 Chapter 2. Money in a Free Society 1. The Value of Exchange How did money begin? Clearly, Robinson Crusoe had no need for money. He could not have eaten gold coins. Neither would Crusoe and Friday, perhaps exchanging fish for lumber, need to bother about money. But when society expands beyond a few families, the stage is already set for the emergence of money. To explain the role of money, we must go even further back and ask, why do men exchange at all? Exchange is the prime basis of our economic life. Without exchanges, there would be no real economy and, practically, no society. Clearly, a voluntary exchange occurs because both parties expect to benefit. An exchange is an agreement between A and B to transfer the goods or services of one man for the goods and services of the other. Obviously, both benefit, because each values what he receives in exchange more than what he gives up. When Crusoe, say, exchanges some fish for lumber, he values the lumber he buys more than the fish he sells, while Friday, on the contrary, values the fish more than the lumber. From Aristotle to Marx, men have mistakenly believed that an exchange records some sort of equality of value, that if one barrel of fish is exchanged for ten logs, there is some sort of underlying equality between them. Actually, the exchange was made only because each party valued the two products in different order. Why should exchange be so universal among mankind? Fundamentally, because of the great variety in nature, the variety in man, and the diversity of location of natural resources. Every man has a different set of skills and aptitudes, and every plot of ground has its own unique features, its own distinctive resources. From this external natural fact of variety come exchanges. Wheat in Kansas for iron in Minnesota, one man's medical services for another's playing of the violin. Specialization permits each man to develop his best skill, and allows each region to develop its own particular resources. If no one could exchange, if every man were forced to be completely self-sufficient, it is obvious that most of us would starve to death, and the rest would barely remain alive. Exchange is the lifeblood, not only of our economy, but of civilization itself. Two, barter. Yet direct exchange of useful goods and services would barely suffice to keep an economy going above the primitive level. Such direct exchange, or barter, is hardly better than pure self-sufficiency. Why is this? For one thing, it is clear that very little production could be carried on. If Jones hires some laborers to build a house, with what will he pay them? With parts of the house, or with building materials they could not use? The two basic problems are indivisibility and lack of coincidence of wants. Thus if Smith has a plow, which he would like to exchange for several different things, say eggs, bread, and a suit of clothes, how can he do so? How can he break up the plow and give part of it to a farmer and another part to a tailor? Even where the goods are divisible, it is generally impossible for two exchangers to find each other at the same time. If A has a supply of eggs for sale and B has a pair of shoes, how can they get together if A wants a suit? And think of the plight of an economics teacher who has to find an egg producer who wants to purchase a few economics lessons in return for his eggs. Clearly, any sort of civilized economy is impossible under direct exchange. Three, indirect exchange. But man discovered in the process of trial and error the route that permits a greatly expanding economy. Indirect exchange. Under indirect exchange you sell your product not for a good which you need directly, but for another good which you then in turn sell for the good you want. At first glance this seems like a clumsy and roundabout operation, but it is actually the marvelous instrument that permits civilization to develop. Consider the case of A, the farmer who wants to buy the shoes made by B. Since B doesn't want his eggs, he finds what B does want, let's say butter. A then exchanges his eggs for C's butter and sells the butter to B for shoes. He first buys the butter not because he wants it directly, but because it will permit him to get his shoes. Similarly, Smith, a plow owner, will sell his plow for one commodity which he can more readily divide and sell, say butter, and will then exchange parts of the butter for eggs, bread, clothes, etc. In both cases, the superiority of butter, the reason there is extra demand for it beyond simple consumption, is its greater marketability. If one good is more marketable than another, if everyone is confident that it will be more readily sold, then it will come into greater demand because it will be used as a medium of exchange. It will be the medium through which one specialist can exchange his product for the goods of other specialists. Now, just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral. More marketability causes wider use as a medium which causes more marketability, etc. Eventually one or two commodities are used as general media in almost all exchanges, and these are called money. Historically many different goods have been used as media. Tobacco in colonial Virginia, sugar in the West Indies, salt in Abyssinia, cattle in ancient Greece, nails in Scotland, copper in ancient Egypt, and grain, beads, tea, cowrie shells, and fish hooks. Through the centuries two commodities, gold and silver, have emerged as money in the free competition of the market and have displaced the other commodities. Both are uniquely marketable, are in great demand as ornaments, and excel in the other necessary qualities. In recent times, silver being relatively more abundant than gold has been found more useful for smaller exchanges, while gold is more useful for larger transactions. At any rate, the important thing is that whatever the reason, the free market has found gold and silver to be the most efficient monies. This process, the cumulative development of a medium of exchange on the free market, is the only way money can become established. Money cannot originate in any other way, neither by everyone suddenly deciding to create money out of useless material, nor by government calling bits of paper money. For embedded in the demand for money is knowledge of the money prices of the immediate past. In contrast to directly used consumers or producers goods, money must have pre-existing prices on which to ground a demand. But the only way this can happen is by beginning with a useful commodity under barter and then adding demand for a medium for exchange to the previous demand for direct use, that is for ornaments in the case of gold. Thus, government is powerless to create money for the economy. It can only be developed by the processes of the free market. A most important truth about money now emerges from our discussion. Money is a commodity. Learning this simple lesson is one of the world's most important tasks. So often have people talked about money as something much more or less than this. Money is not an abstract unit of account, divorceable from a concrete good. It is not a useless token, only good for exchanging. It is not a claim on society. It is not a guarantee of a fixed price level. It is simply a commodity. It differs from other commodities in being demanded mainly as a medium of exchange. But aside from this, it is a commodity. And like all commodities, it has an existing stock. It faces demands by people to buy and hold it, etc. Like all commodities, its price, in terms of other goods, is determined by the interaction of its total supply or stock and the total demand by people to buy and hold it. People buy money by selling their goods and services for it, just as they sell money when they buy goods and services. The emergence of money was a great boon to the human race. Without money, without a general medium of exchange, there could be no real specialization, no advancement of the economy above a bare, primitive level. With money, the problems of indivisibility and coincidence of wants that plagued the barter society all vanish. Now, Jones can hire laborers and pay them in money. Smith can sell his plow in exchange for units of money. The money commodity is divisible into small units, and it is generally acceptable by all. Also, all goods and services are sold for money, and then money is used to buy other goods and services that people desire. Because of money, an elaborate structure of production can be formed, with land, labor services and capital goods cooperating to advance production at each stage and receiving payment in money. The establishment of money conveys another great benefit. Since all exchanges are made in money, all the exchange ratios are expressed in money, and so people can now compare the market worth of each good to that of every other good. If a TV set exchanges for three ounces of gold and an automobile exchanges for sixty ounces of gold, then everyone can see that one automobile is worth twenty TV sets on the market. These exchange ratios are prices, and the money commodity serves as a common denominator for all prices. Only the establishment of money prices on the market allows the development of a civilized economy, for only they permit businessmen to calculate economically. Businessmen can now judge how well they are satisfying consumer demands by seeing how the selling prices of their products compare with the prices they have to pay productive factors, their costs. Since all these prices are expressed in terms of money, the businessmen can determine whether they are making profits or losses. Such calculations guide businessmen, laborers, and landowners in their search for monetary income on the market. Only such calculations can allocate resources to their most productive uses, to those uses that will most satisfy the demands of consumers. Many textbooks say that money has several functions. A medium of exchange, unit of account, or measure of values, a store of value, etc. But it should be clear that all of these functions are simply corollaries of the one great function, the medium of exchange. Because gold is a general medium, it is most marketable. It can be stored to serve as a medium in the future as well as the present, and all prices are expressed in its terms. Money does not measure prices or values, it is the common denominator for their expression. In short, prices are expressed in money, they are not measured by it. Because gold is a commodity medium for all exchanges, it can serve as a unit of account for present and expected future prices. It is important to realize that money cannot be an abstract unit of account or claim, except in so far as it serves as a medium of exchange. 5. The Monetary Unit Now that we have seen how money emerged and what it does, we may ask, how is the money commodity used? Specifically, what is the stock or supply of money in society, and how is it exchanged? In the first place, most tangible physical goods are traded in terms of weight. Weight is the distinctive unit of a tangible commodity, and so trading takes place in terms of units like tons, pounds, ounces, grains, grams, etc. Even those goods nominally exchanging in terms of volume, bale, bushel, etc., tacitly assume a standard weight per unit volume. Gold is no exception. Gold, like other commodities, will be traded in units of weight. One of the cardinal virtues of gold as money is its homogeneity. Unlike many other commodities, it has no differences in quality. An ounce of pure gold equals any other ounce of pure gold the world over. It is obvious that the size of the common unit chosen in trading makes no difference to the economist. One country on the metric system may prefer to figure in grams. England or America may prefer to reckon in grains or ounces. All units of weight are convertible into each other. One pound equals 16 ounces. One ounce equals 437.5 grains, or 28.35 grams, etc. Assuming gold is chosen as the money, the size of the gold unit used in reckoning is immaterial to us. Jones may sell a coat for one gold ounce in America or for 28.35 grams in France. Both prices are identical. All this might seem like laboring the obvious, except that a great deal of misery in the world would have been avoided if people had fully realized these simple truths. Nearly everyone, for example, thinks of money as abstract units for something or other, each cleaving uniquely to a certain country. Even when countries were on the gold standard, people thought in similar terms. American money was dollars, French was francs, German marks, etc. All these were admittedly tied to gold, but all were considered sovereign and independent, and hence it was easy for countries to go off the gold standard. Yet all of these names were simply names for units of weight of gold or silver. The British pound sterling originally signified a pound weight of silver, and what of the dollar? The dollar began as the generally applied name of an ounce weight of silver coined by a Bohemian count named Schlick in the 16th century. The count of Schlick lived in Joachim's Valley, or Joachim's Tull. The count's coins earned a great reputation for their uniformity and fineness, and they were widely called Joachim's Tullers, or finally, Tullers. The name dollar eventually emerged from Tuller. On the free market then, the various names that units may have are simply definitions of units of weight. When we were on the gold standard before 1933, people liked to say that the price of gold was fixed at $20 per ounce of gold. But this was a dangerously misleading way of looking at our money. Actually, the dollar was defined as the name for approximately one-twentieth of an ounce of gold. It was therefore misleading to talk about exchange rates of one country's currency for another. The pound sterling did not really exchange for $5. Actually, the pound sterling exchanged for $4.87, but we are using $5 for greater convenience of calculation. The dollar was defined as one-twentieth of a gold ounce, and the pound sterling was, at that time, defined as the name for one-fourth of a gold ounce, simply traded for five-twentieths of a gold ounce. Clearly, such exchanges and such a welter of names were confusing and misleading. How they arose is shown below in the chapter on government meddling with money. In a purely free market, gold would simply be exchanged directly as grams, grains, or ounces, and such confusing names as dollars, francs, etc. would be superfluous. Therefore, in this section, we will treat money as exchanging directly in terms of ounces or grams. Clearly, the free market will choose as the common unit whatever size of the money commodity is most convenient. If platinum were the money, it would likely be traded in terms of fractions of an ounce. If iron were used, it would be reckoned in pounds or tons. Clearly, the size makes no difference to the economist. Six, the shape of money. If the size or the name of the money unit makes little economic difference, neither does the shape of the monetary metal. Since the commodity is the money, it follows that the entire stock of the metal, so long as it is available to man, constitutes the world stock of money. It makes no real difference what shape any of the metal is at any time. If iron is the money, then all the iron is money, whether it is in the form of bars, chunks, or embodied in specialized machinery. Iron hose have been used extensively as money, both in Asia and Africa. Gold has been traded as money in the raw form of nuggets, as gold dust in sacks, and even as jewelry. It should not be surprising that gold or other monies can be traded in many forms, since their important feature is their weight. It is true, however, that some shapes are often more convenient than others. In recent centuries, gold and silver have been broken down into coins for smaller day-to-day transactions and into larger bars for bigger transactions. Other gold is transformed into jewelry and other ornaments. Now, any kind of transformation from one shape to another costs time, effort, and other resources. Doing this work will be a business like any other, and prices for this service will be set in the usual manner. Most people agree that it is legitimate for jewelers to make ornaments out of raw gold, but they often deny that the same applies to the manufacture of coins. Yet on the free market, coinage is essentially a business like any other. Many people believed in the days of the gold standard that coins were somehow more really money than plain uncoined gold bullion, bars, ingots, or any other shape. It is true that coins commanded a premium over bullion, but this was not caused by any mysterious virtue in the coins. It stemmed from the fact that it cost more to manufacture coins from bullion than to remelt coins back into bullion. Because of this difference, coins were more valuable on the market. 7. Private Coinage The idea of private coinage seems so strange today that it is worth examining carefully. We are used to thinking of coinage as a necessity of sovereignty. Yet after all, we are not wedded to a royal prerogative, and it is the American concept that sovereignty rests not in government, but in the people. How would private coinage work? In the same way we have said as any other business. Each miter would produce whatever size or shape of coin is most pleasing to his customers. The price would be set by the free competition of the market. The standard objection is that it would be too much trouble to weigh or assay bits of gold at every transaction. But what is there to prevent private mitters from stamping the coin and guaranteeing its weight and fineness? Private mitters can guarantee a coin at least as well as a government mint. Abraded bits of metal would not be accepted as coin. People would use the coins of those mitters with the best reputation for good quality of product. We have seen that this is precisely how the dollar became prominent as a competitive silver coin. Opponents of private coinage charge that fraud would run rampant. Yet these same opponents would trust government to provide the coinage. But if government is to be trusted at all, then surely with private coinage government could at least be trusted to prevent or punish fraud. It is usually assumed that the prevention or punishment of fraud, theft, or other crimes is the real justification for government. But if government cannot apprehend the criminal when private coinage is relied upon what hope is there for a reliable coinage when the integrity of the private marketplace operators is discarded in favor of a government monopoly of coinage? If government cannot be trusted to ferret out the occasional villain in the free market in coin why can government be trusted when it finds itself in a position of total control over money and made to base coin, counterfeit coin, or otherwise with full legal sanction perform as the sole villain in the marketplace? It is surely folly to say that government must socialize all property in order to prevent anyone from stealing property. Yet the reasoning behind abolition of private coinage is the same. Moreover, all modern business is built on guarantees of standards. The drugstore sells an eight-ounce bottle of medicine. The meat packer sells a pound of beef. The buyer expects these guarantees to be accurate, and they are. And think of the thousands upon thousands of specialized vital industrial products that must meet very narrow standards and specifications. The buyer of a half-inch bolt must get a half-inch bolt and not a mere three-eighths-inch. Yet business has not broken down. Few people suggest that the government must nationalize the machine tool industry as part of its job of defending standards against fraud. The modern market economy contains an infinite number of intricate exchanges, most depending on definite standards of quantity and quality. But fraud is at a minimum, and that minimum, at least in theory, may be prosecuted. So it would be if there were private coinage. We can be sure that a miner's customers and his competitors would be keenly alert to any possible fraud in the weight or fineness of his coins. Champions of the government's coinage monopoly have claimed that money is different from all other commodities, because Gresham's law proves that bad money drives out good from circulation. Hence, the free market cannot be trusted to serve the public in supplying good money. But this formulation rests on a misinterpretation of Gresham's famous law. The law really says that money overvalued artificially by government will drive out of circulation artificially undervalued money. Suppose, for example, there are one-ounce gold coins in circulation. After a few years of wear and tear, let us say that some coins weigh only 0.9 ounces. Obviously, on the free market, the worn coins would circulate at only 90% of the value of the full-bodied coins, and the nominal face value of the former would have to be repudiated. To meet the problem of wear and tear, private coiners might either set a time limit on their stamped guarantees of weight, or agree to re-coin anew either at the original or at the lower weight. We may note that in the free economy, there will not be the compulsory standardization of coins that prevails when government monopolies direct the coinage. If anything, it will be the bad coins that will be driven from the market. But suppose the government decrees that everyone must treat the worn coins as equal to new fresh coins and must accept them equally in payment of debts. What has the government really done? It has imposed price control by coercion on the exchange rate between the two types of coin. By insisting on the par ratio when the worn coins should exchange at 10% discount, it artificially overvalues the worn coins and undervalues new coins. Consequently, everyone will circulate the worn coins and hoard or export the new. Bad money drives out good money then, not on the free market, but as the direct result of governmental intervention in the market. Despite never ending harassment by governments, making conditions highly precarious, private coins have flourished many times in history. True to the virtual law that all innovations come from free individuals and not the state, the first coins were minted by private individuals and goldsmiths. In fact, when the government first began to monopolize the coinage, the royal coins bore the guarantees of private bankers whom the public trusted far more, apparently, than they did the government. Privately minted gold coins circulated in California as late as 1848. 8. The Proper Supply of Money Now we may ask, what is the supply of money in society and how is that supply used? In particular, we may raise the perennial question, how much money do we need? Must the money supply be regulated by some sort of criterion or can it be left alone to the free market? First, the total stock or supply of money in society at any one time is the total weight of the existing money stuff. Let us assume for the time being that only one commodity is established on the free market as money. Let us further assume that gold is that commodity, although we could have taken silver or even iron. It is up to the market and not to us to decide the best commodity to use as money. Since money is gold, the total supply of money is the total weight of gold existing in society. The shape of gold does not matter, except if the cost of changing shapes in certain ways is greater than in others. For example, minting coins costing more than melting them. In that case, one of the shapes will be chosen by the market as the money of account, and the other shapes will have a premium or discount in accordance with their relative costs on the market. Changes in the total gold stock will be governed by the same causes as changes in other goods. Increases will stem from greater production from mines. Decreases from being used up in wear and tear in industry, etc. Because the market will choose a durable commodity as money, and because money is not used up at the rate of other commodities, but is employed as a medium of exchange, the proportion of new annual production to its total stock will tend to be quite small. Changes in total gold stock then generally take place very slowly. What should the supply of money be? All sorts of criteria have been put forward, that money should move in accordance with population, with the volume of trade, with the amounts of goods produced, so as to keep the price level constant, etc. Few indeed have suggested leaving the decision to the market. But money differs from other commodities in one essential fact, and grasping this difference furnishes a key to understanding monetary matters. When the supply of any other good increases, this increase confers a social benefit. It is a matter for general rejoicing. More consumer goods mean a higher standard of living for the public. More capital goods mean sustained and increased living standards in the future. The discovery of new fertile land or natural resources also promises to add to living standards present and future. But what about money? Does an addition to the money supply also benefit the public at large? Consumer goods are used up by consumers. Capital goods and natural resources are used up in the process of producing consumer goods. But money is not used up. Its function is to act as a medium of exchanges, to enable goods and services to travel more expeditiously from one person to another. These exchanges are all made in terms of money prices. Thus, if a television set exchanges for three gold ounces, we say that the price of the television set is three ounces. At any one time, all goods in the economy will exchange at certain gold ratios or prices. As we have said, money or gold is the common denominator of all prices. But what of money itself? Does it have a price? Since a price is simply an exchange ratio, it clearly does. In this case, the price of money is an array of the infinite number of exchange ratios for all the various goods on the market. Thus, suppose that a television set costs three gold ounces, an auto sixty ounces, a loaf of bread one hundredth of an ounce, and an hour of Mr. Jones' legal services one ounce. The price of money will then be an array of alternative exchanges. One ounce of gold will be worth either one third of a television set, one sixtieth of an auto, one hundred loaves of bread, or one hour of Jones' legal service, and so on down the line. The price of money then is the purchasing power of the monetary unit, in this case of the gold ounce. It tells what that ounce can purchase in exchange, just as the money price of a television set tells how much money a television set can bring in exchange. What determines the price of money? The same forces that determine all prices on the market, that venerable but eternally true law, supply, and demand. We all know that if the supply of eggs increases, the price will tend to fall. If the buyers demand for eggs increases, the price will tend to rise. The same is true for money. An increase in the supply of money will tend to lower its price. An increase in the demand for money will raise it. But what is the demand for money? In the case of eggs, we know what demand means. It is the amount of money consumers are willing to spend on eggs, plus eggs retained and not sold by suppliers. Similarly, in the case of money, demand means the various goods offered in exchange for money, plus the money retained in cash and not spent over a certain time period. In both cases, supply may refer to the total stock of the good on the market. What happens then if the supply of gold increases, demand for money remaining the same? The price of money falls, that is, the purchasing power of the money unit will fall all along the line. An ounce of gold will now be worth less than 100 loaves of bread, one-third of a television set, etc. Conversely, if the supply of gold falls, the purchasing power of the gold ounce rises. What is the effect of a change in the money supply? Following the example of David Hume, one of the first economists, we may ask ourselves what would happen if, overnight, some good fairy slipped into pockets, purses and bank vaults and doubled our supply of money. In our example, she magically doubled our supply of gold. Would we be twice as rich? Obviously not. What makes us rich is an abundance of goods, and what limits that abundance is a scarcity of resources, namely land, labor and capital. Multiplying coin will not whisk these resources into being. We may feel twice as rich for the moment, but clearly all we are doing is diluting the money supply. As the public rushes out to spend its newfound wealth, prices will very roughly double, or at least rise until the demand is satisfied, and money no longer bids against itself for the existing goods. Thus we see that while an increase in the money supply, like an increase in the supply of any good, lowers its price, the change does not, unlike other goods, confer a social benefit. The public at large is not made richer, whereas new consumer or capital goods add to standards of living, new money only raises prices, that is, dilutes its own purchasing power. The reason for this puzzle is that money is only useful for its exchange value. Other goods have various real utilities, so that an increase in their supply satisfies more consumer wants. Money has utility only for prospective exchange. Its utility lies in its exchange value, or purchasing power. Our law, that an increase in money does not confer a social benefit, stems from its unique use as a medium of exchange. An increase in the money supply then only dilutes the effectiveness of each gold ounce. On the other hand, a fall in the supply of money raises the power of each gold ounce to do its work. We come to the startling truth that it doesn't matter what the supply of money is. Any supply will do as well as any other supply. The free market will simply adjust by changing the purchasing power or effectiveness of the gold unit. There is no need to tamper with the market in order to alter the money supply that it determines. At this point the monetary planner might object, all right, granting that it is pointless to increase the money supply isn't gold mining a waste of resources? Shouldn't the government keep the money supply constant and prohibit new mining? This argument might be plausible to those who hold no principled objections to government meddling, though it would not convince the determined advocate of liberty. But the objection overlooks an important point. That gold is not only money, but is also, inevitably, a commodity. An increased supply of gold may not confer any monetary benefit, but it does confer a non-monetary benefit. That is, it does increase the supply of gold used in consumption, ornaments, dental work, and the like, and in production, industrial work. Gold mining, therefore, is not a social waste at all. 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. Gold mining is, of course, no more profitable than any other business. In the long run, its rate of return will be equal to the net rate of return in any other industry. The problem of hoarding The critic of monetary freedom is not so easily silenced, however. There is, in particular, the ancient bugbear of hoarding. The image is conjured up of the selfish old miser, who, perhaps irrationally, perhaps from evil motives, hoards up gold unused in his cellar or treasure trove, thereby stopping the flow of circulation and trade, causing depressions and other problems. Is hoarding really a menace? In the first place, what has simply happened is an increased demand for money on the part of the miser. As a result, prices of goods fall, and the purchasing power of the gold ounce rises. There has been no loss to society, which simply carries on with a lower active supply of more powerful gold ounces. Even in the worst possible view of the matter then, nothing has gone wrong, and monetary freedom creates no difficulties. But there is more to the problem than that, for it is by no means irrational for people to desire more or less money in their cash balances. Let us, at this point, study cash balances further. Why do people keep any cash balances at all? Suppose that all of us were able to foretell the future with absolute certainty. In that case, no one would have to keep cash balances on hand. Everyone would know exactly how much he will spend and how much income he will receive at all future dates. He need not keep any money at hand, but will lend out his gold so as to receive his payments in the needed amounts on the very days he makes his expenditures. But of course, we necessarily live in a world of uncertainty. People do not precisely know what will happen to them or what their future incomes or costs will be. The more uncertain and fearful they are, the more cash balances they will want to hold. The more secure, the less cash they will wish to keep on hand. Another reason for keeping cash is also a function of the real world of uncertainty. If people expect the price of money to fall in the near future, they will spend their money now, while money is more valuable, thus dishorting and reducing their demand for money. Conversely, if they expect the price of money to rise, they will wait to spend money later when it is more valuable, and their demand for cash will increase. People's demands for cash balances then rise and fall for good and sound reasons. Economists err if they believe something is wrong when money is not in constant, active circulation. Money is only useful for exchange value, true, but it is not only useful at the actual moment of exchange. This truth has been often overlooked. Money is just as useful when lying idle in somebody's cash balance, even in a miser's hoard. At what point does a man's cash balance become a faintly disreputable hoard, or the prudent man, a miser? It is impossible to fix any definite criterion. Generally, the charge of hoarding means that A is keeping more cash than B thinks is appropriate for A. For that money is being held now in wait for possible future exchange. It supplies to its owner, right now, the usefulness of permitting exchanges at any time, present or future, the owner might desire. It should be remembered that all gold must be owned by someone, and therefore that all gold must be held in people's cash balances. If there are 3,000 tons of gold in society, all 3,000 tons must be owned and held at any one time in the cash balances of individual people. The total sum of cash balances is always identical with the total supply of money in the society. Thus, ironically, if it were not for the uncertainty of the real world, there could be no monetary system at all. In a certain world, no one would be willing to hold cash, so the demand for money in society would fall infinitely, prices would skyrocket without end, and any monetary system would break down. Instead of the existence of cash balances being an annoying and troublesome factor, interfering with monetary exchange, it is absolutely necessary to any monetary economy. It is misleading, furthermore, to say that money circulates. Like all metaphors taken from the physical sciences, it connotes some sort of mechanical process independent of human will, which moves at a certain speed of flow or velocity. Actually, money does not circulate. It is, from time to time, transferred from one person's cash balance to another's. The existence of money, once again, depends upon people's willingness to hold cash balances. At the beginning of this section, we saw that hoarding never brings any loss to society. Now we will see that movement in the price of money caused by changes in the demand for money yields a positive social benefit, as positive as any conferred by increased supplies of goods and services. We have seen that the total sum of cash balances in society is equal and identical with the total supply of money. Let us assume the supply remains constant, say at 3,000 tons. Now suppose for whatever reason, perhaps growing apprehension, people's demand for cash balances increases. Surely it is a positive social benefit to satisfy this demand. But how can it be satisfied when the total sum of cash must remain the same? Simply as follows. With people valuing cash balances more highly, the demand for money increases and prices fall. As a result, the same total sum of cash balances now confers a higher, real balance. That is, it is higher in proportion to the prices of goods, to the work that money has to perform. In short, the effective cash balances of the public have increased. Conversely, a fall in the demand for cash will cause increased spending and higher prices. The public's desire for lower effective cash balances will be satisfied by the necessity for given total cash to perform more work. Therefore, while a change in the price of money stemming from changes in supply merely alters the effectiveness of the money unit and confers no social benefit, a fall or rise caused by a change in the demand for cash balances does yield a social benefit. For it satisfies a public desire for either a higher or lower proportion of cash balances to the work done by cash. On the other hand, an increased supply of money will frustrate public demand for a more effective sum total of cash, more effective in terms of purchasing power. People will almost always say, if asked, that they want as much money as they can get. But what they really want is not more units of money, more gold ounces or dollars, but more effective units, that is, greater command of goods and services bought by money. We have seen that society cannot satisfy its demand for more money by increasing its supply. For an increased supply will simply dilute the effectiveness of each ounce, and the money will be no more really plentiful than before. People's standard of living, except in the non-monetary uses of gold, cannot increase by mining more gold. If people want more effective gold ounces in their cash balances, they can get them only through a fall in prices and a rise in the effectiveness of each ounce. 10. Stabilize the price level? Some theorists charge that a free monetary system would be unwise because it would not stabilize the price level, that is, the price of the money unit. Money, they say, is supposed to be a fixed yardstick that never changes. Therefore, its value or purchasing power should be stabilized. Since the price of money would admittedly fluctuate on the free market, freedom must be overruled by government management to ensure stability. How the government would go about this is unimportant at this point. Basically, it would involve governmentally managed changes in the money supply. Stability would provide justice, for example, to debtors and creditors, who will be sure of paying back dollars or gold ounces of the same purchasing power as they lent out. Yet, if creditors and debtors want to hedge against future changes in purchasing power, they can do so easily on the free market. When they make their contracts, they can agree that repayment will be made in a sum of money adjusted by some agreed-upon index number of changes in the value of money. The stabilizers have long advocated such measures, but strangely enough, the very lenders and borrowers who are supposed to benefit most from stability have rarely availed themselves of the opportunity. Must the government then force certain benefits on people who have already freely rejected them? Apparently, businessmen would rather take their chances in this world of irremediable uncertainty on their ability to anticipate the conditions of the market. After all, the price of money is no different from any other free price on the market. They can change in response to changes in demand of individuals. Why not the monetary price? Artificial stabilization would in fact seriously distort and hamper the workings of the market. As we have indicated, people would be unavoidably frustrated in their desires to alter their real proportion of cash balances. There would be no opportunity to change cash balances in proportion to prices. Furthermore, improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices and costs, and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards. Money, in short, is not a fixed yardstick. It is a commodity serving as a medium for exchanges. Flexibility in its value in response to consumer demands is just as important and just as beneficial as any other free pricing on the market. Coexisting monies So far we have obtained the following picture of money in a purely free economy. Gold or silver coming to be used as a medium of exchange. Gold emitted by competitive private firms circulating by weight. Prices fluctuating freely on the market in response to consumer demands and supplies of productive resources. Freedom of prices necessarily implies freedom of movement for the purchasing power of the money unit. It would be impossible to use force and interfere with movements in the value of money without simultaneously crippling freedom of prices for all goods. The resulting free economy would not be chaotic. On the contrary, the economy would move swiftly and efficiently to supply the wants of consumers. The money market can also be free. Thus far we have simplified the problem by assuming only one monetary metal, say gold. Suppose that two or more monies continue to circulate on the world market, say gold and silver. Possibly gold will be the money in one area and silver in another, or else they both may circulate side by side. Gold, for example, being ounce for ounce more valuable on the market than silver, may be used for larger transactions and silver for smaller. Would not two monies be impossibly chaotic? Wouldn't the government have to step in and impose a fixed ration between the two, by metalism, or in some way demonetize one or the other metal, impose a single standard? It is very possible that the market, given free rein, might eventually establish one single metal as money. But in recent centuries silver stubbornly remained to challenge gold. It is not necessary, however, for the government to step in and save the market from its own folly in maintaining two monies. Silver remained in circulation precisely because it was convenient for small change, for example. Silver and gold could easily circulate side by side and have done so in the past. The relative supplies of and demands for the two metals will determine the exchange rate between the two, and this rate, like any other price, will continually fluctuate in response to these changing forces. At one time, for example, silver and gold ounces might exchange at 16 to 1, another time at 15 to 1, etc. Which metal will serve as a unit of account depends on the concrete circumstances of the market. If gold is the money of account, then most transactions will be reckoned in gold ounces, and silver ounces will exchange at a freely fluctuating price in terms of the gold. It should be clear that the exchange rate and the purchasing powers of the units of the two metals will always tend to be proportional. If prices of goods are 15 times as much in silver as they are in gold, then the exchange rate will tend to be set at 15 to 1. If not, it will pay to exchange from one to the other until parity is reached. Thus, if prices are 15 times as much in terms of silver as gold, while silver to gold is 20 to 1, people will rush to sell their goods for gold, buy silver, and then rebuy the goods with silver, reaping a handsome gain in the process. This will quickly restore the purchasing power parity of the exchange rate. As gold gets cheaper in terms of silver, silver prices of goods go up, and gold prices of goods go down. The free market, in short, is eminently orderly, not only when money is free, but even when there is more than one money circulating. What kind of standard will a free money provide? The important thing is that the standard not be imposed by government decree. If left to itself, the market may establish gold as a single money, gold standard, silver as a single money, silver standard, or, perhaps most likely, both as monies with freely fluctuating exchange rates, parallel standards, 12, money warehouses. Suppose then that the free market has established gold as money, forgetting again about silver for the sake of simplicity. Even in the convenient shape of coins, gold is often cumbersome and awkward to carry and use directly in exchange. For larger transactions, it is awkward and expensive to transport several hundred pounds of gold. But the free market, ever ready to satisfy social needs, comes to the rescue. Gold, in the first place, must be stored somewhere, and just as specialization is most efficient in other lines of business, so it will be most efficient in the warehousing business. Certain firms then will be successful on the market in providing warehousing services. Some will be gold warehouses, and will store gold for its myriad owners. As in the case of all warehouses, the owner's right to the stored goods is established by a warehouse receipt, which he receives in exchange for storing the goods. The receipt entitles the owner to claim his goods at any time he desires. This warehouse will earn profit no differently from any other, that is, by charging a price for its storage services. There is every reason to believe that gold warehouses, or money warehouses, will flourish on the free market in the same way that other warehouses will prosper. In fact, warehousing plays an even more important role in the case of money. For all other goods pass into consumption, and so must leave the warehouse after a while to be used up in production or consumption. But money, as we have seen, is mainly not used in the physical sense. Instead, it is used to exchange for other goods, and to lie and wait for such exchanges in the future. In short, money is not so much used up as simply transferred from one person to another. In such a situation, convenience inevitably leads to transfer of the warehouse receipt, instead of the physical gold itself. Suppose, for example, that Smith and Jones both store their gold in the same warehouse. Jones sells Smith an automobile for 100 gold ounces. They could go through the expensive process of Smith's redeeming his receipt and moving their gold to Jones' office, with Jones turning right around and re-depositing the gold again. But they will undoubtedly choose a far more convenient course. Smith simply gives Jones a warehouse receipt for 100 ounces of gold. In this way, warehouse receipts for money come more and more to function as money substitutes. Fewer and fewer transactions move the actual gold. In more and more cases, paper titles to the gold are used instead. As the market develops, there will be three limits on the advance of this substitution process. One is the extent that people use these money warehouses, called banks, instead of cash. Clearly, if Jones, for some reason, didn't like to use a bank, Smith would have to transport the actual gold. The second limit is the extent of the clientele of each bank. In other words, the more transactions taking place between clients of different banks, the more gold will have to be transported. The more exchanges are made by clients of the same bank, the less need to transport the gold. If Jones and Smith were clients of different warehouses, this bank, or Smith himself, would have to transport the gold to Jones Bank. Third, the clientele must have confidence in the trustworthiness of their banks. If they suddenly find out, for example, that the bank officials have had criminal records, the bank will likely lose its business in short order. In this respect, all warehouses and all businesses resting on goodwill are alike. As banks grow and confidence in them develops, their clients may find it more convenient, in many cases, to waive their right to paper receipts, called bank notes, and instead to keep their titles as open book accounts. In the monetary realm, these have been called bank deposits. Instead of transferring paper receipts, the client has a book claim at the bank. He makes exchanges by writing an order to his warehouse to transfer a portion of this account to someone else. Thus, in our example, Smith will order the bank to transfer book title to his 100 gold ounces to Jones. This written order is called a check. It should be clear that economically there is no difference whatever between a bank note and a bank deposit. Both are claims to ownership of stored gold. Both are transferred similarly as money substitutes, and both have the identical three limits on their extent of use. The client can choose, according to his convenience, whether he wishes to keep his title in note or deposit form. A third form of money substitute will be token coins for very small change. These are, in effect, equivalent to bank notes, but printed on base metal rather than on paper. Now what has happened to their money supply as a result of all these operations? If paper notes or bank deposits are used as money substitutes, does this mean that the effective money supply in the economy has increased, even though the stock of gold has remained the same? Certainly not. For the money substitutes are simply warehouse receipts for actually deposited gold. If Jones deposits 100 ounces of gold in his warehouse and gets a receipt for it, the receipt can be used on the market as money, but only as a convenient stand-in for the gold, not as an increment. The gold in the vault is then no longer a part of the effective money supply, but is held as a reserve for its receipt to be claimed whenever desired by its owner. An increase or decrease in the use of substitutes, then, exerts no change on the money supply. Only the form of the supply is changed, not the total. Thus the money supply of a community may begin as 10 million gold ounces. Then 6 million may be deposited in banks in return for gold notes, whereupon the effective supply will now be 4 million ounces of gold, 6 million ounces of gold claims in paper notes. The total money supply has remained the same. Curiously, many people have argued that it would be impossible for banks to make money if they were to operate on this 100% reserve basis. Gold always represented by its receipt. Yet there is no real problem any more than for any warehouse. Almost all warehouses keep all the goods for their owners 100% reserve as a matter of course. In fact it would be considered fraud or theft to do otherwise. Their profits are earned from service charges to their customers. The banks can charge for their services in the same way. If it is objected that customers will not pay the high service charges, this means that the bank's services are not in very great demand, and the use of their services will fall to the levels that consumers find worthwhile. We come now to perhaps the thorniest problem facing the monetary economist, an evaluation of fractional reserve banking. We must ask the question, would fractional reserve banking be permitted in a free market? Or would it be prescribed as fraud? It is well known that banks have rarely stayed on a 100% basis very long. Since money can remain in the warehouse for a long period of time, the bank is tempted to use some of the money for its own account. Tempted also because people do not ordinarily care whether the gold coins they receive back from the warehouse are the identical gold coins they deposited. The bank is tempted then to use other people's money to earn a profit for itself. If the banks lend out the gold directly, the receipts, of course, are now partially invalidated. There are now some receipts with no gold behind them. In short, the bank is effectively insolvent, since it cannot possibly meet its own obligations if called upon to do so. It cannot possibly hand over its customer's property should they also desire. Generally, banks, instead of taking the gold directly, print uncovered or pseudo warehouse receipts, that is, warehouse receipts for gold that is not and cannot be there. These are then loaned at a profit. Clearly, the economic effect is the same. More warehouse receipts are printed than gold exists in the vaults. What the bank has done is to issue gold warehouse receipts which represent nothing but are supposed to represent 100% of their face value in gold. The pseudo receipts pour forth on the trusting market in the same way as the true receipts and thus add to the effective money supply of the country. In the above example, if the banks now issue 2 million ounces of false receipts with no gold behind them, the money supply of the country will rise from 10 to 12 million gold ounces, at least until the hocus pocus has been discovered and corrected. There are now, in addition to 4 million ounces of gold held by the public, 8 million ounces of money substitutes, only 6 million of which are covered by gold. Issue of pseudo receipts, like counterfeiting of coin, is an example of inflation, which will be studied further below. Inflation may be defined as any increase in the economy's supply of money, not consisting of an increase in the stock of the money metal. Fractional reserve banks, therefore, are inherently inflationary institutions. Defenders of banks reply as follows. The banks are simply functioning like other businesses. They take risks. Admittedly, if all the depositors presented their claims, the banks would be bankrupt, since outstanding receipts exceed gold in their vaults. But banks simply take the chance, usually justified, that not everyone will ask for his gold. The great difference, however, between the fractional reserve bank and all other businesses is this. Other businessmen use their own or borrowed capital in ventures, and if they borrow credit, they promise to pay at a future date, taking care to have enough money at hand on that date to meet their obligation. If Smith borrows 100 gold ounces for a year, he will arrange to have 100 gold ounces available on that future date. But the bank isn't borrowing from its depositors. It doesn't pledge to pay back gold at a certain date in the future. Instead, it pledges to pay the receipt in gold at any time on demand. In short, the banknote or deposit is not an IOU or debt. It is a warehouse receipt for other people's property. Further, when a businessman borrows or lends money, he does not add to the money supply. The loaned funds are saved funds, part of the existing money supply being transferred from saver to borrower. Bank issues, on the other hand, artificially increase the money supply, since pseudo receipts are injected into the market. A bank, then, is not taking the usual business risk. It does not, like all businessmen, arrange the time pattern of its assets proportionately to the time pattern of liabilities. That is, see to it that it will have enough money on due dates to pay its bills. Instead, most of its liabilities are instantaneous, but its assets are not. The bank creates new money out of thin air, and does not, like everyone else, have to acquire money by producing and selling its services. In short, the bank is already, and at all times, bankrupt. But its bankruptcy is only revealed when customers get suspicious and precipitate bank runs. No other business experiences a phenomenon like a run. No other business can be plunged into bankruptcy overnight simply because its liabilities only possess their own property. No other business creates fictitious new money which will evaporate when truly gauged. The dire economic effects of fractional bank money will be explored in the next chapter. Here we conclude that, morally, such banking would have no more right to exist in a truly free market than any other form of implicit theft. It is true that the note or deposit does exist in its face, that the warehouse guarantees to keep a full backing of gold on hand at all times. But the bank does promise to redeem on demand, and so when it issues any fake receipts, it is already committing fraud since it immediately becomes impossible for the bank to keep its pledge and redeem all of its notes and deposits. Fraud, therefore, is immediately being discovered in the act of issuing pseudo receipts takes place. Which particular receipts are fraudulent can only be discovered after a run on the bank has occurred, since all the receipts look alike, and the late coming claimants are left high and dry. Perhaps a libertarian system would consider general warrant deposits, which allow the warehouse to return any specific warrant deposits, which, like bills of lading, pawn tickets, dock warrants, etc., establish ownership to certain specific earmarked objects. For in the case of a general deposit warrant, the warehouse is tempted to treat the goods as its own property, instead of being the property of its customers. This is precisely what the banks have been doing. If fraud is to be proscribed in a free society, then fractional reserve banking would have to meet the same fate. Fraud is implicit theft, since it means that a contract has not been completed after the value has been received. In short, if A sells B a box labeled cornflakes and it turns out to be straw upon opening, A's fraud is really theft of B's property. Similarly, the issue of warehouse receipts to non-existent goods, identical with genuine receipts, is fraud upon those who possess claims to non-existent property. Suppose, however, that fraud and fractional reserve banking are permitted, with the banks only required to fulfill their obligations to redeem in gold on demand. Any failure to do so would mean instant bankruptcy. Such a system has come to be known as free banking. Would there then be a heavy fraudulent issue of money substitutes, with resulting artificial creation of new money? Many people have assumed so, and believed that wildcat banking would then simply inflate the money supply astronomically. But on the contrary, free banking would lead to a far harder monetary system than we have today. The banks would be checked by the same three limits that we noted above, and checked rather rigorously. In the first place, each bank's expansion will be limited by a loss of gold to another bank. For a bank can only expand money within the limits of its own clientele. Suppose, for example, that Bank A, with 10,000 ounces of gold deposited, now issues 2,000 ounces of false warehouse receipts to gold, and lends them to various enterprises, or invests them in securities. The borrower, or former holder of securities, will spend the new money on various goods and services. Eventually, the money going the rounds will reach an owner who is a client of another bank, B. At that point, Bank B will call upon Bank A to redeem its receipt in gold, so that the gold can be transferred to Bank B's vaults. Clearly, the wider the extent of each bank's clientele, and the more the clients trade with one another, the more scope there is for each bank to expand its credit and money supply. For if the bank's clientele is narrow, then soon after its issue of created money, it will be called upon to redeem. And, as we have seen, it doesn't have the wherewithal to redeem more than a fraction of its obligations. To avoid the threat of bankruptcy from this quarter, then, the narrower the scope of a bank's clientele, the greater the fraction of gold it must keep in reserve, and the less it can expand. If there is one bank in each country, there will be far more scope for expansion than if there is one bank for every two persons in the community. Other things being equal, then, the more banks there are, and the tinier their size, the harder and better the monetary supply will be. Similarly, a bank's clientele will also be limited by those who don't use a bank at all. The more people use actual gold instead of bank money, the less room there is for bank inflation. Suppose, however, that the banks form a cartel and agree to pay out each other's receipts and not call for redemption. And suppose further that bank money is in universal use. Are there any limits left on bank expansion? Yes. There remains the check of client confidence in the banks. As bank credit and the money supply expand further and further, more and more clients will get worried over the lowering of the reserve fraction. And in a truly free society, those who know the truth about the real insolvency of the banking system will be able to form anti-bank leagues to urge clients to get their money out before it is too late. In short, leagues to urge bank runs or the threat of their formation will be able to stop and reverse the monetary expansion. None of this discussion is meant to impugn the general practice of credit, which has an important and vital function on the free market. In a credit transaction the possessor of money, a good useful in the present, exchanges it for an IOU payable at some future date, the IOU being a future good, and the interest charge reflects the higher valuation of present goods over future goods on the market. But bank notes or deposits are not credit. They are warehouse receipts, instantaneous claims to cash, that is, gold, in the bank vaults. The debtor makes sure that he pays his debt when payment becomes due. The fractional reserve banker can never pay more than a small fraction of his outstanding liabilities. We turn in the next chapter to a study of the various forms of governmental interference in the monetary system. Most of them designed not to repress fraudulent issue, but on the contrary, to remove these and other natural checks on inflation. 13. Summary What have we learned about money in a free society? We have learned that all money has originated and must originate in a useful commodity chosen by the free market as a medium of exchange. The unit of money is simply a unit of weight of the monetary commodity, usually a metal, such as gold or silver. Under freedom, the commodities chosen as money, their shape and form are left to the voluntary decisions of free individuals. Private coinage therefore is just as legitimate and worthwhile as any business activity. The price of money is its purchasing power in terms of all goods in the economy, and this is determined by its supply and by every individual's demand for money. Any attempt by government to fix the price will interfere with the satisfaction of people's demands for money. If people find it more convenient to use more than one metal as money, the exchange rate between them on the market will be determined by the relative demands and supplies, and will tend to equal the ratios of their respective purchasing power. Once there is enough supply of a metal to permit the market to choose it as money, no increase in supply can improve its monetary function. An increase in money supply will then merely dilute the effectiveness of each ounce of money without helping the economy. An increased stock of gold or silver, however, fulfills more non-monetary wants, ornament, industrial purposes, etc., served by the metal, and is therefore socially useful. Inflation, an increase in money substitutes not covered by an increase in the metal stock, is never socially useful, but merely benefits one set of people at the expense of another. Inflation, being a fraudulent invasion of property, could not take place on the free market. In some, freedom can run a monetary system as superbly as it runs the rest of the economy. Contrary to many writers, there is nothing special about money that requires extensive governmental dictation. Here too, free men will best and most smoothly supply all their economic wants. For money, as for all other activities of man, liberty is the mother, not the daughter of order.