certain that they will be eventually paid in money (in the narrower sense) for the claims to money that they currently hold, even so, if there is any doubt about the immediacy of the payment, then the claims will no longer be money substitutes. Instead, the public will take into account the delay before receiving payment, and such claims will trade at a discount to the money itself. (Note that if the claims continue to circulate as generally accepted media of exchange, even though everyone knows that redemption at best will occur after some delay, then the claims will have become credit money.)

8. Foreign Bills of Exchange as a Component of the Redemption Fund

A bank cannot increase its issue of money substitutes (consisting of both money certificates and fiduciary media) beyond the demand of its own clientele, for use in their dealings with each other. However, to the extent that sometimes its clients need to exchange their money substitutes when dealing with foreign citizens, the bank has the option of keeping some of its reserve fund in the form of foreign money substitutes, as opposed to money in the narrower sense. (This is because the foreigners with whom the bank’s clients wish to do business, will accept money substitutes issued by institutions from their respective countries.) Yet this practice means that the original bank’s reserve fund has a smaller proportion of money in the narrower sense, and hence that its own money substitutes consist of a higher fraction of fiduciary media (versus money certificates).

Technical Notes

• In modern times, one of the major controversies within the Austrian School concerns the legitimacy of fractional reserve banking. Some Austrians follow Murray Rothbard who argued that bank issuance of fiduciary media leads to the boom-bust cycle and is inherently fraudulent—akin to a warehouse manager renting out the goods that were supposedly placed with him for safekeeping. Other Austrians such as George Selgin and Steve Horwitz call their position “free banking” and believe that there is no reason for banks to necessarily keep 100 percent reserves of money in the narrower sense, in order to fully cover all outstanding customer deposits. The free bankers argue that market forces will determine the proper ratio of money certificates to fiduciary media in a competitive banking system. (Virtually all modern Austrians agree that government-sponsored central banking and fiat currency are both economically destructive and morally illegitimate. The dispute concerns the proper practice of private banks operating in a laissez-faire environment.)

• Continuing with the above note, both groups point to passages in Mises’s writings to lend credence to their position. Even within this very chapter, Mises offers statements that—viewed in isolation—would seem to definitively side with one camp versus the other. (Two of these quotations are the opening selections for the study questions below.) Although Mises agrees with the Rothbardian, 100-percent reserve camp that there is a paradox in the very nature of what fiduciary media claim to be, on the other hand he also agrees with the free bankers that the historical development of fiduciary media economized on resources (that would have otherwise gone into the socially wasteful production of more gold and silver for monetary purposes). Thus Mises does not clearly fall into one camp or the other. (Of course Mises’s own view wouldn’t settle the modern dispute: he could have been simply mistaken, regardless of his position.)

New Terminology

Free banking (among modern Austrians): The doctrine holding that a free market in banking will pick the optimal fraction of reserves, which may be below 100 percent. Free banking theorists do not believe that the issue of fiduciary media per se causes the business cycle, only that excess quantities of fiduciary media do, and that such an outcome is almost always associated with government-supported issues of fiduciary media.

Solvency: The situation in which the market value of an institution’s assets exceeds its liabilities.

Liquidity: The situation in which an institution’s assets will deliver a cash flow allowing it to pay its liabilities on time. (All liquid enterprises are also solvent, but not necessarily vice versa.)

Cash flow: The stream of money payments over time due to an asset or collection of assets.

Hypothecary loans: Loans granted with an asset such as real estate serving as collateral.

Study Questions

1. Explain: “Thus there lies an irresolvable contradiction in the nature of fiduciary media. Their equivalence to money depends on the promise that they will at any time be converted into money at the demand of the person entitled to them and on the fact that proper precautions are taken to make this promise effective. But—and this is likewise involved in the nature of fiduciary media—what is promised is an impossibility in so far as the bank is never able to keep its loans perfectly liquid.” (p. 322)

2. Explain: “The issue of fiduciary media has made it possible to avoid the convulsions that would be involved in an increase in the objective exchange value of money, and reduced the cost of the monetary apparatus.” (p. 323)

3. When Mises says of coins that their “smooth faces tell no tales of the methods by which they have been acquired,” is he making an argument for or against the possibility of customers paying banks for providing them with (fully backed) deposit and checkbook services? (p. 324)

4. Why does Mises say that a single bank with no competitors, or an industry of banks operating with uniform policies, would suffer no limitations on their ability to issue fiduciary media? (pp. 325–26)

5. Explain: “Whether the assets of a credit-issuing bank consist of short-term bills or of hypothecary loans remains a matter of indifference in the case of a general run.” (p. 333)

CHAPTER 19

MONEY, CREDIT, AND INTEREST

Chapter Outline

1. On the Nature of the Problem

Interest accrues as the difference between what a producer pays upfront for inputs versus the total revenue he receives for the product (down the road). Up till now in the book, we have studied the forces that can change the exchange ratio between money and consumer goods, or what are called goods of the first order. Now we will investigate whether changes in the supply of and demand for money can affect the money-prices of goods of higher orders (i.e., producer goods) to a different extent.

Tooke, Fullarton, and other members of the Banking School thought that the banks had no power to influence prices, because any excess issue of fiduciary media would be immediately returned to them. Yet Lord Overstone, Torrens, and other members of the Currency School thought otherwise. They correctly recognized that by lowering the rate of interest, the banks could induce the public to accept more fiduciary media. This is the mechanism through which bank credit policy can influence the purchasing power of money and the rate of interest.

2. The Connexion Between Variations in the Ratio Between the Stock of Money and the Demand for Money and Fluctuations in the Rate of Interest

There are three senses in which variations in the stock of and demand for money can influence the rate of interest. First, in the case of metallic currency, such variations can directly affect the rate of interest by directly affecting the subsistence fund. For example, a fall in the demand to hold gold as money, will release gold into industrial purposes and thereby make the community wealthier, in the same sense as if the amount of wheat stored in silos had increased.

Variations in the stock of and demand for money can influence the rate of interest indirectly and in the long run, by permanently changing the distribution of property and income. For example, a reduction in the stock of money could redistribute wealth into the hands of creditors, who tend to save more. Thus the rate of interest would be permanently lower because the overall rate of saving would have increased.

Finally, variations can influence the rate of interest in the short run as prices adjust to the new realities of the stock of and demand for money. When prices are generally rising, the rate of interest tends to be higher, as entrepreneurs are willing and able to offer more to borrow money. (Nowadays this is called a purchasing power or inflation premium in the contractual rate of interest.) When prices are falling, the rate of interest tends to be lower.

3. The Connexion Between the Equilibrium Rate and the Money Rate of Interest

When the banks issue more fiduciary media, the immediate result is a reduction in the rate of interest. Because the banks typically invest the new issue themselves, or lend it to businesses for productive investment, the subsistence fund tends to increase and the rate of interest will remain permanently lower than the original level (though not as low as it was after its initial drop). However, there is no quantitative relationship between the amount of new fiduciary media issued, and the fall in the interest rate. Indeed, no matter how much new money the banks create and lend out, they will never force the contractual rate of interest below zero percent.

The gratuitous nature of credit refers to the fact that the banks can push down the rate of interest apparently at will. Are there any forces tending to reestablish the natural premium of present versus future goods? Wicksell argued that if the banks push the Money Rate of Interest below the Natural Rate of Interest, that forces will eventually restore the Money Rate back to the Natural Rate. But his argument for why this should occur is unsatisfactory.

4. The Influence of the Interest Policy of the Credit-Issuing Banks on Production

As Böhm-Bawerk explained [see Technical Notes], the rate of interest governs the time for which resources are “tied up” in production processes. The lower the rate of interest, the longer the processes that entrepreneurs will select. In equilibrium, the money rate of interest equals the natural rate, and entrepreneurs invest resources in processes such that their fruits (consumption goods) are completed just as the available savings (subsistence fund) is exhausted. It is technically possible to lengthen the structure of production, but without additional savings, the subsistence fund will not be able to feed the workers while they labor in the longer processes.

When the banks lower the money rate of interest by issuing fiduciary media, they induce entrepreneurs to act as if the subsistence fund had really grown (when in fact it has not). Entrepreneurs borrow money at the lower rates, hire workers, and try to bid away resources from others to begin longer-term processes. A general boom period ensues, where most people feel prosperous.

Yet because the issue of fiduciary media doesn’t actually make society richer, the boom must necessarily come to an end. There are physically not enough savings to carry society forward, until the time when the new (longer) processes yield their final consumption goods. A bust (what we now call a recession) sets in. As the output of consumption goods declines, their prices rise. Realizing their errors, the entrepreneurs discontinue those projects that were only apparently profitable, because of the false interest rate. The prices of producer goods fall, and the money rate of interest returns to the natural rate.

5. Credit and Economic Crises

In practice, the bust occurs when the banks slow down their issue of further fiduciary media, thereby allowing the money rate to rise toward its proper level. Yet even if the banks stubbornly tried to hold the money rate down, eventually they would fail. The growing expansion of the quantity of money in the broader sense drives prices higher and higher, and lenders insist on greater and greater premiums in the contractual rate of interest. The longer the banks hold the money rate below the natural rate, the worse is the eventual crisis.

Technical Notes

• Eugen von Böhm-Bawerk was a successor of Menger and a predecessor of Mises in the development of Austrian economics. One of Böhm-Bawerk’s great contributions was to explain the capitalists’ interest income as a premium given to present versus future goods. For example, suppose consumers would pay $50 for a mature Christmas tree, but would only pay $40 for an airtight claim guaranteeing them a mature Christmas tree to be delivered in twelve months. If these were the final prices as determined by consumers’ subjective preferences, then the market price for an immature tree—one that needed another year to fully develop—would be $40 as well. Assuming nothing else changed, a capitalist who invested $40 in such a tree could wait one year, then sell the mature version for $50, netting a 25 percent annual return on his capital. Thus Böhm-Bawerk explained the ability to earn interest over time as due to the underlying subjective preference for present versus future goods. A capitalist who buys factors of production invests in “future goods” which then grow in market value as they ripen into “present goods.” Also note that the term “ripen” is not reserved for agricultural products: Böhm-Bawerk would say that a capitalist can invest (say) $100,000 in lumber, shingles, labor, and other inputs which represent a future house. Over the months, as the house is built, the goods-in-process gradually become a present house, and hence command a higher market value than the initial $100,000 investment.

• In explaining the boom and bust cycle, Mises relies on Böhm-Bawerk’s capital theory. Böhm-Bawerk viewed the use of capital goods as a “roundabout” way of satisfying goals. For example, if someone wants to get coconuts from tree branches, a direct approach is to climb the tree and grab them with his bare hands. Yet a more roundabout (and physically productive) approach is to spend some time gathering sticks and vines, in order to construct a long pole. Then with this capital good, the person can knock down far more coconuts per hour of his labor. The tradeoff then is between getting more physical output per unit of labor, versus getting the coconuts sooner rather than later. (If the person is ravenous and wants to eat a few coconuts as quickly as possible, he will just climb the tree rather than search for sticks.) Böhm-Bawerk argued that the rate of interest reflected the community’s preferences for the timing of consumption as well as the technical opportunities for increased output resulting from further lengthening (or making more roundabout) the methods of production. If some people in the community saved more (by stockpiling coconuts, say), then the workers would be able to eat while production shifted out of tree-climbing and into pole-production. The savings would have augmented the subsistence fund to tide everyone over until the higher output of the more roundabout processes came online. The rate of interest in this scenario would permanently decline, and society would advance to a permanently higher standard of living, as workers could gather more coconuts per hour with the use of their new tools.

New Terminology

Interest: Income accruing to the owner of future goods as they mature into present goods, due to the higher valuation placed on present versus future goods.

Goods of the first order: Consumer goods.

Goods of higher orders: Goods used to produce consumer goods. (A capital good used to produce a consumer good is a second-order good. A capital good used to produce a second-order good is a third-order good, etc.)

Subsistence fund: A concept used by Böhm-Bawerk to denote the savings the capitalists must have first accumulated, in order to feed and otherwise support the workers as they engage in time-consuming production processes.

Purchasing power/inflation premium: An increase in the contractual rate of interest due to the expected rise in prices.

Study Questions

1. What is “the problem,” the nature of which is outlined in section 1? (pp. 339–46)

2. Why might the distribution of income and property alter the long-run rate of interest? (p. 347)

3. If the Money Rate of Interest is pushed below the Natural Rate of Interest (or more accurately, the normal rate of interest), what happens to commodity prices, according to Wicksell? (p. 355)

4. What are the two main mechanisms by which the money rate of interest rises back to the natural rate, after having been pushed down by the banks? (pp. 362–63)

5. Explain: “Certainly, the banks would be able to postpone the collapse; but nevertheless ... the moment must eventually come when no further extension of the circulation of fiduciary media is possible. Then the catastrophe occurs....” (p. 365)

CHAPTER 20

PROBLEMS OF CREDIT POLICY

Summary

The governments of Europe and America have been guided by the idea that the natural desire of the banks to issue fiduciary media must be checked, in order to avoid economic crises. However, this goal conflicts with the other desires for low interest rates and high selling prices.

Peel’s Bank Act [Bank Charter Act 1844] took the power of issuing new notes away from private banks and vested it completely with the Bank of England, which itself was required to maintain 100 percent metallic backing for any new notes that it issued. However, the Act crucially did not impose such a restriction on the extension of deposits. Peel’s Act thus contained a “safety valve” that prevented a sharp rise in the objective exchange value of money, but at the same time it failed to eliminate economic crises because it erroneously thought they were due exclusively to unbacked notes.

The degradation of the classical gold standard was already well underway before the outbreak of World War I. First, citizens ceased using gold in everyday transactions, and the actual gold was stockpiled in the vaults of each country’s central bank, which issued paper notes instead. Then the gold was even further concentrated into the central banks of just a few major countries, so that not even the central banks (of most countries) had gold in their vaults. Although it would have undesirable deflationary consequences, a transition back to an actual gold currency—in which people used genuine gold coins in daily purchases—is the only realistic check on government-sponsored inflation.

The original étatist arguments for regulating the issue of competing notes by private banks do not look nearly as compelling after the experience of German hyperinflation. The alleged evils of a free market in banking are nothing compared to the actual evils under a government monopoly of the currency.

People must choose between a fiat system regulated by index numbers of prices, or a return to an actual gold currency. In order to prevent recurring economic crises, the absolute prohibition of the further issuance of fiduciary media is necessary. If banks continue with the ability to issue fiduciary media, it leaves open the destruction of the entire monetary system, as a coordinated policy of expansion—perhaps under a World Bank—would have no checks on its inflationary potential.

Chapter Outline

I. PREFATORY REMARK

1. The Conflict of Credit Policies

Since the time of the Currency School, the governments of Europe and America have been guided by the idea that the natural desire of the banks to issue fiduciary media must be checked, in order to avoid economic crises. However, this goal conflicts with the other desires to foster “cheap money” and “reasonable prices,” i.e., low interest rates and high prices for certain producers.

II. PROBLEMS OF CREDIT POLICY BEFORE THE WAR

2. Peel’s Act

Peel’s Bank Act [Bank Charter Act 1844] took the power of issuing new notes away from private banks and vested it completely with the Bank of England, which itself was required to maintain 100 percent metallic backing for any new notes that it issued. However, the Act crucially did not impose such a restriction on the extension of deposits. In other words, private banks could create more fiduciary media by granting loans (not backed by gold) to their customers, thus lowering the rate of interest and expanding the stock of money in the broader sense. In this way, Peel’s Act contained a “safety valve” that prevented a sharp rise in the objective exchange value of money (i.e., falling prices of goods and services), but at the same time it failed to eliminate economic crises because it erroneously thought they were due exclusively to unbacked notes.

3. The Nature of Discount Policy

Many writers, as well as the general public, do not understand the “real” economic forces behind movements in interest rates; instead they view increases in interest rates as arbitrary and unnecessary constraints on the community’s prosperity. For example, it is in the nature of banking that an individual bank must raise the interest rate it charges on new loans, if its reserves of money in the narrower sense are being drained because it has issued more fiduciary media than its competitors. This behavior would occur whether or not government or central bank rules required it.

When it comes to international movements of capital, people also fail to understand that domestic interest rates must reflect conditions in the world market. There is nothing more mysterious in foreign events altering domestic interest rates, than (say) a foreign crop failure raising domestic fruit prices.

4. The Gold-Premium Policy

The Bank of France implemented a well-known gold-premium policy, in which it charged a premium (somewhere in the range of 0.4 to 0.8 percent) on requests to exchange francs for gold, if the gold were going to be invested abroad seeking a higher return. The purpose of the policy was to widen the gap by which the Bank of France could maintain a lower discount rate than prevailed in other countries. The policy hindered capital outflows and inflows, and hindered the full incorporation of France into the world market. The only way to truly insulate Bank policy from the rest of the world market would be to leave the gold standard entirely, adopting credit money or fiat money and thereby suffering inflation.

5. Systems Similar to the Gold-Premium Policy

Central banks have adopted other techniques to hinder the export of gold. For example, they might not surrender gold to exporters in the most convenient form, or they might give worn-out coins that had slightly less metal content than the coins intended for domestic use.

6. The Non-Satisfaction of the So-called “Illegitimate” Demand for Money

Attempts to only provide gold for export when the purpose is “legitimate” would fail to achieve their objective in the long-term, as speculators would find other means to achieve the same end. Moreover, there is a whole spectrum of intermediate cases between “legitimate” demands for commodity importation and “illegitimate” speculation on foreign investments. For example, what if a foreign company wanted to withdraw deposits that it had previously invested in a country? Would the authorities permit a “loss” of gold in this circumstance?

7. Other Measures for Strengthening the Stock of Metal Held by the Central Banks-of-Issue

While central banks-of-issue adopted policies to raise the upper gold point and thus discourage the export of gold, at the same time many adopted policies to reduce the lower gold point and thus encourage imports of gold. The two sets of policies largely offset each other, so that the actual gap between the gold points did not change as much as might have been supposed.

8. The Promotion of Cheque and Clearing Transactions as a Means of Reducing the Rate of Discount

In Germany before the first World War, there was an effort to reduce the German people’s everyday use of gold, and replace it with the use of check and clearing transactions. This would allegedly allow the Reichsbank to hold a larger reserve of metal, and keep a lower discount rate. However, there is no necessary connection between the long-run rate of interest and the quantity of fiduciary media.

III. PROBLEMS OF CREDIT POLICY IN THE PERIOD IMMEDIATELY AFTER THE WAR

9. The Gold-Exchange Standard

During the World War I, the major powers (except the United States) explicitly suspended the gold standard. However, the degradation of the classical gold standard was already well underway before the outbreak of war. First, citizens ceased using gold in everyday transactions, and the actual gold was stockpiled in the vaults of each country’s central bank, which issued paper notes instead. Then the gold was even further concentrated into the central banks of just a few major countries, so that not even the central banks (of most countries) had gold in their vaults. Instead, they too had paper claims entitling them to the gold that was stored elsewhere.

In this way, virtually the entire world became accustomed to using paper as their money, which had a more and more tenuous link to gold. As of 1924, the world price of gold was dominated by the actions of the United States government. Yet such an outcome is the antithesis of the whole rationale for the gold standard: to keep political interference out of money.

10. A Return to a Gold Currency

Although it would have undesirable deflationary consequences, a transition back to an actual gold currency—in which people used genuine gold coins in daily purchases—is the only realistic check on government-sponsored inflation. Had the citizens of the great powers been using gold on the eve of World War I, it would have been much more difficult for their governments to run the printing presses to pay for armaments.

11. The Problem of the Freedom of the Banks

The original étatist arguments for regulating the issue of competing notes by private banks do not look nearly as compelling after the experience of German hyperinflation. The alleged evils of a free market in banking are nothing compared to the actual evils under a government monopoly of the currency.

12. Fisher’s Proposal for a Commodity Standard

The famous American economist Irving Fisher proposed that index numbers would track an average of commodity prices, so that the dollar itself could be defined as a variable weight of gold that possessed constant purchasing power in terms of the commodities in the index.

There are several problems with Fisher’s proposal. First, the various index numbers are arbitrary; there is no scientific way to measure the “true” change in the purchasing power of gold from month to month. Another problem is that the market already has techniques for handling changes in the purchasing power of money; Fisher’s proposal would simply lead to an adjustment of the techniques. Finally, even ignoring the other problems, Fisher’s proposal would not counteract the differential impact that inflation has as it unevenly spreads through the economy. If the price index increases by 1 percent in a certain month, this is because some prices increased by more than 1 percent, while others increased by less.

13. The Basic Questions of Future Currency Policy

People must choose between a fiat system regulated by index numbers of prices, or a return to an actual gold currency. In order to prevent recurring economic crises, the absolute prohibition of the further issuance of fiduciary media is necessary. (Such a prohibition must go beyond Peel’s Act, and include bank deposits as well as notes, for economically the two are equivalent.) If banks continue with the ability to issue fiduciary media, it leaves open the destruction of the entire monetary system, as a coordinated policy of expansion—perhaps under a World Bank—would have no checks on its inflationary potential.

Only by freeing money and banking from political influence can people avoid economic crises while maintaining the highest possible stability of the purchasing power of money.

Technical Notes

• On pages 377–82, Mises describes the “gold-premium policy” implemented by the Bank of France. In the absence of such a premium, investors wouldn’t distinguish between domestic and foreign investments (except perhaps for a slight psychological preference for the former), and would put their capital where it would earn the highest return. If the Bank of England’s discount rate were higher than the Bank of France’s, then French investors would turn their francs in for gold, use the gold to buy bonds in England, then convert the gold back into francs after earning their interest. The result would be a higher rate of return (measured in francs) than if the investors had lent the money in France. However, if turning francs into gold involves payment of a (small) premium to the Bank of France, then investors would only adopt the above strategy if the difference in interest rates were sufficiently large. Therefore, the gold-premium policy gave the Bank of France a wider margin to keep interest rates relatively low, before suffering from an outflow of gold.

• On page 398, Mises points out that most arguments criticizing the operation of a private, competitive banking system were “thoroughly unsound.” The one legitimate argument came from the Currency School, which (correctly) pointed out that if private banks issued notes in excess of their gold reserves (i.e., fiduciary media), this could cause economic crises. Ironically, this danger only exists when the banks all operate under a uniform discount policy—they must all inflate in unison, or else the bank that is the most aggressive will have its fiduciary media returned to it (through clearing operations), and it will quickly lose its gold reserve to its competitors. Yet somehow, these observations led to the call to abolish competitive banknote issue and replace it with a government monopoly. As Mises says, “Now the monopolization of the banks-of-issue in each separate country does not merely fail to oppose any hindrance of this uniformity of procedure; it materially facilitates it.”

New Terminology

Upper gold point: Under the gold standard, the maximum market price of gold (quoted in a country’s currency) above which it is profitable—including all costs of transport, re-coinage, etc.—for foreigners to exchange the domestic currency for gold (at the official redemption rate, which is below the current market price), and have the gold shipped out of the original country.

Lower gold point: Under the gold standard, the minimum market price of gold (quoted in a country’s currency) beneath which it is profitable—including all costs of transport, re-coinage, etc.—for citizens to import gold and exchange it with the authorities at the official redemption rate for the domestic currency.

Study Questions

1. What was the theoretical error of the Currency School, and why was this mistake an “advantage” with respect to the implementation of Peel’s Act? (pp. 369–70)

*2. When Mises claims that a sole bank, engaging in a more inflationary policy than its competitors, would endanger its “solvency” (p. 374), is that consistent with his definition of the term (versus “liquidity”) on page 331?

3. Explain: “The banks would still have to have a discount policy even if there were no legislative regulation of the note cover.” (p. 374)

4. How did France’s gold-premium policy hinder both the outflow and inflow of capital? (p. 382)

5. Explain: “There is only one danger that is peculiar to the issue of notes; that of its being released from the common law obligation under which everybody who enters into a commitment is strictly required to fulfill it at all times and in all places. This danger is infinitely greater and more threatening under a system of monopoly.” (p. 399)