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.