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Monetary Policy and the Free Market

Mises Daily: Friday, October 10, 2003 by

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The fundamental issue in banking and monetary policy is whether government can improve the monetary institutions of the unhampered market. All government intervention in this field boils down to schemes that increase the quantity of money beyond what it otherwise would be. The libertarian case for the abolishment of government intervention in money and banking rests on the insight that the latter serves only redistributive purposes.

Monetary policy is concerned with modifications of the quantity of money. Although policymakers might ultimately seek to control interest rates, unemployment or a stock-market index, the attempt to realize any of these goals through monetary policy presupposes the ability to modify the quantity of money.

For example, to reduce short-term interest rates, policymakers must be in a position to produce additional quantities of money and offer them on the so-called money market, lest they could not exercise any downward pressure on rates at all. Hence, the crucial question is: Who should be allowed to produce or destroy money, and which goals should thereby be pursued?

Banking policy is concerned with analogous questions. Rather than dealing with the production of money it deals with the production of money titles, which can be instantly redeemed into money—as opposed to credit titles or IOUs, which can be redeemed into money only at some future point of time. A bank in the sense that is relevant for banking policy is a firm that issues money titles. The latter include bank notes, check books, credit cards, Internet accounts, Smart Cards, etc. Who should be allowed to issue such money titles, for which purposes, and in which quantities? These are the main questions in banking policy.

The Unhampered Production of Money

On the free market, every individual would have the right to invest his labor and his property in the production of money and to sell or give away his product as he himself sees fit. Every money producer would in this sense pursue his own monetary policy, just as each shoe manufacturer in selling his products pursues his own "foot fashion policy."

The two main questions of monetary policy are thus answered by the very organizing principle of the market: private property. Each individual is a policymaker, making policy with his own property. And each individual pursues the goals that he would like to pursue.

Historically, very different sorts of commodities (gold, silver, copper, shells, tobacco, cotton, etc.) have been used as money. Yet gold and silver have tended to drive out the other monies from the currency market because of their superior qualities for various monetary functions: they are homogenous, durable, easy to recognize, easy to shape, etc.

Their production is subject to the same laws that rule the production of other commodities. Hence, the "monetary policy" of mine owners and of each mint is strictly oriented toward consumer satisfaction, the quantities produced depending only on consumer demand.

Since paper currencies are the dominant type of money in our age, there has been some speculation about the possibility of a free market in paper money or electronic money. Yet not only is there no historical evidence to support this possibility, but noncommodity monies have at all times and places been creatures of the state.

In modern times, the state has introduced paper money by giving a privileged note-issuing bank (the national Central Bank) the permission to suspend the redemption of its notes. While the historical record does not prove that there could be no noncommodity money on the free market, Austrian economists have argued that money must be a commodity by its nature.

Free-Market Banking

On the free market, every individual would have the right to become a banker. Everybody could offer to store other people's money and issue money titles, which in turn would document the fact that money has been deposited with him and can be redeemed at any time.

Conceivably, bankers would also propose investment schemes that bear a certain resemblance to the business of storing money and issuing money titles. For example, they could offer to issue IOUs for money invested in their bank and try to make these IOUs more attractive by promising to liquidate them on demand at face value. They might even issue them in forms that are virtually identical with the forms in which money titles appear: "bank notes," "smart cards," "credit cards," etc. And this in turn might induce some market participants to accept these IOUs as payment in market exchanges, just as they occasionally accept a mortgage or a stock-market paper as payment.

Some economists think that such investment schemes have been realized in the past and call them "fractional-reserve banking." They also use the term "bank notes" to describe the aforementioned IOUs. Still it is important to be aware of the essential differences that exist between them and money titles. Despite resemblance in appearance and use, money title gives claims to money, while the promise to redeem an IOU gives claims to an effort by the banker. While all money titles can be redeemed at any time, if too many receipt owners desire such liquidation at the same time only a part of these IOUs can be liquidated as promised by the banker.

Identical names and identical outer appearance of both money titles and liquid IOUs are not a mere coincidence. In most historical cases, bankers issuing liquid IOUs took pains to hide the real differences distinguishing their product from genuine money titles. Insofar as such efforts are meant to deceive other market participants, fractional-reserve banking is a fraudulent scheme that violates the principles of the free market and merely serves to enrich some individuals (the bankers and their customers) at the expense of all others.

More on Money and Money Titles

This tendency to conflate money and money titles has never ceased ever since 20th-century government decrees fundamentally transformed the nature of central banks and central bank notes. These decrees have (a) given the national central banks the privilege to deny note redemption to their customers and (b) protected these irredeemable central-bank notes by legal tender laws. For lack of better alternatives in the short run, the central bank notes stayed in circulation. Yet now these notes no longer were money titles since they could not be redeemed against anything else. They had become independent goods: paper money.

Similarly, the central banks were no longer banks at all, but had become money producers. Confusion about this transformation was bound to spread since, physically, both the central bank notes and the central bank itself continued to exist without any change of their appearance—an interesting case of what could be called economic transsubstantiation.

This does not mean that money titles ceased to exist. In fact, the government-enacted establishment of paper currencies transformed only the central banks and their products. All other banks continued to issue money titles, with the only difference that the titles they issued referred no longer to the old commodity money, but to the new paper money. Today, the neglect of the fundamental distinction between money and money titles has led to vast speculations about Internet money etc.

Money Production, Banking, and the Government

The great issue in monetary and banking policy is whether free-market banking and the free-market production of money can be improved by schemes relying on coercion. The history of monetary analysis and policy has been the history of debates on the insufficiencies of the unhampered market and on how to remedy them with statist monetary schemes. Virtually all these discussions have revolved around problems of alleged money shortage, and the essence of all institutions designed to overcome these problems is to produce more money than could possibly be produced on the unhampered market.

Mercantilist writers argued that more money meant higher prices and lower interest rates, and that these in turn invigorate commerce and industry. Moreover, taxes can be levied more easily in a monetary than in a barter economy. Thus the mercantilists urged to stimulate imports of gold and silver through tariffs on foreign goods and export subsidies for domestic products. They endorsed fractional-reserve banking to the benefit of the Crown, and they supported special monopoly privileges for "national" or "central" banks.

They had a point: The kings very much profited from increased monetary circulation, which made looting their subjects far easier. However, the French physiocrats and the British classical economists entirely destroyed the rest of the mercantilist scheme. Tariffs and export subsidies cannot permanently increase the domestic money supply, and the amount of money circulating in the economy has no positive impact on trade and industry considered as a whole.

The great contribution of The Currency School to the theory of monetary policy was to show that increasing the quantity of money did not increase the amount of services that money rendered for the nation as a whole. A higher money supply merely leads to higher money prices, but it does not affect aggregate industry and aggregate real output. This is what they had in mind when speaking of money as a "veil" that is superimposed on the physical economy.

Later economists further refined this analysis by giving a more sophisticated account of the impact of money on the real economy. They showed that increases in the money supply bring about two forms of redistribution of income. On the one hand, an increased money supply means that the purchasing power of each money unit is diluted. If this loss of purchasing power is not anticipated, it benefits borrowers at the expense of lenders.

On the other hand, and independently of the anticipations of the market participants, the new money first reaches only some market participants who can now buy more out of an unchanged supply of real goods. All others will buy less at higher prices, since the spending of the additional money units raises the market prices. Hence, while variations of the quantity of money bring no overall improvement for the national economy, they benefit some persons, industries, and regions at the expense of all other market participants.

For a hundred years, the idea that a community could promote its well-being by increasing the money supply beyond what it would be on the unhampered market was discredited among professional economists, even though the influential J.S. Mill undermined this monetary orthodoxy by various concessions.

Then John Maynard Keynes almost single-handedly gave a new life to the old mercantilist policies. The charismatic Keynes was the best-known economist of the best-known economics department of his time. In his writings, public speeches, and private conversations, he used his personal and institutional prestige to promote the idea that multiplying money could achieve more than simply redistribute income in favor of the government and the groups that control it.

Keynesianism has vastly increased government control over the economy. It has given modern states the justification to engage in social engineering on an unheard-of scale and to deeply transform social relations, the geographical allocation of resources, and mass psychology. However, Keynes's greatest legacy is that his ideas keep guiding present-day research in monetary economics.

Today, virtually all publications in academic journals take it for granted that Keynes was right and monetary orthodoxy wrong. Based on the tacit assumption that government can improve money and banking, thus increasing aggregate output, mainstream debates turn around issues of interest for government policymakers. Such issues are, for example, the definition of various monetary aggregates, signalling through the behavior of central-bank officials, various insurance schemes for financial intermediaries, and indicators to predict the impact of monetary policy on prices, interest rates, production, and employment.

There are also free-market economists who discard monetary orthodoxy and try to make the case for a free market in money and banking on mercantilist-Keynesian premises. These economists argue that the supply of money has to be constantly adapted to match the needs of trade or to bring about monetary equilibrium, etc. Yet they think that the institutions needed to ensure this permanent adaptation are most likely to emerge on the unhampered market.

It is difficult to predict which course mainstream thinking in banking and monetary policy will take. For libertarian monetary economists, there are ample and largely unexplored research opportunities relating in particular to the impact of a government-controlled money supply on the economy and on society at large, and to the best ways to abolish government intervention in money and banking.

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Jörg Guido Hülsmann (jgh@mises.org) is a senior fellow of the Mises Institute.

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