Money: Sound and Unsound
Joseph Salerno, my friend and colleague at the Mises Institute, published a book this year entitled Money: Sound and Unsound. The book consists of 26 chapters, which were based on articles he wrote in publications around the globe. The common purpose of all the articles is to explain the principle of sound money to an audience of nonspecialists.
The principle of sound money consists of two things: The first is the affirmation of the market's ability to choose and maintain money and all the enormous benefits this has provided to society. The second is the opposition to government meddling in money and all the negative consequences it has on society.
The book does a marvelous job of presenting all the important theoretical debates on money. There are of course some complex historical episodes that are beautifully disentangled, particularly with regard to the Great Depression. The book is filled with analysis of policy, including some of the very best discussions of inflation and deflation. Finally, in terms of moving forward, the book contains several important essays on the gold standard and how to implement it.
I highly and enthusiastically recommend this book to you. Money: Sound and Unsound is a great accomplishment and it contains the very information that we need to move the world in the right direction. I dedicate my lecture today to Joe's accomplishment and to his goal of restoring the principle of sound money.
Sound vs. Unsound
The principle of sound money acknowledges that money is a vastly important contribution that the market has given to society. Money starts as a commodity used as an intermediary in exchange. For example, I accept tobacco in payment for a labor service, even though I have no desire to consume tobacco, because I know that I can use the tobacco to purchase some tomatoes down at the vegetable stand.
Initially, many goods such as tobacco may serve the purpose of an exchange intermediary. However, there is a natural tendency for particular goods to emerge as the best intermediaries for exchange. Eventually, only a small number of goods endure as the very best commodities to serve as intermediaries.
These goods will naturally have the qualities that allow them to best serve as intermediaries. Those qualities will include being durable, because you would not want an intermediary that might spoil or deteriorate between the time you accepted it and the time you wanted to use it in exchange. Another important quality is that the commodity be divisible, so that you could parcel out the amount of the commodity to be offered in exchange. Tobacco, for example, can be measured by weight to a precise amount. Tomatoes are less divisible and less durable than tobacco. The best intermediaries will also be easy to transport and will thus represent a large value relative to size and weight. They should also be difficult to forge or imitate and easy to store. The commodities that emerge from the market process as the best intermediaries are called money, or the general medium of exchange, because they have the widest salability in the market.
It is important to note that this is not some mysterious process unguided by human choice. Rather, it is an entrepreneurial process whereby certain individuals discover those particular commodities that have the properties required in a particular economy. These individuals benefit from their discoveries — they profit from them. The best entrepreneurial discoveries are eventually emulated and the market is driven in the direction of certain commodities and away from others.
Long ago, people discovered that the best intermediaries for exchange were metals — specifically bronze, tin, copper, silver, and gold. These commodities were extremely durable, highly divisible, easily transported, and difficult to counterfeit. To enhance divisibility, blacksmiths would cut the metals into equal-sized pieces and add their marks to certify the weight and indicate who produced them. In this manner the business of minting coins came into being.
In order to enhance the ability to store and transport money, banks and bank notes came into being. Initially, goldsmiths and silversmiths — who already had a safe place to store their own metals — served as a repository or storage facility for money. In order to enhance the portability of money, paper banknotes emerged as a way of reducing the cost of transport and the risk of theft. Instead of transporting 100 pounds of silver for a trip from London to Paris, I would simply ask my London banker for a banknote for 100 pounds of silver, which I could then cash or redeposit at his corresponding bank in Paris.
This might all seem simple and obvious today, but it is far from that. The complex process whereby money and banking developed could never have been imagined prior to it actually happening. Cigarettes did quickly emerge as money in World War II prisoner-of-war camps in Germany, but only because everyone was already familiar with the use of money. No one would be capable of discovering money in its modern form during prehistoric times. Governments would also be incapable of creating such a system. Governments merely monopolized existing systems of money.
Everyone acknowledges that money is important, but few people realize how important money really is. Without money, the ability to exchange would be extremely limited. Bartering goods is a costly and cumbersome process in which you have to find someone who wants something you have and has something you want. It also requires two people who can come to terms regarding how much they have to relinquish in order to make the exchange. People would have to supply themselves with most of the goods they consumed and would therefore have far less to consume. Specialization and division of labor would be extremely limited. Economies of scale would be extremely limited. Complex goods could not be produced.
You could not circumvent the difficulties of barter simply by going on Craigslist, because Craigslist would not exist. Neither would computers, the Internet, or cell phones.
In other words, the long-term development of our standard of living is based on and coincides with the development of money. There are still societies in Africa, Asia, and the Americas that do not use money, but these are primitive societies in which people live in crude structures with primitive clothing and an uncertain food supply. They have none of the things that we take for granted, such as indoor plumbing, refrigeration, soap, clean underwear, etc. Their lives can be satisfying, but the point is that their social existence is very different from a society based on money, and they have a much lower standard of living.
The principle of sound money is therefore based on commodity monies that emerged in the market, guided by the principles of property, commerce, and entrepreneurship. The system of money did cause various shocks as it developed and spread, and as the economies of isolated cultures became integrated into the system. Such integration is always a messy process, but ultimately monetary integration itself was wholly beneficial.
Any step away from the principle of sound money will have negative consequences for society. Here I am speaking specifically about government intervention into money and banking. The first type of intervention is the monopolization of minting coins. This may have had the initial appearance of being beneficial, as money became homogenous and counterfeiters were punished with the power of government. However, any government monopoly of money leads to the second type of interference, which is debasement or what we call monetary inflation. Governments and counterfeiters shave or clip coins and reduce the size of coins over time in order to have more money to spend. Today, the process of inflation is done electronically with mere bookkeeping entries.
Even if the state did not debase the supply of money, it would still have monopolized money and destroyed the market process. Only with competing money suppliers would it be possible to have certain types of innovation and product development. These changes improve money and better adapt it to changing economic conditions and thereby enhance economic development throughout the economy over time. George Selgin's new book, Good Money, presents a great historical case study where the government partially relinquished its authority over coins, and the market entered the void and provided an improved product.
The types of innovation that have occurred under state monopoly of money have all been negative. They include fractional-reserve banking, bimetallism, the gold-exchange standard, central banking, fiat paper money, the Bretton Woods system, the World Bank and the International Monetary Fund, the current dollar hegemony, and now quantitative easing. Time limitations prevent me from describing the problems with all of these "developments," but rest assured they are amply covered in the Austrian economics literature and on Mises.org.
Needless to say, we have drifted far away from the principle of sound money. We now have a system of fiat paper money with no commodity backing whatsoever. We have a fractional-reserve-banking system that until recently held almost no reserves to back up deposits. And finally, we have a central bank that has embarked upon a series of extreme and unconventional policies. The government's budget deficit, the raison d'être for inflation, is exploding, and we now have future unfunded liabilities — a "fiscal gap" — that have been estimated to be as high as $200 trillion.
With a second round of quantitative easing (QE2) looming, and with the price of gold shooting past $1,400 per ounce, things have gotten so bad that the gold standard is back in the news. On the one hand you have Robert Zoellick, head of the World Bank, who has suggested that gold-price targeting be used as a guide for monetary policy. On the other hand you have New York University economist Nouriel Roubini, who recently attacked gold because it would limit the policy flexibility of the Federal Reserve — i.e., the Fed could not stimulate growth, the Fed could not manage the price level, the Fed could not serve as the lender of last resort, and the Fed could not have bailed out the big banks. Of course, these are precisely the reasons why Austrians do not want a central bank.
Austrians vs. Keynesians
The economics profession was long composed of various schools of economic thought, with the Austrian School consisting of a small but highly innovative group of economists who worked within many of the leading institutions of higher learning. More recently, the Austrian School has grown significantly both inside and outside academia. However, instead of there being a continuum of thought among the various schools, it now feels more like there is one camp of Austrians and another camp of the various types of Keynesians.
The Austrian camp supports what I have labeled and discussed as the positive principles of sound money (commodity money, competitive currencies, free banking, 100 percent reserves on demand deposits). The Keynesian camp supports what I have labeled as the negative principles of sound money, which involve various forms of government intervention. My view is that the Keynesian camp does not really understand how the economy works as a social system that involves the entrepreneurial actions of millions of people. They seem to view the economy as a machine or a single being that they can manipulate with fiscal and monetary stimulus to achieve various results.
I would now like to discuss some examples of the differences between the Austrians and Keynesians. These examples include the Great Depression, deflation, and the proper way out of this economic crisis. These examples are just three of the many things you will find discussed in the Salerno book, which in my opinion is the single best source of information and knowledge about these and many other economic issues related to money.
The Great Depression, which began in 1929 and lasted throughout the 1930s, has been studied by a number of economists. The Keynesian camp has offered several explanations, including the standard answer that the economy suffered from insufficient aggregate demand. However, insufficient aggregate demand is merely a description of the phenomena; it is not an explanation for the phenomena. Milton Friedman said the Great Depression was caused by a fall in the money supply in the early 1930s. Ben Bernanke said the Great Depression was a result of bank failures, which led to a restriction of credit in the early 1930s. These too are descriptions of recessions and depressions; they are not explanations for why they happen. Other economists have even blamed the gold standard for the Great Depression, because it prevented authorities from expanding the money supply.
In contrast, Salerno shows in his book that the Federal Reserve was highly inflationary during the 1920s, setting off a bubble in the stock market and malinvestments throughout the economy. Rather than being deflationary in the 1930s, the Federal Reserve tried and generally succeeded in inflating the money supply. Salerno also points out that we had left the real gold standard in 1914, substituting the Federal Reserve bureaucracy and the gold-exchange standard for the real one. The reason the Depression was "Great" was that Hoover and Roosevelt enacted policies to prevent the market from working and specifically to prevent wages and prices from falling.
This leads to the second example, which is deflation as defined by falling prices. Mainstream economists suffer from a great fear of deflation. Paul Krugman and Ben Bernanke, who were once colleagues at Princeton University before they took on their current high-profile jobs, are both afraid of deflation to the point of being phobic. Austrians like Salerno, on the other hand, think falling prices are a good and natural thing. If production in the economy is increasing and costs are falling, then with a stable money supply prices will fall and paychecks will go further. Deflation is great for the average working person. Entrepreneurs in many industries plan their businesses to anticipate falling prices for their products.
The Keynesians associate deflation with depression, but Salerno explains that the historical association between deflation and depression is weak. Keynesians fear that a little deflation will cause consumers to delay spending and force businesses into bankruptcy, and that this process will cycle out of control into a deflationary spiral. Of course deflation can coincide with depressions; but the depression is caused not by deflation but by the previous inflation that led entrepreneurs to make bad investments.
The reality of deflation is quite the opposite of what Keynesians fear. When an economy goes into recession there is a tendency for prices to fall. The price of capital goods and land fall the most, followed by labor, with consumer goods — especially necessities and nondiscretionary goods — falling the least. As entrepreneurs see the prices of capital goods, land, buildings, and labor falling relative to the price of consumer goods some of them get the idea that they can combine those resources with relatively low prices in order to produce consumer goods with relatively high prices. Rather than causing the economy to cycle out of control into depression, deflation is actually a natural shock absorber that stabilizes the economy.
My final example of the differences between the two schools is the prescription for restoring prosperity. The Keynesians believe that you need to increase the money supply, and now it appears there is no limit on the amount of money to be created. They also believe that there should be stimulus spending by the government, and that too seems now to be unlimited. As part of the stimulus, this spending should be financed by borrowing to increase the deficit and national debt, and this too now seems to be unlimited — whatever is necessary to get the job done.
Austrians view all of these so-called remedies as harmful impediments to the process of economic readjustment. This readjustment is necessary to correct for the malinvestments that occurred during the prior boom (i.e., the housing bubble). The Great Depression, the stagflation of the 1970s, the longstanding weakness of the Japanese economy, and the current crisis all stand as testament to the correctness of our view. The correct view is that government should get out of the way, cut taxes and the size of its own agencies and regulatory bureaucracies, restore a good environment for entrepreneurs, and allow markets to work. Most importantly, government should adopt the principles of sound money. We need to restore the gold standard — which Salerno has written about at great length — close down the Federal Reserve, and return the operation of money and banking back to the marketplace.