9. Anatomy of a Disruption: What Fiat Money Causes

Paper money appears at first sight to be a great saving, or rather that it costs nothing; but it is the dearest money there is.51
– THOMAS PAINE

The word fiat comes from Latin and its meaning amounts to “it shall be” or “let it be done.” Fiat money is not “natural money” in the sense that it could have been created in the free market by voluntary agreement between market players. We can call fiat money—according to the saying “sink or swim”—a coerced money, a decreed money. (With tongue in cheek one could say: If you are forced to call a dog a cat and treat it like one, then the dog is a fiat cat.)

Fiat money has three characteristics: (1) Fiat money is state-monopolized money; the state central banks control the production of money. (2) Fiat money is usually created through lending, which is not matched by real savings.52 It is created “out of nothing” (or ex nihilo in Latin). (3) Fiat money is dematerialized money. It has the form of colorfully printed paper slips (more precisely, pieces of cotton) and entries on computer files (bits and bytes). Whether US dollars, euros, Chinese renminbi, Japanese yen, British pounds, or Swiss francs, they are all fiat money.

Because fiat money is not a natural, free market money—it is not the result of voluntary exchanges—it is not surprising that it suffers from severe economic and ethical deficits. Fiat money is inflationary: it loses its purchasing power over time, because the central banks—in close cooperation with the commercial banks—are continually expanding the supply of fiat money. And if the money supply rises, so do the prices of goods, and this necessarily lowers the purchasing power of money.

Inflation, by the way, can occur with commodity money as well as for fiat money. But because a fiat money supply can be expanded at any time to the politically desired amount, fiat money is much more inflationary than commodity money; and that is also the reason why the state has replaced commodity money with its own fiat money.

The chronic inflation of fiat money ensures that income and wealth are redistributed in a way that does not conform to market conditions, with the first recipients of the newly created money benefiting at the expense of the late recipients. Those who are the first to receive the newly created money can purchase goods at unchanged prices. If the new money spreads through the economy, the prices of goods will rise—or they will be higher compared to a situation in which the money supply had not been increased. The redistributive effect—some getting richer at the expense of many—necessarily occurs, because not all people participate at the increase of the quantity of fiat money.53

As the purchasing power of fiat money melts away over time, savers have no choice but to go to the bank to set up interest-bearing deposits and securities accounts in the hope of earning an interest yield that will protect them from the decline in monetary value. Fiat money thus immensely increases the business and profit opportunities of the banking and financial industry—after all, the customer has to pay fees for accounts, deposits, and transactions. It is therefore anything but surprising that the banking and financial sector in particular is a fervent supporter of the fiat money system!

By putting new money into circulation, preferably through loans that are not covered by real savings, the central bank artificially lowers the market interest rate. The central bank thereby causes a large-scale deception: consumers and entrepreneurs are deluded by an illusion of wealth. They are misled about the true conditions of scarcity; their decisions on consumption, savings, and investment become misguided. This causes serious disturbances in the economic and financial fabric.

The artificially lowered market interest rate tempts people to save less and consume more, and at the same time motivates companies to make new investments. As a result, the economy lives beyond its means. But this is not apparent at first, because the artificially lowered interest rate sets an artificial upswing (boom) in motion. It ensures that corporate profits bubble up, employment increases and wages rise. But the boom is built on sand: after the one-off injection of the new fiat money has had an impact on commodity prices and wages, companies notice that the increased demand for their products was a one-off and not permanent and that their profits are lagging behind expectations.

Investment projects that have been started but not yet completed are then liquidated and reversed. Jobs previously created will be cut and workers’ wages and incomes will fall again. The boom turns into a downturn (bust). The banks in particular contribute to this: the loans that they have granted to consumers and companies are either in default of payment or are canceled. The banks then become more cautious about lending, reducing their risk appetite. The result: the influx of new loans and new fiat money into the economic system dries up.

The market interest rate then begins to rise again, and the economy returns to its original savings-consumption-investment ratio—to the situation that was preferred by market participants before the artificial lowering of the market interest rate, to a situation in which more was saved, less consumed, and less invested than in the artificial boom. But as a result, the boom collapses—and with it the production and employment structure that has developed as a result of artificially lowered interest rates. The result is an economic and financial crisis.

The bust may be painful, but it is economically necessary. It corrects the economic damage caused by the boom: overconsumption and bad investments. The bust ensures that production and employment are adapted back to the actual needs of the customer. But the bust is politically unpopular: Who wants to accept a loss of income, be driven out of traditional markets, forgo accustomed achievements, who wants to have to admit mistakes? Hardly anyone! And so, when the boom threatens to turn into a bust, the public call for cuts in interest rates is loud.

Even lower interest rates are supposed to turn the bust into another boom. The central bank responds to the request—and the game begins all over again. This explains the cycle of boom and bust. However, the damage caused by the distortion of interest rates by the central banks is not yet fully described. The artificially low interest rate upgrades current consumption compared to future consumption. The consequences of this value manipulation can be seen in many ways. For example, interest rate cuts by central banks drive up prices and valuation levels for equities, land, and buildings.54 Mind you, such price increases are the symptoms of one cause—the change in people’s values due to interest rate policy. But interest rate manipulation by central banks has much more far-reaching effects.

The central banks artificially drive people’s time preferences up by manipulating market interest rates downwards.55 When interest rates are artificially lowered, it becomes more important for people to achieve short-term goals compared to long-term goals. Interest rate reduction, for example, encourages a life on credit, i.e., to bring forward consumption opportunities at the expense of the future. Saving goes out of fashion, permanent debt becomes morally acceptable. And when the present and immediate becomes more and more important, the willingness to achieve also decreases: people prefer to work less, because leisure time becomes more important (more about this in chapter 20).

Above all, however, the boom-and-bust cycles for which central bank policies are responsible do most people great harm: they suffer job losses, become socially dependent, and lose their old-age provision. They attribute the cause of their suffering to the free market economy—but not to the state fiat money system. (This erroneous interpretation of the cause of the crisis is provided by the many economists on the state’s payroll, who publicly blame the free markets and not the state!) Entrepreneurs and workers call for even more state intervention in the market to improve the economic situation. This includes in particular the call for even lower interest rates.

Mises expresses this tragedy:

Nothing harmed the cause of liberalism more than the almost regular return of feverish booms and of the dramatic breakdown of bull markets followed by lingering slumps. Public opinion has become convinced that such happenings are inevitable in the unhampered market economy. People did not conceive that what they lamented was the necessary outcome of policies directed toward a lowering of the rate of interest by means of credit expansion. They stubbornly kept to these policies and tried in vain to fight their undesired consequences by more and more government interference.56

And further:

The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the necessary collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.57

The central problem of fiat money is this: the economies get into debt bondage. The ever-increasing debt in the fiat monetary system increases the dependence on the continuation of the low interest rate policy not only for debtors, but also for savers, investors, and the entire production and employment structure. Companies, employees, and government representatives do not want to fail, do not want their debt to end in a large-scale default and a major crisis. In other words, something like “collective corruption”58 emerges.

People become economically and socially dependent on the continuation of the fiat money system. Therefore, it is not surprising that they, in their own interests, advocate measures that maintain the fiat monetary system and the structures it has created and prevent them from collapsing, even if it means dismantling what is left of the free market economy. No wonder that the preferred measure is the policy of interest rate cuts and to expand the supply of credit and money.59

But this only prolongs the crisis, thereby making it bigger. In the words of Ludwig von Mises:

The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.60

It is far from surprising that states that claim to be welfare states insist on their monopoly of money production. The welfare state is a wolf in sheep’s clothing, a deceptive package. Its supporters—little by little and often by stealth—try to use it to realize their socialist dreams in economy and society. Behind the talked-up idea of the welfare state lies an ideological program hostile to freedom—and it bears the name of democratic socialism. The following chapter is dedicated to it.

ABOUT THE MARKET INTEREST RATE AND ORIGINAL INTEREST RATE

What is interest? In order to explain the phenomenon of interest, it makes sense to first distinguish between market interest rates and originary interest rates. The market interest rate is formed by the supply of and demand for savings (used for investment purposes) on the market. In the simplest case, it consists of individual components. These include inflation and risk premiums as well as the so-called originary interest rate.

Originary interest is the result of time preference. It is a category of human action and is explained as follows: action takes time; timeless action cannot be conceptualized without contradictions. Time is therefore a means of achieving objectives and, like any means, time is scarce. Consequently, the actor values the fulfillment of a need in the present more highly than the fulfillment of the need (of the same nature and otherwise under the same conditions) at a later date.

If an actor has an originary interest rate of, say, 2 percent, he will only be prepared to exchange 1 euro, which he owns today for 1.02 euros which he will receive in one year. If he were to receive only, say, 1.01 euros in a year for his current 1 euro, there would be no exchange of “euro today” for “euro in a year”; and there would be no market interest rate either.

Time preference and originary interest differ from person to person, and these can change over time. For example, they can move in the direction of the zero line. But time preference and the originary interest rate can never become zero or negative; they cannot be ignored in people’s values and actions. This statement is not based on any arbitrary (behavioral) assumption but follows from the logic of human action.61

Let’s take the position of the devil’s advocate at this point and think through what it means if the originary interest rate in the economy actually falls to zero: if your personal originary interest rate, dear reader, were 0 percent (if you had no time preference), then you would prefer two apples, which you will only get in ten years or in one thousand years, rather than one apple today. If your originary interest rate were zero, then only “more is better than less” means anything to you, whereas “sooner is better than later” has no meaning for your values and actions.

An originary interest rate of 0 percent would drive the land prices, which result from the discounting of all future land rents to the present, to infinity. Plots of land would be priceless! Anyone who says that the originary interest is zero implicitly denies that resources are scarce—and that can be seen as logically wrong.62 It would mean that you would no longer consume anything of your income, and save and invest everything in order to enjoy more goods: you do not consume today, not tomorrow, not in one year, not in ten years. A completely absurd idea! And a negative originary interest rate is not at all meaningfully conceivable for human logic!

The many examples that mainstream economists offer to justify a negative originary interest rate cannot refute what has been said above. If, for example, the gold market is in contango (i.e., the forward price exceeds the spot price), this does not mean that time preference and the originary interest rates of the market participants are negative. And neither are both negative even if the price you are willing to pay for ice cream next summer is higher than it is today, in winter. In these examples, in addition to the originary interest rate (which is always and everywhere positive), there is another factor in determining value which takes into account the conditions of action at the time when action is taken; this was pointed out by the US economist Frank A. Fetter (1863–1949).

In “pure form,” the originary interest rate only appears in the exchange of a currently available monetary unit for a monetary unit that will only be available in the future, but not in the intertemporal exchange of material goods. There may be pensioners who feel well provided for today and for whom future goods provision is more important than in the present. But even then, these pensioners value a monetary unit that is available today higher than the monetary unit that will only be available in the future: they value one euro today higher than one euro (and of course also 0.95 euros) in ten years. The originary interest rate even of these pensioners is positive; for logical reasons it cannot be zero or negative.

• 51Thomas Paine, Dissertations on Government, the Affairs of the Bank, and Paper Money (Philadelphia: Charles Cist, 1838), p. 52.
• 52Fiat money can also be created by, for example, the central bank printing new money to pay its employees.
• 53See Ludwig von Mises, The Theory of Money and Credit, trans. by J. E. Batson (New Haven, CT: Yale University Press, 1953), pp. 139–43.
• 54Stated simply: if market interest rates fall, this drives up the present values of discounted future payments—and thus also their market prices.
• 55See Thorsten Polleit, A Brief Note on Bank Circulation Credit and Time Preference (Place: Publisher, forthcoming).
• 56Mises, Human Action, p. 441.
• 57Ibid., p. 574.
• 58See Thorsten Polleit, “Fiat Money and Collective Corrupton,” Quarterly Journal of Austrian Economics 14, no. 4 (Winter 2011): 397–415
• 59See Fritz Machlup, Führer durch die Krisenpolitik, vol. 6 of Beiträge zur Konjunkturforschung (Vienna: Verlag Julius Springer, 1934), pp. 41–44.
• 60Mises, Human Action, p. 570.
• 61This can be explained with the logical final figure of the modus (tollendo) tollens: an accepted conditional statement is “If p, then q.” Assuming we observe (or say) “not q,” we conclude that the antecedent is negated, i.e., “not p.” Let us assume that p stands for the statement “Humans act” and q for the statement “The originary interest rate is always and everywhere positive.” If we say, “not q” (i.e., “The originary interest rate is not always and everywhere positive”), then “not p” must apply (i.e., “Humans cannot act”). Here, however, “not-p” is (praxeo-)logically wrong: one cannot deny the sentence “Humans act” without contradiction. Anyone who says, “Humans do not act,” has acted himself and thus contradicts what has been said. For the modus tollendo tollens see Morris R. Cohen and Ernest Nagel, An Introduction to Logic and Scientific Method (1934; repr., New York: Simon Publications, 2002), pp. 101–05.
• 62The assumption of an originary interest rate of zero implies that there is no scarcity in the field of human action—and that is a logical contradiction. See Mises, Nationalökonomie, pp. 479 ff.; also Jeffrey M. Herbener, Comment on “A Note on Two Erroneous Ways of Defending the PTPT of Interest,” Quarterly Journal of Austrian Economics 16, no. 3 (Fall 2013): 317–30, esp. 322 ff.