Through September and into October, I have been discussing the process of how free market action determines what is used as money and how the elite power brokers throughout the world havm slowly taken away the concept of real money (precious metals or other valuable commodities) and replaced it with dishonest or paper money. I think it’s important to understand just how the process or mechanism of paper money creation occurs. I will use the US as our example but there are only relatively minor differences among the many countries throughout the world which use central banking.
All the money which comes from the the Federal Reserve System is not necessarily dishonest but almost all of the honest money eventually is expanded into dishonest money. So let’s begin with the honest portion.
When the government needs funding beyond the amount of taxes it takes in, it offers US Treasury notes or bonds for sale. When these notes and bonds are purchased by private individuals or entities who use savings for the purchase, there is no money creation, only government debt increases. We are aware that many foreigners also purchase the bonds and notes offered by the US Treasury. To the extent that these purchases are the savings of private foreign individuals, again no money creation occurs.
But what happens if there are inadequate private savings or even though the savings may exist, there is not enough desire by private entities to purchase more Treasury bonds or notes? In this case, in accordance with the agreement between the US government and the private banking cartel known as the Federal Reserve Bank (the Fed) which established the Federal Reserve System, the Fed itself will purchase the bonds or notes. In essence, what happens is the US Treasury puts some fancy designs on a piece of paper and calls it a bond or note. A value is established for the bond or note with the US Treasury promising to pay back the face amount plus some amount of interest withing a specified time frame. Typical time frames are 3 months, 6 months, 1 year, 3 years, 10 years and 30 years. The Fed accepts these pieces of paper from the US Treasury and puts them on their books as an asset. In return, the Fed prints up some equally fancy pieces of paper called Federal Reserve Notes (aka dollars) and deposits these in an account at one of the 12 regional Fed banks in the name of the Treasury.
For the Fed, The Treasury bonds or notes are an asset and the dollars deposited in the name of the US Treasury in one of their banks are a liability. But the liabilities and assets are equal and the accounting books balance. For the Treasury, the pieces of paper they printed and sold to the Fed are a liability but the Federal Reserve Notes received from the Fed and deposited in one of the Fed’s banks is an asset. Again the books balance. But it’s clear that this money came from nowhere. It was created simply with the use of a printing press or more likely, with a few key stokes on a computer keyboard. In a later blog, we will discuss more thoroughly the idea of inflation but this process is pure and simple inflation. That is, the money supply has been increased without an increase in either goods or services offered in the markets on which the dollar operates. But actually, we have only witnessed so far the tip of the iceberg.
In both of the scenarios above, in the end, the government has a bank account with one of the Fed banks and there is a sum of money in it. Let’s just for the sake of ease to understand, use round numbers. We will suppose there is $1,000,000 in that account. The government has thousands of projects in which it is spending money. Let’s say that the one million dollars were spent on the reparing of a bridge that collapsed in Minnesota. The contractor who did the work gets this money and puts it in his bank.
Under the fractional reserve rules established by the Fed, this bank can use some of these funds to make loans. This is what fractional reserve banking means. Before the fractional reserve system came into being, banks and savings institutions could only make loans using funds which individuals had placed in long term savings accounts. These savers were not expecting to take their money out from the bank for a long time. They were saving for the future and the bank promised them a return (interest) for leaving it in the bank to use for loans. Both the bank and the individuals savers received a portion of the interest which the bank received for making the loan.
Under the fractional reserve system, the bank is not limited to just long term savings to be used for loans but rather all funds. So lets examine how this works. Going back to that contractor in Minnesota, let’s call his bank A Bank. A Bank now has an extra $1,000,000 on hand. The fractional reserve requirement has been in the range of 10% for many years. So A Bank takes 10% of the $1,000,000 which is $100,000 and places it on deposit with the regional Fed bank and now it has $900,000 available to make loans. A well heeled couple come into the A Bank seeking a loan to build a new house. They are planning a magnificent structure that will cost $1.5 million. They have $600,000 available in cash savings but need an additional $900,000. A Bank just happens to have the funds. After doing the necessary credit check on the couple, A Bank makes the loan. A Bank simply puts the $900,000 in an account in the name of the couple.
The couple already has a contractor. They write a check for $900,000 to the contractor so he can start work and promise to pay the remainder when the job is completed. The contractor takes the check to his bank, B Bank and deposits it in his account. Now B Bank has $900,000 it did not have previously. It takes 10% of that amount, $90,000, and places it on deposit with the local regional Fed back for its fractional reserve requirement. This leaves $810,000 available to make loans.
You can see that we can keep re-iterating this process through a series of loans, additional deposits in banks, subtracting the 10% and so on. Eventually we find that the $1,000,000 deposited in A Bank results in an additional $9,000,000 of money that is nothing but debt. But remember where it came from in the first place. The government either borrowed the original $1,000,000 or simply asked the Fed to create it. Thus we have $10,000,000 of money that was created from nothing and is backed by nothing but debt. This is pretty cool. It seems to me that if one really wants to “make money” in his life time, he should do whatever it takes to become a central banker or simply a high level officer in any bank that is part of the Federal Reserve System.
I wonder if there is a name for a system of interest in which one group of people gets paid for simply creating money from nothing? Thomas Edison summed up the immorality of the system when he said:
People who will not turn a shovel of dirt on the project nor contribute a pound of materials will collect more money…than will the people who will supply all the materials and do all the work.
[ As quoted by Brian L. Bex in The Hidden Hand (Spencer, Indiana: Owen Litho, 1975)]
Let’s consider the purchase of a $200,000 home in which $60,000 represents the cost of the land, architect’s fee, sales commissions, building permits, and so on and that $140,000 is the cost of labor and building materials. If the home buyer puts up $40,000 as a down payment (20%), then $160,000 must be borrowed. If the loan is issued at 7% over a 30-year period, the amount of interest paid will be $223,214. The amount paid to those who loan the money is about 1.6 times greater than that paid to those who provide all the labor and all the materials. It is true that this figure represents the time-value of that money over thirty years and might be justified on the basis that a lender deserves to be compensated for surrendering the use of his capital for half a lifetime. But that assumes the lender actually had something to lend, that he had earned the capital, saved it, and then loaned it for construction of someone else’s house. What are we to think about a lender who did nothing to earn the money, had not saved it, and, in fact, simply created it from nothing? What is the time-value of nothing?
An interesting aspect of creating money from nothing is that as the loan is paid off, money is destroyed or rather simply disappears. Let’s see how this works. The bank creates a note when it leds the money. The note is an asset and the bank notes are a liability. It’s worth noting that the bank notes are not much of a liability because the banks need not redeem the bank notes in anything of value. Remember, this is a fiat money system. The Federal Reserve Notes we use as money are not backed by anything of value. If the depositors at any given bank should become concerned about the credit worthiness of their bank, there are two mechanisms that provide a safety valve.
The first mechanism is the Fed itself. Every bank that is a member of the Fed system (there are very few which are not) is guaranteed to have funds made available to it on extremely short notice. Thus in times past, before the Fed existed, if the depositors in a bank became concerned about the bank’s financial condition, there were “runs” on the bank. Of course, bank notes at that time were worth something because each bank was required to redeem its notes in gold or silver coin. But now our dollars are simply pieces of paper–this is our money. Still, a number of depositors might be concerned about their money. This happened at the Great Northern Bank in England just last year. There were lines running out into the street with individuals trying to get their cash. This might happen because with a fractional reserve system, each bank will have only perhaps 10% of the cash on hand versus claims on that cash. But the Fed provides a system for any bank which might experience this problem. The Fed simply supplies the funds needed to the member bank on a short term basis until the depositors are reassured there is no problem.
The second mechanism is the Federal Deposit Insurance Corporation (FDIC). This is another government agency that insures the accounts of bank depositors. Up until last year, each depositor was guaranteed up to $100,000 in a given bank. During the financial crisis last year, to help ease the concerns of depositors, the government increased this limit to $250,000. The banks all contribute funds to the FDIC so that if a bank should fail each depositor will get all of his money as long as the total does not exceed $250,000. If many banks fail in a short period of time that might put a strain on the FDIC reserve funds, the US government has guaranteed that it will provide the funds necessary. The FDIC plays a role when individual banks mismanages its assets and liabilities. If the bank made too many bad loans and kept these loans on its books, then the FDIC will step in. The FDIC will close the poorly managed bank and transfer the deposit accounts to “supposedly” a more trustworthy bank. The FDIC uses its reserve funds to provide the difference between the bad bank’s assets versus liabilities. So as long as an individual depositor’s funds do not exceed $250,000, his money will simply exist in an account created in his name by the bank named by the FDIC to take over for the failed bank.
But going back to the earlier point that as debts are paid, the money created by the debt disappears. Let’s see how that works. Lets say someone takes out a loan for $10,000 for a year at 9%. The bank simply creates an account or places the money in an existing account in the borrower’s name. The borrower spends the money and the plan is to pay it back at the rate of $909 per month about $80 of which is interest. The note which the bank holds is an asset and the bank notes issued to the borrower are a liability. [As discussed above, it not a real liability because the bank has no real obligation to redeem the loaned out notes with anything of value.]
The borrower starts into his payment plan but he is struggling to make his payments. He decides to take on another part time job to help. The bank wants its floors cleaned and waxed each month and it has an extra $80 coming in each month. The borrower agrees to clean and wax the bank’s floors for $80 per month. So as the borrower makes his monthly payments, the value of the note decreases at the same rate that the liability of the bank notes decreases. The payment of the note in effect extinguishes the dollars created by the debt. But the interest does not just disappear. In effect, the bank bank got its floors cleaned and waxed each month for nothing.
This is the essence of creating money from nothing. By doing almost nothing of any value, the bank was able to get work done on its behalf by the borrower. This is the way the system works. It is a very sophisticated form of serfdom. Because the private bank cartel controls our monetary system, all of us who are forced to use this money are supplying free labor. In the simple example used, the borrower worked directly for the bank. But obviously it does not work this way in normal circumstances. But the net effect is exactly the same. The creator of the money gets the benefit of the exchange value of labor of the borrower.
Ain’t life just grand–for some folks, especially those at the top of the economic barrel.
In Part 5, I explained how most of us had been seduced into giving up our gold backed money for the pure paper money issued by the Federal Reserve Bank. Actually, I’m quite sure that no one reading this has any memory at all of gold coins or gold backed money since the gold confiscation scheme occurred in 1933. However, some may recall that silver coins were still used until 1964. That is when the LBJ administration stopped producing 90% silver coins. Kennedy half dollars continued to contain about 40% silver for a few more years but that’s it. I can recall seeing a few silver dollars when I was a kid but they were rare even then in the late 40′s and early 50′s. What’s the point? The point is that the generations born after say 1950 have no recollection of using anything but paper money. When paper money is all there is and it at least appears to work, then what’s the beef?
But that is the problem; it is all just appearance. “It” just appears to work. Behind the scenes, where the government does not want us to look, see and understand, it does not work. It is all smoke and mirrors–a house of cards that must inevitably collapse. But lets continue with the story I had started.
At the end of WW 2, Bretton Woods was in place. The US was Numero Uno, hands down, no contest, no one else was even close. The US possessed the worlds largest stash of precious metals, over 20 tons of gold and over 8 billion ounces of silver. Other than the fact that our economy had been directed toward the war effort, our industry was virtually untouched by the war. The US began producing for its citizens and for other nations. The US GDP consisted of about 70% production. Made in the USA meant you had a quality product in your possession. Anyone reading this who is my age will remember when in the 1950′s “made in Japan” was an indication of an inferior product. The only things we bought which were made in Japan were cheap things, trinkets and such forth which we didn’t care if they lasted for very long. When the Honda Civic was first offered in the US, it was considered a cheap car, just barely acceptable for transportation. Ditto for the German Volkswagen. The good things, the big ticket items were made at home in the USA.
There are many factors which influenced the changes which have occurred since 1945 but this topic is about gold and money. I’m trying to stay on this topic for now and plan to go back later to fill in some blanks.
You may recall that there was a G-20 meeting recently in Pittsburgh, PA toward the end of September. The essential purpose of this meeting was to whitewash the global reactions by governments and central banks in response to the financial crisis of September 2008. A careful reading of the statement issued by this group of 20 nations will reveal just two important points. First is that governments did collectively intervene starting in late September 2008 after the Lehman collapse to prevent a much larger world financial collapse and to re-invigorate world wide economic growth. The second point made is that it worked. The collective intervention of governments and central banks did prevent the collapse and the world economy is on the virge of new growth. The concluding memorandum said in other words, ”Just trust us, we’ve got your back!”
If this is your own feeling, especially if you trust the US government and the Federal Reserve Bank to get the US economy back on track, then you are most likely going to be disappointed. If you rely on the typical financial gurus to guide your investment portfolios and prepare you for retirement, you are going to be “sadly” disappointed.
But why did we need to convene the G-20 (at great expense, I might add) in Pittsburgh to tell us these two things? I mean, after all, after August 1945, it was the G-1, the United States, Numero Uno, we were in charge. How did we lose it?
As I mentioned in Part 5, we had agreed to the use of our dollar, backed by gold at the exchange rate of $35 per ounce, to serve as an international exchange currency. This was the seal of approval. As long as we could continue to redeem dollars for gold at the agreed upon fixed rate, world wide exchange was not just possible but was, in fact, conducive to economic growth. Everyone used dollars and these dollars were “as good as gold.” Everyone could rely on excess imports being paid off with dollars which could be converted into gold any time a nation had more dollars than it needed.
The problem was that the US was not actually keeping its part of the agreement completely intact. Bretton Woods made the US dollar the reserve currency of the world. This meant that dollars were needed by all nations to settle their balance of payments. But since the US could simply print dollars, settling the balance of payments for the US did not require more production and more exports, all that was needed was more dollars. In the aftermath of WW 2 and into the 1950′s, the excess of dollar creation was quite limited. It’s true that as a country we had embarked on a program of living beyond our means but it was not a blatant or excessively expanded standard of living. The US welfare state had begun but its primary features were a social security system, some limited unemployment compensation and some other still relatively small redistribution schemes like farm subsidies. The funded US debt increased a measly $70 billion between 1945 and 1965. Since the US funded debt has just increased about $1.88 Trillion dollars between 9/30/08 and 9/30/09, it’s clear that excess money printing was quite contained in the early years of Bretton Woods.
After President Kennedy was assassinated, LBJ took over and quickly began expanding the war in Southeast Asia. Then in 1964/65 the Great Society programs were introduced. Taxes on Americans could not be increased enough to cover the added costs without the creation of a backlash from the US population. Thus, now the incentive to crank up the printing presses was greatly encouraged. At the same time, the economies of our allies were gaining strength. Under de Gaulle, the French economy was doing quite well. In addition, de Gaulle was a hard money individual. He began to suspect that the US was using the preferred position of the US dollar to take advantage of other nations involved in international trade. Thus, since France was running a positive balance of payments surplus, he began taking the excess dollars France possessed to the US to get gold as required by the Bretton Woods agreement. A few other nations began doing the same thing.
In the late 1960′s, the US began meeting with England and Germany, as they were our two main allies most closely aligned with US views in the post war period, to establish procedures and policies to maintain confidence in the international trade agreements. Thus, Numero Uno became the G-3. The financial dominance of the US had begun its journey down hill. The US actually had several viable options in 1969/70. First it could just stop printing excess dollars and start living within its economic means. Second, it could do option 1 at a slow pace, slowly devaluing the dollar until it reached parity with the “price” of gold which many estimated to be about $100 per ounce at the time. Third, it could choose to ignore all the warnings and continue on a course of profligacy, spending more than it produced and exported, thus forcing ever more dollar creation.
Nixon was elected in 1968 and moved into the White House in January 1969. So we went from a Democrat president to a Republican president. The fundamental economic and financial policies did not change. No one would stand up to say “We are spending too much money!” Because of the Bretton Woods agreement, the US was bleeding tons of gold to foreign nations who were redeeming their excess dollars. By 1971 the US gold holdings had been reduced to only about 10 tons; Nixon and his advisors realized they could not keep redeeming gold at the current pace for very long. His administration tried to implement some wage and price controls which was not effective because markets, even when they are interfered with by governments, are more powerful than governments as discussed earlier. Then Nixon took the step of unilaterally abrogating the Bretton Woods Agreement in August 1971. The drain on the US gold holdings stopped but the excess spending did not.
But now there was a new dynamic at play, a situation which had never at any time existed in all of the previous recorded history of man. Since the world had been converted to a dollar standard and every government in one form or another, working with its central bank, had removed the idea and reality of gold as money, the entire world market was now just one big floating casino. Under both the gold standard and the gold exchange standard (Bretton Woods) each currency could be valued against gold and thus valued against each other. Now for the first time ever, no currency, no monetary system in the world had any connection to gold. In the past during times of crisis, war and upheaval, individuals could find some way to protect themselves financially. They could move their wealth to other currencies tied to gold or into gold itself. Because gold had been and continues to be much maligned by politicians, bankers and even investment brokers, gold is no longer regarded as money or even (by a very large segment of the population) as a valid investment vehicle.
We have answered the question posed by the title of this on going series of comments. Gold = Money? Emphatically, NO! There are still more pieces of information that need to be filled in so we must press on.
I am not going to catalogue them all, but all of the financial disturbances and economic calamities that have occurred since 1971 can be laid at the door step of eliminating the gold standard or any substitute which even resembles such a standard to keep money honest. Paper is not honest money, gold is honest money. Paper money can be easily created and manipulated; this is the reason that central banks and governments have been slowly moving individuals to accept paper money rather than honest money.
The Rothschild family has a long history of banking in Europe. This family established branches in England, France, Spain, Germany and Italy. They helped to finance many of Europe’s wars. One of the patriarchs of the family, Meyer Amschel Rothschild, is often given credit for this quote or some variation of it:
Permit me to issue and control the money of a nation, and I care not who makes its laws.
If you are not familiar with the Rothschild name or the family history, I strongly suggest spending a few minutes with a Google search. Wikipedia probably has the most concise set of data, but data on the whole family is easily assessable.
Going back to the primary thread idea of this set of comments, the period of time following Nixon’s action in 1971 was a period of financial turmoil as nations sought to establish relative values for their currencies. Remember that nations still are trading with each other. Even though no nation could now get excess dollars turned into gold, they continued to use US dollars as the reserve currency. The US made a strategic decision in the early 1970′s by making an important bargain with Saudi Arabia. The arabs agreed to accept only US dollars in payment for their oil and in exchange, the US agreed to provide strategic military protection to the Saudi government and its oil fields. This agreement helped to set the post Bretton Woods period into a de facto Bretton Woods with no gold backing. Instead, the world currencies were allowed to float in value against each other on a daily basis and the US dollar continued to be the vehicle used to settle accounts. The bank for International Settlements (BIS) helped to sort out the arrangement but since 1971, trading has become very often a roulette wheel. Since currencies float, it is difficult to know for sure that the balance of payments are being correctly compensated when US dollar exchanges are made.
Another insidious feature of this system is that some nations may find it advantageous to slowly lower the value of their currency to enhance their exporting ability. In 1975, the first big inflationary bout arising from Nixon’s 1971 action began to unfold with a wold wide rash of inflation. The G-3 was expanded to the G-6 with the addition of Japan, France and Italy. The goal of the G-6 was to give international prestige and cover for the continued monetary excesses. By now, all nations were involved in creating excess paper money. Some printed lots more than others. In 1976, Canada was added to create the G-7 thus continuing to dilute US financial control. But the mission of the group remained the same: convince people around the world that central banks and governments are in control and there is no need to fear. The BIS and the International Monetary Fund (IMF) are doing the work required (under supervision of the G-7) to keep international finances on an even keel even though some perturbations occur from time to time. But on the inside, excess money was still being created by virtually all governments and their central banks so the real situation continued to deteriorate.
Through the rest of the 70′s and for most of the 80′s there was currency crises or a banking crisis or an economic crisis just about every year. In the US, a serious crisis occurred in 1979 and continued through to 1981. Gold hit $850 per ounce (even though gold was not money) and interest rates exceeded 20% for a period of time while the stock market slumped. In 1987, there was another major stock market crash. Just about every country had some type of problem. The G-7 acted as a united front to keep up the façade that everything was just A-okay. The collapse of the Soviet Union in 1989-1990 provided a nearly two year respite before the financial problems continued displaying themselves. In 1994, Russia was granted observer status to the G-7.
In 1997, Russia was added to the group to create the G-8. But this time there was a major difference. Russia was not a major world trader at the time so why should they be invited to join the exalted group who influence and monitor world trade activity? What had happened was that Russia announced it was in default on its sovereign debt. This sent perturbations around the world. A nation that announces that it can’t pay its debt throws fear into the hearts of traders and financial markets everywhere. If one nation is in default, others could be also. This lion had to be tamed. Russia joins the group, the prosperous nations are in control. The crisis abates and markets are stabilized yet again. The façade continued.
The past decade has continued with constant financial disturbances, some of them quite noticeable. Obviously, 2007 and 2008 were two of the more notable years. And now, if you are following this, the recent G-20 meeting I mentioned toward the beginning of this section comes back into play. The G-20 has been around for a few years, actually since about 1999 when it met with regard to the Asian monetary crisis. Still, its meetings were limited to the finance ministers and central bankers. Heads of state of the G-20 were not involved until November 2008. The heads of state met again in the spring of 2009 and now they have recently concluded their meeting in Pittsburgh. But the Pittsburgh meeting marks a new level. The G-8 has been superseded by the G-20. The statement issued by the G-20 clearly indicates that this expanded group of nations will continue to collude in the future as the G-8, G-7, G-6, G-3 and Numero Uno have done in the past to insure that the façade of safety and security of the international financial system is maintained. As I said at the beginning, this is smoke and mirrors, it is not reality. Danger lurks and we cannot be sure what events the next dawn will bring. Stay alert. Read the news headlines but be aware that what you are seeing in the news is probably not the reality. Federick Bastiat is famous for remarking about the difference between that which is seen and that which is not seen.
The problems created from many years of excess money production have not gone away. Again, there is more to discuss but since we have answered the question “Gold = Money?”, perhaps it is time to change the title.
We are being bombarded daily with misinformation, hucksterism, and just plain old fashioned lying. For example, this week a friend asked me about another ..flation. He had heard of inflation, deflation and even stagflation but not reflation. He was responding to an article I sent him about Barrick Gold (possibly the largest gold mining company in the world) announcing that it was going to close all existing forward sales of its gold product (forward selling is also called hedging). He asked me to rephrase the following quote from the article I sent him in terms that he could understand.
Barrick claims to have made a strategic decision to gain full leverage to the gold price on all future production, and to exploit the effects of global monetary and fiscal reflation expected to span several years. They see a consequent increased risk of higher inflation and a future negative impact on the value of global currencies.
Of course, the problematic phrase is “global monetary and fiscal reflation.” If you do enough searching you may eventually find the following business definition of reflation: a method of reducing unemployment by increasing an economy’s aggregate demand. If any one can understand what this means and can explain this definition and the process it envisions coherently, please post a comment. This is getting to one of the problems that confront us: namely, the hucksters are filling the media with such nonsense that most of us just figure we don’t understand the dismal “science” of economics so we don’t bother to investigate. One of the purposes of this blog is to explain some fundamental economic concepts that can be easily understood if one takes the time to do so and thus relegate these bloviated jerks who constantly use essentially meaningless terms to the never-never land from which they originated.
Thus we enter the next phase of this Gold = Money topic. As we try to understand this topic, it becomes vitally important that we understand what constitutes a free market. Only by understanding the free market concept can we understand sound money and we cannot determine if Gold = Money unless we understand sound money.
My investigations have convinced me that the Austrian school of economic theory has the only convincing, rational and completely coherent theory that needs no other ancillary explanation. The Austrian school started its development in Vienna, Austria in the 1870′s through the teachings of Karl Menger. His student, Eugen von Böhm-Bawerk, continued the development of his ideas and Bawerk’s student, Ludwig von Mises was the central figure of the 3rd generation of Austrian theorists. The Austrian school, in the person of von Mises moved to Switzerland for 6 years, then to England via one of von Mises disciples, Frederic von Hayek. Mises and Hayek both moved to the US in the 1920′s developing the ideas further and attracting more disciples in this country including Murray Rothbard and Henry Hazlitt among others. The US today is the center of Austrian theoretical development and the primary repository of most of the collected works of all Austrian economic theorists.
Ludwig von Mises deserves special credit for the development of this school of economic theory and wrote prolifically throughout his life on various aspects of it. I am going to draw heavily from two of these works in this essay. In 1912 von Mises wrote the original version of his “Theory of Money and Credit” which he revised in 1924, 1934 and added a whole new section to the book in 1952. His “magnum opus” titled “Human Action: A Treatise on Economics” was written in 1949. These two books complement each other to a large extent and neither can be understood in full context without the other. Mises died in 1973, a year before his disciple, von Hayek (by then a US citizen) was awarded the Nobel prize in economics.
I begin then with an extensive quote from Chapter 15: “The Market,” Part 1, “The Characteristics of the Market Economy.” of Mises’ “Human Action:”
The market economy is the social system of the division of labor under private ownership of the means of production. Everybody acts on his own behalf; but everybody’s actions aim at the satisfaction of other people’s needs as well as at the satisfaction of his own. Everybody in acting serves his fellow citizens. Everybody, on the other hand, is served by his fellow citizens. Everybody is both a means and an end in himself, an ultimate end for himself and a means to other people in their endeavors to attain their own ends.
This system is steered by the market. The market directs the individual’s activities into those channels in which he best serves the wants of his fellow men. There is in the operation of the market no compulsion and coercion. The state, the social apparatus of coercion and compulsion, does not interfere with the market and with the citizens’ activities directed by the market. It employs its power to beat people into submission solely for the prevention of actions destructive to the preservation and the smooth operation of the market economy. It protects the individual’s life, health, and property against violent or fraudulent aggression on the part of domestic gangsters and external foes. Thus the state creates and preserves the environment in which the market economy can safely operate. The Marxian slogan “anarchic production” pertinently characterizes this social structure as an economic system which is not directed by a dictator, a production tsar who assigns to each a task and compels him to obey this command. Each man is free; nobody is subject to a despot. Of his own accord the individual integrates himself into the cooperative system. The market directs him and reveals to him in what way he can best promote his own welfare as well as that of other people. The market is supreme. The market alone puts the whole social system in order and provides it with sense and meaning.
The market is not a place, a thing, or a collective entity. The market is a process, actuated by the interplay of the actions of the various individuals cooperating under the division of labor. The forces determining the – continually changing – state of the market are the value judgments of these individuals and their actions as directed by these value judgments. The state of the market at any instant is the price structure, i.e., the totality of the exchange ratios as established by the interaction of those eager to buy and those eager to sell. There is nothing inhuman or mystical with regard to the market. The market process is entirely a resultant of human actions. Every market phenomenon can be traced back to definite choices of the members of the market society.
The market process is the adjustment of the individual actions of the various members of the market society to the requirements of mutual cooperation. The market prices tell the producers what to produce, how to produce, and in what quantity. The market is the focal point to which the activities of the individuals converge. It is the center from which the activities of the individuals radiate.
The market economy must be strictly differentiated from the second thinkable – although not realizable – system of social cooperation under the division of labor; the system of social or governmental ownership of the means of production. This second system is commonly called socialism, communism, planned economy, or state capitalism. The market economy or capitalism, as it is usually called, and the socialist economy preclude one another. There is no mixture of the two systems possible or thinkable; there is no such thing as a mixed economy, a system that would be in part capitalist and in part socialist. Production is directed by the market or by the decrees of a production tsar or a committee of production tsars.
If within a society based on private ownership by the means of production some of these means are publicly owned and operated – that is, owned and operated by the government or one of its agencies – this does not make for a mixed system which would combine socialism and capitalism. The fact that the state or municipalities own and operate some plants does not alter the characteristic features of the market economy. The publicly owned and operated enterprises are subject to the sovereignty of the market. They must fit themselves, as buyers of raw materials, equipment, and labor, and as sellers of goods and services, into the scheme of the market economy. They are subject to the laws of the market and thereby depend on the consumers who may or may not patronize them. They must strive for profits or, at least, to avoid losses. The government may cover losses of its plants or shops by drawing on public funds. But this neither eliminates nor mitigates the supremacy of the market; it merely shifts it to another sector.
It is best to read the above von Mises description at least twice and a thrid or fourth reading will not hurt. We will, over time, refer back to this quote more than once as it is filled with intuitively obvious a priori assumptions that are integral to capitalism. Note especially this sentence in the second paragraph above: “There is in the operation of the market no compulsion and coercion.” In both parts 1 and 2 of this topic, I have emphasized that the commodity that became most useful as a medium of exchange was determined over a long period of time in a free market environment. That is, the participants in the market process were free to use any commodities they wished as the most desirable and it was these which eventually became money or the medium of exchange. And we know from history without any doubt that the most frequently chosen commodity was gold and to a slightly lesser extent, silver.
Eventually, governments (or the state) became involved. We know that as early as about 700 or 650 BC, Lydia began coining gold. An advantage of coins is that the central authority in charge of the process was able to verify the purity and weight of the metal in the coin. The individuals involved in market exchanges were relieved of the process of verifying the weight and purity making exchanges that much simpler. To make this process easier, the concept of standard coinage was introduced. Pre-weighed and pre-alloyed, coins were typically minted by governments in a carefully protected process, and then stamped with an emblem that guaranteed the weight and value of the metal.
It was extremely common for governments to assert the value of such money lay in its emblem and thus to subsequently debase the currency by lowering the content of the valuable metal contained in the coin. This was the genesis of inflation, the ability to expand the money supply without actually adding anything to the capital stock. (To understand capital or capital stock, please see my blog entry dated August 25th, titled Capital.) Of course inflation has become much more sophisticated since then and we shall consider that process.
According to Wikipedia, the initial use of warehouse receipts or tallies being used as money was in Egypt. Initially, paper receipts were issued for grain in storage. The use of grain banks and bills of exchange expanded over time and came into common usage in Europe in the middle ages. As explained by Wikipedia:
The highly successful ancient grain bank also served as a model for the emergence of the goldsmith bankers in 17th Century England. These were the early days of the mercantile revolution before the rise of the British Empire when merchant ships began plying the coastal seas laden with silks and spices from the orient and shrewd traders amassed huge hoards of gold in the bargain. Since no banks existed in England at the time, these entrepreneurs entrusted their wealth with the leading goldsmith of London, who already possessed stores of gold and private vaults within which to store it safely, and paid a fee for that service. In exchange for each deposit of precious metal, the goldsmiths issued paper receipts certifying the quantity and purity of the metal they held on deposit. Like the grain receipts, tallies and bills of exchange, the goldsmith receipts soon began to circulate as a safe and convenient form of money backed by gold and silver in the goldsmiths’ vaults.
Knowing that goldsmiths were laden with gold, it was only natural that other traders in need of capital might approach them for loans, which the goldsmiths made to trustworthy parties out of their gold hoards in exchange for interest. Like the grain bankers, goldsmiths began issuing loans by creating additional paper gold receipts that were generally accepted in trade and were indistinguishable from the receipts issued to parties that deposited gold. Both represented a promise to redeem the receipt in exchange for a certain amount of metal. Since no one other than the goldsmith knew how much gold he held in store and how much was the value of his receipts held by the public, he was able to issue receipts for greater value than the gold he held. Gold deposits were relatively stable, often remaining with the goldsmith for years on end, so there was little risk of default so long as public trust in the goldsmith’s integrity and financial soundness was maintained. Thus, the goldsmiths of London became the forerunners of British banking and prominent creators of new money. They created money based on public trust.
Initially the goldsmiths’ primary function was that of storing money (gold) and eventually bankers developed the next banking function of investing saved money in potentially profitable ventures. But note clearly, that creation of additional gold receipts beyond the amount of gold that was being kept in storage was a false increase in the money supply. Each goldsmith/banker made a decision about how many receipts he could safely issue without destroying the trust of those with whom he did business. Being human, from time to time, bankers would err in issuing too many receipts to the point that depositors of gold would become distrustful enough to ask for the return of their gold. This is called a “run on the bank” if all receipts or simply more receipts were redeemed than there existed gold in the vaults available for redemption.
An individual bank which suffered a “run” was, in the scheme of the overall economy, a blip. The banks were not interconnected and no bank was required to accept or redeem the receipts from another bank. Banks could redeem receipts of other banks if they desired (i.e. it might enhance their own business) but since they were not required to do so, they could redeem them at face value (if the issuing bank had a great reputation) or they could “discount” the receipt at some percentage lower than the face value. Thus if a bank lost all of its assets due to a run, it seldom had a serious effect on other banks. Usually, only the one bank and such of its clients who arrived at the redemption window too late were the losers.
Banking became a centralized system in England in 1694 with the grant by the British government to a Scotsman (William Patterson) to operate a private banking cartel which agreed to fund England’s then current war (the Nine Years’ War, 1688–97, also known as the War of the Grand Alliance) with debt. Funding the war with debt became necessary because the government did not have the funds to continue paying for the war but it did have the power to tax its productive citizens currently and into the future. And in this, dear reader, is the essence of all the dirty little secrets about money, gold, paper substitutes, and central banking.
We will discuss more of the important features and history of money and gold in Part 4.
The USA is in a financial mess. One of the reasons for the mess is the simple fact that most of us who are citizens of this country have an extremely limited knowledge of economics and money. I see this daily in my conversations with friends and acquaintances. One of the objectives of this blog is to help individuals come to a basic understanding of the economic concepts which determine the quality of their lives. Because so few of us understand basic economic ideas, we are easily led by bankers and politicians into making personal and societal decisions that make our lives worse rather than better.
This post is about money because it is one of the most fundamental economic concepts which we deal with every day and yet do not understand. When we want something, perhaps to eat or to make our lives more comfortable, we peel off some of those green pieces of paper in our wallet or just use a plastic card which works as a kind of substitute these days. Mostly we just understand that the other party to our exchange will accept those pieces of paper or the plastic in exchange for whatever item we desire or need. But we must try to get to the fundamental concepts behind the willingness of two parties to make a mutually beneficial exchange.
I’m going to start with a primitive market which I did also in a previous post. In the most primitive of markets, there were very limited exchanges of goods. In fact, money was an unknown concept. Most societies were quite small and at the same time, self sufficient. That doesn’t mean that life was pleasant only that markets as we understand them, did not exist. A small society produced its own essential products needed for survival internally. Life was pretty difficult and there was little if any time for recreational activities. Almost all human activity was devoted just to keeping everyone alive, clothed and fed.
In these societies, it was apparent that food and water, the most essential requirements for life, were not always readily available. Eventually, some folks in these groups realized that food and water were more readily available at different times during the time cycles we understand as years. Some of the smarter people found ways to conserve and save food and water so that both would be available throughout the year.
Eventually the small societies began to come in contact with each other and to interact. Some of the groups were primarily farmers, others were hunters and others were fisherman. I’m sure there were other specialty groups. They began to trade amongst themselves but remember, there was still no concept of money. So the trading was simply a barter relationship. We have no way of assessing relative value but a farmer might have been willing to exchange a bushel of wheat for 5 medium sized tilapia (a fish). Exchanges like this were probably common. But suppose a hunter bagged a 600 lb elk and a 200 lb mule deer. This was more than his family group needed so he set out looking for an exchange. The farmer had only 10 bushels of wheat which the hunter recognized as not being equal to even the 200 lb deer. And time entered into the process. The deer meat which was probably considered more valuable but would rot much sooner than the wheat.
The point is that the barter process could effect an exchange but it was clunky and did not always meet the needs of both parties to the exchange. The small societies began to realize that it was possible to make indirect exchanges. That is, the hunter may not want or need 50 bushels of wheat for his 200 lb deer but the deer meat was a more time sensitive commodity than the wheat. By exchanging it for something that had longer lasting value, the hunter could get very close to the full value of his deer and have a product that would last longer and thus he could delay making another exchange until he knew what his next priority for an exchange would be.
The small societies were constantly searching for items or products that had lasting value. By exchanging their short life value products for other products that retained their value for longer time periods they developed a methodology to delay their final exchanges until they were more sure what would be most needed within their small groups.
These barter groups were constantly looking for items that would provide ever longer time periods before requiring an exchange. As the groups grew and refined their productivity, they came into contact with more groups with whom exchanges could be made. Each new group had the potential to introduce a new product for exchange. Over many years and many exchanges, the primitive markets began to develop into formalized exchanges and the possible exchanges began to develop into structured arrangements. These structures became possible after the precious metals had been discovered. The metals themselves had no intrinsic value but began to be valued simply because they were rare, beautiful and difficult to extract from the earth.
This discussion has possibly created the impression that the precious metals were a clear and early recognized item of exchange. This is not true at all. Different societies valued different items and the items valued changed with time. Such things as sea shells, bird feathers, arduously formed pieces of stone, and many other products were used as long lasting exchange items. It was only over a very long period of time (we do not know how long) that the two primary precious metals, silver and gold, became the most valued items across many multiples of societies as meeting the requirements of a long lasting and valued commodity that could be used to make indirect exchanges.
To understand gold (and less so, silver) as money, we need to consider how the barter process could develop into a more formalized exchange process. But the first step is to fully understand what gives value to any commodity. For example, gold has few uses that are naturally available to man. It cannot be eaten, provide shelter or protection of any kind and indeed, even today is used for very limited industrial purposes. Some folks have gold fillings in their teeth but in the time frame of these primitive societies, there were no dentists and no ability to process gold to use it in this capacity.
In fact, all commodities have value that is determined by large numbers of individuals making decisions about how desirable they are. There are, of course, those items that are necessary for survival. We all need food, water and shelter. Once these basic needs are met, individuals have more flexibility to express their individual desires. We can only guess at how many bushels of wheat would be required for the hind quarter of a 200 lb deer. But the reality is that depending on the desires of the two individuals involved in the exchange, one day it might require 4 bushels and the same trade could be made several days later for only 3 bushels. Of course as the meat is getting older its value is probably dropping.
But lets consider a more difficult trade. Suppose the hunter has just one hind quarter of his 200 lb deer remaining and what he really needs is a new pair of shoes. The farmer still has his wheat and is willing to trade 4 bushels for a hind quarter but the hunter would rather have new shoes so he can continue hunting. Enter a workman in a near by group who is willing trade an extra pair of shoes he just made for two bushels of wheat. As long as these three people can find each other in the proper time frame, a trade can occur. But you can imagine the difficulties involved if the three folks do not know each other and cannot find the correct trade in a time frame that meets the needs and desires of all involved.
If instead, there existed a product that was mutually recognized by all involved in the process as having the approximately the same value and at the same time kept its value for an extended period of time, then the hunter could exchange his hind quarter of deer meat for this product and not be concerned about possibly having to make an exchange first with the farmer. The workman could make a direct exchange for the meat and use this product later to make another exchange for the wheat he wanted.
Another difficulty that might prevent an exchange is when the value perceived by the two individuals in an exchange is not easily subdivided. Suppose the hunter just bagged a wild turkey and he was willing to exchange it for a half gallon of fresh water because he is thirsty after his hunting trip. He meets a man on the road with a gallon jug of water. They agree that a half gallon jug of water for the turkey is an agreeable exchange but neither of them has a half gallon container. It’s possible that no exchange will take place just because of the mechanics of the situation prevent the agreed exchange.
The difficulties of these barter exchanges can be overcome if a product exists that (1) is relatively scarce and thus has a generally recognizable perceived value, (2) is not easily used up (it is durable) or does not decay such that its value changes over time, (3) is relatively easy to subdivide such that the intrinsic character of the product is the same after it is subdivided as it was before, and (4) it is relatively easy to either store or transport it.
A bit of reflection allows one to see that gold and (to a slightly lesser extent) silver come extremely close to meeting all these parameters. Thus it should be no surprise to anyone that gold and silver have been among the most common products (commodities) used as a medium of exchange, otherwise known as money. Gold was valued by multiple civilizations even before the concept of money had been developed so it simply makes sense that its primary use eventually became the most used medium of exchange or money. While the first gold coins were struck in Lydia about 700 BC, it is only in the recent history of world civilizations that gold has become just a barbarous relic and is not treated as money by any government in the world.
Why this has happened is important and needs some discussion thus we will consider some of the more current developments in part two of Gold = Money?