Who should control money? This is a crucial question, as money is the central economic institution in every economy. It is absolutely necessary to facilitate the modern division of labor. So who should have control over money? Should it be the government? Is it necessary for the government to regulate money? Do we need the government to decide what to use as money? Do we need the government to control the quantity of money? Most people today would answer a resounding yes to these questions. After all, if the government doesn’t manage money, then who will?
The government has asserted control over money throughout most of history, so it would seem the likely pick to manage money. However, would it be possible to leave the management of money to the free-market? Can private individuals be trusted with such an important task? To answer this question, let’s examine the origins of money and look at the consequences of government management. But, before we can go there, we must solidly establish the fact that value is subjective, for many economic fallacies rest on the false notion that value is objective.
The Subjectivity of Value
It is crucial to understand that value is subjective. There is no objective way to determine value. The value of something is individually determined by each and every person according to their individual circumstances, preferences, mood, or a million other possible things.
A popular example in the economics world is the story of Robinson Crusoe who gets stranded on a deserted island after his ship crashes. In our example, Crusoe gets the opportunity to save one of two items from the ship before it is lost in the murky depths of the ocean. What would Crusoe choose to save, a vast fortune in gold doubloons, or some tools like a shovel, nails, and a hammer? With the gold doubloons Crusoe could buy anything he wanted; he would be rich! He would have something people consider highly valuable. But he is stranded in the middle of the ocean on a deserted island. Crusoe, first and foremost, must obtain food, water, and shelter or he will die. He can’t eat gold coins and they will probably make a poor blanket too. However, he can use the tools to build a shelter, plant a garden, and survive.
So, what should Crusoe take with him, if he can only save one thing from the ship? The gold coins will be of no use to him if he is dead. If he suspects he will be stranded on the island for a long period of time, he will most likely choose to save the tools because he can use them to survive. However, if he suspects he will be rescued within a day or two, he might choose to save the doubloons, as they will be more useful back in civilization. This is very unlikely, however, and undoubtedly Crusoe would recognize this. Therefore, most likely he will consider the tools more valuable and choose to save them from the doomed ship.
The point of this example is to show that value is subjective. Under normal circumstances (if Crusoe was happily back in civilization), he would probably impute more value unto the gold. However, because he is stranded on a desolate island he will probably impute more value unto the tools, as he can use them to survive. The gold is not objectively more valuable than the tools. The value of these things are determined subjectively by Crusoe according to his preferences and circumstances.
Even our everyday lives are proof that value is subjective. Imagine that you are out shopping at a store. You will undoubtedly see some items that you would consider valuable and worth buying and others that you do not consider valuable and worth buying. But, we all know another person could look at the identical items and conclude something completely different about their value. This is because everyone is different. We all have different tastes and preferences.
For example, let’s say someone values a water glass with dancing flamingos on it. Maybe they find it pleasing to look at, or maybe it has some pleasant memory associated with it (sentimental value). (I am sure you can think of a similar item in your life.) Many other people, however, would look at that same water glass and conclude that it is a piece of junk. Maybe they have a burning hatred for flamingos. There are many reasons why someone might dislike something. Once again, we see that value is subjective.
A Theory of Objective Value
Value is subjective, not objective. This may seem obvious, however many people have tried to determine an objective, scientific way for determining value. For example, a popular, erroneous theory for determining objective value was developed by Karl Marx the “founder” of socialism/communism. His theory is called the labor theory of value. As the name suggests, he believed that the value of a good or service comes from the labor put into it. Therefore, the value of a chair comes from all the labor that the builder put into it. Let’s say it took the builder 10 hours to build the chair. According to Marx, the 10 hours of time spent to build the chair make it valuable. But, what if this builder’s is only capable of building defective chairs that collapse the moment they are sat upon? (This could be a result of bad blueprints, a lack of knowledge by the builder, laziness, or a whole host of other things.) Are the chairs still valuable? The builder still put 10 hours of labor into the creation of the chair. Is the pile of rubbish left after all of the builder’s labor still valuable? According to Marx’s theory of value it is; after all, 10 hours of labor were put in.
Additionally, lets say that there is another builder who can build a solid, properly functioning chair in 9 hours. (This is feasible; this builder could have better blueprints, better know-how, a better work-ethic, etc.) Is his chair less valuable than the first builder’s chair? He only spent 9 hours building the chair as opposed to the other builder’s 10 hours. Is this functioning chair worth less than a pile of rubbish? I think most people would say no.
What if someone labored for 20 hours by repeatedly banging a hammer on a rock? Has this person created something of value? According to Marx’s theory, he has; after all, he labored for 20 hours. Since value is measured by the amount of labor put into something he has created something of value. Obviously this is preposterous. We have a name for these people, time-wasters. Practically nobody will consider the result of this labor valuable (As a caveat, value is subjective, so maybe someone out there will consider this rock valuable for some odd reason, but that is extremely unlikely. For all intents and purposes, we can say practically no one will consider the rock valuable.) Marx’s theory is definitely flawed, as all objective theories of value are. (Marx then uses this theory as the rock to build his philosophies of socialism/communism on. I hope that tells you something about his works.) Labor clearly can not be used to measure value. However, is it possible that money can be used to objectively measure value? Everything has prices denominated in money, so is this possible?
Money Does not Measure Value
Just as labor can not be used to measure value, neither can money. It is easy to fall into the trap of believing that money can measure value because we buy everything with prices denominated in money. Money can’t measure value, but it can be used to compare our subjective values. In other words, we can use money prices to rank our values. It helps us decide when we want this more than that. It doesn’t objectively determine that this is more valuable than that. Value is subjective and money does not change that fact.
Why Exchanges are Possible
The fact that value is subjective is what allows for voluntary exchanges to take place. If the value of something could be determined objectively, then why would anyone trade a thing of higher value for something of lower value? If we can objectively say that 5 apples is less valuable than a T-bone steak. Why would anyone trade the two items? It is safe to say, they wouldn’t; people aren’t purposely going to shortchange themselves.
Additionally, why would anyone trade for something of equal value? For example, in a mystical world of objective value we could say 5 apples equals 5 oranges by some objective standard of value. Why would anyone trade under these circumstances? Why go to the trouble of trading if all you are getting is something equal to what you gave up? If 5 apples objectively equals 5 oranges there is no reason to trade. You are probably saying “No, this isn’t right; there still is a reason to trade because one person might prefer oranges to apples.” Yes, this is absolutely possible; someone totally could prefer oranges to apples, but this is entering the world of subjective value. If someone prefers oranges to apples, then they are subjectively imputing more value unto the oranges. The exchange is no longer equal. It is no longer operating under a objective standard if value.
People are self-interested, so why would someone trade if they don’t expect to benefit from it? (People even seek a benefit when giving away their money to a charity. They either seek to support a cause they believe in or they seek the good feeling that comes from being charitable.) Trading is not a zero-sum game; both parties benefit from the exchange. This is because value is subjective. Both parties in an exchange subjectively value the other’s good more than what they’ve got. If the exchange is voluntary, then both parties benefit.
For example, imagine Joe voluntarily enters a giftshop and trades 20 dollars for a coffee mug. Joe must value the coffee mug more than he values the 20 dollars because why else would he make the trade? Joe is self-interested like all other individuals, so he isn’t going to voluntarily trade for something he values less. He might get buyers remorse after he trades for the mug, however this does not change the fact that when Joe made the trade he expected to benefit from it. The same idea applies to the owner of the giftshop. He values the 20 dollars more than the mug. The subjectivity of value is what makes trading possible. Both parties benefit from the exchange. Because exchanges are possible bartering is possible, and as we will see this makes money possible.
The Origins of Money
The origin of money is a question of sovereignty; whoever created money should ultimately have control over it just as an inventor has control over his invention. Whoever created money would be best fit to manage it. So, it is necessary to examine the origins of money to discover who should control it. But, who was the inventor of money? Was it the civil government? Was it the stroke of genius of a single brilliant inventor? Or, did it arise spontaneously though social interaction? The answer to this question is spelled out perfectly by the renowned economist and historian Murray Rothbard. He writes:
“Economists, of course, admit that our modern national moneys emerged originally from gold and silver, but they are inclined to dismiss this process as a historical accident from which we have now been happily emancipated. But Ludwig von Mises has shown, in his regression theorem, that logically money can only originate in a nonmonetary commodity, chosen gradually by the market to be an ever more general medium of exchange. Money cannot originate as a new fiat name, either by government edict or by some form of social compact. The basic reason is that the demand for money on any “day,” X, which along with the supply of money determines the purchasing power of the money unit on that “day,” itself depends on the very existence of a purchasing power on the previous “day,” X-I. For while every other commodity on the market is useful in its own right, money (or a monetary commodity considered in its strictly monetary use), is only useful to exchange for other goods and services. Hence, alone among goods, money depends for its use and demand on having a pre-existing purchasing power. Since this is true for any “day” when money exists, we can push the logical regression backward, to see that ultimately the money commodity must have had a use in the “days” previous to money, that is, in the world of barter.”
There it is, the origins of money on a silver platter. Money must have value in the past to have value in the future, so, as Rothbard says, we must look “in the world of barter.” Let’s take a trip back in time and examine how money would arise in such a world.
The First Step on the Road to Money
The first step on the road to money is the bartering system. This is the most basic form of exchange. In this system people directly trade one good or service for another. For example, 2 people could exchange an apple and a shoe or a hearty breakfast and a history lecture. Obviously there are some shortcomings with this system. If someone wants a shoe and has an apple to trade for it, then they must find a person who has a shoe and wants an apple more than that shoe. The odds of this are quite low. Or if a history professor wants a delicious meal, then he will have to find a cook who wants a history lecture. Now, the odds are really hitting rock bottom; how many cooks are going to want history lectures? Not many.
This system will get very inconvenient very fast especially for someone who only has obscure items to trade, like a vintage Hot Wheels car for example. The odds of finding a person to trade you the good/service you want in return for something like a vintage Hot Wheels car are infinitesimal. So, unlike today, a vintage Hot Wheels car will be practically useless in trade. Things aren’t looking good for our poor history professor either; nobody is going to want to trade with him. That is why there is very little specialization in barter economies and that is why they are comparatively poor. There would be no history professors in a barter economy. No one would be selling vintage Hot Wheels cars in a barter economy. Most people would only be producing the necessities of life.
Indirect Exchange: The Stepping Stone
In order to overcome the challenges of finding someone to exchange with in a barter system, people start making indirect exchanges. For example, let’s continue with the story of our history professor who wants a delicious meal. He realizes that there aren’t any cooks who will trade him a meal for a history lecture, so he asks the cook what he would want instead. The cooks tells him that he will make him a meal, if he gives him a bushel of apples. So, the history professor now goes searching for a apple farmer who will trade him a bushel of apples for a history lecture. Let’s say the history professor was lucky enough to find an apple farmer who was willing to exchange a bushel of apples for a history lecture. Now he can trade this bushel of apples with the cook and get the meal he wanted so badly. This is an example of a simple indirect exchange. The history professor indirectly exchanged a history lecture for a delicious meal by first exchanging for a bushel of apples.
However, this way of exchanging can get very complicated too. The History professor probably won’t be able to find an apple farmer willing to exchange a bushel of apples for a history lecture. So, he will most likely have to make many indirect exchanges to get the item he wants. He might have to make 5, 10, or even 20 exchanges before he can get the good/service he wants. Clearly, this system is not ideal; it would take astronomical amounts of time to make this many exchanges. So, how is this problem solved? How, do we get to the advanced, prosperous economy of today?
The Second Step
As times goes on, people will notice that there are certain items that many people want. This could be any item, like gold, sea shells, cigarettes, or beaver furs. All of those things have been used as money in history. Yes, even cigarettes were used as money in WWII prison camps. Sea shells (wampum) and beaver furs were used as money in colonial New England. Many people value these items in and of itself for its intrinsic uses. (Getting a smoke was obviously highly valued in WWII prisons.) Over time people realize that these items are highly valued by a lot of people.
Therefore, instead of bartering directly for the items they want, people trade whatever they have for the item they recognize as being valued by a lot of people. This has two benefits. One, they feel confident that they can save this commodity for future use in trade because it is valuable and they expect it to retain this value into the future. Two, it will be much easier for them to find someone to trade them the item they want. This extremely valuable item is desired by many more people, so it will be much easier to find someone willing to trade.
Let’s continue with the example of our poor history professor. Under a barter system he is going to have a very hard time finding people to trade with. But, eventually he recognizes that gold is a highly valued item by many people. Therefore, he gives history lectures to anyone who will give him gold in exchange. Then, he takes this gold and exchanges it for that delicious meal he so desperately wanted. Because gold is valued by many more people it will be much easier for him to find someone to trade with him. The history professor no longer has to find a cook who wants a history lecture. This system of indirect exchange is where money begins to take shape.
The Final Step
As time goes on, people will realize that gold (or it could be any commodity) is a common item being used in exchange. There will be many people like our history professor who realize the benefits of exchanging their goods or services for gold. Therefore more and more people will value gold simply because they can exchange with it. They know they can exchange gold for almost anything they want. Some people may detest gold’s physical properties for some reason, however they will still want it because they know they can exchange it for other things they want.
As time continues on, more and more people will be willing to accept gold in exchanges because of its value in exchange. This creates a snowball effect. As more people accept gold in exchanges it becomes more valuable, which makes more people want it and accept it in exchanges, which makes it even more valuable. Over time as this process goes on, gold will become the accepted medium of exchange. It becomes the most marketable commodity. Now money has become a reality. Private individuals making rational economic decisions in a free-market will create money. But, what would happen if government tried to coercively introduce money? Would it still work?
Can Government Introduce Money
Instead of letting money develop spontaneously what would happen if government tried to introduce it? The government would do this by forcing everyone to conduct all of their exchanges using a certain medium of exchange. There is one main problem with this: no one will know what the new money is worth. Think of it this way: Imagine that someone gave you 20 pieces of paper that said 1 Washington Note. Then you were told to use these 20 Washington notes as money to buy things. Well you aren’t going to have any idea what those Washington notes are worth. Could you get a house for 20 Washington notes, or could you only get a pack of bubblegum for 20 Washington notes? There is no way of knowing. Why would any merchant accept these Washington notes? This is the problem of government introduced money. It doesn’t come out of the world of barter. Therefore, it doesn’t have the history that is necessary for determining it’s value.
When money arises spontaneously everyone does know its worth. This is because the value of the money is based of all of the past exchanges people have done with it. They can think back and remember that they got 5 dozen eggs for a gold coin or 12 history lectures for 2 gold coins. Everyone knows what the value of the gold is because they have done exchanges with it in the world of barter. Government introduced money doesn’t have this history, so it can’t work. This raises the question: Why is gold normally the free-market’s money of choice, if people aren’t forced to use gold as money?
The Characteristics of Money
It has been observed that there are five characteristics common to every commodity that has become money: Divisibility, portability, durability, recognizability, and scarcity. These characteristics aren’t rock-solid rules, but normally the commodity chosen by the free-market to serve as money checks all these boxes and gold does precisely that. Gold is divisible; it can be made into coins or bars of any weight. It is portable; it isn’t hard to carry a handful of gold coins. It is durable; the only way to actually destroy gold is with nuclear reactions. It is recognizable; it has a unique, shiny appearance. It is scarce; there is only a finite supply of gold on Earth and it isn’t very large, plus most of it is buried in the ground. These characteristics helped gold become the most marketable commodity or money. But, how did gold coins originate? We all know that they were used as money in history.
For example, normally grain would make a poor money because it isn’t scarce. It only meets 4 out of the 5 characteristics of money. However, in a serious famine grain could serve as money because it suddenly has become exceedingly scarce. It could even replace gold as money during this time period, as grain might become more valuable. This has happened in history.
The Development of Coins
We now know how a particular commodity becomes money. It is a spontaneous process that arises from people making rational economic decisions. In history, gold or some other metal has commonly served as money due to their characteristics. But, how did gold coins develop? This happens because people realize that it would be convenient to have a standard unit of weight to trade their gold with. It would be very cumbersome to always be checking the weight and fineness of the gold in every transaction that is made. This would be necessary because everyone would have gold in different forms and different weights. Some people might have gold jewelry, others might have bullion, and others might have raw gold ore. The possibilities are endless.
In order to solve this problem some people decided to open mints that manufactured gold into coins of specific weights and fineness. For example, a coin could weigh one ounce and be 95% fine, meaning it is 95% gold and 5% base metal to prevent bending and scratching. People could take their gold of all different forms to the mint to turn it into gold coins. Now, there won’t be any confusion while trading. The costs of trading will go down significantly; everyone will know what the weight and fineness of the gold they are receiving is. The minters are motivated to do this because they recognize that they can charge a fee for their service and profit from it. Minting would not be a free service; there is no such thing as a free lunch. People would have to pay for the convenience of using gold coins. However, throughout history people have preferred the convenience of gold coins, so they were willing to pay the small fee.
But, how will the minters be kept honest? How are we to verify that the gold coins truly are the specified weight and fineness? How do we verify that the minters aren’t stealing from their customers? This is done by all of the competing minters in the minting business. In a free-market, there would be open entry into the minting business. (That means NO government licensure.) Therefore, new competitors would always be entering the minting business because they think they can make a profit by doing it better, faster, or cheaper. In this system a minter’s reputation would be his most valuable asset. If he gets a reputation for creating phony coins, then consumers will go to one of his competitors to get their coins minted and he will go out of business. If a minter can prove a competing minter is creating dishonest coins, then they will have the incentive to expose them because they will gain customers out of it. Maybe their competitors coins are slightly off colored signaling that there is more base metal than specified. Maybe they weighed the coin and it was heavier or lighter than what was specified signaling an improper amount of gold. Whatever the reason might be, competing minters will always have incentive to expose their competitors (because they want more business), so they will have incentive to check their competitors coins for fraud. Therefore, through market competition the minters will be forced to stay honest. A minter’s competitors will indirectly force him to keep his coins at the specified weight and fineness. If a minter tries to cheat, his competitors will expose him and he will go out of business.
The Development of Banks
We have seen how gold gets established as money in a free-market and how it becomes coins. Now how did we get from using gold coins as money to using pieces of paper? These pieces of paper do not have any inherent use like gold does. They aren’t valued for the thing itself like gold is. So, how did we come to be using these green pieces of paper as money today? The rise of paper money came with the development of banks.
It all started when people got tired of carrying around a bunch of gold coins. Gold coins come with their annoyances. They are heavy and they jingle around in your pocket. This makes it easy to know when someone is carrying coins on them, in turn making it easy for thieves to know who to pickpocket. Therefore, just as people invented mints, people invented an institution called banks. In a free-market banks have two functions. One, to store customers gold for safekeeping like a warehouse. Two, to be a loan broker. What I mean by this is that banks bring together lenders and borrowers of money. (These are the functions of banks in a free-market. Modern banks operate under a fractional reserve system, which is much different. We will cover them later.)
The first function of a bank is where paper money comes from. People decide to deposit their coins in a bank because of their inherent disadvantages in return for paper receipts that entitle them to their gold coins. If, at any time, they take these receipts to the bank, they can withdraw their gold coins then and there. The bank simply stores their coins in a safe place for them. A bank is essentially a gold warehouse. In order to make a profit, the banks will charge their customers a storage fee for warehousing the gold. (You know something fishy is going on when the bank offers to store your money for free and pay you interest to do so; there are no free lunches.) Now, for the sake of convenience, people start to trade with the paper receipts instead of the gold coins. They know they can exchange the paper receipts for gold coins at any time, so the paper receipts function as gold coins. The paper is much more convenient than the gold; it is easily foldable and can be put in a wallet. Plus, it is much harder for thieves to know you have it. Therefore, paper bank receipts begin to function as money.
The second function of banks is to connect lenders and borrowers of money (i.e. gold). Banks help borrowers find people willing to lend them money. They help lenders by screening out the bad borrowers, the ones who aren’t likely to pay back the loan plus interest. They will charge a fee for their services; they are not going to give you something for nothing. Most likely, the bank will take a cut of the interest that is paid back on the loan. For example, if the interest rate was 10%, the bank could take 3% netting the lender 7%. The lender must pay the bank somehow for their services. The bank acts like a real-estate agent for loans. Real-estate agents take a cut of the money from the sale of a home and banks take a cut of the money from the interest on a loan. While the money is lent out the lender will not have access to it because it is lent out. He must wait until the borrower is obligated to repay the loan plus interest to see his money again. This is an obvious fact. However, modern fractional-reserve banks corrupt this function by promising people that they can get their money back on demand even though it is lent out to someone else. They basically tell the lender he can get his money back immediately whenever he wants, but this is impossible because the bank doesn’t have the money; it is lent out. The effects of this are discussed in the next section.
Just like money and coins, banks originated on the free-market. Free-market banks serve two functions. To store people gold (money) and to connect borrowers and lenders. Paper money came about because of the convenience of trading with bank receipts. It is important to note: For free-market banks to function, the banks must keep 100% of the gold deposited in their vaults. They also must not issue more receipts than they have gold in reserve. These two practices are done by modern fractional-reserve banks and are inherently fraudulent. Free-market banks will be forced to keep these fraudulent practices to a negligible level. So, what are the differences between free-market banks and fractional reserve banks?
How do Fractional-Reserve Banks Operate
Modern banks are not like the pure free-market banks discussed earlier. They operate under what is known as fractional reserves. (This is only possible due to government intervention, but we will get to that later.) This means they do not hold 100% of their deposits in their vault. It is more likely that they will have something like 10% of their deposits stored in their vaults. Whether the deposits are gold, dollars, or digits doesn’t matter. So, what do the banks do with the money, if they don’t keep it in their vaults? They lend it out, of course. They want to make as much profit as possible and an easy way to do this is to lend out their depositors money and profit from the interest.
But, there is a problem with this. The depositors came to the bank to warehouse their money, to store it for safe-keeping. They did not come to the bank to lend their money and get it back plus interest at a later date. The banks have a contractual obligation to pay the money back on demand. (There are sometimes a few caveats on withdrawing money, but, in general, depositors are supposed to be able to get it on demand.) However, all the depositors can not get their money out on demand like they were promised; the bank doesn’t have all their money stored out back in their vault. The banks have lent out the money and will not get it back until the loans are repaid. Therefore, the banks are breaking their contract with the depositors. This is illegal. Any other business that did this could be sued and put in jail. Not to mention, it is morally wrong to defraud someone by not holding up your end of the deal. The banks can get away with this because they indirectly pay their buddies in the government to turn a blind eye to their activities.
That said, what would happen if all the depositors tried to get their money back, (which is their right)? It would cause a bank run. The bank doesn’t have enough money to hand out to all the depositors (they lent most of it out, so they could profit from the interest). This forces banks to liquidate their assets to meet their obligations. Eventually, banks start to go under, as they hold mostly illiquid assets (long-term loans). Therefore, the banks can’t scrounge up enough money to pay all their depositors, so they go bankrupt. We have a name for this phenomenon, it’s called a bank run. They can be started by smaller banks, businesses, foreign governments, the public, or anyone who has deposited money in banks. Therefore, if enough depositors demand that their money is returned, the bank will go bankrupt. The bank goes under because it can not pay back all of its depositors. This makes the dreaded bank run one of the greatest fears of fractional-reserve bankers.
Additionally, fractional-reserve banks have another trick up their sleave to unjustly enlarge their profit margins. Essentially, they just counterfeit money. Once bank receipts start to circulate as money due to their convenience, the bank might decide to issue more receipts than they have gold in reserve. This trick allows the bankers to get “free money” because the paper receipts function as money. This is inflation. The bank is inflating the money supply by creating phony receipts. This is a danger of using bank receipts as money. However, this increases the risk of bank runs even more for banks. The bank is technically obligated to pay gold on demand for these receipts. That is the reason they function as money. But, the bank doesn’t have that gold; it only created new receipts, not new gold. So, now that there are more receipts in circulation the amount of depositors required to start a bank run has sunk down even further.
In a free-market, the risk of bank runs help to keep banks in check along with the bank’s competitors. A bank’s competitor help keep them in line just like a minter’s competitor. Competing banks are incentivized to expose any particular bank for fraudulent activity. The process is the same, in principle, as it is for the minters, so I will not reiterate myself by going into detail here. If banks engage in either of the two practices above to a great degree, as modern banks do, they will go out of business at the hands of bank runs and their competitors. The more banks inflate, and the less gold they keep in reserve will increase their risk of a bank run. At some point, the bank will be expected to honor its contracts. The holders of the bank’s receipts will demand payment in gold. Fractional-reserve banks do not honor their contracts; they defraud their customers. Their competitors will expose them for doing this. Therefore, the free-market forces banks to self-regulate, for if they don’t, they will be put out of business. So, if the free-market will regulate banks, then how are banks able to get away with theses fraudulent practices today? They do it by getting their buddies in the government involved to protect them. Fractional-reserve banks can only exist because of the government. The government and bankers collude together to create fiat money and central banks. They do it to get more control and more money out of the people.
The Development of Fiat Money
Now, how did we get to our modern system where money is just green pieces of paper with politician’s pictures on them? We don’t trade with receipts that entitle us to gold; the paper entitles us to nothing. Therefore, the only reason they are valuable is that they can be used in exchange. This type of money is known as fiat money. This money has no value in and of itself like gold. As we will see, fiat money also comes with a large array of problems that do no favors for the economy. So, how exactly was this system established?
Fiat money arose as a product of government intervention. It was a way for governments to assert their sovereignty over money. Government’s seek to control people; it is their nature. One method they use to establish this control is by gaining dominion over the central economic institution, money. The dollar (or any other national currency) is the mark of this dominion. Modern governments did this by declaring that no one could turn in their paper receipts for gold coins. They declared that everyone must only trade using the paper receipts. This is how the modern dollar was formed.
This happened in the United States on June 5th, 1933. On this day, president Franklin D. Roosevelt declared that normal depositors could no longer turn in their dollars (paper receipts) for gold. Foreign governments/central banks still retained this right until August, 1971 when president Richard Nixon completely took the dollar off the gold standard. These actions constituted massive theft by the U.S. government. They effectively stole the gold of anyone who had gold stored in banks. Depositors warehoused their gold in banks to keep it safe. They were given receipts that entitled them to receive their gold on demand. It is their property and they have a right to it. This right does not mysteriously vanish when they pay to have a bank store it for them. When the government declared that their receipts were null and void, they violated the contract between the depositor and the bank. They stole the gold of most of the population. Why did the government do this? It is clearly an unjust and illegal act. They did it because it gives them control.
Fiat money gives government and bankers the power to freely inflate the money supply. This gives them more power. They have easy access to “free money;” they can print up more dollars of any denomination whenever they please. They have a monopoly on counterfeiting. Private individuals who print dollars are heavily punished, but it is A-OK for the government/banks to do it. The irony is astounding. When gold (or receipts that represented gold) were used as money, it was much harder for them to do this because gold must be mined. Gold mining is expensive and difficult, which in turn made it hard for the government/banks to inflate the money supply without risking bank runs. Bank runs were the public’s way of asserting their sovereignty over money. When the government denies depositors their right to redeem their receipts for gold, it removes the number one barrier that prevented banks from engaging in fraudulent practices. The government endorses these practices because they benefit from them. This is the result of fiat money, which is always coupled with central banking. So, what is the function of central banks in the story of money?
The Banking Cartels Monopoly over Money
Today our money is controlled by big banking cartels that are in cahoots with the government. From 1896 to 1913 big bankers plotted to create the Federal Reserve system to protect their interests and establish their control over money. They effectively shielded themselves from the free-market forces that keep fractional-reserve banks in check. Big bankers and their buddies (i.e. the government) are now able to grow extremely rich at the expense of the public. The Federal Reserve system allows big banking cartels to get away with this. So, what role do central banks play in all this?
To start, we must go over the economics of cartels. Cartels are groups of big businesses who collude together to establish high prices for their goods/services. They want fat profit margins in everything they sell, for obvious reasons. However, there are a couple of problems that cartels face. In a free-market a cartel’s prices will constantly be undercut by new competitors coming into the market. New competitors will be lured into the field by the high profits that the cartels are making; they want a piece of the profit pie. Then the new competitors will engage in price competition with the cartels, as they recognize that this is a great way to get consumers to buy from them; everybody loves a deal. This is the free-market’s natural defense mechanism against cartels. It makes it impossible for the “big boys” in the cartel to stay in business.
Additionally, there is another problem facing cartels. That is cartel members cheat. This is especially prominent in large cartels with many members where it is difficult to enforce the cartel’s rules. Just like the new competitors coming into the field, certain cartel members will cheat and offer lower prices to attract customers away from other members of the cartel. They do this under the radar, of course, but they do it all the same. These two issues make it impossible for cartels to operate under a free-market. Under these conditions, if cartels maintain their practices, their profit margins will fall and they will go out of business.
So what are cartels going to do? They will not be able to function on a free-market. Therefore, they get their buddies in the government involved. They use the government’s coercive power to protect the cartel. This protection can take many forms. Whether it’s requiring licenses to enter a field, putting high tariffs on foreign goods, a national bank, or any of the other imaginative methods of government interference, they all have the same result. They inhibit the free-market and make it possible for cartels to operate. These schemes are always wrapped in propaganda to make the public think they are for their benefit, but they never are. Today, big bankers run one of the most successful cartels in history. They do it by getting the government to establish a central bank.
How the Banking Cartel Operates
Big national bankers use the government to maintain their cartel. In the United States, (which I will be using as my example) they did this by creating the Federal Reserve system. The Federal Reserve protects the big bankers from the threats they face. But, what threats do the big bankers face? Just like every cartel, they were threatened by new competitors entering the field. This is exactly what happened prior to the establishment of the Federal Reserve. Many smaller regional banks were being created and drawing business away from the large national banks. They did this by offering a better service or, more commonly, a lower price. The big national banks resented their smaller competitors as they were cutting into their bottom line.
Additionally, These smaller regional banks would deposit their money into the big national banks, so that they could earn interest on their deposits. The big national banks liked this because they could then loan out the money and profit on the interest from those loans. However, this also became another threat to the big national banks. This is because the smaller banks would often have to “cash” their deposits because their customers were cashing theirs and they needed the money to meet their obligations. This forced the big national banks to call in their loans because they needed the money to give to the small regional banks. (The banks never have this money on demand in their vaults. It is lent out to their customers, so they can profit from the interest.) This creates a domino effect where banks must liquidate their assets to meet their obligations. Eventually, banks start to go under, as they hold mostly illiquid assets (long-term loans). Therefore, the banks can’t scrounge up enough money to pay all their depositors, so they go bankrupt. This is an example of competing banks causing bank runs. If enough banks demand their money, the dreaded bank run begins and banks will start to collapse.
What was the banker’s solution to this problem? Why it was “elastic” currency, of course. They claimed our currency was too static, old, and that it couldn’t “change with the times.” Looking past all of the public relations propaganda, what they really meant was that they wanted counterfeiting. This is what the Federal Reserve was created for. This is what all national banks are created for. The bankers needed the government to create it because counterfeiting is illegal and wrong. Essentially, they need a government license for counterfeiting. Without the government’s support, the bankers would be arrested like any other counterfeiter. The bankers get this support by creating a market for government bonds. They promise Washington that if they create this national bank, then they will buy government bonds at a stable interest rate. Congress likes to hear this; they will have an easy source of funds. They know there will be a ready market for government debt. Therefore to the bankers delight, the government hops on the counterfeiting bandwagon and creates a central bank. Now both the big bankers and the government can get easy money at the expense of the public through counterfeiting, more commonly know as inflation.
The Federal Reserve (the central bank for the U.S.) was to be the lender of last resort for large banks. That means that they were to be the counterfeiters who bailed out big banks when they couldn’t meet their obligations during a bank run. The Federal Reserve would create money out of nothing to give to the big banks, so they could stay in business. They would only do this for the big banks, however. They had no problems with letting the small banks go under. This was an easy way for the bigger banks to eliminate their hated smaller competitors then buy up their facilities at bankruptcy court. They let them suffer the consequences of a bank run while protecting themselves.
Central banks also create price stability among the banking cartel. The Federal Reserve sets standard rates of inflation for all banks. That way no singular bank can independently massively inflate the money supply and profit from the interest. This is a method to reduce cheating among cartel members. It takes the coercive power of governments to do this. There is no other way to force compliance among cartel members. This is another reason why the big bankers wanted the government involved. They got what they wanted with the quasi government institution, the Federal Reserve. What are the effects of fiat money and central banks on the economy? Do they benefit anyone other than the government and the bankers?
The Problems with Fiat Money and Central Banking
We have seen the origins of fiat money and central banking, now let’s look at the effects they have on the economy. To put it bluntly, fiat money and central banking wreak havoc on the economy. Governments and bankers establish these two things to gain more power and wealth. They do not benefit the average Joe, as the propaganda would have you believe. They redistribute wealth from the population, rich or poor, and put it in the coffers of the government and their banking buddies. The government runs an extensive propaganda program filled with Keynesian economists to cover this up. The heart of their argument is that inflation, (which comes from fiat money and central banking) creates wealth and lessens depressions. These are the two age old arguments that have convinced the public to turn a blind eye to their schemes, and they are dead wrong.
Inflation is Not Wealth
Inflation of a money supply can not create wealth as they claim; it can only redistribute wealth. Money is a unique good because it is essentially only valuable in exchange. No other goods are like this. For example, it is obvious that an increase in the supply of laptop computers is a good thing for everyone because more people will be able to get laptops. If everyone in society was given a shiny brand-new laptop, then everyone would benefit. People value a laptop in and of itself. People do not want to conduct all their exchanges in laptops; they want to use the laptop.
On the other hand, money, especially fiat money, is only valuable in exchange. If everyone in society was given one million dollars, then they would not benefit. This is because prices would rise to match the increase in the money supply, for the same reason that if everyone in an art auction is given more money the bids on the art will go up. Everyone would have much more money to spend, but they would find the prices of everything went up. Therefore, there is no net gain. Fiat money is not valued in and of itself. If people could not use their dollars in exchange, then nobody would care that they got an additional one million of them. Who cares about green pieces of paper with politician’s pictures on them? You can’t eat them. You can’t build anything with them. Outside exchange they are useless. Therefore, the creation of new dollars does not create wealth for society. It can only redistribute wealth from one group to another.
Inflation is a tool of wealth redistribution or in other words, theft. If you were given one million dollars and nobody else was, then you would benefit at the expense of everybody else. You would be able to increase your bids for products and services, but nobody else would without making sacrifices elsewhere. Therefore, you will be able to obtain more goods and services thereby increasing your wealth because you can buy everything at yesterday’s prices. Everyone else will be able to get fewer goods and services thereby decreasing their wealth. (We live in a world of scarcity. So, if you get more of something, somebody else must get less. Unless an entrepreneur creates more of that thing, but this doesn’t happen when new money is created. Inflation only creates new money, not new products.) The new money has not made its way through the economy yet, so prices will not rise immediately. You benefit because you have access to the new money first before prices rise, which gives you access to more goods and services. This is exactly what happens when governments and bankers inflate the money supply. They are able to get more goods and services at the expense of everybody else. This is a way for them to indirectly steal from the public, from you. They get to use the new money first before prices rise- therefore they win and we lose. They get more goods and services we get less. This increases the power of the government. We don’t directly see them stealing our money, but they steal what our money buys, (which is why we want money in the first place; we want to buy things). That is why Austrian economists have given inflation the name, the indirect tax.
The Business Cycle and Depressions
Inflation also does not lesson depressions, as they claim. In fact, inflation indirectly causes the business cycle with its booms and busts. It certainly is not the correct way to curtail depressions. This is a complex topic in and of itself, so I will only provide a basic analysis here. If you wish to dive deeper into this topic, then I highly recommend you read Murray Rothbard’s essay Economic Depressions: Their Cause and Cure, which you can view here. With that said, let’s begin:
Believe it or not, inflation is the root cause of the business cycle. When government authorized central banks to inflate the money supply and then lend it out it artificially lowers interest rates. Interest rates coordinate the allocation of resources in an economy. When interest rates are artificially lowered, it sends false signals to businesses. Because of these false signals businesses make bad investments and resources aren’t allocated correctly. Eventually, this fact comes to light (usually when the central bank stops inflating) and this is when the bust starts. As the economy adjusts to correct the misallocation of resources, the economy goes through a bust. But, how do interest rates send these signals? Let’s look at the function of interest rates in a free-market economy.
The Normal Behavior of Interest Rates
Interest rates represent the demands of the public. When the public saves money it shows their desire for future goods. Consumers are willing to wait until the future to buy things otherwise they wouldn’t save money. Most people will want to make their savings “work for them” by loaning out the money, as that is an easy way to profit from their savings. These people will seek out banks to help them loan to reputable borrowers. When people save more money the banks have more to lend. When banks have more to lend interest rates go down because the more of something there is the lower the price will be. So, when people save more money interest rates go down.
There is another less obvious effect of people saving more money. When people save more money they are obviously not buying goods in the present. They are saving to buy things in the future. When people aren’t buying things in the present, less capital goods need to be devoted to producing things in the present. Therefore, less wood, steel, labor, trucking, etc. will be needed to produce things that satisfy consumer’s desires now. These capital goods will be freed up to be used in the new projects of businesses.
The free-market does a great job at coordinating this entire process. When consumers save money interest rates go down. The lowering of interest rates sends signals to businesses to start long-term projects. Projects that are focused on creating capital (like new factories or machines), so that in the future they can make more profit. Before when the interest rate was higher, it would have been unprofitable for many businesses to start their long-term projects. However, now that it is lower this is no longer the case. The resources will be available to do their projects as they are not needed to make things in the present. Consumers are saving to buy things in the future, so it makes sense to allocate resources into producing more better-quality goods in the future. On the free-market this whole process happens seamlessly. There would be no business cycle. No booms and busts. In reality, the business cycle is a product of the government-endorsed central bank’s inflating of the money supply.
Inflation: The True Cause of the Business Cycle
In reality, the government is who is to blame for the business cycle. We have seen that interest rates are what signal businesses to start their long-term, future-oriented projects. Business cycles are caused by the artificial lowering of interest rates by governments/government-backed central banks. They do this by inflating the money supply then pumping the banks full of cash to lend, which in turn lowers interest rates. When interest rates are changed this way it sends false signals to businesses.
The amazing coordination that the free-market creates gets all messed up. This way interest rates aren’t lowered by people saving money, instead they are lowered artificially. If people aren’t saving money, then they aren’t buying less. If they aren’t buying less, no capital goods will be freed up for use on other projects. The consumers still want to buy goods in the present. However, businesses that have been mislead by false interest rates will start their long-term projects that are aimed at producing in the future. The resources required to build and operate these projects are still being used by the sector of the economy that is producing goods for the present.
The boom is felt in the beginning when businesses start their long-term projects. They are happy because they got cheap (low interest rate) loans. In order to enact their plans, businesses use this new money to increase their bids for labor. Therefore the wages of workers will go up. This makes everyone happy; the economy seems to be booming and everyone is getting more money. This is the new money the banks created (inflation) flowing through the economy. Because all the workers are earning more they can spend more as consumers. However, this boom will not last forever; it was caused by inflation. There was no monumental innovation that lead to a massive increase in goods. All that happened was the central bank printed more pieces of paper. We know that inflation does not create wealth, so there must be something amiss with the boom. Therefore, prices will start to rise as consumers spend all their new money and it makes its way through the economy. There is not an increase in goods, only money. The monetary unit simply becomes worth less because there is more of it. The bust comes once the central banks stops inflating, which it must at some point. If it doesn’t we will go down the road of hyperinflation and the currency will rapidly become completely worthless because there is so much of it.
Once the central bank stops inflating, businesses will see their error. The false signals come to light. Businesses see the signal (the interest rate goes up) that consumers aren’t saving money to buy goods in the future. The interest rate will go up because the banks will have less money to lend. Additionally, the prices of all of the resources required for their projects will go up because the demand for them has gone up with the initiation of the new long-term projects. Therefore, the long-term projects the businesses started will cease to be profitable. Many businesses will be forced to shut down their projects, lay off workers, and lower wages. Now everyone will be seeing a substantially smaller amount of money coming in the door. Couple this with the high prices that inevitably come from inflation and we have the bust.
This process is representative of the misallocation of resources by businesses. During the boom both the consumer-goods and the capital goods sectors of the economy are trying to grow at once. Both sectors are trying to get the resources needed to produce their products. However, there is only a finite number of resources in the economy at any given time. This number can only go up with innovations that increase total production. However, the only new thing created was new pieces of paper (money). Newly created pieces of paper do not magically create more resources. Therefore, there will not be enough resources in existence to allow for the completion of all the new long-term projects of businesses. There was no increase of resources; there was only an increase in paper money. Additionally, consumers were not saving to buy future goods; the interest rate was lowered artificially. Therefore, the businesses producing consumer goods (like iPhones, toys, etc.) will still need the resources to make these goods. Therefore, the resources needed to complete the new long-term projects focused on creating capital will not be there. No new resources were created and no resources will be freed up by a shrinking of the consumer-goods industry. So, the new long-term capital-focused projects of businesses are doomed to fail from the start; there simply aren’t enough resources in existence.
The boom and bust cycle is not a result of the free-market. It comes from the inflation of the money supply by the government and fractional-reserve banks. False signals are sent to businesses due to the tampering with the interest rate. As a result, businesses misallocate resources (like wood, steel, trucking, etc.) into long-term projects. Eventually it comes to light that there are not enough resources in existence to complete the projects, so they must be abandoned. This creates massive waste in the economy, which shows its face as a bust. Therefore, it should come as no surprise that ever since the Federal Reserve’s founding in December of 1913 there has been a steady stream of booms and busts in the economy. Government-backed central banks do nothing to solve this problem; they only worsen it by protecting the perpetrators and allowing them to create fiat money and inflation.
An Additional Few Problems
On top of the two monumental problems above, fiat money and central banking bring about even more complications in the economy. One of these is that it encourages consumption and discourages saving. The value of fiat money is always decreasing because it is constantly being inflated by government. So, when someone tries to save up dollar bills for the future the value of those dollars decreases with every passing moment.
Imagine that someone has saved $50,000 so that they can retire in 20 years. Sadly by the time those 20 years are up the value of their savings will have decreased dramatically. A realistic estimate would be around a 50% decrease in value. So in the end their $50,000 will only be worth about $25,000. They would be stupid to let their money waste away like this, so they are more apt to spend it. They will also most likely enter into much riskier ventures, so that they can have money for the future. If a commodity money (like gold) is used all of this can be avoided because government can’t inflate away its value.
The final problem with fiat money is that its value can potentially drop to zero. This happens when the government or the bankers can’t restrain themselves and inflate to an insane degree. This has happened many times throughout history. A great example is the German hyperinflation of 1923 when 1 U.S. dollar equaled 4.2 trillion German marks. The value of the German mark essentially dropped to nothing. This can’t happen with a commodity money as it will always have its use value. Additionally, commodity monies must be scarce. Therefore, there most likely will never be enough of a commodity money in existence for hyperinflation to happen.
The only thing fiat money and central banks are good for is increasing the power of the government and bankers. It does not benefit the general population. In fact, it is the source of most of our economic ills. Our money is constantly being devalued and we are continually subject to terrible booms and busts. Fiat money and central banks cause this problem; they are not the solution.
Conclusion
The control of money should not be in the hands of the government. They will always abuse the power and use it to their advantage. They do it to gain more control over us and enrich themselves. The free-market should have control over money. It creates an honest standard that prevents fraud. Money, coins, and banks all originated on the free-market and operate perfectly fine under one. Fraud will be kept to a minimal level and the government will not have as much control.
Bankers and the government will lose their power to counterfeit (inflate) the currency, which causes many multitudes of problems. In a true free-market, booms and busts would cease to exist. Our money would not constantly be losing its value to a great degree. In fact, it would actually be the opposite. As producers continue to get more efficient on the free-market they drive prices down, which increases the value of money. This would offset the extremely minimal inflation from gold mining. With a free-market standard everyone would be better off except the government and corrupt bankers. Our system of government-controlled money does not work in our favor. The public needs to wake up and realize this. Don’t buy in to the banker’s and government’s Keynesian propaganda. Government management of money does nothing but enrich and empower the government. The time has come for the people to reassert their sovereignty over money and allow the free-market to manage money to the benefit of all.
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