Part 1 The Natural Production of Money 1 Monies 1. THE DIVISION OF LABOR WITHOUT MONEY

To understand the origin and nature of money, one must first consider how human beings would cooperate in a world without money—in a barter world. Exchanging goods and services in such a barter world confronts the members of society with certain problems. They then turn to monetary exchanges as a means for alleviating these problems. In short, money is a (partial) solution for problems of barter exchanges. But let us look at this in just a little more detail.

The fundamental law of production is that joint production yields a greater return than isolated production. Two individuals working in isolation from one another produce less physical goods and services than if they coordinated their efforts. This is probably the most momentous fact of social life. Economists such as David Ricardo and Ludwig von Mises have stressed its implication: even if there are no other reasons for human beings to cooperate, the greater productivity of joint efforts tends to draw them together. The higher productivity of the division of labor, as compared to isolated production, is therefore the basis of a general “law of association.”¹

Without money, people would exchange their products in barter; for example, Jones would barter his apple against two eggs from Brown. In such a world, the volume of exchanges—in other words, the extent of social cooperation—is limited through technological constraints and through the problem of the double coincidence of wants. Barter exchanges take place only if each trading partner has a direct personal need for the good he receives in the exchange. But even in those cases in which the double coincidence of wants is given, the goods are often too bulky and cannot be subdivided to accommodate them to the needs. Imagine a carpenter trying to buy ten pounds of flour with a chair. The chair is far more valuable than the flour, so how can an exchange be arranged? Cutting the chair into, say, twenty pieces would not provide him with objects that are worth just one twentieth of the value of a chair; rather such a “division” of the chair would destroy its entire value. The exchange would therefore not take place.

2. THE ORIGIN AND NATURE OF MONEY

These problems can be reduced through what has been called “indirect exchange.” In our example, the carpenter could exchange his chair against 20 ounces of silver, and then buy the ten pounds of flour in exchange for a quarter ounce of silver. The result is that the carpenter’s need for flour, which otherwise would have remained unsatisfied, is now satisfied through an additional exchange and the use of a “medium of exchange” (here: silver). Thus indirect exchange provides our carpenter with additional opportunities for cooperation with other human beings. It extends the division of labor. And it thereby contributes to the material, intellectual, and spiritual advancement of each person.

In the history of mankind, a great variety of commodities—cattle, shells, nails, tobacco, cotton, copper, silver, gold, and so on—have been used as media of exchange. In the most developed societies, the precious metals have eventually been preferred to all other goods because their physical characteristics (scarcity, durability, divisibility, distinct look and sound, homogeneity through space and time, malleability, and beauty) make them particularly suitable to serve in this function.

When a medium of exchange is generally accepted in society, it is called “money.” How does a commodity such as gold or silver turn into money? This happens through a gradual process, in the course of which more and more market participants, each for himself, decide to use gold and silver rather than other commodities in their indirect exchanges. Thus the historical selection of gold, silver, and copper was not made through some sort of a social contract or convention. Rather, it resulted from the spontaneous convergence of many individual choices, a convergence that was prompted through the objective physical characteristics of the precious metals.

To be spontaneously adopted as a medium of exchange, a commodity must be desired for its nonmonetary services (for its own sake) and be marketable, that is, it must be widely bought and sold. The prices that are initially being paid for its nonmonetary services enable prospective buyers to estimate the future prices at which one can reasonably expect to resell it. The prices paid for its nonmonetary use are, so to speak, the empirical basis for its use in indirect exchange. It would be extremely risky to buy a commodity for indirect exchange without knowing its past prices; as a consequence, the spontaneous emergence of a medium of exchange is virtually impossible whenever such knowledge is lacking. On the other hand, when it exists, then there can arise a monetary demand for the commodity in question. The monetary demand then adds to the original nonmonetary demand, so that the price of the money-commodity contains a monetary component and a nonmonetary component. Although in a developed economy the former is likely to outweigh the latter quite substantially, it is important to keep in mind that the monetary use of a commodity ultimately depends on its nonmonetary use. The medieval scholastics called money a res fungibilis et primo usu consumptibilis.² It was in the very nature of money to be a marketable thing that had its primary use in consumption.

3. NATURAL MONIES

We may call any kind of money that comes into use by the voluntary cooperation of acting persons “natural money.”³ To cooperate voluntarily in our definition means to provide mutual support without any violation of other people’s property, and to enjoy the inviolability of one’s own property.⁴

The role of private property as a fundamental institution of human society is of course a staple of historical experience and social science. It is also a staple of Christian social thought, rooted in the Sixth and Ninth Commandments. Within the Catholic Church, the popes emphasized that private property must be held inviolable, not out of any juridical dogmatism in favor of the well-to-do, but because they perceived such inviolability to be the first condition to improve the living standards of the masses.⁵ They upheld this notion knowing full well that property owners are often bad stewards of their assets. They upheld it even in the cases in which the owners do not, as a matter of fact, use their private means to promote the good of all of society. And they upheld it in those cases in which the owners did not even have the slightest intention to pursue the common good. In short, the popes championed the distinction between justice and morals—between the right to own property and the moral obligation to make good use of this property.⁶ A violation of one’s moral obligation could not possibly justify the slightest infringement of property rights. Private property is sacred even if it is abused or not used:

That justice called commutative commands sacred respect for the division of possessions and forbids invasion of others’ rights through the exceeding of the limits of one’s own property; but the duty of owners to use their property only in a right way does not come under this type of justice, but under other virtues, obligations of which ‘cannot be enforced by legal action.’ Therefore, they are in error who assert that ownership and its right use are limited by the same boundaries; and it is much farther still from the truth to hold that a right to property is destroyed or lost by reason of abuse or non-use.⁷

In the case of a society in which private property is inviolable, we may speak of a “completely free society” and its economic aspect may then be called a “free market” or a “free economy.” Such an economy, if perfected by charity, truly promotes “economic and civil progress.”⁸ The monetary corollary of such a society is, as we have said, natural money—or rather all the different natural monies that would exist in such a society, for there are good reasons to assume that a free society would harbor a variety of different monies, which would all be natural monies in our sense. Notice that natural money is an eminently social institution. This is so not only in the sense that it is used in interpersonal exchanges (all monies are so used), but also in the sense that they owe their existence exclusively to the fact that they satisfy human needs better than any other medium of exchange. As soon as this is no longer the case, the market participants will choose to discard them and adopt other monies. This freedom of choice assures, so to speak, a grass-roots democratic selection of the best available monies—the natural monies.

Where property rights are violated, especially where they are violated in a systematic manner, we may no longer speak of a completely free society. It is possible that natural monies would still be used in such societies, namely, to the extent that the violations of property rights do not concern the choice of money. But wherever people are not free to choose the best available monies, a different type of money comes into existence—”forced money.” Its characteristic feature is that it owes its existence to violations of property rights. It is used, at least to some extent, because superior alternative monies cannot be used without exposing the user to violence. It follows that such monies are tainted from a moral point of view. They may still be beneficial and used in indirect exchanges, but they are in any case less beneficial than natural monies, because they owe their existence to violations of private property, rather than to their relative superiority in satisfying human needs alone.

Gold, silver, and copper have been natural monies for several thousand years in many human societies. The reason is, as we have said, that their physical characteristics make them more suitable to serve as money than any other commodities. Still we call them natural monies, not because of their physical characteristics, but because free human beings have spontaneously selected them for that use. In short, one cannot tell on a priori grounds what the natural money of a society is. The only way to find this out is to let people freely associate and choose the best means of exchange out of the available alternatives. Looking at the historical record we notice that, at most times and most places, people have chosen silver. Gold and copper too have been used as monies, though to a lesser extent.

4. CREDIT MONEY

Natural money must possess two qualities. It must first of all be valuable prior to its monetary use, and it must furthermore be physically suitable to be used as a medium of exchange (at any rate more suitable than the alternatives). The historical monies we have mentioned so far derive their prior value from their use in consumption. Even in the case of the precious metals this is so. It is true that they are not destroyed in consumption, as for example tobacco and cotton, but they are nevertheless consumed as jewelry, ornament, and in a variety of industrial applications.

Now there are other monies that do not derive their prior value from consumption. The most important cases are paper money and electronic money, to which we will turn below. But there is also credit money, the subject of the current section. As the name says, credit money comes into being when financial instruments are being used in indirect exchanges. Suppose Ben lends 10 oz. of silver to Mike for one year, and that in exchange Mike gives him an IOU (I owe you). Suppose further that this IOU is a paper note with the inscription “I owe to the bearer of this note the sum of 10 oz., payable on January 1, 2010 (signature).” Then Ben could try to use this note as a medium of exchange. This might work if the prospective buyers of the note will also trust Mike’s declaration to pay back the credit as promised. If Mike’s reputation is good with certain people, then it is likely that these people will accept his note as payment for their goods and services. Mike’s IOU then turns into credit money.

Credit money can never have a circulation that matches the circulation of the natural monies. The reason is that it carries the risk of default. Cash exchanges provide immediate control over the physical money. But the issuer of an IOU might go bankrupt, in which case the IOU would be just a slip of paper.

Not surprisingly, therefore, credit money has reached wider circulation only when the credit was denominated in terms of some commodity money, when the reputation of the issuer was beyond doubt, and when it was the only way to quickly provide the government with the funds needed to conduct large-scale war. This was for example the case with the American Continentals that financed the War of Independence and with the French assignats that financed the wars of the French revolutionaries against the rest of Europe. In the early days, credit money had also been issued in other forms than paper. In particular, IOUs made out of leather have been repeatedly used as money starting in the ninth century.⁹

Credit money is only a derived kind of money. It receives its value from an expected future redemption into some commodity. In this respect it crucially differs from paper money, which is valued for its own sake. And this brings us to the next topic.

5. PAPER MONEY AND THE FREE MARKET

So far we have singled out the precious metals to illustrate our discussion because, historically, the precious metals have been the money of the free market, and also because to the present day no other commodities seem to be more suitable to be used as media of exchange. But the contention that gold, silver, and copper are the best available monies seems to be contradicted by the fact that, today, there is virtually no country in the world that uses precious metals as monies. Rather, all countries use paper monies.¹⁰ This universal practice seems to have a ready explanation in the observation that paper money is even more advantageous than the precious metals, for at least three reasons: (1) its costs of production are far lower; (2) its quantity can be easily modified to suit the needs of trade; and (3) its quantity can be easily modified to stabilize the value of the money unit.

Before we turn to analyzing these alleged advantages in more detail, we have to deal with the even more fundamental question of whether paper money is a market phenomenon in the first place. Does it owe its existence to the free choice of the money users, or to legal privileges? If the former is the case, there seems to be no fault with paper money—quite to the contrary. But if it exists only due to compulsion and coercion; that is, due to violations of property rights—its alleged advantages must be examined very carefully.

Now if we turn to the empirical record, we confront the stark fact that, in no period of human history, has paper money spontaneously emerged on the free market.¹¹ No Western writer before the eighteenth century seems to have even considered that the existence of paper money was possible. The idea arose only when paper certificates for gold and silver gained a larger circulation, especially in the context of large-scale government finance.¹² In the eighteenth, nineteenth, and twentieth centuries, various experiments with paper money have taken place in the West.¹³ Governments have issued paper money along with the legal obligation for each citizen to accept it as legal tender. They overrode the stipulations made in private contracts and forced creditors, say, to accept payments in paper “greenbacks” rather than in gold or silver. In most cases, however, governments have transformed previously existing paper certificates for gold and silver into paper money by outlawing the use of gold and silver, and of all other suitable commodities and certificates. The experience of other cultures and times tells the same story. Paper money had been introduced in China in the twelfth century, equally through compulsion and coercion by the ruler.¹⁴ In all known historical cases, paper money has come into existence through government-sponsored breach of contract and other violations of private-property rights. It has never been a creature of the free market.

The historical record does not of course provide a decisive verdict on the question whether paper money can spontaneously emerge on a free market. Can we settle the issue on theoretical grounds? Here the following consideration comes into play. By its very nature, paper money provides only monetary services, whereas commodity money provides two kinds of services: monetary and commodity services. It follows that the prices paid for paper money can shrink to zero, whereas the price of commodity money, will always be positive as long as it attracts a nonmonetary demand. If the prices paid for a paper money fall to zero, then this money can never be re-monetized again, because short of an already-existing price system the market participants could not evaluate the money unit. Thus the use of paper money carries the risk of total and permanent value annihilation. This risk does not exist in the case of commodity money, which always carries a positive price and which can therefore always be re-monetized.

It does not take much fantasy to predict the practical implications of this fact. In a truly free market, paper money could not withstand the competition of commodity monies. The more farsighted and prudent market participants would get rid of their paper money first, and the others would follow in due course. At the end of this process, which could be consummated in but a few seconds, but which could conceivably also last a few years, the paper currency would be completely eradicated.¹⁵

The preceding analysis leads to the conclusion that no money can remain in circulation only because it has been in circulation up to now. The ultimate source of its value—the rock bottom of its value—must be something else than the mere fact that, so far, people have been willing to accept it.¹⁶ All kinds of psychological motivations might provide such a source for a while, but they will all collapse under the pressure of a substitution process of the kind we have described above. What then? Can the armed power of the government keep money in circulation? The government’s fiat can indeed confer value on paper money—the value of not getting into trouble with the police.¹⁷ But this observation only confirms our point that paper money is not a market phenomenon. It cannot flourish in the fresh air of a free society. It is used only when police power suppresses its competitors, so that the members of society are given the stark choice of either using the government’s paper money or forgoing the benefits of a monetary economy altogether.¹⁸

6. ELECTRONIC MONEY

The preceding observations can be directly applied to the case of electronic money. An economic good that is defined entirely in terms of bits and bytes is unlikely ever to be produced spontaneously on a free market, for the very same reasons that we just discussed in the case of paper money. And despite the dedicated efforts of various individuals and associations, no such money has in fact ever been produced since the creation of the Internet made electronic payments possible. At present, only government money has been produced in electronic form; and as in the case of paper money, governments could do this only because they have the possibility to suppress competition.

On the free market, the new information technologies have been unable to create any new monies. They have been able to develop various new instruments to access and transfer money. These new electronic techniques of dealing with money are very efficient and beneficial, but they must not be confused with the creation of electronic money.

2
Money Certificates

1. CERTIFICATES PHYSICALLY INTEGRATED WITH MONEY

The precious metals would have become monies even if coinage had never been invented, because even in the form of bullion their physical advantages outweigh those of all alternatives. There is however no doubt that coinage added to the benefits derived from indirect exchange, and that it therefore contributed to the spreading of monetary exchanges. Coinage allows the exchange of precious metals without engaging in the labor-intensive processes of weighing the metal and melting it down. One can determine a metal weight by simply counting the coins.¹

Coinage endows a mass of precious metal with an imprint that certifies its weight. The typical imprint says something to the effect that the coin weighs a total of so and so many grams or ounces (gross weight), with this or that proportion or absolute content of precious metal (fine weight). This is why coin names were typically the names of weights, for example, the pound, the mark, the franc, or the ecu.

Notice that the service depends entirely on the trustworthiness of the certifier, that is, of the minter. If the market participants cannot trust the certificate, they will rather do without the coin and go through the extra trouble of weighing the metal and possibly melting it down to determine its content of fine metal. A trustworthy coin economizes on this trouble and thus adds to the value of the bullion contained in the coin; for example, a trustworthy 1-ounce silver coin is more valuable than 1 ounce of silver bullion.² People therefore pay higher prices for coins than for bullion, and the minter lives off this price margin.³

Because the value of the certificate depends on the trustworthiness of the minter, coins are typically used within limited geographical areas. Only the people who know the minter are likely to accept his coins. All others will insist on being paid in bullion or in coins they trust. This does not mean that in practice every village needs a different set of coins. The geographical radius within which a coin is used can grow very large and it can even become world encompassing if the minter has an excellent reputation. This was for example the case with the Mexican dollar coins that in the early nineteenth century circulated freely in most parts of the U.S. and which have bequeathed their name to the present-day currency of this country.

Historically, minters have offered additional services that complement the certification of weights. Thus one of the perennial problems of coining precious metals is that used coins might contain a smaller quantity of precious metal than freshly minted coins. If this happens, people are inclined to hold back the good coins for themselves and to trade only the bad coins. To overcome this problem, minters could offer their coins in combination with an insurance service: they could offer to exchange any slightly used coin against a new one. This policy would guarantee the stability and homogeneity of the coinage through time. Thus the insured coins would trade at even higher prices, from which price differential (the premium) the replacement expenses can be paid.

A great number of monetary thinkers from the Middle Ages to our times have held that coinage should be entrusted to the princes or governments, who, because they were the natural leaders of society, were also the people to be naturally trusted. The medieval scholastics knew full well that the princes frequently abused this trust, placing for example an imprint of “one ounce” on a coin that contained merely half an ounce, pocketing the other half of an ounce for themselves. Therefore Nicholas Oresme postulated that the princes did not have the right to alter the coins at all, unless they had the consent of the entire community, that is, the entire community of money users.

Economic science has put us in a position to understand that competitive coinage is an even better way of preserving the trustworthiness of coins. There is no economic reason not to allow every private citizen to enter the minting business and to offer his own coins. It is true that a private minter too might abuse the trust his customers put in him and his coins. But punishment is immediate: he will lose all these customers. People will start using other coins issued by people they have reason to trust more. In a way, this competitive process also fulfills Oresme’s postulate that the entire community of money users decide about coinage. He held that “money is the property of the commonwealth.”⁴ On a free market, the money owners can assert this property right smoothly and swiftly. Each person who no longer trusts the minter A simply stops using A’s coins and begins to use the coins of minter B. Thus he leaves the A community and joins the B community.

Competition in coinage is no panacea. Abuses are always possible and in many cases they cannot easily be repaired. The virtue of competition is that it offers the prospect of minimizing the scope of possible abuses. And its great charm is that it involves the entire community of money users, not just some appointed or self-appointed office holders. Down here on earth this seems to be all we can hope for.

2. CERTIFICATES PHYSICALLY DISCONNECTED FROM MONEY

If certificates may add to the value of bullion then certificates may have a value on their own. Therefore they can also be traded without being physically integrated with the precious metal of which they certify the quantity. Then they are money substitutes.

Issuing such money substitutes was the generally accepted practice in the cities of Amsterdam and Hamburg for almost two centuries. The Bank of Amsterdam (established in 1609) issued paper notes that certified that the holder of the note was the legal owner of so-and-so much fine silver deposited in the vaults of the bank. These banknotes could be redeemed any time at the counters of the Bank, on the simple demand of the present owner.⁵ As a consequence, they were traded in lieu of the silver itself. Rather than exchanging physical silver, people made their purchases with the banknotes that certified ownership of a sum of silver deposited at the Bank.

Apart from paper notes, the main types of such substitutes are token coins, certificates of deposit, checking accounts, credit cards, and electronic bank accounts on the Internet. Despite the physical variety of these types, each of them features three fundamental characteristics: intermediation, titles, and the holding of “reserves.”⁶

Certification in the present case is not as integral as in the case of imprints that are struck in to the money material itself—the regular coins that we discussed above. Rather, the money substitute relates to a quantity of money that is removed from the eyes of the partners to the exchange. The money itself is held at some other place, namely, at the bank or treasury department or whichever other organization has issued the certificate. Thus there is in the present case not only monetary intermediation in the weak sense that a third party certifies quantities of money exchanged by the other two parties; but also in the strong sense that this third party actually physically controls the money at the time of the exchange.

Furthermore, money substitutes do not merely certify the physical existence of a certain amount of precious metal; they are also a legal title to that amount. The rightful owner of a one-ounce-of-silver banknote, for example, is the rightful owner of one ounce of silver deposited in the vaults of the institution that issued the banknote.

Finally, the money supplies held by the issuer of the substitutes are called the “reserves.” This terminology is established in economic science, but it should be used with some caution. Many students of money and banking believe that certificates such as book entries in bank accounts are the real monies, because they are actually used in daily exchanges, whereas the money held by the institutions that make the account entries are just the reserves. But the truth is quite different. In all such cases, the so-called reserves are in fact the real money, whereas the account entries are only money substitutes.⁷

What are the advantages and disadvantages of certificates disconnected from the money itself? The main advantage is that the costs of storage, transportation, and certification (minting) can be reduced. The main disadvantage is that the potential for abuse is greater than in the case of coinage. Fraudulent bankers can embezzle on the property of their customers far more easily than fraudulent minters. A look at the history of institutions reveals that this temptation was virtually impossible to resist, especially when certification was not competitive. In the case of the Bank of Hamburg it took almost 150 years before abuse set in (at any rate, before it became manifest). Other bankers fell from grace much more quickly. For example, the goldsmiths who in the mid-1600s had taken over the certification business in the city of London, after the English king had robbed the gold deposited in the Tower, very soon started using the deposits in their lending operations. Thus they turned themselves into “fractional-reserve bankers,” meaning that only a part (a fraction) of their issue was covered by underlying money reserves.

In short, the potential abuse of substitutes is a very considerable disadvantage. One may therefore justly doubt that on a free market they could have gained any larger circulation. Even David Ricardo, the great champion of paper currency, admitted that it was unlikely that such substitutes could withstand the competition of coins. The only sure way to bring paper notes into circulation was to impose them on the citizenry: “If those who use one and two, and even five pound notes, should have the option of using guineas, there can be little doubt which they would prefer.”⁸

But our point is not to speculate about the significance that paper certificates would have on the free market. We merely wish to point out that paper certificates and token coins might conceivably play a role here, and that they have been used very widely in the past, though very often under some sort of imposition. In a free society, the market participants would constantly weigh the advantages and disadvantages of the various certification products. It is true that they would not be able to prevent all abuses. But again, the point is that a competitive system minimizes the possible damage.

3
Money within the Market Process

1. MONEY PRODUCTION AND PRICES

The basic economic fact of human life is the universal condition of scarcity. Our means are not sufficient to realize all of our ends. In particular, our time is limited and thus we have to make up our mind how to use it, whether in paid work, in family or communal activities, or in personal leisure. But all other means at our disposal are limited too: our cash holdings, our financial assets, the size and quality of our cars and houses, and so on. Thus whatever we do, we have to choose how to use these resources, which also means that we decide at the same time how not to use them.

Now the use of all means of action is conditioned by the law of diminishing marginal value. According to this law, the relative importance of any unit of an economic good for its owner—or, as economists say, the marginal value of any unit—diminishes as we come to control a greater overall supply of this good, and vice versa. The reason is that each additional unit enables us to pursue new objectives that we would not otherwise have chosen to pursue. Therefore, these objectives are necessarily less important for the acting person than the objectives that he would have pursued with the smaller supply. It follows, for example, that the marginal value of an additional mouthful of water is very different for a person travelling in a desert than for the same person swimming in a lake. And the marginal value of a 200 square-foot room added to our house is very different, depending on whether the present size of our house is 500 or 5,000 square feet. Similarly, the marginal value of an additional dollar depends on how many dollars its owner already holds in his cash balance.

It follows that the production of any additional unit of money makes money less valuable for the owner of this additional unit than it would otherwise have been. In particular, it becomes less valuable for him as compared to all other goods and services. As a consequence, he will now tend, as a buyer of goods and services, to pay more money in exchange for these other goods and services; and as a seller of goods and services, he will now tend to ask for higher money payment.

In short, money production entails a tendency for money prices to increase. This tendency will at first show itself in the prices paid by the money producer himself. But then it will spread throughout the rest of the economy because those individuals who sold their goods and services to the money producer now also have larger cash balances than they otherwise would have had. For them too, therefore, the relative value of money will decline and they too will therefore tend to pay higher prices for the goods and services that they desire. It follows that still other people will have higher cash balances than otherwise and thus a new round of price increases sets in, and so on. This process continues until all money prices have been adjusted to the larger money supply. It is true that, for reasons that are too special to warrant our attention at this place, some prices might decrease in this process. But the overall tendency is for prices to increase. Thus the overall tendency of money production is to increase prices beyond the level they would otherwise have reached. This implies in turn that the purchasing power of any unit of money diminishes.

Let us emphasize again that the process through which money production tends to increase the price level is spread out in time. It therefore affects the different prices at different points of time—there is no simultaneous increase of all prices. Furthermore, there is no reason why prices should change uniformly or in some fixed proportion to the change of the money supply. Hence, money production entails a tendency for prices to increase, but this increase occurs step by step in a process spread out through time and affects each price to a different extent.¹

2. SCOPE AND LIMITS OF MONEY PRODUCTION

How much money will be produced on the market? How many coins? How many paper certificates? The limits of mining and minting, and of all other monetary services are ultimately given through the preferences of the market participants. As in all other branches of industry, miners and minters will make additional investments and expand their production if, and only if, they believe that no better alternative is at hand. In practice this usually means that they will expand coin production if the expected monetary return on investments in mines and mint shops is at least as high as the monetary returns in shoe factories, bakeries, and so on.

The returns of the various branches of human industry ultimately depend on how the individual citizens choose to use the scarce resources that they own. In their capacity as consumers, the citizens choose to spend their money on certain products rather than on other products, thus determining the revenue side of all branches of industry. In their capacity as owners of productive resources (labor, capital, land), the citizens choose to devote these resources to certain ventures rather than in other ventures, thus determining the cost side of all branches of industry. Ultimately, therefore, it is the individual citizens who through their personal choices determine the relative profitability of all productive ventures. Each citizen engages in cooperation with some of his fellows, and by the same token he also withholds cooperation from others. This selection process or market process encompasses all productive ventures and therefore creates a mutual interdependence between all persons and all firms.

On a free market, the production of money is fully embedded in this general division of labor. Additional coins are made as long as this production offers the best available returns on the resources invested in it. It is curtailed to the extent that other branches of industry offer better prospects.

Moreover, just as the choices of individual citizens determine the relative extent of the production of money, as compared to other productions, they also determine the number of different coins that will be produced. Above we stated that money was a generally accepted medium of exchange. It is not merely conceivable that several monies will be in parallel use; this has been in fact the universal practice until the twentieth century. In the Middle Ages, gold, silver, and copper coins, as well as alloys thereof, circulated in overlapping exchange networks. At most times and places in the history of Western Europe, silver coins were most widespread and dominant in daily payments, whereas gold coins were used for larger payments and copper coins in very small transactions. In ancient times too, this was the normal state of affairs.

The parallel production and use of different coins made out of precious metals is therefore the natural state of affairs in a free economy. Oresme constantly warned of altering coins, but he stressed that the introduction of a new type of coins was not such an alteration so long as it did not go in hand with outlawing the old coin.²

3. DISTRIBUTION EFFECTS

When it comes to describing the distribution effects resulting from money production, economists ever since the times of Nicholas Oresme and Juan de Mariana typically cite just one such effect. They point out that the increased money supply brings about a tendency for the increase of all money prices—a fall of the purchasing power of money. Then they argue that the reduced purchasing power benefits debtors, because the amount of debt they have to pay back is now worth less than before, and that this benefit therefore necessarily comes at the expense of the creditors.

This way of presenting things is not fully correct. It is true that an increased money supply tends to bring about higher money prices, and thus diminishes the purchasing power of each unit of money. But it is not true that this process necessarily operates in favor of the debtor and to the detriment of the creditor. A creditor may not be harmed at all by a 25 percent decrease in the purchasing power of money if he has anticipated this event at the point of time when he lent the money. Suppose he wished to obtain a return of 5 percent on the capital he lent, and that he anticipated the 25 percent depreciation of the purchasing power; then he would be willing to lend his money only for 30 percent, so as to compensate him for the loss of purchasing power. In economics, this compensation is called “price premium”—meaning a premium being paid on top of the “pure” interest rate for the anticipated increase of money prices. This is exactly what can be observed at those times and places where money depreciation is very high.³

A creditor might actually benefit from lending money even though the purchasing power declines. In our above example, this would be so if the depreciation turned out to be 15 percent, rather than the 25 percent he had expected. In this case, the 30 percent interest he is being paid by his debtor contains three components: (1) a 5 percent pure interest rate, (2) a 15 percent price premium that compensates him for the depreciation, and (3) a 10 percent “profit.”

The same observations can be made, mutatis mutandis, for the debtors. They do not necessarily benefit from a depreciating purchasing power of money, and they can even earn a “profit” when money’s purchasing power increases if the increase turns out to be less than that on which the contractual interest rate was based. It all depends on the correctness of their expectations.

There is however another distribution effect of the production of money. This effect is far more important than the one we have just described because it does not depend on the market participant’s expectations. It is an effect that the market participants cannot avoid by greater smartness or circumspection.

To understand this distribution effect we must consider that exchange and distribution are not disconnected activities. In the market process, they are but one and the same event. Brown sells his apple for Green’s pear. After the exchange, the distribution of apples and pears is different from what it otherwise would have been. Every exchange thus entails a modification of the “distribution” of resources that would otherwise have come into being. It follows that any production of additional goods and services is bound to have such an impact on distribution. The new supply of product redirects the distribution of wealth in favor of the producer.

Consider the case of money production. Here too the additional quantities that leave the production process, when sold, first benefit the first owner: the producer. He can buy more goods and services than he otherwise could have bought, and his spending on these things in turn increases the incomes of his suppliers beyond the level they would otherwise have reached. But the additional money production reduces the purchasing power of money. It follows that it also creates losers, namely, those market participants whose monetary income does not rise at first, but who have to pay right away the higher prices that result when the new money supply spreads step by step into the economy.

Money production therefore redistributes real income from later to earlier owners of the new money. As we have pointed out, this redistribution cannot be neutralized through expectations. Even the market participants who are aware of it cannot prevent it from happening. They can merely try to improve their own relative position in it, supplying early owners of the new money, preferably the money producer himself.

This distribution effect is a key to understanding monetary economies. It is the primary cause of almost all conflicts revolving around the production of money. As we shall see in more detail, it is therefore also of central importance for the adequate moral assessment of monetary institutions.

To avoid possible misunderstandings, however, let us emphasize that the distribution effects springing from production are not per se undesirable. They are an essential element of the free market process, which puts a premium on continual production in the service of consumers and does not reward inactivity.

4. THE ETHICS OF PRODUCING MONEY

Aristotle emphasized the beneficial character of monetary exchanges, which facilitate and extend the division of labor. He merely denounced the practice of turning money into a fetish and desiring it for its own sake.⁴ The scholastic writers of the Middle Ages adopted by and large the same point of view, but they also went beyond Aristotle, who focused on the ethics of using money, by discussing the ethics of money production.⁵

The scholastics did not question the legitimacy of producing money per se. As in the case of using money, however, they stated that money production had to respect certain ethical rules. Nicholas Oresme and others stressed that all coins should be clearly distinguishable from one another. In particular, it would not be licit that a minter produces coins that by their name, imprint, or other features resemble other coins that contain more precious metals.⁶ In other words, the benefits of competition in coinage result from a strict application of the Ninth Commandment: “You shall not bear false witness against your neighbor.”

This is the reason why coins up to the early modern period traditionally had weight names such as mark and franc. But this proved to be an improvident choice because coined metal, as we have seen, has by the very nature of things a different value than bullion metal.⁷ The word “ecu” for example was on the one hand used in the same sense in which we use today the word “ounce”—it was the name of a weight. But it was also the name of a gold coin that (originally) was supposed to be the equivalent of one ounce of silver. Just imagine what it would mean if, today, we had a silver currency consisting of 1-ounce silver coins that we called “ounces.” The expression “ounce” would then be unsuitable to be used in setting up contracts because it is ambiguous. It makes a difference whether we are talking about certified weights, as in coins, or uncertified weights as in gold nuggets. One would therefore have to specify in each contract whether payment is to be made in weight-ounces or coin-ounces. But then the practice of using weight names for coins loses its point. The mere weight name as such is not specific enough.

This does not mean, of course, that the weight contents of fine metal should not be imprinted on the coin. Quite to the contrary, this is exactly what successful minters have done in the past, what they do now, and what they will do in the future. The point is that it makes no sense to call a coin after its content of fine metal; such a name does not reduce ambiguities, but increases them.

Coinage in a competitive system would have to rely on a scrupulous differentiation of the coin producers. It would not be sufficient that each minter print on his coin something like “this coin contains five grams of fine silver” because, as we have seen, some minters would offer additional services such as the exchange of used for new coins. At the very least, therefore, the name of the minter and any supplementary information needed to identify him would be required. Present-day gold coins such as the Krugerrands, the Eagles, and the Maple Leafs already fulfill this requisite: they feature both a unique name and they state the weight of fine gold contained in the coin.

5. THE ETHICS OF USING MONEY

The Catholic tradition warned in the strictest terms against abuses of money, but it did not deny that, if practiced within the right moral boundaries, the use of money and the paying and taking of interest were natural elements of human society.⁸ Jesus himself, when explaining the rewards given to the faithful in the coming Kingdom of Heaven, used an illustration involving the positive use of money and banking. He stated that the Kingdom of Heaven would parallel the reward given for good stewardship of money, and that hell would wait for those who made no use of money at all. Two stewards who used the money entrusted to them in trade and made a 100 percent profit, found the praise of the master and were invited to share in his joy. But one steward who buried the money given to him in the ground was severely chided as “wicked” and “lazy.” The master pointed out that he could have turned the money into some profit by simply putting it in a bank: “Should you not then have put my money in the bank so that I could have got it back with interest on my return?” He therefore commanded his other servants to take the money away from this servant and to throw him out of the house: “And throw this useless servant into the darkness outside, where there will be wailing and grinding of teeth” (Matthew 25: 26–30).

Thus the use of money and banking may very well be considered legitimate from a Christian point of view. In any case, in the present work we are primarily interested in the economics and ethics of producing money rather than of using money in credit transactions.⁹ We can therefore avoid discussing one of the most vexatious problems of Catholic social doctrine, namely, the problem of usury. In very rough terms, usury is excessively high interest on money lent. This raises of course the question how one can distinguish legitimate from illegitimate “excessive” interest. Theologians have pretty much exhausted the range of possible answers. Some medieval theologians went so far as to claim that any interest was usury. Others such as Conrad Summenhardt held that virtually no interest payment that the market participants voluntarily agreed upon could be considered usury.

The teaching office of the Catholic Church has repudiated the former opinion without taking a position on the latter. It rejects “usury” but allows the taking of “interest” on several grounds that are independent of (extrinsic to) the usury problem.¹⁰ It does not endorse on a priori grounds just any credit bargain made on the free market. It affirms that taking and paying interest is not per se morally wrong, but at the same time retains the authority to condemn some interest payments as usurious. This concerns especially the case of consumer credit, because taking interest might here be in violation of charity. Similarly, while interest on business loans is per se legitimate, some business loans might be illegitimate because of particular circumstances. Below we will follow Bernard Dempsey in arguing that interest payments deriving from fractional-reserve banking are tantamount to “institutional usury.”¹¹

4
Utilitarian Considerations on the Production of Money

1. THE SUFFICIENCY OF NATURAL MONEY PRODUCTION

So far we have described how a commodity money system would work in a free market and how this system appears from an ethical point of view. We have also argued that our present paper currencies and electronic currencies could not survive in a truly free market against the competition of commodity monies. They continue to be used because they enjoy the privilege of special legal protection against their natural competitors, gold and silver. At no time in history has paper money been produced in a competitive market setting. Whenever and wherever it came into being, it existed only because the courts and the police suppressed the natural alternatives.

In other words, to have a paper money means to allow the government to significantly curtail the personal liberties of its citizens. It means to curtail the freedom of association and the freedom of contract in a way that affects the citizens on a daily basis and on a massive scale. It means send in the police and to use the courts to combat human cooperation involving “natural monies” such as gold and silver, monies in use since biblical times.

These circumstances weigh heavily against paper money. Using the armed forces of the state to put an entire nation before the stark choice of either using the government’s money, or renouncing the benefits of monetary exchanges altogether—this is certainly not a light matter, but one that requires a compelling and unassailable rationale. To make a moral case for paper money or electronic money, one has to demonstrate that they convey significant advantages for the community of their users (the “nation”), advantages that might compensate for their severe moral shortcomings. The question, then, is whether such advantages exist. Can paper money and electronic money be justified on utilitarian grounds? To this question we now turn.

It is a significant fact that, before the time when paper money first came into being, no philosopher of money ever criticized the then-existing commodity monies on utilitarian grounds. It is true that Plato proposed to outlaw private ownership of natural monies—gold and silver—on political grounds, namely, to ensure that each individual was economically dependent on government.¹ But even Plato did not claim that gold and silver were somehow inadequate as monies, or that monies imposed by the government could render greater monetary services. And neither do we find any such thought in Aristotle or in the writings of the Church fathers and the scholastics. Quite to the contrary! Bishop Nicholas Oresme argued that the money supply was irrelevant for monetary exchanges per se. Changes of the nominal money supply—the “alteration of names”—did not make money more suitable to be used in indirect exchanges, nor less; such changes merely affected the terms of deferred payments (credit contracts), which was also why Oresme opposed them.²

Thus before the sixteenth century there was apparently no problem of hoarding, or of sticky prices, and apparently no need to stabilize the price level, the purchasing power, or aggregate demand. But the champions of paper money are far from seeing any significance in this fact. Gold and silver, they argue, were sufficient for the primitive economies prevailing until the High Middle Ages. But the capitalist economies that emerged in the Renaissance required a different type of money. And the new theories explaining this need arose along with the new paper currencies. So what do we make of these new theories? We have to examine them one by one, even though in the present work we can only address the major ones, trusting that the reader will rely for everything else on other works.

But before we explain the fallacies involved in the most widespread justifications of paper money, let us point out that post-1500 monetary writings not only swamped the world with such justifications, but also provided the rejoinders. We have already mentioned that Oresme argued that the money supply was irrelevant, in the sense that the services derived from monetary exchange did not depend on the quantity of money used. The intellectuals of the Renaissance and of the mercantilist period could never quite get around this fundamental insight. Even those who otherwise justified various inflationist schemes had to acknowledge it.³ Then the classical economists stated very clearly that, in principle, any quantity of money would do; even though they qualified this proposition in the light of various false doctrines they had inherited from their mercantilist predecessors.⁴ The first economist who had a clear scientific grasp of the issue was John Wheatley, the brilliant critic of the monetary thought of Hume, Steuart, and Smith.⁵ But Wheatley never presented a systematic doctrine in print. In the twentieth century, Ludwig von Mises and Murray Rothbard filled this gap. The practical offshoot of their monetary analysis is that no social benefits can be derived from government control over the money supply. In Rothbard’s words:

We conclude, therefore, that determining the supply of money, like all other goods, is best left to the free market. Aside from the general moral and economic advantages of freedom over coercion, no dictated quantity of money will do the work better, and the free market will set the production of gold in accordance with its relative ability to satisfy the needs of consumers, as compared with all other productive goods.⁶

Again, as we have pointed out, this is anything but a novelty in the history of thought. Oresme clearly saw that increases of the nominal money supply would enrich the princes at the expense of the community. But except for very rare and exceptional emergency situations, this was not the price to be paid for some benefit that could not otherwise be obtained. Nominal increases of the money supply were unnecessary from the point of view of the entire commonwealth. The nominal alteration of the coinage, said Oresme,

... does not avoid scandal, but begets it... and it has many awkward consequences, some of which have already been mentioned, while others will appear later, nor is there any necessity or convenience in doing it, nor can it advantage the commonwealth.⁷

The truth is often deceptively simple. It is the errors that are manifold and complicated. So it is at any rate in the case of money. The simple truth is that there is no need for political intervention to impose monies different from the ones that the market participants would have chosen anyway. But many doctrines have been concocted to justify precisely such intervention.⁸ It is not necessary for us to refute all of them in the present work. In what follows we will discuss only the seven most widespread errors.

2. ECONOMIC GROWTH AND THE MONEY SUPPLY

The most widespread monetary fallacy is probably the naïve belief that economic growth is possible only to the extent that it is accompanied by a corresponding growth of the money supply.⁹ Suppose the economy growths at an annual rate of 5 percent. Then according to that fallacy it is necessary to increase the money supply also by 5 percent because otherwise the additional goods and services could not be sold. The champions of this fallacy then point out that such growth rates of the money supply are rather exceptional for precious metals. Gold and silver are therefore unsuitable to serve as the money of a dynamic modern economy. We better replace them with paper money, which can be flexibly increased at extremely low costs to accommodate any growth rates of the economy.

This argument is wrong because any quantity of goods and services can be exchanged with virtually any money supply. Suppose the money supply in our example does not change. If 5 percent more goods and services are offered on the market, then all that happens is that the money prices of these goods and services will decrease. The same mechanism would allow economic growth even when the quantity of money shrinks. Any rate of growth can therefore be accommodated by virtually any supply of natural monies such as gold and silver.

The qualification “virtually” takes account of the fact that there are certain technological limitations on the use of the precious metals. Suppose there are high growth rates over an extended period of time. In this case, it might be necessary to reduce coin sizes to such an extent that producing and using these coins becomes unpractical. This problem is very real in the case of gold. It has never existed in the case of silver—which is also why many informed writers consider silver to be the money par excellence. In any case, such technological problems pose no problem. As Bishop Oresme explained more than 700 years ago, the thing to do in such cases is simply to abandon the use of the unpractical coins, say gold coins, and switch to another precious metal, say silver.¹⁰ And, we may add, on the free market there are strong incentives to bring about such switching promptly and efficiently. No political intervention is necessary to support this process.

A more sophisticated variant of the growth-requires-more-money doctrine grants that any quantities of goods and services could be traded at virtually any money supply. But these advocates argue that, if entrepreneurs are forced to sell their products at lower prices, these prices might be too low in comparison to cost expenditure. Selling product inventories at bargain prices entails bankruptcy for the entrepreneurs.

But this variant is equally untenable, because it is premised on a mechanistic image of entrepreneurship. Fact is that entrepreneurs can anticipate any future reductions of the selling prices of their products. In the light of such anticipations they can cut offering prices on their own cost expenditure and thus thrive in times of declining prices. This is not a mere theoretical possibility but the normal state of affairs in periods of a stable or falling price level. For example, in the last three decades of the nineteenth century, both Germany and the U.S. experienced high growth rates at stable and declining consumer-price levels.¹¹ The same thing is observed more recently in the market for computers and information technology, the most vibrant market since the 1980s, which has combined rapid growth with constantly falling product prices.

3. HOARDING

The foregoing considerations also apply to the phenomenon of hoarding. It is impossible to use money without holding a certain amount of it; thus every participant in a monetary economy hoards money. The reason why the pejorative term “hoarding” is sometimes used in lieu of the more neutral “holding” is that, in the mind of the commentator, the amounts of money held by this or that person are excessive. The crucial question is of course: by which standard?

It is possible to give a meaningful definition of hoarding in moral terms. Some people have a neurotic propensity to keep their wealth in cash. They are misers who hoard their money even when spending it would be in their personal interest. They neglect clothing, housing, education, charity, and so on; and thus they deprive themselves of their full human potential, and in turn deprive others of the benefits that come from social bonds with a developed human being. Notice that this definition of hoarding as pathological behavior does not refer to absolute amounts of money held. Rather it concerns the amounts of money held relative to alternative ways of investing one’s wealth. There are indeed many situations in which it is advisable—both for an individual person and for groups—to hold large sums of cash. For centuries, holding large numbers of gold and silver coins was an important way for people to save their own private pension funds, and in many times and places it was the only way to provide for old age and emergency situations. Similarly, in times of stock market and real-estate booms, it is generally prudent to keep a large amount of one’s wealth in cash. It is true that there are other situations in which even very small sums of money held might be excessive. The point is that the question whether one’s cash balances are just “money held” or whether they are pathological “money hoards” must be determined for each individual case.

The right way to deal with excessive money hoarding is to talk to the persons in question and persuade them to change their behavior. What if these persons remain stubborn? Is it then advisable to apply political means such as expropriation or an artificial increase of the money supply? The answer to these questions is in the negative. Hoarding per se might be pathological, but it does not deprive other people of what is rightfully theirs. And in particular it does not prevent the efficient operation of the economy.

As we have stated above, the absolute money supply of an economy is virtually irrelevant. The economy can work, and work well, with virtually any quantity of money. Hoarding merely entails a reduction of money prices; hoarding on a mass scale merely entails a large reduction of money prices. Consider the (completely unrealistic) scenario of a nation hoarding so much silver that the remaining silver would have to be coined in microscopically small quantities to be used in the exchanges.¹² In a free society, the market participants would then simply switch to other monies. Rather than paying with silver coins they would start using gold coins and copper coins.

Now suppose that, despite the foregoing considerations, a government bent on fighting money hoards would set out to artificially increase the money supply anyway. Would this policy reach its goal? Not necessarily. There is at least an equal likelihood that the policy would actually promote hoarding. The increased money supply would raise the money prices being paid on the market above the level they would otherwise have reached. And this makes it necessary for people to hold larger cash balances. Now it is true that the increase in individual cash balances is not necessarily in strict proportion to the increase of the price level. Thus it is possible that people will, relatively speaking, reduce their demand for money as a consequence of the policy. But it is just as likely that the policy will have no such effect, or that it actually produces the opposite effect.

Thus we conclude that hoarding cannot serve as a pretext for the artificial extension of the money supply. In some extreme cases it might merit the attention of spiritual leaders and psychologists. But it is never a monetary problem.

4. FIGHTING DEFLATION

Still another variant of the same basic fallacy that we just discussed is the alleged need to fight deflation.

The word “deflation” can be defined in various ways. According to the most widely accepted definition today, deflation is a sustained decrease of the price level. Older authors have often used the expression “deflation” to denote a decreasing money supply, and some contemporary authors use it to characterize a decrease of the inflation rate. All of these definitions are acceptable, depending on the purpose of the analysis. None of them, however, lends itself to justifying an artificial increase of the money supply.

The harmful character of deflation is today one of the sacred dogmas of monetary policy.¹³ The champions of the fight against deflation usually present six arguments to make their case.¹⁴ One, in their eyes it is a matter of historical experience that deflation has negative repercussions on aggregate production and, therefore, on the standard of living. To explain this presumed historical record, they hold, two, that deflation incites the market participants to postpone buying because they speculate on ever lower prices. Furthermore, they consider, three, that a declining price level makes it more difficult to service debts contracted at a higher price level in the past. These difficulties threaten to entail, four, a crisis within the banking industry and thus a dramatic curtailment of credit. Five, they claim that deflation in conjunction with “sticky prices” results in unemployment. And finally, six, they consider that deflation might reduce nominal interest rates to such an extent that a monetary policy of “cheap money,” to stimulate employment and production, would no longer be possible, because the interest rate cannot be decreased below zero.

However, theoretical and empirical evidence substantiating these claims is either weak or lacking altogether.¹⁵

First, in historical fact, deflation has had no clear negative impact on aggregate production. Long-term decreases of the price level did not systematically correlate with lower growth rates than those that prevailed in comparable periods and/or countries with increasing price levels. Even if we focus on deflationary shocks emanating from the financial system, empirical evidence does not seem to warrant the general claim that deflation impairs long-run growth.¹⁶

Second, it is true that unexpectedly strong deflation can incite people to postpone purchase decisions. However, this does not by any sort of necessity slow down aggregate production. Notice that, in the presence of deflationary tendencies, purchase decisions in general, and consumption in particular, does not come to a halt. For one thing, human beings act under the “constraint of the stomach.” Even the most neurotic misers, who cherish saving a penny above anything else, must make a minimum of purchases just to survive the next day. And all others—that is, the great majority of the population—will by and large buy just as many consumers’ goods as they would have bought in a nondeflationary environment. Even though they expect prices to decline ever further, they will buy goods and services at some point because they prefer enjoying these goods and services sooner rather than later (economists call this “time preference”). In actual fact, then, consumption will slow down only marginally in a deflationary environment. And this marginal reduction of consumer spending, far from impairing aggregate production, will rather tend to increase it. The simple fact is that all resources that are not used for consumption are saved; that is, they are available for investment and thus help to extend production in those areas that previously were not profitable enough to warrant investment.

Third, it is correct that deflation—especially unanticipated deflation—makes it more difficult to service debts contracted at a higher price level in the past. In the case of a massive deflation shock, widespread bankruptcy might result. Such consequences are certainly deplorable from the standpoint of the individual entrepreneurs and capitalists who own the firms, factories, and other productive assets when the deflationary shock hits. However, from the aggregate (social) point of view, it does not matter who controls the existing resources. What matters from this overall point of view is that resources remain intact and be used. Now the important point is that deflation does not destroy these resources physically. It merely diminishes their monetary value, which is why their present owners go bankrupt. Thus deflation by and large boils down to a redistribution of productive assets from old owners to new owners. The net impact on production is likely to be zero.¹⁷

Fourth, it is true that deflation more or less directly threatens the banking industry, because deflation makes it more difficult for bank customers to repay their debts and because widespread business failures are likely to have a direct negative impact on the liquidity of banks. However, for the same reasons that we just discussed, while this might be devastating for some banks, it is not so for society as a whole. The crucial point is that bank credit does not create resources; it channels existing resources into other businesses than those which would have used them if these credits had not existed. It follows that a curtailment of bank credit does not destroy any resources; it simply entails a different employment of human beings and of the available land, factories, streets, and so on.

In the light of the preceding considerations it appears that the problems entailed by deflation are much less formidable than they are in the opinion of present-day monetary authorities. Deflation certainly has much disruptive potential. However, as will become even more obvious in the following chapters, it mainly threatens institutions that are responsible for inflationary increases of the money supply. It reduces the wealth of fractional-reserve banks, and their customers—debt-ridden governments, entrepreneurs, and consumers. But as we have argued, such destruction liberates the underlying physical resources for new employment. The destruction entailed by deflation is therefore often “creative destruction” in the Schumpeterian sense.¹⁸

Finally, we still need to deal with the aforementioned fifth argument—deflation in conjunction with sticky prices results in unemployment—and with the sixth argument—deflation makes a policy of cheap money impossible. Because these arguments are of a more general nature, we will deal with them separately in the next two sections.

5. STICKY PRICES

In the past eighty years, the sticky-prices argument has played an important role in monetary debates. According to this argument, the manipulation of the money supply might be a suitable instrument to re-establish a lost equilibrium on certain markets, most notably on the labor market. Suppose that powerful labor unions push up nominal wage rates in all industries to such an extent that entrepreneurs can no longer profitably employ a great part of the workforce at these wages. The result is mass unemployment. But if it were possible to substantially increase the money supply, then the selling prices of the entrepreneurs might rise enough to allow for the re-integration of the unemployed workers into the division of labor. Now, the argument goes, under a gold or silver standard, this kind of policy is impossible for purely technical reasons because the money supply is inflexible. Only a paper money provides the technical wherewithal to implement pro-employment policies. Thus we have here a prima facie justification for suppressing the natural commodity monies and supporting a paper money standard.

This argument grew into prominence during the 1920s in Austria, Germany, the United Kingdom, and other countries. After World War II, it became something like a dogma of economic policy. But this does not alter the fact that it is sheer fallacy, and it is not even difficult to see the root of the fallacy. The argument is in fact premised on the notion that monetary-policy makers can constantly outsmart the labor unions. The managers of the printing press can again and again surprise the labor-union leaders through another round of expansionist monetary policy. Clearly, this is a silly assumption and in retrospect it is very astonishing that responsible men could ever have taken it seriously. The labor unions were not fooled. Faced with the reality of expansionist monetary policy, they eventually increased their wage demands to compensate for the declining purchasing power of money. The result was stagflation—high unemployment plus inflation—a phenomenon that in the past thirty years has come to plague countries with strong labor unions such as France and Germany.

6. THE ECONOMICS OF CHEAP MONEY

Another widespread fallacy is the idea that paper money could help to decrease the interest rate, thus promoting economic growth. If new paper tickets are printed and then first offered on the credit market, so the argument goes, the supply of credit is increased and as a consequence the price of credit—interest—declines. Cheap money is now available for businessmen all over the country. They will invest more than they otherwise would have invested, and therefore economic growth will be enhanced.

There are actually a good number of different fallacies involved in this argument, and it is impossible for us to deal with all of them here.¹⁹ Suffice it to say that capitalists invest their funds only if they can expect to earn a return on investment—interest—and that they do not seek merely nominal rates of return, but real returns. If they expect the “purchasing power” of the money unit (PPM) to decline in the future, they will make investments only in exchange for a higher nominal rate of return. Thus suppose Mrs. Myers plans to lend the sum of 100 oz. of silver for one year to a businessman in her neighborhood, but only in exchange for a future payment of 103 oz. Suppose further that she expects silver to lose some 5 percent of its purchasing power within the following year. Then Mrs. Myers will ask for another 5 oz. (making the total future payment 108 oz.), so as to compensate her for the loss of purchasing power.

Now the question is whether (1) printing new money tickets will in fact decrease the real interest rate and (2) whether, if it does decrease the real interest rate, this will be an economic boon.

To answer the first question, we have to bring anticipations back into the picture. If the capitalists realize that new paper notes are being printed, they can expect a decline of the PPM and thus they will ask for a higher price premium. If the price premium is an exact compensation for the decline of the PPM, the real interest will be unaffected. In this case, the artificial increase of the money supply would entail merely a different distribution of capital among businessmen, and thus a different array of consumer goods being produced. Some businessmen and their customers will win, whereas other businessmen and their customers will lose. But there will be no overall improvement.

Now suppose that the capitalists overestimate the future decline of the PPM. In this case, the real interest rate would actually increase and many businessmen would be deprived of credit they could otherwise have obtained. Again, the consequence would be a different distribution of capital among businessmen, and thus a different array of consumer goods being produced. But there would be no overall improvement or deterioration.

Yet it is also possible that the capitalists underestimate the future decline of the PPM. This might be the case, in particular, when they are unaware of the fact that more paper notes are being printed. It is this scenario that the advocates of cheap money commonly have in mind. But the hope that tricking capitalists into accepting lower real interest rates entails more economic growth is entirely unfounded. It is true that in the case under consideration the real interest rate would decline under the impact of new paper money being offered on the credit market. It is also true that this event is likely to incite businessmen to borrow more money and to start more investment projects than they otherwise would have started. Yet it would be a grave error to infer that this is tantamount to enhanced economic growth. The case is exactly the reverse.

At any point of time, the available supplies of factors of production put a limit on the number of investment projects that can be successfully completed. What the artificial decrease of the real interest rate does is to increase the number of projects that are launched. But the total volume of investments that can be completed has not thereby increased, because this volume depends exclusively on the productive resources that are objectively available during the time needed for completion. The artificial decrease of the interest rate therefore lures the business community into all kinds of investments that cannot be completed. In terms of a biblical example, they could be said to start building all kinds of towers, only to discover after a while that they just had the resources to build the foundations, but not to finish the towers themselves (Luke 14:28–30). The labor and capital invested in the foundations are then lost, not only for the investor, but for the entire commonwealth. They could have been fruitfully invested in a smaller number of projects, but the artificial decrease of the interest rate prevented this. In short, economic growth is diminished below the level it could otherwise have reached.

To sum up, it is by no means sure that politically induced increases of the money supply will lead to a decrease of the interest rate below the level it would have reached in a free economy. The success of cheap-money policy is especially unlikely when the policy is not adopted on an ad-hoc basis, but turned into a guiding principle of economic policy. But the fundamental objection to this policy is that it is counterproductive even if it succeeds in decreasing the interest rate. The consequence would be more waste and thus less growth.

7. MONETARY STABILITY

The second-most widespread monetary fallacy relates to the problem of monetary stability. The conviction that money should be an anchor of stability in the economic world is very old. But to understand this postulate in a proper way, it is necessary to distinguish two very different meanings of “monetary stability.”

The first meaning stresses the stability of the physical integrity of commodity money (in particular, the physical composition of coins made out of precious metals) through time. In this sense, monetary stability does have a precise meaning. From a purely formal point of view, it can therefore be a possible postulate of ethical monetary policy. It is a postulate relating to the production of money. No producer shall make coins bearing the same imprint but containing different quantities of precious metal. Monetary stability in this sense is not only unobjectionable, but truly a presupposition of a well-functioning economy. And it is this sense of monetary stability that was stressed in the Bible and in authoritative texts of the Middle Ages.²⁰

Notice that monetary stability in the sense of a stable physical integrity of commodity money results in a relatively stable “purchasing power” of the money unit (PPM). When mining is less profitable than other branches of industry—which tends to be the case when the price level is high—then less money will be produced and money prices will tend to decline. And when mining is more profitable—usually when the price level is low—then more money will be produced and money prices will therefore tend to rise. All of this is of no importance whatever for the benefits that can be derived from monetary exchanges. It is true that a great decrease of the PPM is conceivable when extremely rich and cost-efficient new mines are discovered. But notice two things. First, in a free economy, the market participants can very easily protect themselves against any unwanted eradication of the PPM by simply adopting other monies. Second, as a matter of fact, no such violent depreciations of the PPM have ever occurred in the case of precious metals. The famous “gold and silver inflation” of the sixteenth and seventeenth century increased Europe’s money stock according to certain estimates by not more than 50 percent²¹; according to others by up to 500 percent.²² However, this happened over a period of some 150 years. Thus the average growth rate of the money supply lay somewhere between 0.3 and 3.3 percent per annum. By contrast, in our days of paper money, even the countries enjoying a “conservative” monetary policy experience far greater increases of the money supply. For example, in the U.S. and in the European Union, the stock of “base money” (paper notes plus accounts held at the central banks) has been increased by annual rates of between 5 and 10 percent during the past five years.

Now let us turn to the second meaning of monetary stability. It connotes the stability of the purchasing power of the money unit (the PPM). The first thinker to formulate the postulate of a stable PPM was Saint Thomas Aquinas in the thirteenth century. He argued:

The particular virtue of currency must be that when a man presents it he immediately receives what he needs. However, it is true that currency also suffers the same as other things, viz., that it does not always obtain for a man what he wants because it cannot always be equal or of the same value. Nevertheless it ought to be so established that it retains the same value more permanently than other things.²³

Notice that Saint Thomas realized perfectly well that a stable PPM was not a natural outcome of the market process. It was in his eyes an ethical postulate. However, no major writer before him believed that a stable PPM was a meaningful policy objective. Aristotle had observed that the prices of all things are in a continuous flux, and that money was no exception.²⁴ And that was it. Even after Aquinas, most scholastics sided on this issue with the Greek philosopher rather than with Saint Thomas. To the extent that late scholastics such as Martín de Azpilcueta, Tomás de Mercado, Pedro de Valencia, and others stressed a postulate of monetary stability at all, they meant the stable physical composition of coins.²⁵ Only starting from the seventeenth century, did secular writers from John Locke to David Ricardo to Irving Fisher come to endorse the postulate of a stable PPM. Today, this postulate lies at the heart of most contemporary writings on the problem of monetary stability. It is also a widely accepted definition among contemporary Catholic writers on monetary affairs.²⁶ However, despite its popularity it is fraught with ambiguities and is liable to lead to wrong policy conclusions.

It is a matter of course that a stable PPM is “a major consideration in the orderly development of the entire economic system.”²⁷ The question is merely how to balance this consideration with other considerations of a moral and economic nature. On the free market, as we have seen, there is a tendency for the selection of the best monies, including in terms of PPM stability. As long as the citizens are free to choose their money, they can avoid exposure to any violent fluctuations of the PPM by simply switching to other monies. The question, then, is whether the stabilization of the purchasing power of money is such an overriding goal that it would justify the establishment of government control over the money supply, in order to “fine-tune” the purchasing power to an extent that would not spontaneously result from the market process. The ideal of such fine tuning inspired a great intellectual movement in the early twentieth century. Under the leadership of the American economist Irving Fisher and others, this movement paved the way for the complete triumph of paper money.²⁸

In practice, the Fisherian stabilization movement was an abject failure. Throughout the entire twentieth century, in all countries, the purchasing power of money managed by public authorities declined and oscillated as never before in the entire history of monetary institutions. However, despite this rather devastating empirical record, one could hold that, in theory at least, the case for monetary stabilization is still valid and that it simply needs to be applied much better than in the past. In order to assess this contention it is necessary to examine whether, in principle at least, one can fine-tune the PPM, and whether such fine-tuning could possibly be warranted in the first place. To these questions we now turn.

First of all notice that the notion of “purchasing power of money” (PPM) cannot be given an impartial definition. The PPM is in fact the total array of things for which a unit of money can be exchanged. If the price of telephones increases while the price of cars drops, it is impossible to say by any impartial standard whether the PPM has increased or decreased. One can of course make up some algorithm that “weighs” the prices of cars and telephones and so on, and brings them under a common mathematical expression or index. But such indices are not some sort of constant measuring stick of economic value. For one thing, the constituents of the price index are in need of incessant adaptation (they need to be changed) to take account of the changes in the array of goods and services offered on the market in exchange for money. Moreover, and most importantly, no such index conveys generally valid information. Different persons buy different goods; therefore, some of them might experience a rise of prices (of the prices they have to pay) while others experience a drop of (their) prices in the very same period. The quantitative statement of the index reflects just an average of very different concrete situations. But it is concrete circumstances, not some average, that count for human decision-making.

We cannot do more here than scratch the surface of these technical problems.²⁹ Our point is that, from a purely formal point of view, monetary stability in the sense of a stable PPM cannot be easily translated into a clear-cut political postulate. The very concept of PPM is fraught with ambiguities that can only be overcome by more or less arbitrary decisions of those charged to apply it. The political implications are momentous. The PPM criterion gives great and arbitrary powers to those charged with making up the algorithm.

Now let us assume for the sake of argument that these very considerable problems did not exist. Let us assume that monetary stability in the sense of a stable PPM could in fact be unequivocally defined. Then the question is: Would it be expedient to postulate a stable PPM? As we have said, this question is answered affirmatively by a great number of contemporary writers on monetary economics. The basic rationale is that one of the chief functions of money is to serve as a standard of value. Businessmen and others use money prices in their economic calculations, and to make these calculations as accurate as possible it is necessary to have a stable standard of value.

When is money a stable standard of value? Here we encounter a certain variety of opinions. For example, according to Locke and others, this was the case if the national money supply did not change. According to David Ricardo and others, it was the case if the money unit preserved its purchasing power. According to Hayek and others, it was the case if the total amount of money spending did not change.³⁰ But it does not matter much which of the above definitions we adopt. The basic rationale for a stable standard of value is a spurious one in all cases.³¹

The nature of business calculation is not to measure the absolute “value” of a firm’s assets, but to compare alternative courses of action. Suppose Jones has a capital of 1,000 ounces of gold and that he can use them to either set up a shoe factory or establish a bakery. He expects the shoe factory to yield 1,100 ounces or 10 percent gross return, and the bakery to yield 1,200 ounces or 20 percent gross return. This comparison is the essence of business calculation. Stability of the PPM does not at all come into play. Jones can calculate with equal success under a stable, a growing, or a declining PPM.³² His calculus can be exact when the national money supply increases, decreases, or remains frozen. And it can be exact irrespective of whether the total amount of money spending changes or remains the same as before.

In the light of these considerations, it appears that older writers such as Oresme were right all along to neglect the stable PPM criterion, and to keep their attention focused on monetary stability in the sense of the physical integrity of coinage.

8. THE COSTS OF COMMODITY MONEY

One great disadvantage of natural monies such as gold and silver seems to be their relatively high cost of production. According to a widespread opinion that became popular through the writings of classical economists Adam Smith and David Ricardo, paper money could do the monetary job just as well, and at much lower production costs.

It is true that producing a 1-ounce silver coin, which we might call “one dollar,” entails much higher costs than producing a banknote that bears the same name. But it does not follow that this is necessarily a disadvantage. The natural costs that go in hand with producing gold and silver are in fact a supreme reason why these metals are better monies than paper. The fact that they are costly means that they cannot be multiplied at will; and this in turn means that commodity monies such as gold and silver feature a built-in natural insurance against an excessively depreciating purchasing power of money.³³ In this crucial respect they are far superior to paper-money notes, which can be multiplied ad libitum and which, as universal experience shows, have been multiplied and are currently being multiplied in far greater proportions than gold and silver ever have.

Hence, the comparison between commodity monies and paper money should not be cast in too narrow terms. Relevant benefits do not just consist in some arbitrarily narrow “exchange service,” as we have just argued, but include things like guarantees against inflation. And the relevant costs are not just the cost of fabricating the different monetary objects, but total costs entailed by each system. Even the most ardent advocates of paper money have conceded that our current monetary regime is hardly a bargain. For example, consider that central banks and other monetary authorities have built up huge bureaucracies, and that the Fed-watching industry (people employed to interpret and forecast the policy of the monetary authorities) is similarly important.³⁴ These two items alone add up to a significant payroll next to which the expenses for mining and minting look much less “costly” than the Ricardians portray. And notice the irony that mining and minting are still with us in the age of paper money!

There is of course nothing wrong with experimenting with cheaper alternatives to gold and silver coins. Nothing would preclude such experiments in a free society. All we can say is that in the past all such experiments have lamentably failed. And the advocates of paper money therefore hardly ever seriously considered establishing their pet scheme on a competitive basis. Ricardo and his followers advocate the coercive replacement of a more costly good by a cheaper one. Clearly, in all other spheres of life, we would reject any such proposal as extravagant and outrageous. We do not coerce all members of society into driving only the cheapest cars because they satisfy some arbitrarily conceived “transportation needs” at lowest cost. We do not impose rags and hovels on people who prefer clothes and houses. Neither is there a reason to impose paper money on those who prefer the monies of the ages.

Thus another standard justification for paper money does not hold water. And the same demonstration can be delivered for all other economic theories that purport to explain why it should be beneficial to suppress the natural commodity monies and to replace them with a political makeshift such as paper money. We could go into much length delivering these demonstrations. The point of the foregoing pages was to exemplify the general thesis that there is no utilitarian rationale for the institution of paper money, the money of our times. This thesis will serve as the starting point for the following discussion of the various abuses that can be made, and which unfortunately have been made, in the realm of the production of money.