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Money Part IV - The Prosecution Rests. Fiat Paper Money Calls Its First Three Witnesses

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March 17, 2009 – Comments (7)

"Woe to those who call good evil, and evil good." - Isaiah 5:20

I start this blog with the same quote which I ended the last. You are about to bear witness to its importance.  In this tour de force series on the roots of Money Production and, as you will see, the roots of our current and future financial problems, it is time to hear the other side's case. I have taken the hammer to fiat paper money, attempting to show the reader just how unethical and impractical unbacked paper money is as a long term monetary solution. Now it's time to hear from the defenders of fiat money. First, let's review where we are at.

Part 1 - The origins of money were discussed. It was shown that natural money (gold, silver, copper, etc) always arose without government decree in market economies. The theory of monetary and nonmonetary value was presented to teach about the difference between metals and paper as a means of indirect exchange. We looked at possible reasons why governments would outlaw metals, or certificates redeemable in metal, as currency and replace them with unbacked paper.

Part 2 - An argument was made the unbacked paper money and property rights are mutually exclusive. Christian scholars presented the case that property rights are absolutely sacred as the best means for improving the lives of the masses.  Therefore, from a Christian perspective, unbacked paper money is unethical.

Part 3 - In this study on Inflation, or monetary base expansion, I demonstrated the purpose of currency distortion - to benefit government and politically connected businessmen and bankers at the expense of the poor and middle class. We covered the various forms of inflation and how they came into existence. Finally, we explained how excessive monetary base expansion, through fractional reserve lending and central bank inflationary policy, causes the booms and busts that are so frequently confused with unfettered capitalism.

Now it wouldn't be fair or ethical if I didn't present the arguments for paper money, and I will do that here. I have selected the most common arguments, with a nod to Jorg Hulsmann's great book The Ethics of Money Production and Murray Rothbard's What Has Government Done to My Money?, but I don't wish to attack a strawman. If you find any problems with my presentation, please let me know. The point of this entire lengthy exercise is to share knowledge. After all, in order to endorse paper money it must have significant advantages. One could not argue that freedom of association, civil liberties, and the use of monies that have been in circulation since at least biblical times should be outlawed unless they had a very good reason, right? Here in Part 4 of our study of money we will examine three common arguments for paper money. We will finish the paper defense by looking at three more in Part 5 due to character limits and limitations on my time.

THERE IS NOT ENOUGH GOLD OR SILVER TO MAKE OUR DYNAMIC ECONOMY WORK.

Fiat paper argument: Suppose the economy grows at a rapid rate, let's say 8% per year. In order to maintain that growth, the monetary base must be expanded at an equal rate. This is clearly impossible with gold or silver, at least certainly in the long run. Without a corresponding growth in the money supply, the economy will contract and the subsequent bust will wipe out businesses, investors, and lead to a depression. This is often refereed to as the Assignment Theory of Value, first developed by John Law, and later expressed in more detail by Schumpeter and Wieser.

Counter argument: Monetary growth and economic growth need not be dependent. In the above example, should the economy grow by 8% and monetary growth stagnate, the economic growth would mean a reduction in prices with no change in "real" wealth. There would be 8% more goods and services, but on average all goods and services would decrease by 8%. In fact, during the period of 1871-1900, both the American and Germany economies grew at high rates despite monetary supply decreases! (A Monetary History of the United States, Milton Friedman).

Fiat paper argument: Even if monetary and economic growth are independent, enough growth would be render coins useless as they would have to shrink to ridiculous sizes to make small purchases possible. This would be insanely impractical. It is especially true in the case of gold.

Counter argument: In every market in history, lower valued coins were introduced to satisfy this need. The monetary supply market has always adjusted and there is no reason to think it won't continue. Silver became the most prevelant money for precisely this reason. No government intervention was ever necessary. Furthermore, silver or gold backed paper (or electronic) money has also fulfilled this need.

Fiat paper argument: Even so, the reduction in prices due to this disjointed growth will lead to bankruptcies as entreprenuers are forced to sell items at lower prices than initially calculated before the economic expansion.

Counter argument: Entrepreneurs are not machines. They can easily adjust and anticipate future reductions of the selling prices of their products. They can even thrive in a declining price environment by properly reducing operating and supply costs as prices drop. The most astute entrepreneurs will propser in a declining price environment.

Bottom line: The idea that there is not enough gold or silver to go around, or to support economic growth, doesn't hold water. Let's see what else fiat money can offer in its defense.

NATURAL MONEY LED TO HOARDING

Fiat paper argument: An economy can only operate efficiently when money is moving through it. In the old days, people hoarded money, limiting economic growth. Hoarding becomes excessive and reduces the amount of money available for everyone else, thus depriving them of the resources necessary to improve their livelihood. Only the forceable expropriation of the money, or a willful increase in the money supply can alleviate the danger of hoarding. That willful increase can only come about with unbacked paper money. Case closed.

Counter argument: Not so fast, big guy. You may have overstated your case. Hoarding money is a pathological problem and a very rare one at that, Holding money is something quite different indeed. A person can have a virtually limitless number of excellent reasons to hold money. Perhaps they wish to hold excess cash for emergency rainy day funds. Is that excessive? Certainly not, so why punish them with inflation simply to prevent hoarding? Seems a bit unethical. What about the entrepreneur accumulating capital for expansion of his/her current operation? Or the retiree that withdraws a portion of his retirement fund from stocks or bonds he deems too risky? Are these people hoarding money? What measurement will you use to determine what is excess hoading? The fact is that hoarding is a rare phenomenon. Please show me the billionaires that hoard cash. I see them spending massive amounts constantly. The only people I see doing the hoarding are central bankers, who now control nearly all of the world's gold. Now, that's hoarding!

Bottom line: The effects of hoarding are negligible in any economy, but especially in a dynamic one. Any decrease in money supply is immaterial anyway as shown above precisely by the fact that monetary supply and economic growth are independent factors anyway.

THESE PRICES ARE STICKY! YUCK!

Fiat paper argument: Suppose a situation arises where unions successfully negotiate significant wage increases. The subsequent fallout, should the success be widespead, could lead to very high unemployment should entrepreneurs be unable to support labor at their new costs. If these entrepreneurs can not raise prices on the goods they must either go out of business or lay off substantial amounts of the labor force. Either way, the resulting spiral will lead to economic contraction and possibly a depression. By manipulating the money supply, artificially increasing the amount of money in circulation, we can eliminate this sticky price of labor. The increase in money will lead to an increase in the amount that entrepreneurs can charge for goods, thus allowing them to reintegrate the unemployed labor force. Voila! This is clearly impossible on a gold or silver standard.

Counter argument: Sounds simple enough, but I need to ask you something: How many times do you think you can outsmart the labor unions? The first time you pull this off, don't you think labor leaders will realize that any gains they received in negotiation were wiped out by your inflationary policies? Do you think they are that dumb? In response to your monetary machinations, labor unions just factored in their reduction in purchasing power in their next round of negotiations, thus demanding even higher wages, leading to more unemployment. And the cycle goes on.

Bottome line: Sticky Price theory was surprisingly prevalant in Europe after WWII and, predictably, led to higher unemployment and constantly larger wage demands from labor unions.

Up next: In Part 5 we will continue to examine arguments for paper money. I think we'll continue to see they don't hold water.

"Paper money eventually returns to its intrinsic value -- zero" - Voltaire

David in Qatar

7 Comments – Post Your Own

#1) On March 17, 2009 at 6:23 PM, chk999 (99.97) wrote:

For some reason this reminds me of Don Quixote.

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#2) On March 17, 2009 at 6:40 PM, tfirst (28.90) wrote:

Long torches and pitchforks.....

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#3) On March 17, 2009 at 6:43 PM, DaretothREdux (42.53) wrote:

David,

When you get a chance I would like you to further address the fractional reserve banking system. I have a friend who believes that with a 100% reserve banking system that not enough money would ever be loaned out for us to have the economic growth that we have experienced for the last 100 years.

Thanks,

Dare

P.S. Great post. Keep tilting at windmills! There is a reason the story of Don Quixote survives...perhaps its because we respect anyone who fights a battle they might never be able to win.

Courage is not a man with a gun in his hand. It's knowing you're licked before you begin but you begin anyway and you see it through no matter what. You rarely win, but sometimes you do.

-Atticus Finch, To Kill a Mockingbird by Harper Lee

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#4) On March 17, 2009 at 6:52 PM, RVAspeculator (29.66) wrote:

Great post....

And the result of a Fiat money system is my blog post from today..  :)

http://caps.fool.com/Blogs/ViewPost.aspx?bpid=164801&t=01001808419327792238

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#5) On March 17, 2009 at 6:56 PM, whereaminow (22.93) wrote:

Thanks Dare,

The difference with Quixote should be obvious. If you studied economic calculation problems you will see that systemic collapse of paper money is inevitable. The argument is already won, it's just a matter of warning people before it happens. Mises didn't live in a fairy tale. After he and Hayek predicted the Great Depression, they just went back to work after it happened. Same goes for Ron Paul and modern day critical thinkers after this last collapse. They just go back to work. So that's what we'll do.

I'd like to talk more about fractional reserve banking so we'll see if I can get that in. This is already turning into a much bigger project than I had planned. Go figure. I'm fit for government work!

David in Qatar

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#6) On March 17, 2009 at 8:02 PM, nuf2bdangrus (< 20) wrote:

A government that can create money out of thin air is a government that will always promise more things to the have nots by expropriating them from the have's, either through taxation or inflation, because the vary nature of humanity is there will be more poor than rich.  The uber rich are always in collusion with the government, and they receive money first in inflation (look at the deals GS, MS etc are getting from the Fed)

 

In fact, inflation is the stated goal of the Fed now, they just can't acheive it because deleveraging is occuring and destroying "wealth" faster than the government can create it.

 

Prices will fall until deleveraging is done, then inflation shall come in when everybody (the public) is trapped on the wrong side of being the lender at under market rates (Cd's, treasuries etc)

 

The biggest bubble out there is US treasuries.  Beware the confiscator.

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#7) On March 17, 2009 at 8:09 PM, whereaminow (22.93) wrote:

nuf2bdangrus,

Excellent analysis. I think you're spot on. Thanks for the comments.

David in Qatar

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