This article is now a place holder. I realized that to fully attack the question of sound money, I must first discuss inflation and the business cycle. I will re-write this article once I am done with those. In the meanwhile please see the other articles on money. And below are the conclusion and references from previously:
Conclusion
The above discussion yields 3 conclusions. First, that we should affirm the markets choice for money. Second, that a fiat money system removes accountability from government. Third, that fiat money causes structural damage to the production structure and undermines the process of wealth creation. The only viable monetary system is a 100% gold standard (or whatever standard the market selects).
References
The case for the barbarous relic, by Lew Rockwell.
Ludwig von Mises on sound money.
Price stability, by Frank Shostak.
Price stability, by Thorsten Polleit.
Thursday, September 27, 2007
Monday, September 24, 2007
Fractional Reserve Banking
In the previous article we looked at free market banking institutions. We discussed that money is the commodity (historically gold and silver) selected by the market as the preferred medium of exchange, and that gold warehouses serve as an efficient means to store and trade gold. In this article we look at fractional reserve banking, which is the practice of banks lending out their customers deposits in multiples. This appears to be at odds with our discussion in previous articles, so we scrutinize the practice to see if we cannot reconcile the apparent inconsistency.
Savings and lending
Before we discuss fractional reserve banking, it is important to understand the essence of savings and lending. The first myth to dispel is that money is wealth. Money is not wealth; real wealth is tangible physical goods. Your house, your furniture, your car, your golf clubs -- those are real wealth. Money, as the medium of exchange, is a claim on real wealth. Therefore, the act of saving is the expression of an individual’s preference to relinquish his claim on wealth today for a future date. It is very important to understand this. Money is a convenience that arose to facilitate trade. Before money, every trade was an exchange of real wealth (barter). With the introduction of money, every trade is still an exchange of real wealth, just temporally disconnected because the receiver of the money doesn’t complete his side of the trade (receive his goods) until he spends the money he received in exchange for his goods.
This is true of lending as well. Jones borrows $1000 today to purchase goods and services. Tomorrow he repays $1000, but is actually repaying what the money can purchase. He borrows real wealth, and returns real wealth. Therefore, lending entails a transfer of real wealth from lender to borrower. The existence of money tends to obfuscate this insight, but does not change it.
Bank lending
Recall that gold warehouses are storage facilities. An individual depositing money at a warehouse does not relinquish his or her ownership of it, and more importantly, does not relinquish his or her claim on real wealth. The money is still theirs to spend, it is just being safeguarded. This arrangement is a checking account. Alternately, the depositor may instruct the warehouse to lend out their money through a savings account. Here, a depositor relinquishes his or her ownership of the money to the lending institution and thus the would-be borrower. Restated, the depositor relinquishes his or her claim on real wealth in favor of the borrower. In this manner, real wealth is saved, and lent out. The transaction is still a trade of real wealth where money is merely the intermediary.
(The restrictions on savings accounts may actually be quite lax. There is a clear precedent in how mutual funds are structured today.)
Fractional reserve banking
Historically, gold warehouses (or was it goldsmiths?) found that their customers rarely withdrew their deposits; mainly because the receipts to the deposits were as good as the deposits themselves and thus came to be traded in their lieu. Therefore, much of the gold remained in the vaults untouched. Lending this gold at interest, they could make a good profit with repercussions only if more gold was demanded for withdrawal than was currently in the vault. Thus the practice of fractional reserve banking was born. Today, this basic scheme is operate on a large scale by all banks in a government regulated environment. The government establishes a reserve ratio, which sets the fraction of deposits that must be held at the bank. Thus, if the reserve ratio is 0.1, then 10% of all deposits must be held at the bank and 90% are free to be lent out. This has the net effect of allowing 9 times the deposited amount to be lent out. Here is how the process works:
Jones deposits $1,000 at bank A. With a 0.1 reserve ratio, bank A can lend out $900 of that deposit and keep $100 on hand as reserves. Let us say they lend out $900 and it makes its way to Smith – either he borrowed it, or the real borrower used it to pay him. Smith now has $900 that he deposits at another bank, B. Bank B, in turn, keeps $90 as reserve (10% of $900) and lends out $810 to someone else. This $810 is spent and deposited at bank C, which keeps $81 as reserves and lends out $729 to someone else. As this process continues, the total amount lent out by the various banks in the system adds up: $900 + $810 + $729 + …. The sum of this series is $9,000. The total held in reserve also adds up: $100 + $90 + $81 + $72 … = $1,000. Thus $9,000 of lending is supported by $1,000 in reserves. This is why most commentators will state that fractional reserve banking allows the lending of multiples of reserves. Technically, it is not the bank that received the initial deposit that can lend out a multiple, but rather the system as a whole creates it through the process described above.
Having described the mechanism, let us examine it more carefully. When Jones deposits $1,000 in his checking account, bank A issues him a receipt stating that he has $1,000 on deposit. This is a promise to pay $1000 dollars on demand. If bank A lends out $900 of that $1000 then they are no longer capable of honoring their liability to Jones. What they are banking on (excuse the pun), is that Jones will not attempt to withdraw his money before they are paid back on the loan they made. With a single customer, Jones, this is a reasonable risk. However, with hundreds of customers, it becomes far less risky since they can siphon funds between accounts and repay Jones with someone else’s deposit. What they fear then is a run on the bank where a critical mass of customers simultaneously demands withdrawals in excess of total reserves, making them insolvent.
It should be apparent to the reader by now that this is fraud, plain and simple. Some commentators will describe it as counterfeiting, but I think fraud is a more appropriate term as counterfeit bills are not at the root of the fraud. Far more important, however, are the consequences of fractional reserve banking on the economy.
Inflation and the business cycle
If you read my articles on inflation, it should be clear that fractional reserve banking is highly inflationary because it is nothing but an increase in the money supply. This, of course, is accompanied by all the attending ills of inflation, but none more so than the business cycle.
Recall that money is only a claim on real wealth. When Jones deposits his $1000 in his checking account, he does not relinquish this claim; he is merely choosing not to exercise it. When his money is lent out and spent on goods or services, those goods and services are diverted to individuals who would not have otherwise received them. Had Jones instead stuffed his mattress with the cash, he would have maintained his claim on real wealth and not lent out his money. However, placing it in a bank, he has unwittingly been defrauded into relinquishing his claim on real wealth and lending out his money. This is known as forced savings and is vitally important in understanding the business cycle. It is demonstrable that forced savings along with other related factors causes market dislocations that result in booms and busts. The business cycle is not an inherent instability in the free market caused by “animal spirits”. To suggest so betrays a highly superficial and childish understanding of the macro economy and catallactics. The business cycle is, in fact, a direct result of inflation and government intervention as Austrian have carefully detailed beginning with the publication of Von Mises’s masterwork on money and capital, The Theory of Money and Credit. I will explore these ideas more completely in my article on the business cycle. You can read Rothbards introduction here or Gene Callahans explanation here.
Conclusion
It has been shown that savings and lending are voluntary acts on the part of the lender and borrower to trade real wealth now and in the future. Fractional reserve banking undermines this, creating instability in the economy, and resulting in the business cycle. Further, fractional reserve banking should be correctly identified as fraud because it enables the multiplication of money and creates counterfeit claims to the unchanged pool of real wealth. One common argument often put forth by apologists is that the bank, through fractional reserve banking, can pay interest on deposits thus benefiting the depositor. That this argument is actually accepted in debate today is testament to how badly understood the theory of money and banking is. Whatever is gained in nominal interest payments is lost -- and more -- through inflation. The creation of fake receipts does not also coincidentally create real wealth; it only dilutes claims to it. Thus if the depositor had 10% of the money supply before (a claim to 10% of real wealth), he has less than 10% after, thus commanding a smaller claim on real wealth. Even if he has more dollars, those dollars are worth less. Thus, he enjoys a nominal gain, but suffers a real loss.
References
Rothbard on fractional reserve banking.
Rothbards great introduction to money and banking.
Mises on money, by Gary North.
Money, Banking, and the Federal Reserve, complete transcript.
Savings and lending
Before we discuss fractional reserve banking, it is important to understand the essence of savings and lending. The first myth to dispel is that money is wealth. Money is not wealth; real wealth is tangible physical goods. Your house, your furniture, your car, your golf clubs -- those are real wealth. Money, as the medium of exchange, is a claim on real wealth. Therefore, the act of saving is the expression of an individual’s preference to relinquish his claim on wealth today for a future date. It is very important to understand this. Money is a convenience that arose to facilitate trade. Before money, every trade was an exchange of real wealth (barter). With the introduction of money, every trade is still an exchange of real wealth, just temporally disconnected because the receiver of the money doesn’t complete his side of the trade (receive his goods) until he spends the money he received in exchange for his goods.
This is true of lending as well. Jones borrows $1000 today to purchase goods and services. Tomorrow he repays $1000, but is actually repaying what the money can purchase. He borrows real wealth, and returns real wealth. Therefore, lending entails a transfer of real wealth from lender to borrower. The existence of money tends to obfuscate this insight, but does not change it.
Bank lending
Recall that gold warehouses are storage facilities. An individual depositing money at a warehouse does not relinquish his or her ownership of it, and more importantly, does not relinquish his or her claim on real wealth. The money is still theirs to spend, it is just being safeguarded. This arrangement is a checking account. Alternately, the depositor may instruct the warehouse to lend out their money through a savings account. Here, a depositor relinquishes his or her ownership of the money to the lending institution and thus the would-be borrower. Restated, the depositor relinquishes his or her claim on real wealth in favor of the borrower. In this manner, real wealth is saved, and lent out. The transaction is still a trade of real wealth where money is merely the intermediary.
(The restrictions on savings accounts may actually be quite lax. There is a clear precedent in how mutual funds are structured today.)
Fractional reserve banking
Historically, gold warehouses (or was it goldsmiths?) found that their customers rarely withdrew their deposits; mainly because the receipts to the deposits were as good as the deposits themselves and thus came to be traded in their lieu. Therefore, much of the gold remained in the vaults untouched. Lending this gold at interest, they could make a good profit with repercussions only if more gold was demanded for withdrawal than was currently in the vault. Thus the practice of fractional reserve banking was born. Today, this basic scheme is operate on a large scale by all banks in a government regulated environment. The government establishes a reserve ratio, which sets the fraction of deposits that must be held at the bank. Thus, if the reserve ratio is 0.1, then 10% of all deposits must be held at the bank and 90% are free to be lent out. This has the net effect of allowing 9 times the deposited amount to be lent out. Here is how the process works:
Jones deposits $1,000 at bank A. With a 0.1 reserve ratio, bank A can lend out $900 of that deposit and keep $100 on hand as reserves. Let us say they lend out $900 and it makes its way to Smith – either he borrowed it, or the real borrower used it to pay him. Smith now has $900 that he deposits at another bank, B. Bank B, in turn, keeps $90 as reserve (10% of $900) and lends out $810 to someone else. This $810 is spent and deposited at bank C, which keeps $81 as reserves and lends out $729 to someone else. As this process continues, the total amount lent out by the various banks in the system adds up: $900 + $810 + $729 + …. The sum of this series is $9,000. The total held in reserve also adds up: $100 + $90 + $81 + $72 … = $1,000. Thus $9,000 of lending is supported by $1,000 in reserves. This is why most commentators will state that fractional reserve banking allows the lending of multiples of reserves. Technically, it is not the bank that received the initial deposit that can lend out a multiple, but rather the system as a whole creates it through the process described above.
Having described the mechanism, let us examine it more carefully. When Jones deposits $1,000 in his checking account, bank A issues him a receipt stating that he has $1,000 on deposit. This is a promise to pay $1000 dollars on demand. If bank A lends out $900 of that $1000 then they are no longer capable of honoring their liability to Jones. What they are banking on (excuse the pun), is that Jones will not attempt to withdraw his money before they are paid back on the loan they made. With a single customer, Jones, this is a reasonable risk. However, with hundreds of customers, it becomes far less risky since they can siphon funds between accounts and repay Jones with someone else’s deposit. What they fear then is a run on the bank where a critical mass of customers simultaneously demands withdrawals in excess of total reserves, making them insolvent.
It should be apparent to the reader by now that this is fraud, plain and simple. Some commentators will describe it as counterfeiting, but I think fraud is a more appropriate term as counterfeit bills are not at the root of the fraud. Far more important, however, are the consequences of fractional reserve banking on the economy.
Inflation and the business cycle
If you read my articles on inflation, it should be clear that fractional reserve banking is highly inflationary because it is nothing but an increase in the money supply. This, of course, is accompanied by all the attending ills of inflation, but none more so than the business cycle.
Recall that money is only a claim on real wealth. When Jones deposits his $1000 in his checking account, he does not relinquish this claim; he is merely choosing not to exercise it. When his money is lent out and spent on goods or services, those goods and services are diverted to individuals who would not have otherwise received them. Had Jones instead stuffed his mattress with the cash, he would have maintained his claim on real wealth and not lent out his money. However, placing it in a bank, he has unwittingly been defrauded into relinquishing his claim on real wealth and lending out his money. This is known as forced savings and is vitally important in understanding the business cycle. It is demonstrable that forced savings along with other related factors causes market dislocations that result in booms and busts. The business cycle is not an inherent instability in the free market caused by “animal spirits”. To suggest so betrays a highly superficial and childish understanding of the macro economy and catallactics. The business cycle is, in fact, a direct result of inflation and government intervention as Austrian have carefully detailed beginning with the publication of Von Mises’s masterwork on money and capital, The Theory of Money and Credit. I will explore these ideas more completely in my article on the business cycle. You can read Rothbards introduction here or Gene Callahans explanation here.
Conclusion
It has been shown that savings and lending are voluntary acts on the part of the lender and borrower to trade real wealth now and in the future. Fractional reserve banking undermines this, creating instability in the economy, and resulting in the business cycle. Further, fractional reserve banking should be correctly identified as fraud because it enables the multiplication of money and creates counterfeit claims to the unchanged pool of real wealth. One common argument often put forth by apologists is that the bank, through fractional reserve banking, can pay interest on deposits thus benefiting the depositor. That this argument is actually accepted in debate today is testament to how badly understood the theory of money and banking is. Whatever is gained in nominal interest payments is lost -- and more -- through inflation. The creation of fake receipts does not also coincidentally create real wealth; it only dilutes claims to it. Thus if the depositor had 10% of the money supply before (a claim to 10% of real wealth), he has less than 10% after, thus commanding a smaller claim on real wealth. Even if he has more dollars, those dollars are worth less. Thus, he enjoys a nominal gain, but suffers a real loss.
References
Rothbard on fractional reserve banking.
Rothbards great introduction to money and banking.
Mises on money, by Gary North.
Money, Banking, and the Federal Reserve, complete transcript.
Tuesday, September 11, 2007
Free Market Banking
In the previous article we looked at money and how it arises in the market. We determined that money is a commodity that is selected by the market as the medium of exchange. Only a commodity with prior value can gain this status, as exemplified by Mises' regression theorem. The commodity that gained wide acceptance was precisely gold, and to a lesser extent silver. Although money is the lifeblood of the market economy, as physical gold it has not realized its full potential -- for that, we need banking.
Recall that money should be portable, divisible, and durable. Gold is all of these, however, for large transactions, it can still prove cumbersome. There is also the added complication of storage. Even though physical gold eliminates many costs of barter exchange, such as time and effort, it cannot eliminate all costs, particularly transaction and storage costs. However, the market has a solution: money warehouses. I use the term warehouses and not banks because free market banking is different from the current fractional reserve system. In order to understand this difference it is important to first look at how warehouses would function in a free market and then consider the differences with the current banking system.
Banking as a convenience
In a free market, money warehouses function as depositories, much like how any storage facility works today. The owner deposits his gold, pays a storage fee, purchases insurance if desired, and receives a receipt certifying the deposit. This receipt entitles him to immediate withdrawal of his gold at a moments notice. Precisely how the receipt at any storage facility today allows one to retrieve their property whenever they desire.
Storage fees and insurance costs are unavoidable no matter how gold is stored. Storing gold anywhere, whether at home, in the backyard, or buried under a tree incurs costs. Sometimes these are indirect (time, effort, lost opportunity) and not recognized as costs, but they still exist. In addition, there is always the risk of theft and insurance is necessary to protect against this. Clearly the price paid for insurance is commensurate with the safety of the storage facility. Due to the benefits of specialization, money warehouses can offer the lowest storage and insurance costs. In fact, there is a huge economic incentive for money warehouses to forward integrate their business to provide storage as well as insurance. This ensures rock-bottom fees, and aligns the incentives of the customer and warehouse: now neither wants the gold stolen; the customer for obvious reasons, and the warehouse because they are on the hook as sellers of the insurance policy.
Warehouses greatly reduce the cost of storing gold, but what about transaction costs? They serve to lower these as well. Suppose Smith and Jones enter a trade where Smith agrees to pay Jones 100 ounces of gold. To fulfill his commitment, Smith must withdraw gold from his warehouse and deliver it to Jones. Jones then deposits it in his own warehouse for safekeeping. This requires time and effort. Alternately, Smith can write Jones a check, which, when cashed, instructs Smiths warehouse to pay Jones 100 ounces of gold, drawn on Smiths account. Most likely Jones will deposit the check at his own warehouse. If they belong to the same warehouse this is a simple bookkeeping entry. If they are customers of different warehouses this can still be cost effective since the two warehouses can aggregate all such trades between their customers and physically settle in the manner most convenient. Economies of scale ensure that the costs borne are lower than individual transactions. Presumably, Smith and Jones prefer low costs and high convenience so they opt to pay the service fee for using their warehouses rather than making a direct exchange.
We see that money warehouses play an important role in making gold more cost effective as the medium of exchange. Ultimately, however, they are nothing more than a convenience. They merely serve to lower the costs and increase the convenience of trading physical gold. This is not to say that lending institutions paying interest on gold deposits will not exist in a free market. They absolutely will. However, they should be recognized as distinct from money warehouses. This will be discussed more clearly in the next article on fractional reserve banking.
Paper money
While the system above is already a vast improvement over direct exchange, there is still one further improvement we can envision. If the receipts issued by a gold warehouse are redeemable by the bearer of the receipt, then individuals can simply trade receipts as if trading actual gold. These paper receipts, or bank notes, eliminate transaction costs, but introduces a new risk: counterfeiting -- the notes may be fake. However, again due to economies of scale, well known and trusted warehouses can issues hard to counterfeit notes, similar to federal reserve notes (dollars) today. This situation presents the same risk as using dollars today, so it is highly conceivable that it can evolve and be sustained in a free market. In fact, this phenomenon has been observed repeatedly throughout history, but unlike the system today, there will be no monopoly on the issuance of bank notes.
(An interesting corollary is the origin of the word "dollar", which can be traced to thalers, silver money coined by the Count von Schlick. These private coins gained wide reputations for their integrity. Most people recognizing the seal were willing to trust the integrity of the coin, much as anyone recognizing the seal on federal reserve notes today is willing to trust the integrity of the note. Why should it be any different with private bank notes?)
Conclusion
Banking in a free market takes the shape of money warehouses which serve as a secure place to store gold and an efficient way to trade it. Since warehouses issue receipts that are redeemable at a moments notice, they must keep all the gold on the premises at all times. They are not the owners, they are merely the caretakers. To do otherwise is fraud or theft. This will be discussed more clearly in the article on fractional reserve banking. The best known example of free market banking has been the Banca della Piazza del Rialto, which grew to become the center of Venetian commerce. Another example is the Bank of Hamburg, which was eventually compromised when Napolean took control of it.
In the article on fractional reserve banking we will also look at the structure of free market lending institutions. It should be clear, however, that gold warehouses, as described above, are not lending institutions. They are merely storage facilities to lower the costs of transacting in gold.
As for whether bank notes will be widespread, it is very likely so, but it will depend on the relative costs. Only the market can decide. As individuals evaluate alternatives and make choices, they will decide if they prefer checking accounts or bank notes. Each individual, weighing his preferences against the costs and risks and deciding on the former, the latter, or a hybrid of the two, will have the effect of the market selecting the most appropriate solution. When Austrians talk about to the market "selecting" a good or services, it is precisely this phenomenon that they are referring to. It derives from profit-loss accounting, an extremely important concept in understanding how markets function.
References
Rothbard's must read introduction to money and banking.
Recall that money should be portable, divisible, and durable. Gold is all of these, however, for large transactions, it can still prove cumbersome. There is also the added complication of storage. Even though physical gold eliminates many costs of barter exchange, such as time and effort, it cannot eliminate all costs, particularly transaction and storage costs. However, the market has a solution: money warehouses. I use the term warehouses and not banks because free market banking is different from the current fractional reserve system. In order to understand this difference it is important to first look at how warehouses would function in a free market and then consider the differences with the current banking system.
Banking as a convenience
In a free market, money warehouses function as depositories, much like how any storage facility works today. The owner deposits his gold, pays a storage fee, purchases insurance if desired, and receives a receipt certifying the deposit. This receipt entitles him to immediate withdrawal of his gold at a moments notice. Precisely how the receipt at any storage facility today allows one to retrieve their property whenever they desire.
Storage fees and insurance costs are unavoidable no matter how gold is stored. Storing gold anywhere, whether at home, in the backyard, or buried under a tree incurs costs. Sometimes these are indirect (time, effort, lost opportunity) and not recognized as costs, but they still exist. In addition, there is always the risk of theft and insurance is necessary to protect against this. Clearly the price paid for insurance is commensurate with the safety of the storage facility. Due to the benefits of specialization, money warehouses can offer the lowest storage and insurance costs. In fact, there is a huge economic incentive for money warehouses to forward integrate their business to provide storage as well as insurance. This ensures rock-bottom fees, and aligns the incentives of the customer and warehouse: now neither wants the gold stolen; the customer for obvious reasons, and the warehouse because they are on the hook as sellers of the insurance policy.
Warehouses greatly reduce the cost of storing gold, but what about transaction costs? They serve to lower these as well. Suppose Smith and Jones enter a trade where Smith agrees to pay Jones 100 ounces of gold. To fulfill his commitment, Smith must withdraw gold from his warehouse and deliver it to Jones. Jones then deposits it in his own warehouse for safekeeping. This requires time and effort. Alternately, Smith can write Jones a check, which, when cashed, instructs Smiths warehouse to pay Jones 100 ounces of gold, drawn on Smiths account. Most likely Jones will deposit the check at his own warehouse. If they belong to the same warehouse this is a simple bookkeeping entry. If they are customers of different warehouses this can still be cost effective since the two warehouses can aggregate all such trades between their customers and physically settle in the manner most convenient. Economies of scale ensure that the costs borne are lower than individual transactions. Presumably, Smith and Jones prefer low costs and high convenience so they opt to pay the service fee for using their warehouses rather than making a direct exchange.
We see that money warehouses play an important role in making gold more cost effective as the medium of exchange. Ultimately, however, they are nothing more than a convenience. They merely serve to lower the costs and increase the convenience of trading physical gold. This is not to say that lending institutions paying interest on gold deposits will not exist in a free market. They absolutely will. However, they should be recognized as distinct from money warehouses. This will be discussed more clearly in the next article on fractional reserve banking.
Paper money
While the system above is already a vast improvement over direct exchange, there is still one further improvement we can envision. If the receipts issued by a gold warehouse are redeemable by the bearer of the receipt, then individuals can simply trade receipts as if trading actual gold. These paper receipts, or bank notes, eliminate transaction costs, but introduces a new risk: counterfeiting -- the notes may be fake. However, again due to economies of scale, well known and trusted warehouses can issues hard to counterfeit notes, similar to federal reserve notes (dollars) today. This situation presents the same risk as using dollars today, so it is highly conceivable that it can evolve and be sustained in a free market. In fact, this phenomenon has been observed repeatedly throughout history, but unlike the system today, there will be no monopoly on the issuance of bank notes.
(An interesting corollary is the origin of the word "dollar", which can be traced to thalers, silver money coined by the Count von Schlick. These private coins gained wide reputations for their integrity. Most people recognizing the seal were willing to trust the integrity of the coin, much as anyone recognizing the seal on federal reserve notes today is willing to trust the integrity of the note. Why should it be any different with private bank notes?)
Conclusion
Banking in a free market takes the shape of money warehouses which serve as a secure place to store gold and an efficient way to trade it. Since warehouses issue receipts that are redeemable at a moments notice, they must keep all the gold on the premises at all times. They are not the owners, they are merely the caretakers. To do otherwise is fraud or theft. This will be discussed more clearly in the article on fractional reserve banking. The best known example of free market banking has been the Banca della Piazza del Rialto, which grew to become the center of Venetian commerce. Another example is the Bank of Hamburg, which was eventually compromised when Napolean took control of it.
In the article on fractional reserve banking we will also look at the structure of free market lending institutions. It should be clear, however, that gold warehouses, as described above, are not lending institutions. They are merely storage facilities to lower the costs of transacting in gold.
As for whether bank notes will be widespread, it is very likely so, but it will depend on the relative costs. Only the market can decide. As individuals evaluate alternatives and make choices, they will decide if they prefer checking accounts or bank notes. Each individual, weighing his preferences against the costs and risks and deciding on the former, the latter, or a hybrid of the two, will have the effect of the market selecting the most appropriate solution. When Austrians talk about to the market "selecting" a good or services, it is precisely this phenomenon that they are referring to. It derives from profit-loss accounting, an extremely important concept in understanding how markets function.
References
Rothbard's must read introduction to money and banking.
Wednesday, September 5, 2007
Money
For my first post I would like to look at one of the most important aspects of the market economy: money. In fact, I would go as far as to say that the prerequisites for a prosperous and stable society are precisely property rights and sound money. Nothing more, nothing less. I will talk about property rights at a later date once I have gotten the easy stuff out of the way. For now, I think the reader will agree that allowing theft is probably not a good idea if one wants to build a prosperous and stable society.
Origin of money
To understand what money is and how it evolved, we need to look at the role it plays in the market economy. Without money, we would be living in what is called a barter economy. A barter economy is characterized by direct exchange. If Jones the baker wants an apple, he will trade with the grocer by offering the grocer a loaf of bread. They both agree on how many apples each loaf is worth and make an exchange. Easy enough, but what if Smith the economics professor wants to get a haircut? He needs to find a barber willing to trade him a haircut in return for an economics lesson. This may prove quite hard to do. This problem in the barter economy is known as the double coincidence of wants -- both Smith and the barber must be looking for each others services in order for an exchange to take place. As is evident, this greatly reduces the ease with which people can trade and thus undermines the division of labor.
Suppose, instead of Smith, that Jones the baker had wanted to get a haircut. Do you think it would be easier or harder for him to find a barber willing to trade him a haircut for a loaf of bread? Intuitively, it should be apparent that it would be much easier. What about Davis the shoemaker? Presumably he would have an easier time than Smith, but probably have to look a little longer then Jones. This difference in how readily certain goods are accepted in trade is what Menger termed their saleability (marketability, liquidity).
Smith, if he was any good as an economics professor, understands this concept and also that his services are not very saleable. Therefore, in order to satisfy his daily needs, he realizes that he needs to have a reserve of highly saleable goods on hand. If he wants a haircut, instead of looking for a barber that wants an economics lesson, which can be costly in time and effort, he need only dip into his stock of highly saleable goods and get himself a haircut from the closest barber. Further, whenever he gives someone an economics lesson, he can request as payment highly saleable goods and thus build his reserve. By acting in this manner what he is doing is using highly saleable goods not for personal consumption, but rather as a means to facilitate trade in the future. He is using them as a medium of exchange.
In order for something to be effective as a medium of exchange it needs to be
The definition of money is precisely that good (or goods) which serves as the medium of exchange. At different times and places many goods have been used as the medium of exchange, including lumber, tobacco, and even cell phone airtime in some parts of Africa today. However, the market has selected one good in particular, gold, to be the universally preferred medium of exchange. There are very important reasons for this that will be discussed at length in the article on sound money. The current system, however, is based on government fiat paper money that is not backed by gold, silver, or anything for that matter. It would appear that this undermines our discussion, but it does not for reasons that will become clear shortly.
As one particular good becomes widely accepted as the preferred medium of exchange, it's demand rises. People now value it for whatever reason they valued it earlier, as well as because it has become money. It has its original non-monetary value (industrial or aesthetic), as well as its monetary value (can be readily traded). In the process of gaining monetary value, the good assumes further saleability as people are more likely to accept it in trade because they know still others are more likely to accept it in trade, and so on. This is self-reinforcing, and the end result is that money often gains much more monetary value than non-monetary value. This has been the case with gold; it has become much more valuable after it was widely accepted as money. Even today the major driver of the price of gold is investment demand. Also think about what the most saleable good is today. It is precisely federal reserve notes, what we call money. Remember they are backed by nothing, they are merely pieces of paper, but everyone will readily trade for them because they have monetary value -- can be exchanged for goods and services at a future date.
It should be clear at this point that a good cannot naturally arise in the market as money unless it is already highly saleable (for whatever reason). That is, it must have some original value to form a starting point. This is the essence of Mises' regression theorem. Even the current monetary system does not escape this need. When the federal reserve notes that we use as money today were first issued, they were redeemable in gold. Once they gained monetary value to offset the fact that they are nothing but pieces of paper, Nixon was able to close the gold window and sever any ties they had with gold. They did not fail because they had become saleable on account of acquiring monetary value. However, it is important to realize that they are an "unnatural" phenomenon because they required government force (legal tender laws and false demand in terms of income taxes only payable in federal reserve notes). It is impossible for fiat money to arise in a free market. If a critical mass of people realizes this, fiat money may very well be rejected (it is, in the economic sense, a bubble) and society will return to a commodity based money, such as the gold standard.
Conclusion
We will look at fiat money versus gold in more detail when we discuss sound money. For now it should be clear money is a commodity that naturally arises in the free market as the preferred medium of exchange. Individuals vote by choosing to accept certain goods over others and eventually one is selected as the best. Historically, this has been gold, and to a lesser extent silver. Although fiat money is unnatural, once it has gained monetary value, it is no different than gold in that regard. However, there are other important differences.
Some people will claim that money is a store of value and a unit of account. With the caveat that value is purely subjective and cannot be "stored", this is true. Money tends to maintain its "value" (it's purchasing power). I say tends because there is always the threat of inflation. It is also a unit of account because the prices of all goods are expressed in the monetary unit. However, these are both consequences of it being the medium of exchange.
A final note: the theory of money and credit is one area where Austrian economics clearly differentiates itself mainstream economics. Important books include Mises' Theory of Money and Credit, and Jesus Huerta de Soto's Money, Bank Credit, and Economic Cycles.
Please read the next article on banking.
References
Must read article by Rothbard.
Money, Bank Credit, and Economic Cycles by Jesus Huerta de Soto.
Theory of Money and Credit by Ludwig von Mises.
Study guide to money.
Origin of money
To understand what money is and how it evolved, we need to look at the role it plays in the market economy. Without money, we would be living in what is called a barter economy. A barter economy is characterized by direct exchange. If Jones the baker wants an apple, he will trade with the grocer by offering the grocer a loaf of bread. They both agree on how many apples each loaf is worth and make an exchange. Easy enough, but what if Smith the economics professor wants to get a haircut? He needs to find a barber willing to trade him a haircut in return for an economics lesson. This may prove quite hard to do. This problem in the barter economy is known as the double coincidence of wants -- both Smith and the barber must be looking for each others services in order for an exchange to take place. As is evident, this greatly reduces the ease with which people can trade and thus undermines the division of labor.
Suppose, instead of Smith, that Jones the baker had wanted to get a haircut. Do you think it would be easier or harder for him to find a barber willing to trade him a haircut for a loaf of bread? Intuitively, it should be apparent that it would be much easier. What about Davis the shoemaker? Presumably he would have an easier time than Smith, but probably have to look a little longer then Jones. This difference in how readily certain goods are accepted in trade is what Menger termed their saleability (marketability, liquidity).
Smith, if he was any good as an economics professor, understands this concept and also that his services are not very saleable. Therefore, in order to satisfy his daily needs, he realizes that he needs to have a reserve of highly saleable goods on hand. If he wants a haircut, instead of looking for a barber that wants an economics lesson, which can be costly in time and effort, he need only dip into his stock of highly saleable goods and get himself a haircut from the closest barber. Further, whenever he gives someone an economics lesson, he can request as payment highly saleable goods and thus build his reserve. By acting in this manner what he is doing is using highly saleable goods not for personal consumption, but rather as a means to facilitate trade in the future. He is using them as a medium of exchange.
In order for something to be effective as a medium of exchange it needs to be
- Highly saleable: as we have already discussed.
- Portable: so it can be carried to the place of exchange, or just on someone's person in anticipation of an exchange.
- Durable: probably wouldn't work to keep it under ones mattress to find it has perished a week later.
- Divisible: so exactly as much as needed can be exchanged.
The definition of money is precisely that good (or goods) which serves as the medium of exchange. At different times and places many goods have been used as the medium of exchange, including lumber, tobacco, and even cell phone airtime in some parts of Africa today. However, the market has selected one good in particular, gold, to be the universally preferred medium of exchange. There are very important reasons for this that will be discussed at length in the article on sound money. The current system, however, is based on government fiat paper money that is not backed by gold, silver, or anything for that matter. It would appear that this undermines our discussion, but it does not for reasons that will become clear shortly.
As one particular good becomes widely accepted as the preferred medium of exchange, it's demand rises. People now value it for whatever reason they valued it earlier, as well as because it has become money. It has its original non-monetary value (industrial or aesthetic), as well as its monetary value (can be readily traded). In the process of gaining monetary value, the good assumes further saleability as people are more likely to accept it in trade because they know still others are more likely to accept it in trade, and so on. This is self-reinforcing, and the end result is that money often gains much more monetary value than non-monetary value. This has been the case with gold; it has become much more valuable after it was widely accepted as money. Even today the major driver of the price of gold is investment demand. Also think about what the most saleable good is today. It is precisely federal reserve notes, what we call money. Remember they are backed by nothing, they are merely pieces of paper, but everyone will readily trade for them because they have monetary value -- can be exchanged for goods and services at a future date.
It should be clear at this point that a good cannot naturally arise in the market as money unless it is already highly saleable (for whatever reason). That is, it must have some original value to form a starting point. This is the essence of Mises' regression theorem. Even the current monetary system does not escape this need. When the federal reserve notes that we use as money today were first issued, they were redeemable in gold. Once they gained monetary value to offset the fact that they are nothing but pieces of paper, Nixon was able to close the gold window and sever any ties they had with gold. They did not fail because they had become saleable on account of acquiring monetary value. However, it is important to realize that they are an "unnatural" phenomenon because they required government force (legal tender laws and false demand in terms of income taxes only payable in federal reserve notes). It is impossible for fiat money to arise in a free market. If a critical mass of people realizes this, fiat money may very well be rejected (it is, in the economic sense, a bubble) and society will return to a commodity based money, such as the gold standard.
Conclusion
We will look at fiat money versus gold in more detail when we discuss sound money. For now it should be clear money is a commodity that naturally arises in the free market as the preferred medium of exchange. Individuals vote by choosing to accept certain goods over others and eventually one is selected as the best. Historically, this has been gold, and to a lesser extent silver. Although fiat money is unnatural, once it has gained monetary value, it is no different than gold in that regard. However, there are other important differences.
Some people will claim that money is a store of value and a unit of account. With the caveat that value is purely subjective and cannot be "stored", this is true. Money tends to maintain its "value" (it's purchasing power). I say tends because there is always the threat of inflation. It is also a unit of account because the prices of all goods are expressed in the monetary unit. However, these are both consequences of it being the medium of exchange.
A final note: the theory of money and credit is one area where Austrian economics clearly differentiates itself mainstream economics. Important books include Mises' Theory of Money and Credit, and Jesus Huerta de Soto's Money, Bank Credit, and Economic Cycles.
Please read the next article on banking.
References
Must read article by Rothbard.
Money, Bank Credit, and Economic Cycles by Jesus Huerta de Soto.
Theory of Money and Credit by Ludwig von Mises.
Study guide to money.
Monday, September 3, 2007
References
An introduction to the Austrian school at mises.org.
Here is a quick list of some important resources on mises.org that I have found useful in the past.
Here is a quick list of some important resources on mises.org that I have found useful in the past.
- Quiz: a good way to see how familiar one is with the Austrian and other schools of thought. Just fyi, it is actually on the longer side.
It is multiple choice with 4 possible answers, one from each of the following schools of thought: Austrian, Chicago, Neoclassical, Socialist. Once you complete and hit submit, all the answers are listed and identified. If nothing else you can treat the answer page as a FAQ about where each school stands on various issues. I found this very useful when I first started out because it helped my identify the important issues (the questions), and where each major school stands on those (the answers). - Articles: form a great window into Austrian economics.
- Study Guide: (almost) exhaustive resource of anything and everything Austrian.
- FAQ: on the Mises Institute and Austrian economics.
- Mises Blog.
- Quotable Mises.
Introduction
Hello and welcome to my blog. Here I will attempt to explain Austrian Economics in the tradition of Mises and Rothbard. Although both Mises and Rothbard make, what would appear to some, as quite extraordinary claims -– especially in the realm of monetary and capital theory -- they are actually not that for off the beaten path of Nobel laureates Friedman and Hayek, or the great economists of previous centuries, such as Riccardo, Smith, Say, and Cantillon. However, the truly fundamental difference between Austrian and mainstream economics (here I clump Friedman but not Hayek with the mainstream) is the Austrian commitment to an epistemically sound foundation for the field of economics. Specifically, while the mainstream approaches economics (and by extension the rest of the social sciences) with a positivist lens, Austrians recognize that positivism is an incomplete epistemology, especially when dealing with human actors, and thus reject its validity in the social sciences. In this introductory article, I would like to explore this notion briefly and also share some thoughts on the nature of economic inquiry.
The first thing to stress is that, despite the inherent contradictions in positivism (described later in this article), it should not be confused as having failed humanity. Positivism in the natural sciences (physics, chemistry, biology, etc) has been fabulously successful at explaining the world around us. In fact, it has been so successful that it has been mistakenly confused as the scientific method, while the true scientific method has fallen into obscurity and has only really been kept alive by the Austrians. The reason for this is because what is known as the synthetic a priori can only advance so far in the natural sciences that in order to gather any knowledge of the world around us, we must rely on the synthetic a posteriori. Thus, having observed the success of the latter and the apparent failure of the former in the natural sciences, those without a good appreciation of epistemology have mistakenly confused the latter as science and the former as crank science; whereas, in reality, they are two sides of the same coin.
Contrasting the social sciences with the natural sciences, a very curious phenomenon occurs, which is that the deductive based synthetic a priori now becomes far more important than its inductive based cousin, because, while one can build controlled experiments with atoms and molecules, one can do no such thing with human beings. Atoms and molecules obey laws of causality that can be isolated in a laboratory and thus induced from specific observations and controlled experiments. In the social sciences, no such corollary exists. All knowledge, is, and should be, deductive. The reason for this is two fold. First, different people will react differently faced with the same situation since each has his own unique subjective value system. And second, there is a temporal element that the natural sciences do not face. Atoms and molecules will behave identically regardless of when the experiment is performed. The same cannot be said for humans. Thus we cannot understand the science of human action unless we first understand that humans act. No such understanding is necessary in the natural sciences.
At this point I realize that I have used terms somewhat casually assuming familiarity on the part of the reader, so let me attempt to formalize the discussion. Wikipedia describes positivism as
And further, at what point has the positivist either proposed or performed an experiment to actually demonstrate his claim? Until he does so, should we not reject its authenticity, per his own urgings?
The argument I have put forward above is detrimental to positivism, but not sense perception. Sense perception has two aspects, the deductive a priori, and the inductive a posteriori. The former is apodictic while the latter is empirical. Placing the validity of sense perception in the former allows us to ascertain, with apodictic certainty, that sense perception is the only valid epistemic framework. In fact, all disciplines, even the natural sciences, will collapse if one fails to recognize the various a priori premises that one implicitly assumes. For example, the physicist is lost if he does not implicitly assume the regularity of nature or the inviolability of logic. Neither of these are determined via hypothesis testing or experimentation. In fact, they are logically prior to any such action; hence the term a priori.
At this point the reader should have noticed that I am using the terms a priori and a posteriori slightly differently than their accepted meaning in scientific circles today. This is not sloppiness; I have very good reasons for doing so. I believe the reason the positivist is so quick to dismiss the a priori is because they are unclear about its correct interpretation. They consider it knowledge prior to experience. However, it is more correctly understood as knowledge post experience, but prior to experimental verification. It is deduced from axioms that are only known because they are observed via the senses. A simple example will illustrate: consider the axiom of consciousness: that i am conscious. I doubt the reader will dispute its status as authentic knowledge of reality. However, it does not need to be experimentally verified because it is self evidently true: it is axiomatic. To see why, try disproving it. Any attempt to do so fails because one must use their conscious faculties to disprove the statement, thus implicitly proving the statement. The act of disproving it results in a performatory contradiction. Further, it is derived from sense perception because I ascertain that I am conscious only having first observed that I am, in fact, conscious. And it is not a posteriori since it does not need to be experimentally verified once observed and determined. In fact, it is impossible to falsify, thus making it "unscientific" according to the positivists, which is clearly absurd since it is very clearly authentic knowledge.
I realize this "introduction" to my blog has, in fact, been quite dense. I promise that the rest of my blog is not, as it is written for the layman with no background in economics or philosophy. This article is a necessary introduction because the biggest problem with economics today is simply the lack of understanding of basic epistemology amongst its practitioners. If the reader has followed the argument outlined here, they are well on their way to understanding why Austrian economics is the correct approach to economics and the mainstream are the pseudo scientists, despite their vehement arguments to the contrary.
For more details, please see here.
The first thing to stress is that, despite the inherent contradictions in positivism (described later in this article), it should not be confused as having failed humanity. Positivism in the natural sciences (physics, chemistry, biology, etc) has been fabulously successful at explaining the world around us. In fact, it has been so successful that it has been mistakenly confused as the scientific method, while the true scientific method has fallen into obscurity and has only really been kept alive by the Austrians. The reason for this is because what is known as the synthetic a priori can only advance so far in the natural sciences that in order to gather any knowledge of the world around us, we must rely on the synthetic a posteriori. Thus, having observed the success of the latter and the apparent failure of the former in the natural sciences, those without a good appreciation of epistemology have mistakenly confused the latter as science and the former as crank science; whereas, in reality, they are two sides of the same coin.
Contrasting the social sciences with the natural sciences, a very curious phenomenon occurs, which is that the deductive based synthetic a priori now becomes far more important than its inductive based cousin, because, while one can build controlled experiments with atoms and molecules, one can do no such thing with human beings. Atoms and molecules obey laws of causality that can be isolated in a laboratory and thus induced from specific observations and controlled experiments. In the social sciences, no such corollary exists. All knowledge, is, and should be, deductive. The reason for this is two fold. First, different people will react differently faced with the same situation since each has his own unique subjective value system. And second, there is a temporal element that the natural sciences do not face. Atoms and molecules will behave identically regardless of when the experiment is performed. The same cannot be said for humans. Thus we cannot understand the science of human action unless we first understand that humans act. No such understanding is necessary in the natural sciences.
At this point I realize that I have used terms somewhat casually assuming familiarity on the part of the reader, so let me attempt to formalize the discussion. Wikipedia describes positivism as
the philosophy that the only authentic knowledge is knowledge that is based on actual sense experience. Such knowledge can come only from affirmation of theories through strict scientific method.Interestingly, I do not disagree with the first statement. The only valid epistemic position is sense perception. What I disagree with is the latter assertion that such knowledge can only be achieved through the scientific method of observation, experimentation, and hypothesis testing. This latter statement is, at best, incomplete, and at worst, patently false. Consider for a moment its implication on itself; for, if all authentic knowledge must be derived through the scientific method of experimentation and hypothesis testing, then the truth value of that statement too, in order to be considered authentic knowledge, must be derived through the scientific method of experimentation and hypothesis testing, thus rendering it a mere hypothesis that may be falsified at any time and not an absolute truth forming the basis of the positivist philosophy. The contradiction should be apparent. In their zeal to place all knowledge within the a posteriori, the positivist have shot themselves in the foot by making the scientific method -- and thus, by extension, sense perception -- optional. However, the validity of sense perception is not optional. The problem is the positivists naive understanding of epistemology which allows him no room to maneuver out of this dilemma short of special pleading.
And further, at what point has the positivist either proposed or performed an experiment to actually demonstrate his claim? Until he does so, should we not reject its authenticity, per his own urgings?
The argument I have put forward above is detrimental to positivism, but not sense perception. Sense perception has two aspects, the deductive a priori, and the inductive a posteriori. The former is apodictic while the latter is empirical. Placing the validity of sense perception in the former allows us to ascertain, with apodictic certainty, that sense perception is the only valid epistemic framework. In fact, all disciplines, even the natural sciences, will collapse if one fails to recognize the various a priori premises that one implicitly assumes. For example, the physicist is lost if he does not implicitly assume the regularity of nature or the inviolability of logic. Neither of these are determined via hypothesis testing or experimentation. In fact, they are logically prior to any such action; hence the term a priori.
At this point the reader should have noticed that I am using the terms a priori and a posteriori slightly differently than their accepted meaning in scientific circles today. This is not sloppiness; I have very good reasons for doing so. I believe the reason the positivist is so quick to dismiss the a priori is because they are unclear about its correct interpretation. They consider it knowledge prior to experience. However, it is more correctly understood as knowledge post experience, but prior to experimental verification. It is deduced from axioms that are only known because they are observed via the senses. A simple example will illustrate: consider the axiom of consciousness: that i am conscious. I doubt the reader will dispute its status as authentic knowledge of reality. However, it does not need to be experimentally verified because it is self evidently true: it is axiomatic. To see why, try disproving it. Any attempt to do so fails because one must use their conscious faculties to disprove the statement, thus implicitly proving the statement. The act of disproving it results in a performatory contradiction. Further, it is derived from sense perception because I ascertain that I am conscious only having first observed that I am, in fact, conscious. And it is not a posteriori since it does not need to be experimentally verified once observed and determined. In fact, it is impossible to falsify, thus making it "unscientific" according to the positivists, which is clearly absurd since it is very clearly authentic knowledge.
I realize this "introduction" to my blog has, in fact, been quite dense. I promise that the rest of my blog is not, as it is written for the layman with no background in economics or philosophy. This article is a necessary introduction because the biggest problem with economics today is simply the lack of understanding of basic epistemology amongst its practitioners. If the reader has followed the argument outlined here, they are well on their way to understanding why Austrian economics is the correct approach to economics and the mainstream are the pseudo scientists, despite their vehement arguments to the contrary.
For more details, please see here.
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