There exists a certain amount of confusion today about what money truly is, how it originated and who should produce it (the government or private individuals). For this reason, it is useful to provide a brief summary of the origin or money and the differences between the various types of money. In this manner it will become clear that money should only be produced by the market.
According to Ludwig von Mises [i], money evolved from the practice of indirect exchange. Indirect exchange is where the seller of a particular good sells his good for another good, not for the purposes of consuming that that second good but because it is highly marketable. In other words, now that he has obtained this highly marketable good, he has full confidence that he can now sell it to obtain the consumption goods he ultimately desires. This highly marketable good is the common medium of exchange and is generally known as money. There are secondary functions (store of value, measure of value, etc.) but these merely derive from the medium of exchange function.
The question remains, why is this good so highly marketable in the first place? What original characteristics made it so desirable for people to use it as money?
To answer this question we must define what a good is. Carl Menger[ii] identifies the following prerequisites for a good:
- A human need for the item
- Capacity for the item to satisfy this need
- Human knowledge that the item can satisfy this need
- Sufficient control of the item such that one can satisfy their need.
Absent one or all of these prerequisites the thing ceases to become a good. Menger also notes that some items are treated by people as though they were goods even though they lack all four of these prerequisites. This occurs when attributes are “erroneously ascribed to things that do not really possess them” or when “non-existent human needs are mistakenly assumed to exist”. Menger called such items imaginary goods.
Next we must determine what makes a good valuable. Menger[iii] makes it clear that there are two qualities that imbue a good with value. The first is that it should be an economic (i.e. scarce) good. In other words, the requirements (or demand) for a good must be greater than the quantity of the good available. Second, men must be “conscious of being dependent on command of them for the satisfaction of our needs”. To summarise, only scarce goods which we know can satisfy our needs have value.
Now we know what a good is and what gives it value, but what makes it useful as money? According to Jorg Guido Hulsmann[iv], to be used as money the good must be marketable. It must be a commodity; i.e. a valuable good that can be widely bought and sold. One must know that if they sell their produce and receive this commodity in return, that they can instantly sell this commodity to obtain the goods they desire (i.e. food, clothing, etc.).
The monetary use of a commodity is derived from its non-monetary use. When we consider how money comes into being (through indirect exchange) we know this must be the case. This is because (as Hulsmann[v] tells us) the prices initially being paid for a commodity’s non-monetary use allow one to estimate the future price for the commodity when it is resold. This is the basis for its use in indirect exchange.
In the case of gold or silver, it is obvious that these commodities have a value independent of their monetary use. Gold has historically primarily been used as jewellery and today, like silver, it has many industrial uses that establish a non-monetary value.
It is clear now that paper money established by government fiat cannot have any non-monetary value. It is not a good (according to the definition by Menger) or a commodity that can be widely bought and sold. No man desires paper money for its own sake. It cannot satisfy any need of man. As such, the quantity available infinitely exceeds the requirements for it. It is valueless. It is arguably, an imaginary good, as described by Menger. Value has been attributed to it by the government even though none exists.
Paper money is useless to individuals and is only truly useful to the government which can use it to more easily tax us. But if fiat currency has no value why then do people accept it in payment for goods and services rendered?
Over time people became accustomed to accepting “paper” money certificates having previously received and transferred warehouse receipts in the form of banknotes. Nominally, these banknotes were backed by gold and people were generally confident of receiving gold from banks should they wish to redeem the banknote for such. (In truth, however, banks, generally holding fractional reserves, strongly discouraged their customers from redeeming their banknotes).
Later, the practice of fractional reserve banking in which such banks issue banknotes only partially backed by specie was legalised. In time only one bank (i.e. the central bank) was granted a monopoly on the issuance of banknotes governed by a gold standard in which each banknote can be exchanged for a fixed amount of gold.
This bank note monopoly would be reinforced with legal tender laws, put in place by the government. Having taken control of money in this way, the government can “fiddle” the money supply in its favour by manipulating the gold standard (by arbitrarily fixing the exchange rate between bank notes and gold) until finally specie payments are permanently suspended. At this point, the population has already become accustomed to paper money and whether or not it is backed by gold no longer seems important to them. There is no significant protest of what is in effect, an appalling violation of property rights. In the final stage, governments completely remove the gold backing from banknotes, granting them a new and powerful method of taxing the population.
Some critics argue that paper money has value not because of the government but because someone will always accept it. This of course does not take in account the progression described above nor does it consider what would happen in a free market of money. Were the government to cease its intervention in the money market people would attempt to hoard hard money (gold, silver, etc.) and spend only the paper money in an attempt to rid themselves of this worthless “currency”. Everyone would want to spend the paper money and no one would want to accept it. The value of paper money would quickly fall to zero in a free market. Paper money has nominal value today because the government has full control of money production.
Misconceptions of money
Confusion concerning the difference between gold money and paper money is common. To some money is money and what does it matter whether it is made of gold or paper? Going further, some observers suggest that the best way to determine which money is superior is to allow fiat paper money and gold money to circulate in the free market and see what happens. This is nonsense. As we have seen above, paper money has no value and without government support would vanish very quickly. Further, in a free market, there would be no such thing as fiat money.
A further misconception concerns the gold standard. There are those who propose that our monetary problems would be solved if we would only return to a gold standard. Often it seems that people confuse gold money with a gold standard. They are not the same. A gold standard is fundamentally a legal tender law established by the government. It sets up an exchange rate between banknotes and specie (gold) which can be modified to suit the government and suspended at will (in times of war for example) in order to raise funds via inflation or protect favoured banks from bankruptcy.
There are those who consider money to be credit and vice versa. While credit can conceivably serve as part of an indirect exchange (Hulsmann[vi]), it is not money per se. It has certain disadvantages when compared to commodity money. For example, credit is not homogeneous but can vary in terms of maturity, interest rate, amount, and of course the creditworthiness of the borrower. Credit money is unlikely to be widely traded by individuals since it carries credit risk (i.e. the risk that the borrower will be unable of repaying the credit note). Thus, it is unlikely that credit money will ever arise on the free market as the primary money. Rather, it will remain the primary province of investors and money lenders.
Why should money be produced by the market and not the government?
Money should and can only be produced by the market. The market will select the most efficient valuable commodity (gold, silver, etc.) as the optimal money. This protects individuals from the costs of monetary manipulation by government (including the ultimate results we are witnessing now, the collapse not just of major banks but also the governments who are their clients). Market selected money also reduces the likelihood and severity of the business cycle as it places a significant constraint on the fraudulent operations of fractional reserve banks.
Fiat paper money produced by the government represents a massive violation of people’s property rights and effectively amounts to fraud, counterfeiting and theft on a grand scale. There can be no rational ethical or economic argument in favour of government intervention in money. Fiat paper money is the tool by which government surreptitiously transfers wealth from the general population to itself or those whom it favours.
Can gold ever be inflationary?
Inflation is properly defined as an increase in the number of banknotes that is not backed by specie (i.e. gold). Defined thus, we can see immediately that an increase in gold does not cause inflation or result in the business cycle. As Murray Rothbard[vii] tells us and as discussed above, gold provides a non-monetary value in addition to its monetary value, and so an increase in gold implies an increase in the wealth of society (greater amounts of gold for industrial, medical or consumer purposes). Will prices of other goods in terms of gold increase? Possibly, but now we can see the confusion that can occur as a consequence of erroneously defining inflation as merely a rise in prices. An increase in gold would be no more an issue than an increase in the supply of iron ore, oil or any other critical raw material.
Inflation is a result of some form of fraud (fractional reserve banking) or counterfeiting. Consider the recent stories of tungsten filled gold bars – if true, then someone is getting something for nothing. The buyer of the gold bars is paying in anticipation of receiving the value of a certain quantity of gold but in reality is receiving significantly less. The buyer is receiving a “fraction” of the value he expects. The value of this “gold” bar has been inflated and losses will result. It follows therefore that losses will result from the fractional reserve system of banking, especially when the buyer of a gold certificate discovers that there is insufficient gold to cover the value of his certificate.
To conclude, we have found that the optimal money derives its value from its prior non-monetary use (i.e. that of being a valuable commodity). Paper money has no prior non-monetary use and thus derives its value from government legal tender laws. In other words, it has merely an imagined value. In free market, there would be no fiat paper money. Government has no place in the production of money. Free money protects the population from the costs of fractional reserve banking and stunts the growth of government. Furthermore, with free market gold money (or similar) inflation will be limited to the illicit activities of fractional reserve banks thus the length and depth of the business cycle will be greatly reduced.
[i] Ludwig von Mises, The Theory of Money and Credit (New Haven: Yale University Press, 1953) 30-37.
[ii] Carl Menger, Principles of Economics (Ludwig von Mises Institute, 2007) 52-53.
[iii] Ibid. 114-115.
[iv] Jorg Guido Hulsmann, The Ethics of Money Production (Ludwig von Mises Institute, 2008) 23-24.
[vi] Ibid. 28-29.
[vii] Murray Rothbard, The Mystery of Banking (Ludwig von Mises Institute, 2008) 47-48.