I thought I should address a couple of points that I consider to be misconceptions and that frequently come up in discussions with the audience or other speakers when I present my views on the fundamental problems with fiat money. I am not always in a position to correct these misconceptions right then. They are often woven into questions on other points and I have to leave them uncommented as not to disrupt the flow of the debate. My book is, I believe, quite clear on these points, so I could simply refer people to Paper Money Collapse. But, for whatever reason, it is still the case that many in my audience make inferences from similar arguments to my arguments, and I fear that some of the differences between these positions might get overlooked. These differences are not unimportant, and I think it is worthwhile to highlight and clarify them.
The first point is related to the question what gives money its value? The second point is, is fractional-reserve banking fraudulent and should it be banned on the basis of property rights?
Let’s first restate the central premise of Paper Money Collapse. The main message is that today’s mainstream views on money are flawed. The most important difference between commodity money, such as a proper gold standard, and ‘paper money’, such as our present fiat money system, is the elasticity of the money supply. In the former, money is essentially inelastic, in the latter it is perfectly elastic. The present consensus holds that elasticity is a big advantage. It makes fiat money, if managed properly, superior as it allows monetary authorities to stabilize the economy. This position provides the intellectual foundation for our present fiat money arrangements. My argument is that this is false, and that the opposite is true, and that this was already understood and explained some time ago by eminent economists: the elasticity of the money supply in a fiat money system, and the constant expansion of the money supply under present arrangements in particular, systematically distorts relative prices, disorients economic actors and destabilizes the economy over time. Imbalances accumulate, which obstruct further growth and which will be countered with accelerated money injections, destabilizing the economy further. Elastic money is unnecessary, suboptimal, unstable, and ultimately unsustainable.
It is clear that my analysis rehabilitates the gold standard. It was not only unnecessary to abandon the gold standard it was a major mistake. It is also immediately clear that I consider fractional-reserve banking an inherently destabilizing force in the economy. Even when money was essentially gold and the supply of money proper inelastic, fractional-reserve banks managed to circulate fiduciary media, that is, claims on gold that are supposed to be redeemable in gold but are not fully backed by gold. To the extent that the public used these fiduciary media the same way it used money proper (gold), the supply of what was used as money in the economy expanded and an element of elasticity was introduced into the overall money supply, even under a gold standard. Fractional-reserve banking makes money elastic, expands the money supply -within limits, so therefore only to a degree – and causes economic dislocations. Most mainstream economists today do not even consider these distortions as they work under the entirely untenable assumption that constant money injections are harmless as long as inflation stays within tolerable ranges.
Now let me address the misconceptions on these two points that often appear to enter the debate. Some critics of fiat money and advocates of the gold standard express the following sentiments, which I consider to be unfounded and which are very different from my position: “How could we even have come to accept pieces of paper that are not backed by anything of value as money? Money has always been backed by tangible assets and it should again be backed by something tangible. Gold and silver have intrinsic value but paper money has an intrinsic value of zero. The public gets fooled into accepting these pieces of paper as money. If it realized how money was created and that it was not backed by anything, the public would dump it. Only gold (or silver) can ever be money.”
Those views are not always expressed this bluntly but a trace of them is often apparent in discussions about the failure of paper money, and because they point in the same direction as my arguments – toward the abolishment of state fiat money and a return to hard money, most probably gold – they are still not my views. In fact, I consider them to be wrong. They include fundamental misconceptions about money.
Who or what bestows value on money?
Do the paper tickets in your wallet have value? Of course, they do. They are valuable.
Why are they valuable? For one reason and one reason only: Because others in society accept these paper tickets as a medium of exchange. They accept them in exchange for goods and services in the knowledge that they can trade them again for goods and services from others.
This social convention – and only this social convention – makes these paper tickets money and thus bestows value on them. That is why paper money is money and that is why you act quite rationally when you hold some of your wealth in the form of these paper tickets (how much of your wealth is a different question) and when you use them as a medium of exchange.
Most money today is not even paper money but immaterial money. It only exists as bits on a computer hard-drive. Do these bits have value? Of course, they do. As long as others in society accept them in exchange for goods and services, as long as others accept them as money, they are money. They have exchange value. They are immaterial and of no use whatsoever, other than as a medium of exchange for as long as people accept them as a medium of exchange, which – on a purely conceptual level – might be forever.
Who bestows value on these paper tickets or bits on the computer hard-drive? The trading public does. And who determines how valuable these forms of money are? The trading public does. And who can remove the value from these paper tickets or this virtual money? The trading public.
Now consider a proper gold standard. All money is gold. Who determines the exchange value of each gold coin? You got it: the trading public does. Gold also has value as an industrial commodity or as an item of jewellery (in contrast to paper tickets and binary digits) but this value – its non-monetary value – only really played a role when gold made the transition from industrial commodity to monetary commodity, when it was first used as money. At that point its previous use-value as a commodity became the reference point for its first ever use as money. Once gold had become widely used as a medium of exchange or as a monetary asset, however, it was the public’s demand for such a monetary asset – the public’s demand for money – that determined gold’s exchange value. From that moment on – and this moment occurred a few thousand years ago – it was demand for gold as a form of money that determined its price, not its residual use as an industrial commodity, which at this point only retained secondary importance.
We conclude that the only thing that makes any substance or non-substance money and that bestows an exchange value on this substance or non-substance is the use of it as a medium of exchange, a facilitator of trade, by the trading public. Once something has become money – and in order to be money it has to be widely accepted as money – its physical properties, or even the absence of any physical properties, are entirely unimportant. They are, for lack of a better word, ‘immaterial’. Money only has exchange-value and no direct use-value. For its use as money and for determining its exchange value as money (its purchasing power in trade) it does not matter one bit what other use-value, if any, the monetary asset may have. One paper dollar has the specific exchange value it has today not because of any other use-value it has – because it evidently has none other than being a medium of exchange – but simply by its exchange value in trade. The same is true of gold. An ounce of gold has the value it has today because of the specific demand for it as a monetary asset. It would retain its monetary value even if, by some act of magic, it lost overnight all its use-value as an industrial commodity or an item of jewellery. Would this affect gold’s price and lead to a one-off adjustment in the gold price? Probably. But it would not make gold worthless. I am even fairly confident, although nobody can be certain, that the drop in price would be relatively small.
The whole doltishness of Warren Buffett’s tiresome refrain that people are stupid to buy and hold gold as it doesn’t produce anything and, by the way, if you put all gold on one big heap what could you do with it, hehehe, now becomes apparent. The man may be able to read balance sheets and income statements. He evidently does not understand monetary economics. — What good would it do us if we piled all paper money in one big heap? Maybe we could have a nice fire. And all those immaterial money units that the Fed and the banks create on their computers – you cannot even put them into any pile, Mr. Buffett. Yet, all these things have value and it is quite reasonable to hold some of your wealth in the form of these ‘things’.
Mr. Buffett, statist that he is, does not object to you holding any of your wealth in state-issued paper dollars or in immaterial deposit money at Bank of America, in which he – increasingly a supporter of big business, the establishment and the status quo – has a stake. Just you holding gold, that bothers him.
Why gold is coming back
The reason why more and more people begin to prefer holding physical gold rather than paper money or electronic ledger money at shaky banks is not – at least not first and foremost – because of the physical properties of gold versus those of these other monies. The reason is that more and more people expect, correctly in my view, that the trading public, which always is the entity that bestows exchange value on or removes exchange value from any form of money, will bestow ever less value on paper money and electronic money going forward. Why? Because these forms of money are being produced in ever larger quantities for political reasons. Not their physical properties, or lack thereof, are the central problem with paper money and present forms of electronic money but the complete elasticity of their supply in present monetary arrangements. More specifically, the central problem today is that the massive over-issuance of these types of money over recent decades has created substantial imbalances that now cause considerable headaches for the banks and the various governments and that will most certainly result in ever more paper and electronic money being produced to fend off the painful dissolution of these imbalances.
If the central problem with fiat money were its physical characteristics than we would not have to know anything about economics or about the specific process of paper money creation and its impact on the economy in order to pass a negative judgement on this form of money. But I do not think that this is possible. That today’s money consists of otherwise worthless pieces of paper or of immaterial electronic book entries is not the problem. What matters is the process of money creation and the impact on the economy. Once we have understood this process it is clear that the elasticity of the money supply is at the core of the problem and that we have now reached a point at which the further and accelerated production of these forms of money is almost a certainty. And that is why investing in gold makes sense, as gold is the oldest, most widely established form of money – the one with the most universal and longstanding social convention backing it – and as its supply is both inelastic and by its nature fundamentally outside the politicized process of modern fiat money creation.
Sometimes people tell me that they hesitate to buy gold as its value rests merely on others considering it valuable. What if we woke up tomorrow and people no longer considered this metal a monetary asset and thus especially valuable? This is a fair point but it applies logically to any form of money. The value of the paper money in your wallet and the electronic money in your bank account equally rests on the public continuing to accept them as money. Any form of money is only money through the acceptance of the trading public. There is no other potential source that its value could be derived from.
It is important to stress that the government does not and cannot bestow value on its paper money. This seems to be a widespread myth, as evidenced by this quote from, Philip Coggan’s recent book Paper Promises (p. 37):
“If people think that the value of something is equal to the cost of creating it, which in the case of paper and electronic money is virtually zero, then why do we accept it at all? We know there is no longer enough gold or silver to support it. The answer must be that we have faith in the government that stands behind it. The government can raise the taxes necessary to give the currency value.”
This is evidently wrong. The government does not support or back its paper money with anything. It is irredeemable money. You can take your state paper money notes to the state central bank but all you will get in exchange for them is new, freshly printed paper notes with the same numbers printed on them. The paper money in circulation does not constitute a claim on any assets that the government may possess or any reserve that the central bank may hold or any taxes that the government may collect. It is not a claim on the state at all. It is, in fact, a claim on nobody. Therefore, it is not debt. Today’s banknotes are, just like gold, assets that are nobody’s liability (in contrast to the electronic deposit money that is a liability of the specific bank that issued it and that will in fact disappear when the bank disappears). But this means the government does not guarantee money’s purchasing power. If these pieces of paper money retain any purchasing power at all it is because the trading public continues to use them as money.
In the debates on the present Greek crisis one often gets the perception that paper money would collapse if the states went bankrupt. This is completely unfounded. Sovereign default is only a threat to paper money – and a serious threat at that – because states, even when they are defaulting, retain the monopoly of paper money creation and when they are about to go bankrupt they tend to issue ever more money to sustain their spending and to appear solvent. The threat to money’s purchasing power thus comes again from the risk of over-issuance, and is again linked to the elasticity of the money supply, and not the creditworthiness of the state. If the ECB stopped printing euros, many European states would soon run out of money and default, and so would many banks, but that would not diminish the euro’s value as money, as a medium of exchange among the eurozone’s trading public, at least not that of the paper euros in circulation or the electronic euros in surviving banks. If the trading public could be confident that the market would not be swamped with paper euros in order to bail out overstretched eurozone banks and governments, there would be no reason to stop using this currency. Note that in a proper gold standard, the state would merely be a money-user, just like any household or company, and would have to manage its own finances sensibly, and if it didn’t do so, it would default on its obligations, yet nobody would stop using gold as money in response.
So, yes, the public may suddenly, one morning, decide to no longer consider gold money but I would suggest that the risk of the public no longer considering state paper money money is considerably bigger. And again, the reason is not the different physical composition but the fact that paper money is issued by the state for a reason, namely to facilitate the availability of credit beyond the availability of true, voluntary savings, and as this has now led to economic distortions of surreal magnitude, the political owners of the paper money franchise will print ever more of it. Gold is being remonetised by the public – always the ultimate arbiter of what is money and what is money’s purchasing power – because gold not only has a longer history of being money than any of the present paper monies, a history that spans all civilizations and the entire globe, it is also apolitical money, not issued by any central authority and, this is the most important aspect, with its supply essentially inelastic.
You may not wake up tomorrow to a world in which paper money is worthless but you most certainly wake up to a world in which more state paper money circulates but probably not more gold.
Elasticity and materiality
But is the elasticity of the money supply not intimately linked to the physical characteristics of the monetary substance? To say money is paper or a binary digit, is that not the same as to say money’s supply is fully elastic? Not quite, for we can imagine an immaterial form of money with a fixed supply, at least we can imagine such a thing since Satoshi Nakamoto invented Bitcoin. Bitcoin is immaterial — it only exists as virtual money on the internet. But equally it is commodity money because it is based on a cryptographic algorithm, which requires time and considerable computing energy to create Bitcoins and which is designed so that the overall supply of Bitcoin is strictly limited. Bitcoin shares with today’s electronic money that represents items on bank balance sheets the feature of immateriality. But in every other aspect it is much closer to gold: Bitcoin’s supply is strictly limited and inelastic, just as is the case with gold. Bitcoin has no issuing authority that benefits from a money-creation monopoly. Neither has gold. Bitcoin is not linked to any sovereign state. Neither is gold. Bitcoin exists outside the state-sponsored fiat-money-addicted banking sector. So does gold.
Whether Bitcoin can ever compete with gold or potentially even replace it is a hotly debated topic. We do not have to discuss it here. The point was simply to show that the key problem with today’s monetary arrangements is their politically motivated elasticity and that this feature is fundamentally different from money’s materiality.
Fractional-reserve banking and fraud
We can now address the second point that frequently comes up when discussing the unsustainability of present fiat money arrangements and that is the question whether fractional-reserve banking (FRB) is fraudulent and whether it should be banned on grounds of private property violation.
Today pretty much all banks are fractional-reserve banks. They can create money – book-entry money or deposit money – on the basis of limited reserve-money (physical cash in their vaults and deposits held at the central bank). Thus, unlike fund managers, banks not only channel savings into investment, they are also in the business of money creation. Most of the registered money stock in modern economies is simply a book-entry on bank balance sheets.
To analyze the fundamentals of FRB it is best to go back to the early days of deposit-banking when money was still essentially gold because back then the distinction between ‘original’ money (gold) and the ‘derivative’ money created by the banks (banknotes for example) was more apparent. The story goes something like this: When somebody deposited gold with a bank he received a banknote in return and was promised that he could immediately reclaim his deposited gold upon presenting the banknote. Banknotes began to be used as payment in economic transactions and to circulate in the economy as money because it was obviously more convenient to use paper tickets to pay rather than heavy gold coins, and the recipient of the banknote could always reclaim the gold. As long as all banknotes were backed by physical gold the supply of money did not expand. This was still a 100 percent gold standard, and the banknotes were simply a new form of payment technology, a means to transfer ownership in money more conveniently.
This changed when the banks began to lend the deposited gold to third parties or, to make it easier, they kept the gold but issued more banknotes than they had gold in their vaults and lent these banknotes to third parties as part of their lending activities. Of course, they still promised to repay all notes in gold when presented to them. Banknotes that are not fully backed by gold are not money proper but fiduciary media, claims on money that are not fully backed by money. Now there was money proper and fiduciary media circulating in the economy side by side. The overall supply of what was used as a medium of exchange in the economy had expanded. The supply of money was extended through FRB.
Critics of FRB argue that this process involves a property rights violation. The original depositor retains ownership in the deposited gold but the bank issues multiple claims on the same amount of gold, and whoever presents the banknote first, probably even somebody who never deposited gold in the first place but who obtained the banknote as payment in a commercial transaction, has the gold delivered to him. This appears to be a logical and convincing argument but there is one problem with it: FRB has been conducted for about 300 years. Have depositors not realized by now that they are being defrauded? If this is indeed fraud, how can the practice survive for so long?
One response is that most people do not understand how FRB works and that the banks misrepresent it. I do not think this is a valid point. To my knowledge, no bank today pretends that deposited cash is simply locked up in the vault waiting to be collected by the depositor at a later stage. Everybody knows (or should know) that banks lend deposited money to third parties. How else would they obtain the income to pay interest on the deposited money? That banks pay interest on deposits (at least in ‘normal’ times) should already give the game away. Think about it: What would you say if you valet-parked your car and the young man taking the car keys from you would offer to pay you a fee for having control of the car for a few hours? Wouldn’t you be suspicious? Would you really think he would just park the car somewhere safe and he is paying you for the privilege of doing so? –If deposit banking were indeed just about safekeeping then the depositor should pay the bank for its safekeeping services, not the bank the depositor for getting control of the money.
I believe the correct answer is that the depositor knows what is going on but that he does not care about the deposited gold as such. This follows directly from our analysis above. Remember the depositor deposits gold that he considers money. He does not care that this is a tangible asset, that it is shiny and has certain other physical properties. He does not consider this gold to be an industrial commodity or a piece of jewellery. It is money – a medium of exchange. When he deposits it with the bank he receives a banknote that is — equally a medium of exchange. The depositor has not given up anything. As long as the fiduciary medium he now possesses has the same purchasing power as the deposited gold – and this is the precondition for FRB to work – he has not foregone any economic benefit. The gold was a medium of exchange that provided him with limitless spending flexibility. The banknote he now holds in return for the deposited gold is equally a medium of exchange that provides him with limitless spending flexibility. In fact, the assumption of the banker that most depositors may never ask for their gold back is not absurd at all. As long as not too many banknotes get circulated, thus having their purchasing power meaningfully diluted, or as long as the issuing bank does not run into trouble, the banknotes may circulate forever. These are, of course, risks that the depositor shoulders but in compensation he receives interest on his deposited gold – which in fact the early goldsmiths paid as early as the late seventeenth century! – and he has the additional benefit of the convenience of paper tickets. The bottom-line is that the willing and knowing participation of the depositor in the FRB scheme is no riddle at all but may be a fully rational subjective choice.
I believe that the analysis of the anti-FRB economists rests too much on the analogy with other safekeeping contracts. When valet-parking my car, I hand over a valuable consumption good in return for a useless and pretty much valueless piece of paper. The benefit I receive from owning a car and the benefit I receive from holding a little paper ticket (well, there is no real benefit at all in the latter) are hardly comparable. That I may never reclaim my car and be content with holding that piece of paper forever is hardly a realistic assumption. But in the case of FRB it is. Exchanging money proper for fiduciary media means exchanging one medium of exchange for another medium of exchange.
I am not arguing that FRB is fine. All I am saying is that it is entirely conceivable that depositors voluntarily and knowingly participate in it. The problem with FRB is not that the depositors get defrauded but that it introduces an element of elasticity into the money supply. Thereby FRB undermines itself. When the banking sector in aggregate manages to lower reserve ratios and expands the overall money supply via FRB, they inevitably start a credit boom, and we know that this boom will end in a bust. FRB leads to business cycles, as Austrian Business Cycle Theory has explained so well. And it is in the business cycle downturn that the FRB banks run into trouble and that the public begins to distinguish again between fiduciary media, which are bank liabilities, and money proper, which is nobody’s liability. Again, we are back at the point of elasticity, which is the real Achilles heel of our system.
This is already a pretty long blog — so I stop here. I will conclude by saying briefly what I think is the one thing that needs to be done: It is to get the state out of money and banking completely. No central bank, no lender of last resort, no inflation targets, no bank regulation, no deposit insurance, no government backstops. All these modern interventions are supposed to make banking safe but what they really do is make money more elastic as they greatly incentivize banks to lower their reserve ratios and extend the money supply. This makes the economy less stable and banks ultimately less safe. Much less safe. These state interventions are nothing but gigantic state subsidies for FRB. This is what needs to stop. The state should not (and in my view cannot) ban FRB. It should simply cease to subsidize it and to socialize its costs.
In the meantime, the debasement of paper money continues.