[Presented at the 2013 Austrian Economics Research Conference, Mises Institute, Auburn, Alabama]
One of Ron Paul’s great accomplishments is that the Federal Reserve faces more opposition today than ever before. Readers of this site will be familiar with the arguments: the Fed enjoys special government privileges; its interference with market interest rates gives rise to the boom-bust business cycle; it has undermined the value of the dollar; it creates moral hazard, since market participants know the money producer can bail them out; and it is unnecessary and at odds with a free market economy.
Unfortunately, not all Fed critics, even among Ron Paul supporters, approach the problem in this way. A subset of the end-the-Fed crowd opposes the Fed for peripheral or entirely wrongheaded reasons. For this group, the Fed is not inflating enough. (I have been told by one critic that our problem cannot be that too much money is being created, since he doesn’t know anyone who has too many Federal Reserve Notes.) Their other main complaints are (1) that the Fed is “privately owned” (the Fed’s problem evidently being that it isn’t socialistic enough), (2) that fiat money is just fine as long as it is issued by the people’s trusty representatives instead of by the Fed, and (3) that under the present system we are burdened with what they call “debt-based money”; their key monetary reform, in turn, involves moving to “debt-free money.” These critics have been called Greenbackers, a reference to fiat money used during the Civil War. (A fourth claim is that the Austrian School of economics, which Ron Paul promotes, is composed of shills for the banking system and the status quo; I have exploded this claim already—here, here, and here.)
With so much to cover I don’t intend to get into (1) right now, but it should suffice to note that being created by an act of Congress, having your board’s personnel appointed by the U.S. president, and enjoying government-granted monopoly privileges without which you would be of no significance, are not the typical features of a “private” institution. I’ll address (2) and (3) throughout what follows.
The point of this discussion is to refute the principal falsehoods that circulate among Greenbackers: (a) that a gold standard (either 100-percent reserve or fractional reserve) or the Federal Reserve’s fiat money system yields an outcome in which outstanding loans cannot all be paid because there is “not enough money” to pay both the principal and the interest; (b) that if the banks are allowed to issue loans at interest they will eventually wind up with all the money; and that the only alternative is “debt-free” fiat paper money issued by government.
My answers will be as follows: (1) the claim that there is “not enough money” to pay both principal and interest is false, regardless of which of these monetary systems we are considering; and (2) even if “debt-free” money were the solution, the best producer of such money is the free market, not Nancy Pelosi or John McCain.
To understand what the Greenbackers have in mind with their proposed “debt-free money,” and what they mean by the phrase “money as debt” they use so often, let’s look at the money creation process in the kind of fractional-reserve fiat money system we have. Suppose the Fed engages in one of its “open-market operations” and purchases government securities from one of its primary dealers. The Fed pays for this purchase by writing a check on itself, out of thin air, and handing it to the primary dealer. That primary dealer, in turn, deposits the check into its bank account—at Bank A, let us say.
Bank A doesn’t just sit on this money. The current system practically compels it to use that money as the basis for credit expansion. So if $10,000 was deposited in the bank, some $9,000 or so will be lent out—to Borrower C. So Borrower C now has $9,000 in purchasing power conjured out of thin air, while Person B can still write checks on his $10,000.
This is why the Greenbackers speak of “money as debt.” The $9,000 that Bank A created in our example entered the economy in the form of a loan to Person B. In our system the banks are not allowed to print cash, but they can do what from their point of view is the next best thing: create checking deposits out of thin air. Banks issue loans out of thin air by opening up a checking account for the customer, whose balance is created out of nothing, in the amount of the loan.
The Greenbacker complaint is this: when the fractional-reserve bank creates that $9,000 loan at (for example) 10 percent interest, it expects $900 in interest payments at the end of the loan period. But if the bank created only the $9,000 for the loan itself and not the $900 that will eventually be owed in interest, where is that extra $900 supposed to come from?
At first this may seem like no problem. The borrower just needs to come up with an extra $900 by working more or consuming less. But this is no answer at all, according to the Greenbacker. Since all money enters the system in the form of loans to someone—recall how our fractional-reserve bank increased the money supply, by making a loan out of thin air—this solution merely postpones the problem. The whole system consists of loans for which only the principal was created. And since the banks create only the principal amounts of these loans and not the extra money needed to pay the interest, there just isn’t enough money for everyone to pay off their debts all at once.
And so the problem with the current system, according to them, is that our money is “debt based,” entering the economy as a debt owed to a bank. They prefer a system in which money is created “debt free”—i.e., printed by the government and spent directly into the economy, rather than lent into existence via loans by the banks.
In the comments section at my blog I have been told by a critic that even under a 100-percent gold standard, with no fractional-reserve banking, the charging of interest still involves asking borrowers to do what is literally impossible for them all to do at once, or at the very least will invariably lead to a situation in which the banks wind up with all the money.
All these claims are categorically false.
It is not true that “there is not enough money to pay the interest” under a gold standard or a purely free-market money, and it is not even true under the kind of fractional-reserve fiat paper system we have now. It certainly isn’t true that “the banks will wind up with all the money.” There are plenty of reasons to condemn the present banking system, but this isn’t one of them. The Greenbackers are focused on an irrelevancy, rather like criticizing Barack Obama for his taste in men’s suits.
I want to respond to this claim under both scenarios: (1) a 100-percent gold standard with no fractional reserves; and (2) our present fractional-reserve, fiat-money system.
In order to do so, let’s recall what money is and where it comes from.
Money emerges from the primitive system of barter, in which people exchange goods directly for one another: cheese for paper, shoes for apples. This is an obviously clumsy system, because (among a great many other reasons I trust readers can conjure for themselves) paper suppliers are not necessarily in the market for cheese, and vice versa.
A money economy, on the other hand, is one in which goods are exchanged indirectly for each other: instead of having to be a hat-wanting basketball owner in the possibly vain search for a basketball-wanting hat owner, the basketball owner instead exchanges his basketball for whatever is functioning as money—gold and silver, for example—and then exchanges the money for the hat he wants.
People dissatisfied with the awkward and ineffective system of barter perceive that if they can acquire a more widely desired and more marketable good than the one they currently possess, they are more likely to find someone willing to exchange with them. That more marketable good will tend to have certain characteristics: durability, divisibility, and relatively high value per unit weight. And the more that good begins to be used as a common medium of exchange, the more people who have no particular desire for it in and of itself will be eager to acquire it anyway, because they know other people will accept it in exchange for goods. In that way, gold and silver (or whatever the money happens to be) evolve into full-fledged media of exchange, and eventually into money (which is defined as the most widely accepted medium of exchange).
Money, therefore, emerges spontaneously as a useful commodity on the market. The fact that people desire it for the services it directly provides contributes to its marketability, which leads people to use it in exchange, which in turn makes it still more marketable, because now it can be used both for direct use as well as indirectly as a medium of exchange.
Note that there is nothing in this process that requires government, its police, or any form of monopoly privilege. The Greenbackers’ preferred system, in which money is created by a monopoly government, is completely foreign and extraneous to the natural evolution of money as we have here described it.
And make no mistake: money has to emerge the way we have described it. It cannot emerge for the first time as government-issued fiat paper. Whenever we think we’ve encountered an example in history of a pure fiat money being imposed by the state, a closer look always turns up some connection between that money and a pre-existing money, which is either itself a commodity or in turn traceable to one.
For one thing, pieces of paper with politicians’ faces on them are not saleable goods. They have no use value, and therefore could not have emerged from barter as the most marketable goods in society.
Second, even if government did try to impose a paper money issued from nothing on the people, it could not be used as a medium of exchange or a tool of economic calculation because no one could know what it was worth. Are three Toms worth one apple or seven fur coats? How could anyone know?
On the other hand, the money chosen by the market can be used as a medium of exchange and a tool of economic calculation. During the process in which it went from being just another commodity into being the money commodity, it was being offered in barter exchange for all or most other goods. As a result, an array of barter prices in terms of that good came into existence. (For simplicity’s sake, in this essay we’ll imagine gold as the commodity that the market chooses as money.) People can recall the gold-price of clocks, the gold-price of butter, etc., from the period of barter. The money commodity isn’t some arbitrary object to which government coerces the public into assigning value. Ordering people to believe that worthless pieces of paper are valuable is a difficult enough job, but then expecting them to use this mysterious, previously unknown item to facilitate exchanges without any pre-existing prices as a basis for economic calculation is absurd.
Of course, fiat moneys exist all over the world today, so it seems at first glance as if what I have just argued must be false. Evidently governments have been able to introduce paper money out of nothing.
This is where Murray Rothbard’s work comes in especially handy. In his classic little book What Has Government Done to Our Money? he builds upon the analysis of Ludwig von Mises and concisely describes the steps by which a commodity chosen by the people through their voluntary market exchanges is transformed into an altogether different monetary system, based on fiat paper.
The steps are roughly as follows. First, society adopts a commodity money, as described above. (As I noted above, for ease of exposition we’ll choose gold, but it could be whatever commodity the market selects.) Government then monopolizes the production and certification of the gold. Paper notes issued by banks or by governments that can be redeemed in a given weight of gold begin to circulate as a convenient substitute for carrying gold coins. These money certificates are given different names in different countries: dollars, pounds, francs, marks, etc. These national names condition the public to think of the dollar (or the pound or whatever) rather than the gold itself as the money. Thus it is less disorienting when the final step is taken and the government confiscates the gold to which the paper certificates entitle their holders, leaving the people with an unbacked paper money.
This is how unbacked paper money comes into existence. It begins as a convertible substitute for a commodity like gold, and then the government takes the gold away. It continues to circulate even without the gold backing because people can recall the exchange ratios that existed between the paper money and other goods in the past, so the paper money is not being imposed on them out of nowhere.
Free-market money, therefore, is commodity money. And commodity money is not “debt-based” money. When a gold miner produces gold and takes that gold to the mint to be transformed into coins, he simply spends the money into the economy. So free-market money does not enter the economy as a loan. It is an example of the “debt-free money” the Greenbackers are supposed to favor. I strongly suspect that many of them have never thought the problem through to quite this extent. If what they favor is “debt-free money,” why do they automatically assume it must be produced by the state? For consistency’s sake, they should support all forms of debt-free money, including money that takes the form of a good voluntarily produced on the market and without any form of monopoly privilege.
The free-market’s form of “debt-free money” also doesn’t require a government monopoly, or rely on the preposterously naive hope that the government production of “interest-free money” will be carried out without corruption or in a non-arbitrary way. (Any “monetary policy” that interferes with or second-guesses the stock of money that the voluntary array of exchanges known as the free market would produce is arbitrary.)
But now what of the Greenbacker claim that interest payments, of their very nature, cannot be paid by all members of society simultaneously?
This is clearly not true of a society in which money production is left to the market. The Greenbacker complaint about interest payments in a fractional-reserve system is that the banks create a loan’s principal out of thin air, and that because they don’t also create the amount of money necessary to pay the interest charges as well, the collective sum of loan payments (principal and interest) cannot be made. Some people, the Greenbackers concede, can pay back their loans with interest, but not everyone.
But this is not what happens in the situation we have been describing, in which the money is chosen spontaneously and voluntarily by the individuals in society, and in which government plays no role. Money in this truly laissez-faire system is spent into the economy once it is produced, not lent into existence out of thin air, so there is no problem of “debt-based money” yielding a situation in which “there is not enough money to pay the interest.” There is no “debt” created at any point in the process of money production on the free market in the first place. The free market gives us “debt-free money,” but the Greenbackers do not want it.
Suppose I, a banker, lend you ten ounces of gold, at 10 percent interest. Next year you will owe me 11 ounces: ten ounces for the principal, and one ounce for the interest. Where do you earn the money to pay me the interest? Either by abstaining from consumption to that extent and saving up the money, or by earning it through providing goods or services to others. In other words, you earn the money to pay the interest the same way you earn the money to pay for anything else.
(Even under the classical gold standard, in which gold backed only some of the paper money in circulation, there is still a portion of the money supply—namely, the money substitutes that have gold backing—that were not lent into existence, and which can therefore serve as the source of interest payments.)
Although the “there isn’t enough money to pay the interest” argument fails, I want to take up a related warning about sound money—a warning I noted at the beginning of this essay—that I read in the comments section of my blog: moneylending at interest by the banks will yield a long-run outcome in which the bankers have all the money.
The argument runs like this: if banks can lend 1,000 ounces of gold today and earn 100 ounces in interest (assuming a 10 percent rate of interest) at the end of the loan period, then in the next period they’ll have a new total of 1,100 ounces to lend out, and in turn they can earn 110 in interest on that. Then they’ll have a total of 1,210 ounces, and when they lend that out they’ll earn 121 ounces in interest. In the next period they’ll have 1,331 (which is 1,210 plus the 121 they earned in interest in the previous period) ounces, etc. Eventually, they’ll have everything.
This is completely wrong, although even if it were right, presumably even bankers need to buy things at one point or another, so the money would be recirculated into the economy in any case. The money commodity itself rarely yields people so much utility that they will hold it at the expense of food, water, clothing, shelter, entertainment, etc. And when it is recirculated, the same money can be used to make interest payments on multiple loans.
The more important reason that red flags should be going up here is that this warning would apply to any business, not just banking. For example, if Apple sells us great electronic equipment, it earns profits. Those profits allow it to invest in more efficient production processes, which means Apple will be able to produce even more and better computers and other devices next year. If we buy those, Apple will have still more profits, which means they’ll be able to produce still more and better products the year after that, and before you know it, Apple will have all our money.
So what’s left out of these scenarios? Demand. Consumers do not have an infinite demand for electronic products. If Apple keeps producing more iPods, it will have to sell them at lower and lower prices in order to induce us to buy them. This is economics 101—the law of demand, derived in turn from the law of marginal utility. The more electronics I buy, the less utility I derive from additional units of such goods (and thus the less eager I am to purchase more). Meanwhile, as my remaining cash balance is depleted by these purchases, the marginal utility of my remaining money increases (and thus the more eager I am to hold on to that money rather than exchange it for still more consumer electronics).
The same goes for consumer (and producer) loans. The Greenbacker objection assumes that demand for loans is infinite. Like zombies, we’ll continue to demand loans no matter what the interest rate, and banks will always be able to find more people willing to take on more credit. But as we saw above, in order to induce us to absorb a greater supply of Apple electronics, and/or to induce additional buyers to enter the market, the prices of those goods had to fall.
This principle holds true for credit as well. To induce us to accept an increasing supply of credit, the banks will have no choice, given the law of demand, but to lower the rate of interest. Two consequences follow. As they earn less in interest, they will be less able to afford to pay their customers competitive interest rates on savings accounts and on financial products like CDs. And as those customers turn away from the banking system in search of higher yields outside banking, the banks will have less to lend. These twin pressures place an upper limit on the amount of credit the banks can extend.
So you can breathe easy. The banks won’t wind up with all the money after all.
On the free market, the production of money would occur in the same way that the production of any other good takes place, with no money producer being granted any monopoly privilege. The average person doubtless has a difficult time imagining how money could exist without a monopoly producer. Wouldn’t everyone want to go into the money-production business? After all, you get to create money. Why, I’ll just create my own money and spend it! Isn’t that naturally more lucrative than producing other goods?
First of all, no one can expect to print pieces of paper with his face on them and spend them into circulation. Nobody would accept them, needless to say, and as we have seen, it is impossible for money to be introduced ex nihilo in this way. The only kind of money that can emerge on the free market is one that, at least at one time, had been considered a useful commodity. Paper money can come into existence on the free market and without coercion if it serves as a redemption claim for the commodity money, but irredeemable paper money cannot originate without government threats or violence.
Again, as we saw previously, the pattern is this: a commodity is freely chosen by market participants to serve as money, for convenience paper receipts fully convertible into that money begin to circulate as money substitutes, and finally the government removes the commodity backing from the paper and only the paper circulates. That is in fact what happened in the United States in 1933.
So your friend Joe shouldn’t expect in a free market to be able to print up some paper notes with his face on them and be able to exchange them for goods and services. In addition to the logical problems with this that we examined before, he’d also look crazy for even trying such a thing.
Also, as with every other industry, profit regulates production. The production of money, like the production of all other goods, settles on a normal rate of return, and is not uniquely poised to shower participants in that industry with premium profits. As more firms enter the industry, the rising demand for the factors of production necessary to produce the money puts upward pressure on the prices of those factors. Meanwhile, the increase in money production itself puts downward pressure on the purchasing power of the money produced.
In other words, these twin pressures of (1) the increasing costliness of money production and (2) the decreasing value of the money thus produced (since the more money that exists, ceteris paribus, the lower its purchasing power) serve to regulate money production in the same way they regulate the production of all other goods in the economy.
Once the gold is mined, it needs to be converted into coins for general use, and subsequently stamped with some form of reliable certification indicating the weight and fineness of those coins. Private firms perform such certification for a wide variety of goods on the free market. This service is provided for newly coined money by mints.
Banking services would exist on the free market to the extent that people valued financial intermediation, as well as the various services, such as check-writing and the safekeeping of money, that banks provided.*
The intermediation of credit consists of borrowing money from savers, pooling those funds, and using those pooled funds to extend loans to borrowers. Banks earn the interest-rate differential that exists between the rates they charge to borrowers and the rates they pay to savers. The pooling of savings and the identification of projects to which those funds can temporarily be directed is an important service in a market economy.
And as with the production of all other goods and services on the market, credit intermediation is regulated by profit. It cannot be multiplied indefinitely, as a great many Greenbacker commentators appear to believe. In the same way that high profits in any industry attract newcomers to that industry and thereby dissipate those profits, a high interest-rate differential between borrowers and savers will attract more people into credit-intermediation services. These entrants will need to pay higher interest rates to savers in order to acquire additional funds to intermediate to borrowers. Conversely, in order to attract additional borrowers they will need to lower the interest rates charged to those borrowers. These twin pressures—higher rates paid to savers, and lower rates earned from borrowers—dissipate bank profits and place an upper bound on credit intermediation activities. So again, the banks face a natural limit to their activities, and cannot earn all our money.
So far, we have considered the case of a gold standard or a pure free market in money. But under a non-market system of fiat-money and fractional-reserve banks the Greenbackers’ concerns are still misplaced. There are plenty of reasons to criticize fiat money and fractional-reserve banking, but since the case against them is undercut by false arguments, I want to take apart this particular false argument.
We know from our earlier analysis that money has to emerge on the market as a useful commodity, and that the state theory of money, whereby money has value only when and because the state declares it to have value, is untenable.
When Franklin Roosevelt confiscated Americans’ gold in 1933 and gave them paper money in exchange, this money did not enter the system “as debt.” It was a simple act of conversion of specie into paper. (Thanks to J.P. Koning for tracking down that link.) This is how all hard-money systems become fiat ones: the precious metal that backs the currency is taken away, and the people are left only with paper given to them in exchange for their metal. And since that portion of the money stock that consists of the redemption of the people’s specie into paper is not debt-based—the government is giving them the money, not lending it—it becomes a permanent portion of the overall money stock from which interest payments can be drawn. There is, therefore, always a portion of the money stock that is unconnected to any debt, so there is no built-in process even in a fractional-reserve fiat paper system by which debts must be collectively unpayable.
Under the gold standard as it existed in the United States, the banks issued both kinds of money substitutes in the Misesian typology: money certificates (paper that serves as a receipt for gold on deposit) and fiduciary media (paper that, while physically indistinguishable from money certificates, does not correspond to any gold on deposit; this is what the banks create when they want to increase the money supply beyond just the stock of gold). Only the fiduciary media would qualify as being “debt-based money,” because only the fiduciary media enters the system as new loans. The money substitutes that correspond to gold in the banks’ reserves are not debt-based. They do not enter the economy in the form of a loan. They enter the economy as receipts for gold on deposit with the banks. This portion of the money stock, too, becomes a permanent fund, even after the transition to a fiat money system, from which interest payments can be drawn.
Remember, once again, that when people pay banks interest on their loans, these interest payments themselves will in large measure be spent into the economy by employees of the bank. The same unit of money can thus be used to pay principal or interest on multiple loans as it circulates again and again. There is no reason that bankers or anyone else would want to earn profits and never spend or invest them, unless someone happens to be a fetishist deriving pleasure from literally rolling in the money itself. This is unusual.
Far and away the best defenses and descriptions of a pure free market in money are Jörg Guido Hülsmann’s book The Ethics of Money Production and Jeffrey Herbener’s astonishing 2012 congressional testimony before Ron Paul’s monetary policy subcommittee. I strongly urge you to read at least the Herbener testimony. It is beautifully written and its logic practically compels the reader’s assent. (While you’re at it, watch this video in which Professor Herbener explains why he became an Austrian mid-career, even though he stood to gain nothing professionally by doing so.)
In short, there is no need to replace the Fed with another government creation. There is no good reason to replace the Fed’s monopoly with a more directly exercised government monopoly. All we need for a sound money system are the ordinary laws of commerce and contract.
Let’s oppose the Fed for the right reasons, and let’s oppose it root and branch: not because it doesn’t create enough money out of thin air (is this really a fundamental critique of the Fed, after all?) but because the causes of freedom, social peace, and economic prosperity are at odds with any coercively imposed monopoly, and because the naive confidence in the American political class that the Greenbacker alternative demands is beneath the dignity of a free people.
(Thanks to Robert Murphy for his comments on this essay.)
*There is a tradition within the Austrian School, particularly among Rothbardians, of separating these functions of banks. Banks can act as money warehouses or as credit intermediaries, or as both. These are not the same thing. It is possible to imagine banks that offer one service or the other, as well as to conceive of banks that offer both services but distinguish sharply between them. Checking deposits, for instance, would be available to customers on demand, and so in that case the bank would be operating as a money warehouse, while savings accounts, CDs, etc., would be considered a loan to the bank, with which the bank could engage in intermediation activities.
