In this article I* would like to continue in the tradition of Mises, Rothbard, and Salerno to analyze how sound monetary regimes affect the quality of money. The value of money, as of any other good, depends on its usefulness or quality in the eye of its user. Money’s quality can be defined as “the capacity of money, as perceived by actors, to fulfill its main functions, namely to serve as a medium of exchange, as a store of wealth, and as an accounting unit” (Bagus 2009, pp. 22–23). Changes in money’s quality affect the demand for money and, consequently, its purchasing power. The quality of a monetary regime, in turn, may be defined as the capacity of a monetary system to provide an institutional framework for a good medium of exchange, store of wealth, and accounting unit.

While the quality of a monetary system or regime is perceived subjectively by actors, there are several objective characteristics that tend to influence this perception. In a trial and error process actors normally do not base their perceptions of their institutional framework on poor whims, as they suffer the consequences of poor judgment. Guided by the objective qualities of monetary systems, actors tend to benefit as they can hedge against depreciation or gain from appreciation of the currency. They can protect their monetary wealth more efficiently. In this article we will analyze these objective qualities of “good” monetary systems.

Connection Between the Quality of Monetary Regimes and Money’s Purchasing Power

The quality of monetary systems has been neglected in the literature.1 Comparative analyses of monetary systems from an institutional perspective are rare.2 Neither do textbooks delve into the qualities of monetary systems, an exception being White (1999). Rather, monetary policies within the setting of our current fiat money systems are analyzed, sometimes enriched by a narrative of the evolution of some historical monetary regimes, yet without providing a comparison of them. The neglect of a comparison might be caused by the belief that we have found the best monetary system. Fiat monetary systems are controlled by a central bank and can be manipulated to provide a supposedly perfect money fulfilling its functions as a medium of exchange, store of value, and unit of account. Moreover, qualities of monetary regimes are hardly measurable or usable in econometric analysis which makes the question unattractive for modern econometric research. Recently, the financial crisis has led to doubts about the set up of the financial system and the monetary system in particular, which makes a comparative analysis of the monetary system timely.

The quality of monetary systems influences the demand for money and, thereby, money’s purchasing power. While much emphasis has been put on the quantity of money and its influences on money’s purchasing power, money’s quality, and the quality of monetary systems are equally important for money’s price, if not more so. In fact, money’s quantity may be interpreted as one of several characteristics that determine money’s quality and the likelihood and capacity of monetary regimes to increase or decrease money’s quantity is one of the important characteristics of the quality of a monetary regime.

Changes in monetary systems may lead to sudden changes in money’s quality and purchasing power. More specifically, a change in the monetary regime may lead to a pronounced change in the valuation of money in relation to other goods. Imagine that actors regard the new monetary system as a worse provider of a medium of exchange, store of wealth, and accounting unit than the preceding system. Actors value money less intensely with respect to other goods. This may be illustrated by an example of an individual’s value scale before and after the regime changes.

Value scale before regime change

.
.
.
20th      5th $10 bill
21st      Hamburger meal
22nd     6th $10 bill
23rd      cheeseburger
24th      7th $10 bill
25th      Bottle red wine
26th      Bottle white wine

In our example our person having seven $10 bills in his pocket would not buy wine priced at $10. However, she would give up one $10 bill for a cheeseburger that she values higher than the 7th bill she owns. She would also spend the 6th bill for the hamburger meal valued higher. Let us look at the value scale of the regime change by which the perception of money’s quality falls. The new monetary regime is in the eyes of actors providing a worse medium of exchange, store of value, and unit of account than the preceding regime.

Value scale after regime change

.
.
.
20th      Hamburger meal
21st      Cheeseburger
22nd      Bottle red win
23rd       5th $10
24th       Bottle white wine 25th
6th         $10
26th       7th $10

We see that goods tend now to be ranked higher on the value scale relative to money units than before.3 After the change, the person would give $10 for a bottle of white wine. She would also buy red wine, cheeseburger, or a hamburger meal with $10. The prices of these good would tend to increase. Without any increase in the quantity of money, money is valued less in comparison to goods due to the qualitative deterioration of the monetary regime. Money’s purchasing power decreases. Brisk changes in purchasing power may be caused by a change in monetary regime. This gives us reason to analyze the quality of different monetary regimes and how changes to them influence their quality.

Qualities of Monetary Regimes

Monetary regimes provide a framework within which money fulfills its functions. As the unit of account function is fulfilled by nearly all monetary systems equally well and it is impaired only in extreme situations, we will concentrate of the characteristics of good medium of exchange and store of value.4

We will begin with the characteristics of a good medium of exchange and the influence on it by a monetary regime. A good medium of exchange has low storage and transportation costs. Other properties are easy handling, durability, divisibility, resistance to tarnish, homogeneity, and ease in recognition. These properties hardly change today as paper-based fiat standards have eased the physical usability of the monetary unit, as well as the costs to provide it. In commodity standards these qualities may change when society switches from one commodity to the other. For instance, a change from a silver to a gold standard may imply an increase in the quality of money as gold is more durable than silver, which suffers from oxidization. A more relevant property of a medium of exchange is the number of users. More users imply more demand for the medium of exchange. As more people accept it in trade, the medium of exchange is more useful. Changes in monetary systems may increase the number of users and thereby the quality of the money. For instance, at the end of the nineteenth century ever more countries left their silver standards to adopt the gold standard. The increased use of gold as a currency increased its quality as money. Similarly a switch from Germany’s Deutsche mark to the more widely used Euro or from national fiat currencies to a world fiat money increases the quality of money as a medium of exchange. The tendency of an increase in the quality of money as a medium of exchange is, however, counteracted by possible decreases in its functionality as a store of value.

Ironically, maybe the most important characteristic for a medium of exchange is the existence of ample non-monetary demand for the money as either a consumer good or a factor of production. The demand for other, non-monetary purposes assures that there exist unsatisfied wants which are intense and permanent (Menger 1892, p. 5). The non-monetary demand serves as “insurance” for the money holder as it stabilizes its value due the constant demand.5 If the money is demonetized, in the worst case scenario, by the government or because people turn to another medium of exchange, it will still retain its use value. A money with a very low or no non-monetary demand loses almost all its value in a demonetization. Its value is totally dependent on the monetary demand for the good and the confidence in it. Its value tends to be more volatile than the value of a money that has a stabilizing non-monetary demand. If the insurance breaks away even without any change or expected change in money’s quantity, its quality is reduced, leading to a tendency for its purchasing power to decrease. This is so, because the risk of demonetization and a complete loss of value for money holders without a non-monetary demand insurance is greater than for a monetary unit with a use value. Without this insurance, the demand for money tends to fall, leading to a fall in purchasing power. Therefore, if there is a switch from a monetary regime with ample non-monetary demand such as a gold standard to a monetary regime without a relevant non-monetary demand such as a fiat money standard, the quality of the money regime is reduced, independent of (expected) quantity changes.

The store of value function is another important function of money. There are several characteristics of a good store of wealth.

One of its most important characteristics is the possibility of increases in its quantity. Different monetary regimes allow for different mechanisms to increase the quantity of money, thereby influencing money’s quality. Thus, monetary systems may set strict and less strict limits for increases in the money supply. A switch from a monetary system that strictly limits the quantity of money and its possible increases to a monetary system that makes increases in the money supply more likely and less predictable implies a deterioration of the quality of money.

For the quality of the monetary regime the stability of the financial system it fosters is also important. There are monetary regimes that are more prone to generate business cycles, over-indebtedness and illiquidity than other regimes. Business cycles, over-indebtedness and illiquidity may provoke interventions and bailouts on part of the government or monetary authorities. In the wake of the bailouts the quantity of money is often increased, or even the quality of the monetary system is diluted. For instance, redemption into specie might be suspended or a new monetary order may emerge (e.g., the introduction of a world fiat money). Consequently, money’s quality is affected negatively by a change toward a more instable monetary system.

The probability of demonetization is a related factor influencing money’s quality. Some monetary systems are more prone to demonetization than others. Systems that come along with an instable financial sector may lead to collapse or public bailouts that endanger the confidence in the monetary unit. Another factor that affects money as a store of value is the potential for general manipulation by the government. Interventions by the government often decrease the quality of money in its own favor by increases in money’s quantity or through a deterioration in the reserves backing it. A government could, for instance, confiscate the gold reserves of its fiat currency to pay for expenditures thereby decreasing the quality of money. Some systems are less prone to government intervention than others where the government has a stronger foothold in the system.6 The more independent a monetary regime is from the government, the higher is the quality of the currency. A switch to a monetary system more dependent or open to interventions by a government means a deterioration of money’s quality.

A 100 Percent and Free Gold Standard

I will now analyze the quality of money in different monetary regimes.7 I will start with the highest quality monetary regime and work my way downward to systems of lower quality. In a 100 percent gold standard, only gold (or 100 percent backed gold certificates) is money and banks hold 100 percent reserves for their demand deposits. The following analysis applies mutatis mutandis to other 100 percent commodity standards such as a 100 percent silver standard.8 I picked the example of gold out for two reasons: the historic importance of the gold standard and its unique qualities.

A 100 percent and free gold standard offers all the qualities of good money. Gold has a relatively high value in a small size, thus reducing storage and transportation costs. It is easy to handle in exchange and easily divisible. It is homogenous. Its grade is easy recognizable and it is resistant to tarnish. There exists a tremendous non-monetary demand for gold all over the world. Gold is also relatively hoardable as it can be bought and sold in large amounts without losses. Moreover, the production costs of gold are very high, as is the existing gold stock. Anyone can mint coins; the government has no foothold in the monetary system. Gold is, thus, difficult to manipulate by governments. Only by outright coin clipping or by changing the monetary regime itself can the government manipulate gold. Furthermore, these two kinds of gold manipulations can face strong resistance, as they are highly visible when gold is in the hands of the citizenry.

In addition, in a 100 percent gold standard there is unlimited and unconditional redemption. The banking system is per definitionem liquid; it cannot be brought down by a bank run, as there are 100 percent reserves. The economy and the government are less likely to have negative effects on the quality of money than in other regimes. This is so, because a 100 percent gold standard strengthens the economy and puts limits on the spending of government. As there is by definition no credit expansion and no artificial reduction of interest rates, there is no credit created business cycle. And as taxation is unpopular and government debt cannot be monetized but has to be paid out of taxes, government has to be fiscally more responsible. The tendency toward slowly falling prices in such a system when economic growth exceeds increases in gold production makes debts less attractive.9 Overindebtedness is therefore quite unlikely.

In a free 100 percent gold standard there exists also monetary competition. No one imposes gold as money and other monies can compete freely with it. The competition in the production of money ensures the quality of money. Bad money is pushed out of the market by good money (Hayek 1978, pp. 1–3).10 Only the money that best fulfills and keeps fulfilling the function as unit of account, storage of wealth and a medium of exchange prevails under free competition. There is no central bank, no monetary monopoly or legal tender laws. Hence, there will be a discovery process for the best currency. Different issuers in a trial and error process compete in offering currencies to their customers. Inefficient producers of money disappear. Only the efficient producers of money that produce money in a quantity and quality fitting consumers’ wishes best will survive. As money users usually prefer a stable currency, there will be a competitive process toward stable currencies.

Lastly, the monetary system tends to be stable. 100 percent reserves on demand deposits ensure that no bank runs on demand deposits will lead to a banking crisis. Moreover, there are harsh limits to other types of maturity mismatching, i.e., borrowing short and lending long (Bagus 2010; Bagus and Howden 2010). Borrowing short and lending long is a very risky business. Competitors, by assuming short-term debts and not rolling over the debt, might drive banks into bankruptcy. Speculators may also short bank stocks and try to instigate a run on the short-term liabilities of banks. Customers will attend those banks that limit this risky behavior. In short, in a free market maturity mismatching is strictly limited and there is no reason why banks would systematically err about the amount of short-term renewable savings. More importantly, the promoters of excessive maturity mismatching such as government guarantees for banks are limited, or absent, as there is no central bank that could roll over short-term debts nor credit expansion increasing constantly the money supply making a roll-over of short-term debts easier. The financial system in a 100 percent gold standard is, therefore, very stable. The chance that governments will be tempted to bailout the financial system diluting the value of money or the monetary regime is reduced.

Fractional Gold Standards

I will now analyze fractional reserve gold standards with different properties. I will not explore every theoretical possibility but will concentrate on the historical monetary regimes. The first fractional reserve standard is a gold coin standard.11 In a gold coin standard banks hold fractional reserves and gold coins are in circulation. A gold coin standard contains the same properties in regard to its functions as a medium of exchange as a 100 percent gold standard. Gold is not perishable, homogeneous, has a great value in a small bulk, etc.

The main difference concerning the quality of the money, though, comes with money’s function as a store of wealth. In a gold coin standard, money is easier to manipulate for governments than in a 100 percent gold standard, as the government typically holds the monopoly of the mint. In addition, banks are allowed to produce fiduciary media, i.e., money substitutes not backed by gold. The banking system does not necessarily have to hold 100 percent reserves, as credit expansion is possible. Credit expansion, by causing business cycles, weakens the economy and helps to monetize government debts. In a recession, there is the danger of government bailouts diluting money’s value. Recessions may also be used as a pretext to increase government’s foothold in the economy, for instance by installing a central bank. If a central bank is installed, the quality of money falls even more, as this agency is a foothold of the government into the monetary system that is likely to reduce the quality of money further.

Moreover, credit expansion serves as a promoter of maturity mismatching, i.e., borrowing short and lending long. In the case of roll over problems of short-term debts, banks may use their own deposits as a substitute for financing. In addition, credit expansion tends to increase the money supply which reduces the risk of maturity mismatching. The financial system becomes more unstable by the tendency for excessive maturity mismatching. This makes a government bailout implying a deterioration of the money standard more likely.

Furthermore, an important difference of a fractional gold standard and a 100 percent gold standard is the effect of increases in the quantity of money on its quality. When in a 100 percent gold standard new gold is mined, this gold naturally is of the same quality as the old money. The quality does not deteriorate. Yet, when in a fractional gold standard, the amount of fiduciary media, i.e., paper money, increases, the quality of the currency decreases, as there are less gold reserves per monetary unit. The reserve ratio shrinks and the average backing of the currency deteriorates.

Gold Bullion Standard

The gold bullion standard tends to emerge from a gold coin standard. When in a gold coin standard, credit expansion creates recurrent banking crisis, and banks tend to press for the installation of a lender of last resort, the central bank. At the same time, banks are interested in a reduction of coins in circulation which is realized in a gold bullion standard, where the government does not mint coins. Typically, the gold reserves are centralized in a central bank. The currency is backed by gold bullion and the reserves centralized in a central bank. The currency can be exchanged against bullion at a fixed rate. Gold coins likely disappear from circulation.

In such a system the quality of money is reduced vis-à-vis a gold coin standard. It is more difficult to hoard gold as only bullion can be exchanged against currency. Due to the difficulties of redeeming and transporting bullion, less currency will be redeemed into gold and gold will practically disappear from day-to-day transactions. Consequently, banks can reduce their gold reserves. This allows for greater credit expansion, which, via business cycles, weakens the economy and helps to monetize government debt. As banks tend to reduce their reserves, they become more illiquid. Greater credit expansion and the introduction of a central bank reduce also the risk of maturity mismatching. Excessive maturity mismatching adds to the instability of the financial system. The higher probability of bailouts and further denigration of the regime deteriorates the quality of the currency.

As there is a lower amount of gold in the hands of the public it is easier for the government to suspend redemption altogether without leading to a double standard and facing the resistance of people to hand over their gold. Thus, the government can manipulate the money and deteriorate the money standard easier.

Gold Exchange Standard

The next step down in the quality of monetary standards is a gold exchange standard. A gold exchange standard is a fixed exchange rate system like the Bretton Woods system. Currencies are pegged at a fixed rate with a main currency that can be redeemed into gold bullion. Only central banks can redeem one currency into gold bullion through the main central bank which was the case during the Bretton Woods era with the Federal Reserve System.

A gold exchange standard leads to a further centralization of gold reserves and allows the banking system outside the main country to expand credit on top of the main currency. The main banking system also is likely to use its privileged position in order to expand credit. The system sows the seeds of its own collapse if the main country expands credit, thus imposing a cost on the rest. The exploitation of this position will then meet the resistance of the other countries who start to demand redemption as happened in the case of Bretton Woods, when the French government demanded payment in gold.

As a consequence of a higher capacity for credit expansion, business cycles will become more volatile, harming the economy. In addition, monetization of debt on a larger scale becomes possible. Maturity mismatching increases and the financial system grows more unstable increasing the chance of diluting bailouts. The tendency toward price inflation also increases, which in turn incentivizes people to take on debts. The population’s day-to-day connection with gold becomes looser and less resistance will be felt when the connection is cut by the government altogether.

It should be pointed out that becoming the main currency in a gold exchange standard may in some sense increase the quality of this main currency. It is very profitable to be an international reserve central bank (Rittershausen 1962, p. 408). Other central banks hold reserves of the main currency at very low interest rates. Other central banks must fear devaluations that would imply losses in their assets. When a currency becomes the main currency it implies therefore an increase in its quality. Other economic agents are more likely to accept and hold this currency.

Within these fractional reserve standards we may distinguish between systems where the unit of account and medium of exchange are separated and those where they coincide. In systems where unit of account and medium of exchange are separated, people calculate in a currency such as gold but pay also with another medium of exchange such as bank notes or deposits. These notes and deposits may have a discount in relation to payments in specie. Therefore, a credit expansion may lead to a higher discount leaving unharmed the integrity of the gold currency. Prices denominated in bank notes increase but not denominated in specie. If, on the other hand, bank notes and deposits have to be accepted at par due to legal tender laws, the quality of the system decreases. Credit expansion in this case cannot lead to a discount anymore but deteriorates the quality of specie as prices denominated in gold increase.

Fiat Paper Money Standard

A brisk change in the quality of the monetary regime occurs when redemption is finally suspended altogether leading to a fiat paper currency. In a fiat paper money standard as the world has been on since 1971, not even central banks are able to redeem the currency against bullion. There is no guarantee anymore to receive any specific amount of gold for the currency. Hence, the quality of the money has declined.12

There is a wide divide between redeemable claims to gold as in the gold standards discussed above and unredeemable paper money. Unredeemable paper money presents a claim on something that is not specified. Fiat paper money fluctuates in value according to the holder’s belief of what the fiat money will be able to purchase. This estimation may fall very low and easily to zero. It is completely dependent on trust. If trust evaporates its value may well fall to zero, without dramatic changes in the money’s quantity.

The capacity of irredeemable paper money to serve as a store of wealth is dominated by this uncertainty. Nothing of this sort happens with a (convertible) money certificate that, for instance, can be exchanged at any moment against gold. As Rist (1966, p. 200) summarizes: “In short, convertibility is not a mere device for limiting quantity; convertibility gives notes legal and economic qualities which paper money does not possess, and which are independent of quantity.” Therefore, when the redemption of bank notes and deposits in a gold standard is suspended, the quality of money, from one second to the next, is reduced (independently from what might happen to money’s quantity).

Once redemption is suspended, there is no safety net for the value of the currency to fall back to. Money is not connected any longer with the industrial demand for gold. The “insurance” of a strong industrial demand for the money holder is gone.13

Production costs of new paper money are very low, increasing the likelihood of increases in the money supply. Moreover, as redemption is suspended, the last control against government manipulation is gone. The floodgates for governmental manipulation of the money supply are open. Now the only restriction for government is its own will to put a limit on the production of additional money. These limits are typically formalized through the statutes and mandates of the central bank.

As a central bank can print an unlimited amount of money and bail out banks, moral hazard ensues. Maturity mismatching increases and reserve ratios are reduced. Credit expansion leads to more volatile business cycles harming the economy. The monetization of government debts by using the printing press has become easier. The financial system becomes even more fragile than before. Government bailouts become more likely and deteriorate the quality of money. As a consequence, money practically loses its function as a good store of wealth. Price inflation becomes a feature of everyday life. As people become accustomed to increasing prices, they start to incur more debt. Both the indebtedness and fragility of the economy increase. Thus, at the instant the monetary system is deteriorated to fiat paper money system, the quality of money declines sharply.

Switching Monetary Regimes and Money’s Purchasing Power

Changes in the quality of money can be made within a certain monetary regime and by changing the monetary regime. Any move up the qualitative ladder explained above from the bottom to the top, i.e., from a fiat paper money, to a gold exchange standard, to a gold bullion standard, to a gold coin standard to a 100 percent free gold standard implies a substantial improvement in quality. Any move down the qualitative ladder implies a deterioration of the quality of money and a tendency for price inflation. Downward movements have been more common in history. Especially in preparation of or during war efforts, monetary regimes were often changed for the worse (Rittershausen 1962, p. 366).

Improvements in monetary regimes have occurred in history. For instance, resumptions of specie payments, i.e., a change from a fiat paper money to some variant of a gold standard have occurred in history at various times; especially when specie payment was suspended during war and later resumed. Examples are the resumption of specie payment in Great Britain after the Napoleonic Wars and after World War I, as well as the resumption of specie payment after the U.S. Civil War in 1879. When it is expected that specie payment will be resumed, people expect the quality of money to increase and money’s price can rise immediately. This is probably one cause of the price deflation in the U.S. before the resumption of specie payment in 1879 (Bagus 2015). Another example is Peel’s Bank Act of 1844 which prohibited the issue of unbacked bank notes. The failure of Peel’s Bank Act was to not include bank deposits in the provision. The introduction of a 100 percent reserve ratio for demand deposits as well, would have increased the quality of the monetary regime strongly.

In general, however, the evolution has been downward from gold standards of a higher quality to gold standards of a lower quality and finally to fiat money standards. In fact, once we step down from a 100 percent gold standard, the seeds are sown for a progressive deterioration of the money regime. Government gets a foothold in the monetary system. Credit expansion by the central bank lead to excessive maturity mismatching, overindebtedness, and financial instability. In the crisis caused by these monetary regimes, bailouts tend to occur leading to higher government debts which are later monetized. In theses crises the regime is also often denigrated. For instance, redemption of specie payments may be suspended in a banking crisis.

Conclusion

Beside money’s quantity also its quality influences its purchasing power. In this paper we have analyzed the quality of monetary regimes which consists in providing an institutional framework for a good medium of exchange, store of value and medium of account. Changes in monetary regimes may lead to substantial changes in money’s quality and thereby affect money’s demand and purchasing power. The highest quality regime contains a 100 percent gold standard. Fractional-reserve gold standards contain the seeds of their own deterioration, leading via credit expansion to economic and banking crisis. Via progressive government intervention and centralization of reserves a gold coin standard deteriorates into a gold bullion standard and a gold exchange standard.

The switch from a gold exchange standard to a fiat paper standard is a watershed. There is no non-monetary demand for the money unit anymore. Its value is solely maintained by trust and confidence while the insurance of an ample non-monetary demand has vanished. Government and central banking control monetary affairs totally. Recurrent recessions and bailouts of the financial system become likely, deteriorating the quality of money. Future research may focus more on the qualities of different monetary regimes and how their switch affects the quality of money and also economic growth. A switch to a higher quality regime of money in a recession may positively affect confidence and economic growth.

References

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——. 2010. “Austrian Business Cycle Theory: Are 100 Percent Reserves Sufficient to Prevent a Business Cycle?” Libertarian Papers 2(2) 2010.

——. 2009. “The Quality of Money.” Quarterly Journal of Austrian Economics 12(4): 41–64.

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——. 2009b. “The Federal Reserve and Eurosystem’s Balance Sheet Policies During the Subprime Crisis: A Comparative Analysis.” Romanian Economic and Business Review 4(3): 165–85.

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• *Philipp Bagus is professor of economics in the Department of Applied Economics I at Universidad Rey Juan Carlos, Madrid, Spain. Professor Bagus was a summer research fellow in 2006 and 2009. This chapter is an extension of the theoretical perspective developed in the article “The Quality of Money,” for which the he received very valuable comments by Professor Salerno. The author wishes to thank David Howden for excellent comments on the present article. Joseph T. Salerno has not only been a very important mentor and friend for me. With his humor, positive attitude, and generous support he is a precious asset for Mises Institute summer fellows such as I was for two years. Thank you, Joe. With his articulate, intransigent and courageous support of sound money, he is an invaluable asset for the Austrian school. He not only always stands up to defend the theoretical advances of Mises and Rothbard, he also has added to the corpus of Austrian theory.
• 1Bagus (2009) discusses the quality of money in general. Bagus and Schiml (2009, 2010) and Bagus and Howden (2009a, 2009b) analyze the quality of the currency unit through the central bank’s balance sheet. Bagus and Howden (2011) point out that Iceland’s central bank adopted an explicit lender of last resort function that deteriorated the quality of Iceland’s monetary regime.
• 2The mainstream focuses narrowly on the aspect of central bank independence and mostly neglects all other aspects.
• 3Salerno (2006, p. 52) refers in this context to “the relative rankings of goods and of money among market participants.” This relative ranking is immediately and potentially strongly affected by changes in monetary regimes.
• 4As Röpke states, referring to the German 1922–1923 hyperinflation (1954, p. 121), money’s functions often disappear in a certain order. First, money ceases to be used as storage of wealth, when actors start to think that it continuously will lose value. Second, when the fluctuations of the value of money increase and money loses its value faster, money loses its function as a unit of account. People started to calculate in other units. In 1923, they started to calculate in gold and even the German government calculated its taxes in gold mark. The last function that is lost in a hyperinflation is the function as medium of exchange. People progressively started to use foreign exchange to transact (Bresciani-Turroni 1968, p. 89). In November 1923, the mark was completely abandoned as a medium of exchange.
• 5The main disadvantage of Bitcoin is that it virtually lacks such an “insurance.”
• 6Herbener (2002, p. 11) points out that the government is likely to use those footholds to switch to ever more interventionary monetary regimes: Given any foothold in monetary affairs, the state would always move step by step to an inflationary monetary regime, the exercise of which would eventually cripple, if not destroy, the market itself. Given the power to coin gold, the state would come to suppress the coinage of private mints by waiving its mintage fee. Once securely dominant as a money producer, it would make its coins legal tender, leading to the possibility of seigniorage from debasement. Likewise, if the state had the power to issue money substitutes, it would suppress the issue by private banks by waiving the printing or accounting fees. Once securely dominant as a money substitute producer, the state would rescind redemption to capture the revenue from inflating the stock of its, now, fiat paper money.
• 7For an analysis of the devolution of monetary systems see also Hoppe’s (1994) analysis. Hoppe shows how money and credit deteriorates as a result of government intervention. Rittershausen (1962, p. 334) and Veit (1969, p. 88) offer classifications of monetary regimes. Rittershausen focuses on the legal tender and emphasizes that systems were beside specie also bank liabilities are legal tender diminish the quality of the currency. His classification is similar to mine.
• 8Similary, gold and silver may be in use simultaneously.
• 9For an analysis of growth deflation see Salerno (2003).
• 10For the advantages of currency competition see Klein (1974) and Vaubel (1977, 1988).
• 11Again, the analysis applies mutatis mutandis to other fractional reserve commodity standards.
• 12The fall in the quality of money helps to explain historical price inflations. When the U.S. went off the gold standard in March 1933, wholesale price soared 14 percent over 1933 and 31 percent by 1937. When the U.S. went off the gold reserve standard (the Bretton Woods system) in August 1971, wholesale price increased 4.35 percent during the rest of the year, more than 13 percent between 1972 and 1973, and over 34 percent between 1972 and 1974 (Hazlitt 1978, p. 76).
• 13One might argue that “de facto” redemption, i.e., interventions of the central bank selling its assets are an insurance. However, there is no legal insurance or security whatsoever that central banks will intervene at the point of time the money holder wants.

Austrian* economists have not ventured into the field of international economics very often and most of the exceptions wrote their work a long time ago. This is the case with the work on money and credit by Mises (1953 [1924], esp. pp. 170–86), Hayek’s discussion of monetary nationalism (1999 [1937], esp. pp. 61–73), Machlup’s (1939, 1940) and Haberler’s (1950) contributions, and Rothbard’s brief discussion in Man, Economy, and State (2004 [1962], esp. pp. 828ff.).

Of the few recent contributions made to this field, two authored by Salerno (1994a; 1994b) highlight the subjectivist perspective that Mises (1953 [1924]) holds about the determinants of the purchasing power of money in geographically separate locations. Physically identical goods in different locations are different economic goods even if we assume away all transportation costs. Because people often value separate economic goods differently, prices of physically identical goods in different locations might vary even in general equilibrium.

The insight that there can be an equilibrium with different prices between physically identical goods in different locations is important from the perspective of the absolute purchasing power parity theory, which is one of the models that tries to explain foreign exchange rates. This theory assumes the law of one price and implies that equilibrium exchange rate must equalize prices of physically identical goods across different currency areas when the prices of the goods are converted into same currency. Currently available data, however, bring this idea of absolute purchasing power parity into question: the general consensus is that in spite of high variability of foreign exchange rates, it takes a number of years at best before the exchange rate adjusts to a deviation from parity (Rogoff 1996; Taylor and Taylor 2004). It is this “purchasing power parity puzzle” (Rogoff 1996) that Mises’s subjectivist view on purchasing power of money can explain: if physically identical goods in different locations are different economic goods, it is not surprising that they have different price tags when the prices are expressed in the same currency and that absolute purchasing power parity does not hold. Yet, at the same time, there can still be a tendency toward equilibrium in the exchange rate between two currencies. The equilibrium exchange rate, however, does not reflect the purchasing power parity condition but rather the subjective valuations of goods in each currency area, given the prices of those goods in their respective domestic currencies.

In what follows, I develop the argument from the previous paragraph. I first review the insights of Mises and Salerno on the subjectivist theory of the purchasing power of money and then look at how these insights apply in the setting of two currency areas with a floating foreign exchange rate. In conclusion, I formulate the underlying subjectivist theory of foreign exchange rates.

Subjective Valuation Differentiates Purchasing Power of Money Across Space

In the section on “Alleged Local Differences in the Cost of Living,” Mises (1953, pp. 175–78) stresses the importance of the position of goods in space when considering the valuation of those goods and their relative prices. He illustrates how important the location of goods is by comparing the prices in Karlsbad, a desired spa destination, and prices in other cities. While the same type of good costs more in Karlsbad than in other cities, the price difference is justified because goods in Karlsbad are perceived as different types of goods. In other words, “[i]f [person] has to pay more in Karlsbad for the same quantity of satisfactions, this is due to the fact that by paying for them he is also paying the price of being able to enjoy them in the immediate neighborhood of the medicinal springs” (Mises 1953, pp. 176–77).

To generalize the previous example, one can say that the position of a good in space matters — geographic location is an important characteristic of an economic good that can change one’s perception of this good, and consequently its value and price. Physically identical goods in different locations can then be priced differently even in equilibrium (Mises 1953, pp. 177–78; Salerno 1994b, pp. 251–52).

Arbitrage Does Not Equalize Purchasing Power of Money Across Space

One can object that while the demand for goods might differ by location, the difference at least does not apply in the case of tradable goods, which can be easily transported from one place to another. The demand for apples in the city of Meadville in Northwestern Pennsylvania, for example, might be lower than the demand for apples in Manhattan, incentivizing suppliers to distribute apples accordingly and eventually equalize the prices of apples in both places. If the existing relative supply of apples in these two places results in lower relative price of apples in Meadville, this incentivizes entrepreneurs to ship apples from Meadville to Manhattan to equalize the profits from selling apples in the two different places. Assuming perfect competition and zero transportation costs, one might say that profits equalize when the price of apples in Meadville is the same as the price of apples in Manhattan.

However, since tradable goods are usually bundled with non-tradable complements as Rogoff (1996, pp. 649–50) and Taylor and Taylor (2004, pp. 136–37) briefly note, location also affects the prices of tradable goods. Shelf-space, for example, is one such non-tradable complement: returning to the apple parable, a sufficient lack of shelf-space in Manhattan may fail to incentivize shop-keepers to supply enough apples to equalize prices between Meadville and Manhattan. In this case, the opportunity cost of supplying so many apples is too high; Manhattan shop-keepers would rather use the scarce shelf-space to offer other products while keeping the price of apples relatively high.

To generalize the example, one can say that tradable goods often need to be bundled with non-tradable complements when sold in specific geographic locations. Since these complements might be subjectively valued and priced differently across locations, opportunities to arbitrage price differentials across space are limited. This limitation might then lead to price differentials between physically identical goods sold in different geographic locations.

Subjective Valuation Differentiates Purchasing Power of Money also Across Currency Areas

The conclusion that physically identical goods can vary in equilibrium prices between different locations also applies to the case of two separate currency areas. This application suggests that foreign exchange rates do not necessarily correspond to the absolute purchasing power parity of the respective currencies. To illustrate this point, I will use a modified version of the previous section’s apple parable.

Assume that there are only two places in the world: Manhattan and London. Each city has its own independent fiat currency so that people in Manhattan use the dollar ($) and people in London use the pound (₤). Let’s assume an equilibrium where an apple in Manhattan costs $6 and where a physically identical apple located in London sells for ₤2. Assuming away transportation costs, the absolute purchasing power parity theory says that the equilibrium exchange rate between dollars and pounds is $6 per ₤2, i.e., $3/₤1. If the foreign exchange rate was different, the purchasing power parity theory suggests that this would create a state of disequilibrium with associated arbitrage opportunities that buyers and sellers will exploit until the exchange rate $/₤ is equal to the ratio of the price of apple expressed in dollars over the price of apple expressed in pounds.

However, the subjectivist insight proposed by Mises (1953) and emphasized by Salerno (1994a; 1994b) suggests a very different conclusion about the equilibrium exchange rate. Following the example, even if $6 and ₤2 are the equilibrium prices of apple in Manhattan and London respectively, the two prices tell us little about the equilibrium foreign exchange rate between dollars and pounds. The difference in geographic location means that apple in Manhattan and apple in London represent two different economic goods. The difference means that while $6 is the price of an apple in Manhattan, we cannot necessarily infer from this that in equilibrium people are willing to pay the pound equivalent of $6 for an apple in London. People might be paying more or less for an apple in London than its dollar equivalent, depending both on the demand for apples in London and on the prices and subjective values of complementary non-tradable goods necessary to sell apples in London. Assuming that the equilibrium price of an apple in London is ₤2, this implies the exchange rate $/₤ can be below or above the absolute purchasing power parity of $3/₤1.

Purchasing power of money is therefore unequal across currency areas in the same way it is unequal across different geographic locations within the same currency area. Goods with identical physical characteristics but different locations are different economic goods (Salerno 1994a, p. 107). In equilibrium, such goods can have different prices when their respective prices are converted into the same currency unit. As a result, equilibrium foreign exchange rate does not have to equalize the prices of goods across currency areas and therefore does not have to adhere to the absolute purchasing power parity condition.

Foreign Currency is Valued Subjectively as a Means Toward Goods in Its Currency Area/p>

If absolute purchasing power parity is not the equilibrium condition for the foreign exchange rate between two currencies, what are the equilibrium conditions? It is important to realize in this regard that people demand money because it is medium of exchange (Mises 1953, pp. 30ff.) — a medium of directly purchasing goods in its corresponding currency area. Assuming that money does not have non-monetary uses, people value different currencies against each other depending on the economic goods they can procure with those respective currencies (Mises 1953, pp. 180–81).

The foreign exchange rate of a currency thus depends on the prices that people expect to pay for goods using the currency. If expected prices increase in one currency, demand for that currency drops at the foreign exchange market and its exchange rate becomes less favorable; if the expected prices decrease, the demand for the currency increases and its exchange rate becomes more favorable. In contrast to the absolute purchasing power parity theory, however, the relationship between the foreign exchange rate between two currencies and the prices of goods that people using each currency can buy is qualitative and does not follow a pre-determined mechanical formula. The numerical imprecision of the law explaining determinants of foreign exchange rates is a necessary consequence of the fact that most of the goods that people buy with each currency are different economic goods that people value subjectively. People’s subjective valuations therefore act as a filter for every price change of a good expressed in that currency: people ultimately decide to what extent the price change has an effect on their demand for the currency in question.

Conclusion: Subjectivism and International Economics

In his 1994a and 1994b articles, Salerno restored attention regarding Mises’s subjectivist approach to monetary theory and international economics. This approach helps us to understand why economists have been struggling to empirically confirm the absolute version of the purchasing power parity theory. They have been unsuccessful because the theory assumes the law of one price for goods that have identical physical characteristics but which differ in location. Because the difference in location means that these goods are in reality different economic goods, the law of one price does not have to hold and the absolute purchasing power parity can be violated even in equilibrium. The subjectivist approach to international economics thereby gives us yet another illustration of the importance of subjectivism in economics that was emphasized by Hayek (1952, p. 31).

References

Haberler, Gottfried. 1950. The Theory of International Trade. William Hodge & Company.

Hayek, Friedrich A. von. 1952. The Counter-Revolution of Science. Glencoe, Ill.: Free Press.

——. 1999 [1937]. “Monetary Nationalism and International Stability.” In Stephan Kresge, ed., The Collected Works of F. A. Hayek, Vol. 6: Good Money Part II: The Standard, pp. 37–100. London: University of Chicago Press and Rutledge.

Machlup, Fritz. 1939. “The Theory of Foreign Exchanges.” Economica, n.s. 6(24): 375–97.

Machlup, Fritz. 1940. “The Theory of Foreign Exchanges.” Economica, n.s. 7(25): 23–59.

Mises, Ludwig von. 1953 [1924]. The Theory of Money and Credit. New Haven, Conn.: Yale University Press.

Rogoff, Kenneth. 1996. “The Purchasing Power Parity Puzzle.” Journal of Economic Literature 34(2): 647–68.

Rothbard, Murray N. 2004 [1962]. Man, Economy, and State with Power and Market. Scholar’s Edition. Auburn, Ala.: Mises Institute.

Salerno, Joseph T. 1994a. “Ludwig von Mises’s Monetary Theory in Light of Modern Monetary Thought.” Review of Austrian Economics 8(1): 71–116.

——. 1994b. “International Monetary Theory.” In Peter Boettke, ed., The Elgar Companion to Austrian Economics, pp. 249–57. Aldershot, Hants, England and Brookfield, Vermont: Edward Elgar.

Taylor, Alan M., and Mark P. Taylor. 2004. “The Purchasing Power Parity Debate.” Journal of Economic Perspectives 18(4): 135–58.

• *Simon Bilo is assistant professor of economics at Allegheny College, Meadville, Pennsylvania. This paper is a revised version of selected sections of my 2006 M.A. thesis. I would like to thank Peter Boettke, Per Bylund, Gene Callahan, Jan Havel, Marek Hudík, Juraj Karpiš, Shruti Rajagopalan, Walter Stover, Lawrence White, and participants of the Graduate Student Paper Workshop at GMU for their valuable comments and suggestions during earlier drafts of this paper. A draft of the paper was also presented at the Austrian Scholars Conference in 2009. I gratefully acknowledge the financial help that I received from the Mercatus Center at George Mason University while working on this project. All the usual caveats apply. I have known Joseph Salerno for about ten years. These were ten formative years for me — I was an undergraduate student in Prague back then; now I am teaching economics myself. Salerno played an important role in this journey of mine: he was my adviser in the summer of 2005 at the Mises Institute, he kindly agreed to write letters of recommendation for me when I was applying for graduate school, and we would see each other when the two of us were attending the Colloquium on Market Institutions and Economic Processes at New York University.

Economists* beyond a certain age will recall a simple mnemonic when listing money’s main functions: “Money is a matter of functions four, a medium, a measure, a standard, a store.” The four functions of the categorization of money are known today as the, (1) medium of account, (2) measure (or unit) of value, (3) standard of deferred payments, and (4) store of value. The rhyme alludes to the fact that economists thought that money served a somewhat broader role once upon a time than it does today.

The mnemonic also makes clear that money has several well-defined uses, unlike other economic concepts, like “goods” which have innumerable uses subjectively determined by their users, or a “price” which is the unique objective embodiment of these uses. In this way, money is special.

Due to good luck endued in him by his parents, Joe Salerno is of the age necessary to be included in the group of economists who cut their teeth in monetary economics by learning this rhyme. Unfortunately, he may well be old enough to have forgotten it, as well as where he left his glasses, his wife’s birthday, their anniversary, and all sorts of other things important to his life!1

In this chapter I will revisit the use of this simple mnemonic to underscore what money is. I will then use these insights to augment Salerno’s (1987) work on the “true money supply.”

Money is as Money Does

In an unsettling way, the old adage that “money is as money does” has a ring of truth to it. When defined, as it commonly is in introductory economics textbooks, as “the generally accepted medium of exchange,” money can be a variety of goods, provided they meet three criteria: (1) that the good is used to settle exchanges, (2) that the good is the final means of settlement, i.e., not credit, and (3) that the economic community generally accepts such a good to settle exchanges. Economists then move on to a discussion of whether a “good” is a candidate for inclusion in the definition of the money supply when it satisfies all three of these conditions. The result is any of the common “M” measures of money.

While it is trivially true that money is as money does, there must be a better way to approach the problem. The old trusty mnemonic hints at how we can proceed.

In the common story of the origin and evolution of money, one central aspect is the reduction of transaction costs (i.e., Menger 1871, chap. 8, 1892). In a moneyless world there is a double-coincidence of wants problem, as elaborated by Jevons (1875, p. 3). As the scope of trades is limited and the costs associated with setting an agreeable price once trading partners do meet is high, there is an incentive for traders to use specific goods that are widely demanded to settle their transactions. As more individuals use these few specific goods to settle their exchanges, they gain a value for exchange purposes in addition to the value they possess for direct use. The process ends when one (or very few) goods begin to be traded solely for exchange purposes, and their acceptance is due to the knowledge that they can be easily traded with, and accepted by, another individual. Money is the outcome of this process, and it is also clear that whatever good is functioning as money will also be the generally accepted medium of exchange as a result.

Money’s use during its evolutionary process is clearly for exchange purposes but there is also an additional role of great importance. Mises (1949, pp. 244–51) sheds light on this by way of his equilibrium construct of the “evenly rotating economy” to demonstrate when money is not necessary. Only in a world of full certainty — one where all expenditures are known in advance, both in magnitude and timing — would money not be necessary. The reason comes from a simple opportunity cost analysis.2

Since money functions as the final means of settlement, it is also always and everywhere a present good. Indeed, money functions as the present good par excellence and as such yields no interest payment. Holding money will always force an individual to incur a cost in terms of the yield on whatever other best but foregone option is available to him. Rather than forego an opportunity by holding money, if the individual knew in advance what his monetary demands would be he would either lend his money at interest until it was needed, or would turn to the futures market to settle his future transactions at some discounted value in the present.

Depart from the perfectly certain world, however, and one runs into the intractable problem of how to best meet his future needs. As Mises (1949, pp. 14, 249) shows, money serves as a security hedge to guard against these uncertain situations. The key problem is that “[u]ncertain of what, when, where or the amount of future expenditures, individuals demand to hold an amount of money to safeguard against this uncertain future” (Bagus and Howden 2013, p. 236).

Of course, other highly liquid money substitutes can also serve this role to some degree. Rothbard (1962, p. 713) refers to these as goods as a type of “quasi money,” but to the extent that they are not perfectly liquid assets or the final means of settlement, they cannot function as “money.”

Thus, while a highly liquid very short-term bond may substitute for money in some ways, the fact that it is never the final means of settlement and is itself open to some degree (however small) of default risk forever trap it in the category of quasi moneys and stop it from claiming a monetary status. Chief among these quasi moneys in today’s economy are money market mutual funds (currently amounting to about $2.7 trillion) and liquid assets used as collateral by the shadow banking industry.3

In this brief discussion of the evolution and use of money there are several roles taking place concurrently. The most obvious one is the medium of exchange — a unit to transfer in settlement of pecuniary obligations. There is also the role of money in mitigating our felt uncertainty, however. In order to function accordingly, we must identify what the relevant uncertainties are that the individual will face.

Having already commented on the unknowledge of what, how much or when we will need purchasing power in the future, we can now comment on why money is held as a hedge against these expectations. After all, most individuals can and do hold a variety of liquid non-money financial assets to assist them with their future expenses, e.g., equities, short-term bonds or certificates of deposit. All of these non-money financial assets have a risk inherent in them which the money holder must overcome.

It is useful to think about financial assets in terms of two characteristics — when are they available, and what value they will have at that moment when they are used. The first criterion can be divided into two categories. A good is either a present good, i.e., it can be used at any time, or it is a future good, i.e., its value cannot be realized until some point in the future. The values in question also come in two distinct forms. A financial asset either trades at par or market value, with the latter fluctuating as per supply-demand conditions in the market. All financial assets can be classified according to these characteristics, as in Figure 1.

In the scope of financial assets, money is unique. It is the only good that is available at a moment’s notice and at par value. The par value nature of a financial asset comes from the fact that its payout is defined in terms of itself. One dollar held as currency or on deposit equals one dollar of purchasing power. Likewise, bonds are denominated in terms of money units (e.g., dollars), such that the purchaser receives a set nominal amount of said currency units upon maturity. In contrast, financial assets that trade at market value are purchased in terms of “shares” (or a claim to shares in the case of a future), with each share deriving its value from an underlying asset, whether it exists in the present or the future. When an individual buys a share in a company, the value is defined as a percentage of the company’s future earnings stream, discounted to the present at an appropriate discount rate.

Equities and money are both present goods in the sense that their respective values, or purchasing powers, are unleashed at a moment’s notice. The owner of equity is forever unsure of the value he will receive for the sale of his shares, however, as it is dependent on market conditions at the time of sale. The owner of a bond is assured the value of his asset, but only if he waits until maturity to sell it. (He can, of course, sell at any moment though the value he receives will be dependent on supply-demand conditions at the time, i.e., he will receive the market value at that moment in time, effectively making the bond an equity investment ex post.)

In a superficial sense, money is demanded because it is highly liquid. Yet this cannot be the sole reason money is demanded, as other financial assets such as equities and heavily traded debt securities are also highly liquid. Money is also demanded because its nominal purchasing power is guaranteed, as it is with bonds if we abstract from default risk. Thus, in some ways money exhibits features of equity securities (e.g., high liquidity) and other features more common in debt (e.g., par value redemption).

More to the point, money is demanded because of its uniqueness. Money is the only asset that is able to combine both features — par value and on demand availability — into one package. It is this combination that makes money such an exceptional, and also essential, part of a portfolio of financial assets.

Money as Medium of Exchange and Unit of Account, Present and Future

Thus far I have been able to establish some characteristics of money without making reference to its specific functions. Actually, the causality runs the other way ‘round. There are some specific roles needed to be filled in the economy, and money (broadly defined for the moment) is the good that emerges to serve these roles. To understand why, consider two of the common functions of money in our introductory mnemonic. To jog the younger reader’s mind (as well as Joe’s): “Money is a matter of functions four: a medium, a unit, a standard, a store.”

The obvious two functions that correspond to what any introductory economics course teaches us are those of the unit of account and medium of exchange. In one very important way, these two roles share a common link. They both perform their role in the present. Money serving as a numéraire to express prices allows for value comparisons in the here and now, and when we exchange money we settle our transactional obligations instantly. Thus, the unit of account and medium of exchange are both present functions of money.

Although we commonly think of money in terms of these present functions, is it also possible for money to have future functions? Again, returning to our mnemonic we see that the other two roles — the store of value and standard of deferred payments — are important roles that money is expected to perform at some future date. Whether money will prove itself to be a useful store of value will not be known until the future is revealed. Long-dated contracts can be defined in terms different than the common unit of account by the standard of deferred payments.4

Each of money’s four roles has a temporal dimension, but they also have a common connection by the general category of use that they are satisfying. Generally speaking money is either used to price a good for sale (if one is the seller) or exchange for the good to complete the transaction (if one is the buyer). Figure 2 shows how money’s four roles dovetail with the two criteria defining their demand. Money, by serving in any of these four functions, is demanded to set prices or exchange for goods, either now or in the future.

As previously alluded to, one monetary good need not serve all of these roles simultaneously. Historically, many goods have served as pricing units without also being exchanged to settle transactions. Although gold and other precious metals have commonly served as pricing units in recent history, accounts abound of other, less common goods, performing the same role. Cigarettes in POW camps (Radford 1945), large circular Rai stones on the South Pacific islands of Palau and Yap (Bryan 2004) and even slave women (cumal) in Early Medieval Ireland (Nolan 1926) are well-known (and well-used) examples provided by economists.

Likewise media of exchange are varied over history, though much less so than with the units of account. The reason for this is straightforward. As per Menger’s theory of the evolution of money, for money to achieve the status of the “generally accepted medium of exchange,” it must be broadly demanded throughout the economy. Together with some of the objective properties of precious metals (e.g., divisibility, durability, difficulty to counterfeit, etc.), metallic goods were used because of the assuredness that the recipient would accept them.

Pricing units need not be chosen mindful of this constraint. Instead they have been selected for criteria that include general knowledge of their value, constancy of value of time (or, at least, a non-volatility of value compared to the values of other goods), and ease of recognition. Divisibility has never been an issue for pricing units, as fractions of any unit can express value as well as any whole number. Fractions of women were used to define fines in ancient Ireland, though these prices were not paid with the aid of a steady-handed surgeon. Instead they were settled with another good functioning as a medium of exchange, at the going exchange rate of that good for women.5

Money’s four roles are a direct outgrowth of the fact that what we call “money” is actually the combination of several functions commonly embodied in one good. Denominating the prices of all goods in terms of one good brings great computational ease when comparing the opportunity costs of alternatives. Not only is the calculation provided by money prices “a device for lowering transaction costs relevant to deliberate search,” it is also the embodiment of a social arrangement allowing for spontaneous learners to easily recognize overlooked opportunities (Kirzner 1979, p. 150).

As an example, a simple economy consisting of ten goods to exchange against each other would have 45 “prices” if there was not a single good used to express their value with a common denominator.6 Using one of these ten goods to express all other prices results in only nine prices (with the price of the good in terms of itself, one, making an additional tenth “price”). In the modern economy, the number of goods is many orders of magnitude greater than this example. The average car, to take one small component of the vast number of goods produced in the American economy, has upwards of 15,000 separate parts. If these individual parts were transacted without a common pricing unit, there would be over 112 million separate exchange ratios! Since the automotive industry is less than 2.5 percent of the whole American economy, I leave it to the reader to consider the number of “prices” that could exist across the United States lacking a common denominator through the unit of account. Needless to say it is doubtful that such computational complexity resulting from direct exchange ratios would allow for anything more than a simplistic, nearly autarkic, economy.7

Money may be a present good, but the people who use it are always future oriented. Thus there will be a necessary forward-looking perspective on each of money’s two roles, in addition to their demands in the present.

The store of value, being the future extension of the medium of exchange role, is probably the simplest future-oriented function to understand. Money is demanded in the present to settle current debt and transactional obligations. However, due to the uncertainty inherent in the future, there will need to be a medium of exchange demanded today to fulfill requirements in the future. The exact dates and magnitudes of these expenses are as yet unknown, but the money saved today must retain its value, or purchasing power, until that unknown future date.

Thus, the store of value function is the other side of the medium of exchange coin. Economists often couch their discussion of the store of value function as if it was a way to transmit wealth to the future. Such an understanding of the role obfuscates the issue. Money is not demanded to transmit wealth into the future, although it can certainly perform this role. Almost no one holds a sum of money today because he is preserving his “wealth” for the future. After all, there is an opportunity cost to using money for this role given its lack of interest return. In its place, investment vehicles commonly perform this task.

Money serving as a store of value is more correctly thought of as the property whereby money will only be demanded today based on its expected purchasing power in the future. This future purchasing power will be determined by how well the medium of exchange preserves its value, i.e., functions as a store of value. Note that this is quite different from more typical discussions of storing wealth for the future in the general sense, something which is not unique to the monetary asset. We are here concerned with money’s ability to preserve its value to be used in the future for monetary needs, which are, incidentally, the same category of needs that money is demanded for in the present as a medium of exchange.

The standard of deferred payments functions as the reverse side of the unit of account coin. It is the ability of a good to express the value of other goods, but over a longer time horizon than the standard unit of account. As an example of this distinction today, despite having lost 98 percent of its purchasing power over the last 100 years, the U.S. dollar has managed to do so with constancy. Each year prices increase by around 3 percent on average, notwithstanding some outlying periods. On a year-to-year basis the U.S. dollar performs well as a unit of account, and, e.g., a clothing shop, can take comfort in knowing the price tag made in one year will suffice for the following year as well; menu costs are minimal. Over longer periods the dollar has performed terribly and lacking an alternative good to use as the standard of deferred payments, Americans have had to suffer the costs of hedging their bets on long-term contracts denominated in dollars.

When using the term “money,” what economists have in mind is actually any of the four specific roles performed by money. In this way, one reason that monetary economics has become so confused is that the very adjective in its title is ill-defined. Furthermore, with the exception of select works in the now well-aged “New Monetary Economics” literature (Black 1970; Hall 1982a, b; Greenfield and Yeager 1983), very few serious attempts have been made to look at money’s individual roles in isolation of their shared embodiment in a single good. General equilibrium models are at a loss to incorporate money since they have no scope for a medium of exchange. It has been difficult to integrate money into basic utility analysis since money confers no direct utility, unlike other goods. (And since utility analysis forms the bedrock of microeconomics, the economics profession has long grappled unsuccessfully at providing “microfoundations” for monetary economics.) In short, much has been lost by using one word — money — to describe four different functions.

Multiple or a Unique “Monetary” Good?

The source of the muddled state of present monetary economics stems, at least in part, from the simple fact that for the better part of a century, one good has served all four monetary roles. This is understandable given that the enforcement of legal tender laws effectively forces one good (i.e., the legal tender) to serve all roles simultaneously. Before the passage of such laws in the mid-nineteenth century, an American could purchase a home with a mortgage denominated in ounces of gold and furnish it with goods priced in U.S. dollars. Neither dollars nor gold would be needed to pay for either transaction, as silver could be exchanged at the market rate. With the advent of legal tender laws, prices could still be struck in any good, but the payer would always be able to use U.S. dollars in settlement. As a result, U.S. dollars became the dominant pricing unit, both for current and long-dated contracts.

Yet there is still another reason why one good would assume all roles concurrently. Consider the origin of the demand for money. Mise’s use of the evenly rotating economy illustrates that it is only the existence of uncertainty that makes money a necessity. Money need not exist as a medium of exchange, not in any abstract sense anyhow, since any contract can be settled with a future if its magnitude and timing are known in advance (or an option if not even the timing is known).

Money is held to mitigate the holder from the uncertainty concerning his future transactions needs. In this way, one may get the impression that money’s key role is the store of value —the ability for it to unleash purchasing power in the future. Such thinking is also erroneous, as there are several assets that can provide more-or-less good stores of value over time. (It is often recollected that one ounce of gold has purchased a good men’s suit for hundreds, if not thousands, of years.)

The way that money insures the holder from uncertainty stems from its unique properties as a financial asset, as in Figure 1. It is the unique good that is redeemable at par value at a moment’s notice. From this simple fact we can derive three important insights about what money is.

The first is that a good only functions as “money” when its two general functions coincide. Specifically, if a good is used as the pricing unit and is also exchanged to settle transactions, it will by necessity trade at par value. At the same time, since money is the generally accepted medium of exchange it will also be available on demand since the timing of future transactions cannot be estimated, evenly probabilistically, in the present. This is important to the extent that we can see why money takes on its specific role in the schema of financial assets, a position attributable to the specific monetary demands by individuals.

The second insight is that we can better explain what is not money. In short, any asset not trading at par value and available on demand cannot be so categorized. The reason is that it would negate the original reason why money is held — to mitigate uncertainty. Holding an asset as “money” even though it is not available on demand (e.g., a future or a bond) entails a degree of risk since there is no guarantee that the purchasing power will be available at that moment when the holder demands it. What good is a 30-year bond to the holder as money if he requires funds in ten years’ time?

On the other hand, holding a good that trades at market value (e.g., equities) will give the holder no assurance that its value will be retained, either in whole or in part, at that moment when the holder needs it. Holding Enron shares may have seemed to satisfy an individual’s demand for money superficially, but when it turned out that his shares were worthless, he moved on to satisfy this monetary role by means of another good.

Thus only goods available on demand and at par value can survive as money, and these two criteria are only fulfilled when a good is used as a pricing unit and as a medium of exchange simultaneously.

Finally, we gain some insight into better defining what the money supply is. Currency obviously fits the bill, but what of bank accounts? To the extent that they are guaranteed to be paid on demand and at par value, demand deposits also comprise an important component of the money supply. Herein lays two important caveats. Fractional-reserve banks do not necessarily come with either of these assurances. As recent events in Cyprus have made clear, fractional-reserve deposits are effectively equity holdings masquerading as money. When bank assets lost sufficient value to render them illiquid, depositors were paid out a corresponding fraction of their account’s value, an event akin to receiving the market value of a number of shares. Alternatively, some fractional-reserve banks honor the par value redemption of their deposits, but only after the depositor incurs a waiting period to receive his funds. Such a condition is imposed in nearly all banking systems on redemption requests above a certain amount.

Historically, a similar condition was used liberally on fractional-reserve deposit accounts under the guise of the “option clause.”8 This has since been heralded as a stabilizing force of free-banking systems lacking a guarantor such as a central bank to function as a lender of last resort (White 1984, pp. 28–29; Selgin 1988, pp. 161–62; Selgin and White 1994, pp. 17–26). Such advocacy gets the problem of stabilizing the monetary system exactly backwards. Solving the problem of banking instability by removing the on demand criterion, even if for only a short while, removes one-half of the key features making money so unique. It also removes one-half of the reasons why money is demanded.

Thus, deposits held in fractional-reserve bank deposits are a tenuous component of the money supply. Provided that the issuing bank can maintain on demand and par value redemption, there is no significant problem. Changing either of these aspects effectively removes the asset from the upper-left quadrant in Figure 1, and relegates the former “money” to some other financial role.

(Re)defining the Money Supply

Defining the money supply is tricky business. This is so not least because of what criteria define monetary assets, but also because some of those assets are not capable of performing their jobs without serious caveats. I will close with some brief and sundry comments on Salerno’s (1987) definition of the “true money supply.”

In writing this pithy article, Salerno builds from the theoretical framework of Rothbard (1963, pp. 83–86; 1978; 1983, pp. 265–62) used to accurately define the money supply. In doing so Salerno diverges from Rothbard by excluding life insurance net policy reserves, owing to the fact that very few, if anyone, considers them to be part of the money supply. Since the supply in question is concerned with the “generally accepted” medium of exchange, Salerno excludes this component due the lack of perception that it is money on the part of money holders.

While this exclusion is warranted if one is concerned with money as the “generally accepted medium of exchange,” it is unwarranted if one defines “money” under a different set of criteria. As money is demonstrated herein to be defined as “the unique financial asset that is available at par value, on demand,” the inclusion of life insurance policy reserves is not only warranted, but necessary. Indeed, some works, e.g., Nash (2009), Lara and Murphy (2010), point to the use of life insurance policies as a bank account, and thus implicitly include these reserves in the money supply.

Salerno also excludes money market mutual funds (MMMF) because they are not instantly redeemable, nor are they par value claims to cash. While they may look like this at first glance, a MMMF is an equity claim to a managed investment portfolio of short-term, high-grade financial assets. Cases where these funds have “broke the buck,” i.e., the net asset value of the underlying portfolio drops below the value of MMMF claims to the assets, have historically resulted in either the owners receiving less than the par value of their holdings, or a capital infusion from the fund’s sponsors. Likewise, Salerno excludes short-term time deposits on the grounds that they are not available on demand.

More common attempts to define the money supply have suffered from an ad hoc approach, as is the case with the common “M” measures.9 Austrian economists have made great strides by realizing that the money supply can be defined by the two main reasons that money is demanded, whether to facilitate payments or to provide an uncertainty hedge. Most notably this approach follows Rothbard (1962, pp. 756–62) in defining the reservation demand to hold money separately from its exchange demand (Howden 2013, p. 21).

Ultimately, definitions of the money supply are tricky because they grapple with four problems at once. These four problems allude to money’s four roles, as listed in the opening mnemonic. I will end this chapter with one approach to measure money, and draw one implication.

In one way, money defines prices that will need to be paid for with the medium of exchange. The stock of exchange media available to settle these prices is one “money supply.” For simplicity I suggest we call this “exchange supply of money,” Mx.

Money as used to price goods comes with one complication. At any given time there is a set of obligations priced in terms of the money unit that require the medium of exchange to settle (e.g., debts coming due). To this set we can include those goods desired (but not obliged) to be purchased, which are priced in the money unit and which the medium of exchange will be required to settle (e.g., consumers and producers goods). The sum of these prices, or units of exchange, comprises what we can call the “pricing supply of money,” Mp. There is also a known amount of units of account that will arise at a future date, due to existing debt contracts yet to be fulfilled. The standard of deferred payments, thus, can also be defined with some degree of certainty in the present and we can call this the “future pricing supply of money,” Mp´.

This approach to defining the money supply gives rise to several distinct quantities, only one of which has any bearing to the more commonly given measures. While the Mx supply is easily understood, both Mp and Mp´ are determined not by any monetary factor, but instead by the demand of individuals to purchase goods and services (whether on the current spot market or on some futures market in the past). Readers will see an affinity between this approach and Salerno (2006), whereby prices are not the result of the demand for money per se (as is commonly extrapolated from the quantity theory of money), but are rather the result of the demands for goods and services which in turn create the pricing money supplies, Mp and Mp´.

One implication of, and benefit from, using several “money” supplies is that it allows for an alternative method to look at how the purchasing power of the medium of exchange fluctuates over time. If, e.g., Mx < Mp, the value of the medium of exchange must rise to clear the market. Since some of the prices that comprise the supply of pricing units of money, Mp, are fixed at a pre-defined value (e.g., those resulting from a previous debt contract), either the prices of goods contained in Mp will fall, or the real value of the supply of the medium of exchange, Mx, will rise. Of course, these implications are just two sides of the same coin.

References

Bagus, Philipp, and David Howden. 2013. “Some Ethical Dilemmas of Modern Banking.” Business Ethics: A European Review 22(3): 235–45.

Barnett, William A. 1980. “Economic Monetary Aggregates: An Application of Aggregation and Index Number Theory.” Journal of Econometrics 14: 11–48.

Black, Fisher. 1970. “Banking and Interest Rates in a World without Money: The Effects of Uncontrolled Banking.” Journal of Bank Research 1: 9–20.

Bryan, Michael F. 2004. “Island money.” Federal Reserve Bank of Cleveland Commentary, Feb. 1. (Accessed 1 Sept. 2014). Available: www.clevelandfed.org/research/commentary/2004/0201.pdf

Checkland, S. G. 1975. Scottish Banking: A History, 1695–1973. Glasgow: Collins.

Graeber, David. 2011. Debt: The First 5,000 Years. Brooklyn, N.Y.: Melville House

Greenfield, Robert, and Leland B. Yeager. 1983. “A Laissez-Faire Approach to Monetary Stability.” Journal of Money, Credit and Banking 15: 302–15.

Hall, Robert E. 1982a. “Monetary Trends in the United States and United Kingdom: A Review from the Perspective of New Developments in Monetary Economics.” Journal of Economic Literature 20: 1552–56.

——. 1983b. “Explorations in the Gold Standard and Related Policies for Stabilizing the Dollar.” In Robert E. Hall, ed., Inflation: Causes and Effects, pp. 111–22. Chicago: University of Chicago Press.

Howden, David. 2009. “Fama’s Efficient Market Hypothesis and Mises’s Evenly Rotating Economy: Comparative Constructs.” Quarterly Journal of Austrian Economics 12(2): 3–12.

——. “The Quantity Theory of Money.” Journal of Prices & Markets 1(1): 17–30.

Jevons, William Stanley. 1875. Money and the Mechanism of Exchange. London: C. Kegan Paul.

Kirzner, Israel M. 1979. Perception, Opportunity and Profit: Studies in the Theory of Entrepreneurship. Chicago: University of Chicago Press.

Lara, L. Carlos, and Robert P. Murphy. 2010. How Privatived Banking Really Works — Integrating Austrian Economics with the Infinite Banking Concept, 2nd edition. Nashville, Tenn.: United Services and Trust Corp.

Menger, Carl. 1871 [2007]. Principles of Economics. J. Dingwall and B. F. Hoselitz, trans. Auburn, Ala.: Mises Institute.

——. 1892. “On the origin of money.” Economic Journal 2(1): 239–55.

Mises, Ludwig von. 1949 [1998]. Human Action: A Treatise on Economics. Scholars Edition. Auburn, Ala.: Mises Institute.

Nash, R. Nelson. 2009. Becoming Your Own Banker: Unlock the Infinite Banking Concept, 5th ed. Birmingham, Ala.: Infinite Banking Concepts.

Nolan, Patrick. 1926. A Monetary History of Ireland. London: King.

Radford, R. A. 1945. “The Economic Organisation of a P.O.W. Camp.” Economica 12(48): 189–201.

Rothbard, Murray N. [1962] 1993. Man, Economy, and State: A Treatise on Economic Principles. Auburn, Ala.: Mises Institute.

——. 1963. America’s Great Depression. Princeton, N.J.: D. Van Nostrand.

——. 1978. “Austrian Definitions of the Supply of Money.” In Louis M. Spadaro, ed., New Directions in Austrian Economics, pp. 143–56. Kansas City: Sheed Andrews & McMeel.

——. 1983. The Mystery of Banking. New York: Richardson & Snyder.

Salerno, Joseph T. 1987. “The ‘True’ Money Supply: A Measure of the Supply of the Medium of Exchange in the U.S. Economy.” Austrian Economics Newsletter (Spring): 2–6.

——. 2006. “A Simple Model of the Theory of Money Prices.” Quarterly Journal of Austrian Economics 9(4): 39–55.

Selgin, George A. 1988. The Theory of Free Banking. Totowa, N.J.: Rowan and Littlefield.

Selgin, George A., and Lawrence H. White. 1994. “How Would the Invisible Hand Handle Money?” Journal of Economic Literature: 17: 18–49.

Singh, Manmohan. 2012. “The Other Deleveraging.” IMF Working Paper No. 12/178. Washington: International Monetary Fund.

White, Lawrence H. 1984. Free Banking in Britain. Cambridge, Mass.: Cambridge University Press.

• *David Howden is professor of economics and chair of the Department of Business and Economics at St. Louis University, at their Madrid campus, Madrid Spain.
• 1Amongst other things important to his life, I will take the liberty to include the first time Joe met me. By my “young” mind’s recollection, this was at a dinner at a taco house in Auburn, Alabama, some balmy early June evening in 2008. This was the first of two summers I would spend at the Ludwig von Mises Institute as a summer fellow under the guidance of Joe. Thank you, Joe, for your intellectual encouragement, mentoring and, of course, friendship, over these past six years.
• 2Confusions suffered while interpreting the results of Mises’ evenly rotating economy commonly center on misunderstandings of what role money is embodying within it. Specifically, it is not necessary for money to circulate as a medium of exchange but it is of importance that it exists to denominate prices (Howden 2009, 8 n.8).
• 3Notoriously difficult to define or measure, some estimates place the size of the shadow banking system in the United States at $19 trillion as at year-end 2011 (Singh 2012). By way of comparison, the True Money Supply figure, defined in Salerno (1987) and elaborated on below, was substantially smaller at the end of 2011 — $7.3 trillion.
• 4A weight of gold served this purpose for most of history, even when a different currency unit was used in exchange for more short-term oriented pricing. This changed in the United States starting with the Legal Tender Act of 1862 (which, despite a tumultuous start was finally ruled constitutional in the 1884 case of Juilliard v. Greenman, 110 U.S. 421). Despite contracting for settlement in a different good than was commonly used as the medium of exchange, legal tender laws effectively make the standard of deferred payments (as well as the other monetary functions) the same as the preferred money of the state. Since payment must be accepted if rendered in the legal tender, even a pre-agreed alternative cannot be upheld in a court of law.
• 5Although using fractions of women to pay fines could lead to more accurate convictions and judicious verdicts, as with King Solomon’s ruling to “split the baby,” as recounted in 1 Kings 3: 16–28.
• 6An economy with n goods will result in (1/2)(n-1)(n) direct exchange ratios.
• 7Confusions around the origin and emergence of money commonly treat the unit and account and medium of exchange interchangeably. David Graeber (2011) is unconvinced by Menger’s evolutionary theory, relying on anthropological data that seems to suggest there was never a time when direct exchange existed, an important first step in the path to a money emerging as a form of indirect exchange. As proof, Graeber points to the lack of pricing boards showing prices expressed in terms of multiple goods. In this criticism, Graeber asks too much and too little. Too much because he extends what is really an example of a lack of multiple units of account as means to express prices to conclude that there was never a time with multiple goods functioning as media of exchange. On the other hand he asks too little by expecting there to be evidence of a primitive society expressing prices in terms of all, or many, other goods. Given the computational problems discussed above for a small economy not using a common unit of account, I would expect that this monetary function was eclipsed by one, or a very small number of, goods in anything more advanced than a very primitive society, thus explaining the lack of anthropological evidence from very early human developments.
• 8Checkland (1975, p. 85) describes the Scottish free-banking period as one of “continuous partial suspension of payments.”
• 9Alternative measures of the quantity of money run into similar difficulties. The “Divisia” monetary aggregates developed by Barnett (1980) use what are essentially the same types of money and money substitutes as in the more common M measures, though weighted by their expenditure share instead of evenly.

Textbook* descriptions of financial markets draw a clear and seemingly unambiguous distinction between spot and future transactions. Whereas future transactions are often confined to derivatives markets, everyday trades on stocks, bonds or other assets are said to be spot. Furthermore, common descriptions of spot transactions usually do not distinguish between (i) the time a trade is agreed upon and (ii) the time it is paid for and delivered, as both are assumed, by definition, to take place virtually at the same point in time.

This chapter provides a theoretical investigation of high-frequency trading (HFT), which arises from the lag existing — even for seemingly spot transactions — between steps (i) and (ii). To this end, I shall redefine the dichotomy between spot and future transactions when the settlement of trades does not occur in real time but with a lag, and when this lag can be exploited by algorithms, computerized techniques or human decisions.

High-frequency trading consists of trade exposures opened and closed between settlement dates by market participants ensuring that their net open exposure at the settlement time is zero (implying that none of the trades performed intraday are either paid for or delivered). HFT transactions are not akin, for conceptual understanding, to usual trades that would merely be executed “faster” or to positions being liquidated after a shorter period of time. One distinguishing characteristic of HFT activities is that they can be performed with virtually zero cash or securities’ holdings in the first place, as the trader ensures a zero net position at the settlement date.

This chapter investigates two questions. First, does HFT imply that intraday buy and sell trades are performed using temporarily ex nihilo created fiat money? Second, can the case where securities are agreed-upon but never delivered create multiple (therefore conflicting) but valid property rights on particular assets? The issue at hand resembles those raised by fractional reserve banking. Importantly, this chapter does not comment on the status of high-frequency trading under various legal systems or jurisdictions — this is left for future research — and instead focuses only on the theoretical conditions under which the above-mentioned consequences may occur.

If the above questions are to be given a positive answer, then serious consequences follow as regards intraday liquidity management in payment and settlement systems. An example is that of “failures to deliver” arising from high-frequency trading from naked short selling, whereby a trading institution is not able to deliver at settlement date securities it has been selling during the day.1 Other consequences may relate to intraday collateral management, for instance in the case where securities are bought and delivered as collateral before the settlement of the initial purchase. Besides economics, ethical and legal issues raised by the potential over-issuance of property rights through high-frequency trading activities are akin to those raised by Mises (1996) or Huerta de Soto (2011) in the case of fractional reserve banking. An overview of Mises’s views on fractional reserve banking and monetary theory can be found in Salerno (1994).

Answering the above questions requires a careful analysis of the consequences of the lag between the time trades are agreed and the time they are paid for and delivered. I will show that, when clearing and settlement do not occur in real time, trades that are usually — theoretically and/or legally — described as spot must be treated as futures if a careful economic analysis is to be conducted. I also provide a criterion to distinguish between spot and future trades. Finally, I show that the over-issuance of property rights arising from HFT exists when transactions which should be treated as futures are legally or factually treated as spot.

The remainder of the chapter is structured as follows. First, high-frequency trading is described and is shown to be merely the exploitation of the lag between the time trades are agreed upon and the time they are settled. Its fundamental difference with other (“usual”) trading activities is also highlighted. Then, the distinction between spot and future transactions is refined. Trades on financial markets where settlement is delayed are shown to be meaningfully understood as futures. Finally, I define the conditions under which certain legal treatments of high-frequency trades as spot or as future transactions may lead to the over-issuance of property rights, thus give rise to liquidity risk in payment and settlement systems.

High-Frequency Trading as the Exploitation of Delayed Settlement

I shall start by examining the nature of high-frequency trading and the conditions under which it arises. High-frequency trading on an exchange platform consists of trades usually performed by computer algorithms so as to benefit from private information regarding the order flow or from small price variations over short horizons (ranging from a few milliseconds to a few hours). The major characteristic of high-frequency trading algorithms is that they ensure a virtually zero net open exposure at the end of each trading day, so that no cash or securities have to be physically delivered. High-frequency trading has recently become a sizeable phenomenon on financial markets, as it represents up to 70 percent of all trades on some organized stock exchanges (see Swinburne 2010).

I do not propose an extensive review of the literature (which can be found in Gomber et al., 2011). Most of the academic work revolves around the consequences of high-frequency trading on particular aspects of the price system, typically on the price formation mechanisms (bid-ask spreads, “price discovery” mechanisms, etc.).2 For instance, one oft-mentioned concern relates to the fact that high-frequency trading may amplify price volatility to the extent of triggering “flash crashes.”3 Among the main findings documented in the empirical literature are a reduction in trading costs and bid-ask spreads (see Brogaard 2010; Hasbrouck and Saar 2010) and a decline in short-term volatility (see Jarnecic and Snape 2014 or Brogaard 2011). Contrasting with the existing literature, this chapter focuses on an issue of a completely different order, largely neglected up to now. I do not focus on the empirical or theoretical consequences of high-frequency trading on particular aspects of the price system, but instead provide a theoretical analysis of high-frequency trading as regards property rights on cash and on traded securities. More precisely, do HFT activities lead to the over-issuance of property rights or to the ex nihilo creation of money?

An essential preliminary to be mentioned is a key institutional feature of present-day financial systems, namely the lag that exists on financial markets between the time trades are agreed (prices and quantities are decided upon) and the time payment and delivery actually take place. Whereas trade orders can be executed at any point in time during the trading day, clearing and settlement occur at one point only during the day, usually at the end of the trading session or up to T+72 hours. It is of utmost importance to highlight that such a time lag for so-called spot transactions is essentially institutional, i.e., that it does not primarily exist as a consequence of any physical or operational constraint. With the advent of computerized technologies at all stages of post-trade processing, real-time settlement (or quasi real-time settlement, as several actors have to be coordinated) could be a perfectly valid and implementable contractual or legal framework. For instance, real-time gross settlement systems (abbreviated RTGS4 ) exist for interbank payments — such as Fedwire in the United States and TARGET2 in Europe.

As a preliminary, I shall examine the extent to which high-frequency trades differ from other (“usual”) trades and show that high-frequency trading primarily exists as a consequence of delayed settlement. One key theoretical question for my purposes is actually whether high-frequency trades are akin to “usual” trades that are performed faster (an asset being bought at some date and sold a short moment — from microseconds to several hours — later), i.e., trades that could be fully described in theoretical terms by the canonical description of exchange phenomena (see Mises, 1996, for example). I aim to show that high-frequency buy-and-sell trades cannot be understood theoretically as a combination of spot buy and sell transactions.

I shall begin with a mere description of the steps involved in any combination of spot buy and sell transactions. For trader A, a usual buy-and-sell transaction amounts to (i) agreeing with B on prices and quantities, (ii) paying the agreed-upon monetary units to B in exchange for the agreed-upon good, and at a later date (iii) agreeing with C on prices and quantities and finally (iv) delivering the agreed-upon good to C in exchange for the agreed-upon monetary units.

On the contrary, high-frequency buy-and-sell operations do not imply, at any time, either any disbursement of cash or any physical delivery of a security or good. This is due to the fact that steps (i) and (iii) occur between two settlement dates, so that the buy and sell transactions never have to be paid for or delivered. If a buy-and-sell operation is performed within a few seconds, or even within a few hours, it will never have to be physically settled. One characteristic of high-frequency trading is indeed that investment positions are held for short periods of time so that net exposures are virtually zero at the end of each trading day, when clearing and settlement occur. As a result, high-frequency trading activities can virtually be performed with zero initial cash and zero initial securities (neglecting trading fees or initial cash balances to be maintained at the exchange platform). One may thus move in and out of investment positions thousands of times a day without having either to pay for the securities it buys or to physically deliver the securities it sells. A trader who consistently ensures a zero net open exposure at the end of the trading day can perform his activities without any holding of either cash or securities in the first place.

It must be clear at this stage that the latter feature — the absence of any physical payment or delivery — exists only because of the delayed settlement of all trades. If trades were to be cleared and settled in real time, or in approximately real time, then high-frequency trading would essentially disappear as it would become impossible to trade without virtually any cash or securities initial endowment. What would remain would eventually be buy-and-sell trades that are executed “quickly,” but not high-frequency trades. In order to further understand high-frequency trading, the legal consequences of delayed settlement have to be clearly grasped.

Spot vs. Futures and the Status of Financial Trades

Given delayed settlement, can trades on financial markets be regarded as spot transactions? A clear understanding of the distinction between spot and future transactions is of utmost importance for my purposes, as each of these transactions implies different consequences regarding the property rights at stake. What is usually referred to as a spot transaction is a transaction where both (i) the agreement between two parties on prices and quantities and (ii) the payment on one side, the delivery of the agreed-upon goods on the other side (or clearing and settlement) occur virtually at the same time, meaning that the time span between steps (i) and (ii) is insignificant for human action and for economic theory. One can see that what is crucial to the definition of a spot transaction is whether settlement is delayed or not.

The dichotomy, however, is not as clear-cut as it seems. Strictly speaking, agreement on prices and quantities on one side, and payment and delivery on the other side, are very unlikely to occur at the exact same time in everyday exchanges. Think of a baker who gives a piece of bread to a customer and receives cash only a few seconds after both parties agreed on prices and quantities. Clearly, considering physical time, there is a lag between the agreement between the parties and the process of payment and delivery. Does this imply that this transaction should not be considered as spot but as future? Considering physical constraints, what lag is low enough so that a transaction can be considered spot and not future? One hour? Ten seconds? One microsecond? Phrased this way, the question is misleading and the distinction between spot and future transactions has to be rephrased. The relevant time to be considered is not the physical time but the time of human action. More precisely, one is faced with the problem of continuums in human action and economic behavior. Rothbard (2001, pp. 264–65) argues:

The human being cannot see the infinitely small step; it therefore has no meaning to him and no relevance to his action. Thus, if one ounce of a good is the smallest unit that human beings will bother distinguishing, then the ounce is the basic unit. … If it is a matter of indifference for a man whether he uses 5.1 or 5.2 oz. of butter, for example, because the unit is too small for him to take into consideration, then there will be no occasion for him to act on this alternative.

Similarly, if the lag between the time a trade is agreed and the time it is paid for and delivered has no relevance for human action, then it does not make sense to label as future a transaction where such lag is, say, of 10 seconds. Asserting that it is irrelevant for human action means that the buyer of the agreed-upon good does not and cannot engage in any other transaction or operation involving property rights on the good between the time prices and quantities are decided upon and the time payment and delivery take place. For example, the good bought cannot be pledged as collateral once its purchase is agreed but before it has actually been received. What fundamentally distinguishes a spot from a future transaction is not the physical time lag that virtually always exists (even if very short) between the time a trade is agreed and the time it is paid for and delivered, but whether this time lag is relevant and meaningful for human action. A similar argument has recently been made by Bagus and Howden (2012), who distinguish between demand and term deposits in the debate on fractional reserve banking.

Consider a trading platform with a low level of computerized automation, a relatively low speed of order execution (as compared to present-day speeds) and an end-of-day clearing and settlement. This is roughly akin to what used to exist about fifteen years ago before the tremendous technological improvements underwent by trading platforms. On such an exchange, a lag between clearing and settlement exists but it is essentially irrelevant for human action, as it cannot be exploited — or possibly very marginally. Thus, everyday transactions on such a platform can, without any major theoretical difficulty,5 be treated legally and conceptually as spot.

The whole picture changes with technological improvements when high-frequency trading arises, i.e., when the lag between the time trades are agreed upon and the time they are paid for and settled can be meaningfully exploited. More precisely, a security that has been bought at some point during the day can then be re-sold before being first physically received. Faced with the above-outlined continuum problem, I explained that the distinction between spot and future transactions is to be expressed not in terms of the physical time between agreement and settlement but in terms of time meaningful for human action. Therefore, if high-frequency trades are to be understood as trades that are agreed upon but never paid for and delivered, they can no longer be understood as spot transactions and can conceptually be defined more meaningfully as future transactions. Future transactions differ from spot transactions in that they are agreed in the present but paid for and delivered at a future date, so that the time lag between the agreement on prices and quantities on one side, and the clearing and settlement on the other, is no longer irrelevant for economic and legal theory. In terms of property rights, spot and future transactions are different in esse. Spot transactions are the exchange of property rights over present goods, whereas future transactions are the exchange of claims on property rights on future goods.

If it is clear that high-frequency trades are to be considered as futures, what about trading positions that are kept open until the settlement date, i.e., transactions that will indeed be paid for and delivered? An important issue to highlight is that nothing makes it possible to distinguish ex ante a high-frequency trade from any other trade. When a buy or sell order is executed on the market (“execution” here referring not to the fact that a trade is paid for and delivered, but merely to the fact that a buyer is matched with a seller, i.e., that an agreement on prices and quantities is reached), nothing makes it possible to identify trades of two different types as there cannot exist prescience, at least for an external observer, about whether the position will be liquidated or not before the settlement date. All trades are potentially high-frequency trades ex ante. When there is no real-time settlement, all trades must therefore be regarded as futures in the first place, so as to account for the institutional lag between the time of order execution and the time of clearing and settlement. Indeed, the possibility that a particular trade be high-frequency always exists before the settlement time. In this context, trading positions that are left open over at least one settlement date can be considered similar to future contracts that are kept until maturity, whereas trading positions that are liquidated before settlement date are akin to future contracts that are never delivered.

Legal Treatment and Consequences for Property Rights

All transactions that are usually regarded as spot in economic analysis have been shown to be better understood as futures. Moreover, I explained how different are the implications of spot and future transactions in terms of property rights. Following the above analysis, one needs now to investigate how various legal or contractual arrangements may result or not in the over-issuance of property rights or in the ex nihilo creation of fiat money. Can one think of cases where such over-issuances from high-frequency trades exist because of the lag between the time trades are agreed and the time they are cleared and settled?

First, if all trades on financial markets are to be seen as futures, it must be emphasized that future transactions do not entail any over-issuance of property rights. When one sells at some date a security to be delivered in the future, it does not matter at all whether he actually owns the security in the first place. To understand this, the distinction between a present good and a future good must be restated. What is exchanged in a future transaction is a claim on a future good against a claim on future money. One must emphasize that only claims are exchanged, so that no property rights on present money or securities are exchanged (or involved in any way). Therefore a future transaction, if properly dealt with contractually and legally, is not and cannot imply any over-issuance of property rights. The only point in time where property rights on actual physical securities and on money matter is at the maturity date, i.e., when the future transaction has to be settled. The same reasoning applies for any trade (including high-frequency trades) correctly understood as a future trade. When a security “is bought” during a trading session, what is actually bought is a claim on a future security to be delivered at the settlement time (say, the end of the trading day). Similarly, what is sold in such a transaction is not present money but a claim on future money. If all trades on financial markets are to be treated legally and contractually as future transactions in this precise sense, then high frequency trading does not imply any over-issuance of property rights. A high-frequency trader would then be perfectly akin6 to a trader on futures markets who buys and sells contracts on oil, currencies or whatever securities but consistently unwinds his positions before the maturity date (i.e., never gets delivered with the underlying assets nor pays for any of these assets). Such traders consistently trade claims on future goods but never wait for the maturity of the future contract. This cannot lead to the over-issuance of property rights. In such a case, it is likely beneficial to market liquidity, similar to dealers in futures markets providing liquidity to end-user investors.

Alternative theoretical cases shall nevertheless be considered. Up to now, I have explained without further explanation that high frequency trading does not imply the over-issuance of property rights if trades are “treated legally and contractually as future transactions.” Such a proviso is of the utmost importance. Confusion may indeed come from the fact that what has been here described as future transactions is usually, in textbook explanations of the phenomenon, described as spot transactions. What if trades that are factually futures (as they are paid for and delivered only at an end-of-day settlement date) were to be treated legally and contractually as spot? Or, in other terms, what if an inconsistency in the legal framework exists, so that delayed settlement is the norm for transactions legally treated as spot? Once again, I shall make clear that the issue whether trades are treated as future or as spot under various legal systems or jurisdictions is complex and is not discussed in the present chapter, as my focus is on economic theory only.

In this case, a high-frequency trader buying a security during the day (to be delivered at the end of the trading day) could possibly engage in other operations involving property rights on a present security — not only claims on property rights on future securities — for example by pledging this security as collateral. Until either the settlement date or the date the position is liquidated, there would be two seemingly legitimate owners of the exact same security. This case would clearly result in an over-issuance of property rights that are not backed by actual physical securities. This is reminiscent of “circulation credit” or “inflation” in Mises’s sense (Mises 1981; Salerno 2000). Similarly, assume that a seller is able to use intraday the cash he is supposed to be delivered only at the settlement date — for example to repay a maturing debt — then such cash must be considered as ex nihilo created fiat money, as no one renounced yet to this quantity of money in the present. Once again, this would merely be an over-issuance of fiat money, which may have serious implications for liquidity risk in payment and settlement systems in a stressed environment.

Conclusion

This chapter provided a theoretical examination of high-frequency trading, focusing on whether it creates either additional property rights that are not backed by physical securities or ex nihilo created money. This is likely to occur as high-frequency traders can buy and sell large amounts of securities without virtually any cash or securities endowment in the first place. One key feature for a theoretical understanding of high-frequency trading is that it exploits the lag between the time trades are agreed and the time they are paid for and settled. In turn, high-frequency trading as it is currently practiced would essentially disappear if clearing and settlement were to be implemented in real time.

Whereas the time lag between the execution of a trade (i.e., the matching of a buyer and a seller) and its settlement has long been virtually irrelevant for human action as it could not be exploited — or only to a very limited extent — the advent of electronic trading platforms and of computerized trading algorithms enabled exploiting this lag to a greater extent. What used to be considered as spot transactions without any major conceptual difficulty can no longer fit the stylized description of a spot transaction, i.e., a transaction where payment and delivery occur virtually at the same time as the agreement on prices and quantities. Given that powerful computer techniques enable exploiting smaller and smaller lags (nowadays a few microseconds), the dichotomy between spot and future transactions has to be re-thought. Faced with the continuum problem, I argue that the distinctive criterion which ultimately matters is not the physical time lag that almost necessarily exists between trade agreement and delivery, but whether this lag is meaningful for human action — or, eventually, for algorithms executing models designed by humans. In that regard, all transactions usually regarded as spot have to be treated conceptually as futures with the advent of high-frequency trading techniques (of course, as long as the institutional lag between trade execution and delivery is maintained).

Turning to a legal analysis of high-frequency trading, I show that — in a system where settlement is delayed — the issue whether an over-issuance of property rights exists ultimately depends on whether it is treated legally as spot or future. If high-frequency trades are properly dealt with as futures — i.e., not as an exchange of property rights on goods, but as claims on property rights on goods — then no such consequences follow. This implies, for example, that traded securities cannot be pledged as collateral before they are physically delivered. On the contrary, if high-frequency trades are treated legally, contractually or factually as spot, then there exists over-issuance of property rights, even though it is for short time periods. This gives rise to liquidity risk in payment and settlement systems.

Following the above analysis, two research directions are to be outlined for future work. First, I set a theoretical framework indicating under which legal arrangements high-frequency trading may or not lead to the over-issuance of property rights. A survey of the existing legal frameworks in the United States or in Europe would be highly valuable as a complement. Second, from a theoretical perspective, the framework set out above could be extended to the study of another controversial market practice, namely naked short-selling. Naked short-selling occurs when a security is shorted before being first borrowed or located. A legal issue therefore is whether it is fraudulent in that one is selling something he does not own in the first place. This practice could be fruitfully analyzed not as the shorting of a security but as the shorting of a claim on a security, therefore as a future.

References

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Brogaard, J. 2010. “High-Fraquency Trading and its Impact on Market Quality.” Northwestern University Working Paper.

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Gomber, P., Arndt, B., Lutat, M., Uhle, T. 2011. High-Frequency Trading. Goethe Universität.

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Huerta de Soto, Jesús. 2011. Money, Bank Credit and Business Cycles. Auburn, Ala.: Mises Institute.

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• *Guillaume Vuillemey is a PhD student in economics at Sciences Po, Department of Economics, Paris, France. I was a summer research fellow at the Mises Institute in 2009, under the guidance of Professor Joseph Salerno.
• 1On the extent of failures to deliver in the United States, see SEC Fails-to-Deliver Data.
• 2Another issue regarding high-frequency, which has been less dealt with in the literature, is the extent to which it is akin to insider trading, as some high-frequency traders benefit from their technological superiority to get market information (on incoming buy and sell orders especially) ahead of other market participants. This issue is not addressed in the present chapter.
• 3The most prominent example of so-called “flash crash” occurred on May 6, 2010, when the Dow Jones Industrial Average plunged by about 9 percent before recovering in a few minutes. High-frequency trading algorithms have been shown to play a role in the amplification of the drop (see SEC, 2010).
• 4A comprehensive overview of RTGS payment systems is provided by the Bank of International Settlements (1997).
• 5In a world where the automation of stock exchanges through computer systems is low or inexistent, i.e., where high-frequency trading or multiple intraday transactions on the same security are virtually not possible, treating as spot a transaction that is technically future (with a maturity of a few hours up to 24 hours) may only matter in case of bankruptcy — for example, if bankruptcy is declared between the time a trade was agreed and the time it was supposed to be paid for and delivered.
• 6One slight difference is that one party usually has to pay a present premium in order to enter a future transaction. This, however, is not a necessary element of a future contract. The only payment that a high-frequency trader has to make — like any other trader — is the trading fee to the exchange platform.