Artisan:

“I’m speaking about loans given to the government in particular, which are not to be held by the European Central Bank whereas they directly amount 98% of the Fed budget”

On the real bills view, the problem with the central bank (CB) buying the bonds of its own government is partly the fact that the CB can be pressured into accepting bonds that are worth less than the currency issued, and partly the fact that the CB would be backing a dollar with bonds that are themselves denominated in dollars. Thus, when the dollar drops in value, the bonds drop in value too, but since these bonds back the dollar, the dollar falls a little more, etc. This means it’s unwise for any CB to buy any assets denominated in its own currency, even though that’s just what most of them do.

Mike sproul:
I’m not sure I quite understand your point. You mean to buy bonds labelled in the own currency to “back the money” is kind of unwise (on that I agree of course), and yet, everyone does it…
But still, this doesn’t make a difference from buying bonds issued by a private corporate and labelled in the same currency, does it? So that doesn’t answer my question: what is the idea behind that different CB regulation (no government bonds please) in Europe?

Anyways, here’s to the funny arguments I checked on Gene Callahan’s web page in detail:

“Libertarians must be against golden meteorite falling to earth since it causes inflation”
- the probability that this happens make it a welcome event among libertarian, I believe, as compared to the unavoidable probability that the Fed Reserve will buy old government bonds, which in turn INCREASE the Fed’s warranty on bank assets 5 times or more .

“banks need FR to “earn” money”
Banks don’t need FR to earn money. They can charge a competitive interest rate that makes their deals profitable.

“A restitution contract between a bank and an account holder always has to feature some agreed misfortune clause like robbery, making it possibly void and likewise risky under 100% Banking”
- But 100% Banks will insure against losses caused by bank robbing, or they will go broke.

It seems to me thus the real problem is that FRBanks don’t go broke (they’re backed by government raising taxes). Instead, the private people do.

Artisan:
“But still, this doesn’t make a difference from buying bonds issued by a private corporate and labelled in the same currency, does it? So that doesn’t answer my question: what is the idea behind that different CB regulation (no government bonds please) in Europe?”

The inflationary feedback I mentioned happens whenever a CB buys anything denominated in its own currency–private bonds included.

The “no government bonds” rule is meant to prevent a repeat of the European hyperinflations of the 1920′s, where governments demanded (say) 100 marks from the CB and gave the CB a bond worth considerably less in return.

@Mike Sproul.

The “no government bonds” rule is meant to prevent a repeat of the European hyperinflations of the 1920′s, where governments demanded (say) 100 marks from the CB and gave the CB a bond worth considerably less in return.

Why would this not happen in the case of corporate bonds open market purchase? European CB is free to buy those. Do you have a source for this assumption by any chance?

Artisan:

“Why would this not happen in the case of corporate bonds open market purchase? European CB is free to buy those.”

Yes; a corporation could also exert undue pressure on the CB to buy its bonds at inflated prices, but the hyperinflations of the 1920′s were caused by governments exerting undue pressure on the CB, and all the significant inflations I can think of were also caused by CB’s buying government bonds. That’s why the prohibition focused on government bonds.

“Do you have a source for this assumption by any chance?”

Not off the top of my head, but you’d probably find some useful info, and lots of sources, by looking up “The Ends of Four Big Inflations” (1981) by Thomas Sargent, (working paper #158 at FRB Minneapolis)

Is this post too big? This is from De Soto’s section labelled “IGNORANCE OF LEGAL ARGUMENTS” in his “MONEY, BANK CREDIT, AND ECONOMIC CYCLES”:

Theorists of fractional-reserve banking tend to exclude legal considerations from their analysis. They fail to see that the study of banking issues must be chiefly multidisciplinary, and they overlook the close theoretical and practical connection between the legal and economic aspects of all social processes.

Thus free-banking theorists lose sight of the fact that fractional-reserve banking involves a logical impossibility from a legal standpoint. Indeed at the beginning of this book we explained that any bank loan granted against demand-deposit funds results in the dual availability of the same quantity of money: the same money is accessible to the original depositor and to the borrower who receives the loan. Obviously the same thing cannot be available to two people simultaneously, and to grant the availability of something to a second person while it remains available to the first is to act fraudulently.

Such an act clearly constitutes misappropriation and fraud, offenses committed during at least the early stages in the development of the modern banking system, as we saw in chapter 2.

Once bankers obtained from governments the privilege of operating with a fractional reserve, from the standpoint of positive law this banking method ceased to be a crime, and when citizens act in a system backed in this way by law, we must rule out the possibility of criminal fraud. Nevertheless, as we saw in chapters 1 through 3, this privilege in no way provides the monetary bank-deposit contract with an appropriate legal nature. Quite the opposite is true. In most cases this contract is null and void, due to a discrepancy concerning its cause: depositors view the transaction as a deposit, while bankers view it as a loan. According to general legal principles, whenever the parties involved in an exchange hold conflicting beliefs as to the nature of the contract entered into, the contract is null and void.

Moreover even if depositors and bankers agreed that their transaction amounts to a loan, the legal nature of the monetary bank-deposit contract would be no more appropriate. From an economic perspective, we have seen that it is theoretically impossible for banks to return, under all circumstances, the deposits entrusted to them beyond the amount of reserves they hold. Furthermore this impossibility is aggravated to the extent that fractional-reserve banking itself tends to provoke economic crises and recessions which repetitively endanger banks’ solvency. According to general legal principles, contracts which are impossible to put into practice are also null and void. Only a 100-percent reserve requirement, which would guarantee the return of all deposits at any moment, or the support of a central bank, which would supply all necessary liquidity in times of difficulty, could make such “loan” contracts (with an agreement for the return of the face value at any time) possible and therefore valid.

The argument that monetary bank-deposit contracts are impossible to honor only periodically and under extreme circumstances cannot redeem the legal nature of the contract either, since fractional-reserve banking constitutes a breach of public order and harms third parties. In fact, because fractional-reserve banking expands loans without the support of real saving, it distorts the productive structure and therefore leads loan recipients, entrepreneurs deceived by the increased flexibility of credit terms, to make ultimately unprofitable investments. With the eruption of the inevitable economic crisis, businessmen are forced to halt and liquidate these investment projects. As a result, a high economic, social, and personal cost must be borne by not only the entrepreneurs “guilty” of the errors, but also all other economic agents involved in the production process (workers, suppliers, etc.).

Hence we may not argue, as White, Selgin, and others do, that in a free society bankers and their customers should be free to make whatever contractual agreements they deem most appropriate.157 For even an agreement found satisfactory by both parties is invalid if it represents a misuse of law or harms third parties and therefore disrupts the public order. This applies to monetary bank deposits which are held with a fractional reserve and in which, contrary to the norm, both parties are fully aware of the true legal nature and implications of the agreement.

Hans-Hermann Hoppe158 explains that this type of contract is detrimental to third parties in at least three different ways. First, credit expansion increases the money supply and thereby diminishes the purchasing power of the monetary units held by all others with cash balances, individuals whose monetary units thus drop in buying power in relation to the value they would have had in the absence of credit expansion. Second, depositors in general are harmed, since the credit expansion process reduces the probability that, in the absence of a central bank, they will be able to recover all of the monetary units originally deposited; if a central bank exists, depositors are wronged in that, even if they are guaranteed the repayment of their deposits at any time, no one can guarantee they will be repaid in monetary units of undiminished purchasing power. Third, all other borrowers and economic agents are harmed, since the creation of fiduciary credit and
its injection into the economic system jeopardizes the entire credit system and distorts the productive structure, thus increasing the risk that entrepreneurs will launch projects which will fail in the process of their completion and cause untold human suffering when credit expansion ushers in the stage of economic recession.159

In a free-banking system, when the purchasing power of money declines in relation to the value money would have were credit not expanded in a fractional-reserve environment, participants (depositors and, especially, bankers) act to the detriment of third parties. The very definition of money reveals that any manipulation of it, society’s universal medium of exchange, will exert harmful effects on almost all third-party participants throughout the economic system. Therefore it does not matter whether or not depositors, bankers, and borrowers voluntarily reach specific agreements if, through fractional-reserve banking, such agreements influence money and harm the public in general (third parties). Such damage renders the contract null and void, due to its disruption of the public order.160 Economically speaking, the qualitative effects of credit expansion are identical to those of the criminal act of counterfeiting banknotes and coins, an offense covered, for instance, by articles 386–389 of the new Spanish Penal Code.161 Both acts entail the creation of money, the redistribution of income in favor of a few citizens and to the detriment of all others, and the distortion of the productive structure. Nonetheless, from a quantitative standpoint, only credit expansion can increase the money supply at a fast enough pace and on a large enough scale to feed an artificial boom and provoke a recession. In comparison with the credit expansion of fractional-reserve banking and the manipulation of money by governments and central banks, the criminal act of counterfeiting currency is child’s play with practically imperceptible social consequences.

The above legal considerations have not failed to influence White, Selgin, and other modern free-banking theorists, who have proposed, as a last line of defense to guarantee the stability of their system, that “free” banks establish a “safeguard” clause on their notes and deposits, a clause to inform customers that the bank may decide at any moment to suspend or postpone the return of deposits or the payment of notes in specie.162 Clearly the introduction of this clause would mean eliminating from the corresponding instruments an important characteristic of money: perfect, i.e., immediate, complete, and never conditional, liquidity. Thus not only would depositors become forced lenders at the will of the banker, but a deposit would become a type of aleatory contract or lottery, in which the possibility of withdrawing the cash deposited would depend on the particular circumstances of each moment. There can be no objection to the voluntary decision of certain parties to enter into such an atypical aleatory contract as that mentioned above. However, even if a “safeguard” clause were introduced and participants (bankers and their customers) were fully aware of it, to the extent that these individuals and all other economic agents subjectively considered demand deposits and notes to be perfect money substitutes, the clause referred to would only be capable of preventing the immediate suspension of payments or failure of banks in the event of a bank run. It would not prevent all of the recurrent processes of expansion, crisis and recession which are typical of fractional-reserve banking, seriously harm third parties and disrupt the public order. (It does not matter which “option clauses” are included in contracts, if the general public considers the above instruments to be perfect money substitutes.) Hence, at most, option clauses can protect banks, but not society nor the economic system, from successive stages of credit expansion, boom and recession. Therefore White and Selgin’s last line of defense in no way abolishes the fact that fractional-reserve banking inflicts severe, systematic damage on third parties and disrupts the public order.

Paul Edwards:

“we explained that any bank loan granted against demand-deposit funds results in the dual availability of the same quantity of money: the same money is accessible to the original depositor and to the borrower who receives the loan. Obviously the same thing cannot be available to two people simultaneously, and to grant the availability of something to a second person while it remains available to the first is to act fraudulently.”

I think this is the crux of your argument. Trouble is that fractional reserve banking does not make the same thing available to two people simultaneously. If paper dollars are backed by silver AND the IOU’s (in turn backed by land) then it is as if the silver and the land have both been coined into money. Bankers don’t create money without getting collateral in exchange, so every dollar issued must be backed by an exclusive claim by the bank on something of value. In the limit, the maximum amount of money banks will create is equal to the aggregate value of all the goods in the economy that could possibly be offered as collateral. As long as the terms of money issue are agreed to by the banker and his customers, there is no fraud. Furthermore, your contention that fractional reserve banking causes inflation assumes the correctness of the quantity theory–you assume it will cause inflation and is therefore fraudulent. But on real bills principles it will not cause inflation and is therefore not fraudulent on any level.

Paul Edwards: “In a free market, only one commodity in a period of history can be money.”

Money is any commodity used to facilitate exchange. In a free market, people tend to gravitate towards the use of one commidity for money because you get the “unit of accounting” benefits that go along with that, but your original statement is too strong.

The real problem with Mike Sproul’s line of reasoning is not that IOUs can’t or won’t be used as money, but that they will automatically be discounted against the thing that they are an IOU for, because they are a future claim, not a present claim. Consequently, (absent of fraud) they won’t serve well as assets on top of which even more IOUs can be issued. In other words, there is an automatic and very strong restraint on the ability of the banks to expand the money supply as long as the banks must explicitly distinguish between present and future claims, and as long as they’re held accountable to those claims. Competition amongst banks in a free market will impose those restraints, which is why banks have of always looked to government to reduce or eliminate these restraints, which the government does in exchange for financing government debt.

Paul,

Hoppe and Mises observe that a free market tends toward the use of a single commodity as money.

Yhis is not the same thing as stating that money is the single most marketable commodity, or that the market has once and for all decided that money is gold.

Any commodity used to facilitate indirect exchange is functioning as money. Some things tend to have properties that make them superiorly suited for use as money. These properties include fungibility, durability, portability, divisability, and demand (independent of its use as money). Collectively, these properties can be described as “remarketability,” and under free-market conditions, gold just happens to be really well-suited for use as money.

But we don’t live under free-market conditions, and tyrants and charlatans have teamed up to replace gold with magical symbols–magical symbols that they can print up any time they want. They have succeeded.

The problem is that, as in the Weimar Republic, the parasite is in danger of killing its host.

I wrote: “This is not the same thing as stating that money is the single most marketable commodity,”

Paul replies: “I don’t understand the basis on which you come to this conclusion, but in any event, I strongly disagree, and I don’t think you can support this claim. But I am open to hearing you try.”

Yes, the single most marketable commodity in a given market is very likely being used as money, but that’s not the Austrian definition of money. The existence of a single most marketable commodity doesn’t mean that other things aren’t simultaneously being used as money in different situations.

Mises uses the notion of the evenly-rotating economy as an intellectual tool to help us understand how markets work. But the main lesson of the evenly-rotating economy is that although economies tend to approach this ideal evenly-rotating state, they never get there because conditions are always changing and information is always imperfect.

The notion of a single money is the same. A free market will tend toward the use of a single commodity as money, but this doesn’t mean that there aren’t times and situations where other things are used as money, even in a free market.

But these are indeed nits when the topic is central banking.

“The fundamental problem with Mike’s line of reasoning is that it ignores and goes counter to Mises’s theory of money. A great deal of Mises must be refuted before Mike can begin to make an argument supporting his position. And i don’t expect Mike to be refuting Mises in the near future.”

The real bills doctrine also goes completely counter to Henry Thornton, Keynes, Marshall, Wicksell, etc., and I don’t have any plans to write a dictionary-sized refutation of any of them. They all started from the view that when paper money is inconvertible, it must be unbacked, and so they set out to explain the puzzle of how an unbacked piece of paper can have value.

The real bills doctrine says that paper money was never unbacked in the first place, and that being inconvertible is not the same thing as being unbacked. Furthermore, there are two kinds of convertibility: physical convertibility, where a dollar is convertible into an ounce of silver, and financial convertibility, where a dollar is convertible into a dollar’s worth of the bank’s assets. As long as a bank maintains financial convertibility, physical convertibility is irrelevant. For example, after the xmas shopping season ends, people will bring their dollar notes back to the bank wanting silver in exchange, but the bank could head off this demand be selling its assets for paper dollars before the dollars return to the bank, thus heading off the demand for physical convertibility into silver. The dollars can be physically inconvertible, but they are certainly financially convertible, and certainly backed. Hence there was never any “puzzle” for Thornton et. al. to explain, and their monetary theory becomes irrelevant.

And BTW: Who made Mises the god of monetary theory? I’d be hard-pressed to come up with anything he ever said on the subject that had not been endlessly repeated from at least the time of Adam Smith and Thornton.

“And BTW: Who made Mises the god of monetary theory? I’d be hard-pressed to come up with anything he ever said on the subject that had not been endlessly repeated from at least the time of Adam Smith and Thornton.”

In the Theory of Money and Credit, Mises initiated his project to bring the analysis of money under the framework of subjective, marginal utility analysis. He did not complete this project until 1940 with publication of the German-language predecessor of Human Action. Whatever opinion one holds regarding the correctness of Mises’s monetary framework, his analysis of money, while to some extent in the Austrian School tradition of Menger and Böhm-Bawerk, was largely original and path breaking, and certainly not in the mold of the mainstream economics profession then, now, or at any intervening time.

Paul: “Only in the later stages of a barter economy is there such a possibility for doubt about what commodity is money. In an established monetary economy, there is no further question of what is money and as each moment passes, this money, whatever it is, becomes further entrenched as the sole money.”

There is a huge advantage to using as money whatever commodity it is everyone else is also using as money, which is the force which eventually “entrenches” a given commodity as money. But this no more precludes the use of other commodities as money than it precludes barter. Yeah, it’s gonna be rare, but it is not apodictically ruled out as it were.

The relevance to Mike Sproul’s arguments is that banks can issue, and even have issued claims againt their assets, which included debt owed to them. My understanding was that these shares as a rule weren’t used as money–at least not under what were more free-market-like conditions. It took legal tender laws and some banker-friendly court rulings before they got away with that.

As I said, the real problem with his arguments is that the inflationary actions of the banks that he is trying to defend as fundamentally legitimate, although not logically impossible, simply wouldn’t happen under genuinely free-market conditions. His arguments, like most of what passes for economics these days, are merely ex post facto apologia for the massive fraud that is fiat currency.

I wrote: “the real problem with his arguments is that the inflationary actions of the banks that he is trying to defend as fundamentally legitimate, although not logically impossible, simply wouldn’t happen under genuinely free-market conditions.”

Mike Sproul: “Of course they would happen, and they have happened, with or without banks. 100-some years ago, it was common for a merchant to accept a customer’s IOU for goods sold. The “bill of exchange” as it was called, would trade from hand to hand as money.”

No, I meant that, in a free market, no bank would survive long using such an IOU as an asset upon which to pyramid further IOUs. Banks that pulled these kind of tricks found themselves going out of business. Contrary to the mumblings of modern bank apologists, this was a good thing.

Paul: “If two monies could exist side by side in an economy in a free market, even if rarely, then it would certainly be incorrect to state, as Mises does, that the prices of money ‘cannot be expressed in terms of money.’”

Mises is not incorrect. He’s just making a different point.

The use of a commodity as a unit of accounting is a consequence of the use of that commodity as money. It is not what defines that commodity as money. This is the point I think Mises is making, and it’s exactly one of the forces which makes an economy tend toward the use of a single commodity as money. If someone decides to use some other commodity as money, they forego the accounting benefits, but that doesn’t at all mean it’s impossible to use something else as money.

A given economy may have settled on gold as the commodity that it uses as its primary unit of accounting. This doesn’t stop someone within that economy from selling their goods or services for silver with no intention of using that silver for anything other than exchanging that silver for yet other goods and services that they intend to consume. In that case, silver is certainly being used as money. And the situation is certainly not that inconceivable.

As for Mises’ point, it’s merely that the value of money as money can only be expressed in tems of its purchasing power of other goods, not in any formal definition of its use as money. I don’t think it had anything to do with the valuation of one money in terms of another in the sense of comparing the price of gold with silver for example.

I was only a child when Nixon came on television to tell us that gold was no longer going to be fixed at $35 dollars an ounce. Even as young as I was, I wondered why the government should be able to tell people that gold had to be $35 dollars an ounce. In my mind, money was dollars. Gold was just something you could buy with it. This is the fallacy I think Mises was addressing in the text you quoted.

If you want to define money as that single most remarketable commodity that is used as the standard unit of accounting within a given economy, then everything you’ve written is correct. However, I’m not aware that Mises was defining money this way so much as elaborating on its nature. And even if he was defining money this way, we are still left with the fact that people can and do use more than one commodity as a medium of exchange even in a free economy.

As for your point about banks and warehouse receipts, you are of course correct.

Mike Sproul: “Merchant A accepts customer B’s IOU, (worth one dollar, and called one dollar) [...]”

Merchant A would only have accepted customer B’s IOU if Merchant A knew customer B personally and trusted them, or at the very least wanted to do them a favor. To anyone else, it would not have been worth one dollar, but would have been discounted from that value based on how unlikely and inconvenient it would have been to redeem that IOU. And none of them would have called it a dollar.

Continuing: “which B deposits in Bank C [...]”

It’s unlikely a bank would have accepted the IOU as money under free-market conditions. See above.

Continuing: “receiving 1 checking account dollar in exchange. Bank C then lends B’s IOU to customer D, who spends it.”

This is the point at which the bank is simultaneously committing fraud and inflating the money supply. Whatever it is B owes in place of the IOU is currently already owned by somebody else (possibly B him/herself). Consequently, at best, the bank note spent by customer D is a future claim on an asset currently owned by somebody else. In practice, it’s a fradulent claim on an asset the bank doesn’t actually own. The result is that there are now two claims on a given asset being used as money, bidding up prices higher than they would otherwise be.

Going on: “The paper dollar is backed by B’s assets, and nobody would accept it if they didn’t believe B’s assets were sufficient.”

In practice, in a free market, people didn’t accept it. So the banks teamed up with the government passing legal tender laws to force people to accept it. More than that, they required taxes be paid in the government-favored bank’s notes to further create demand for them.

It’s the single biggest con job in the history of the world. It has all the sophistication of a parlor trick, yet the banks and the government continue to get away with it…

Mike Sproul: “A accepts B’s IOU because B has sufficient assets to back it. For example, the bank accepts my IOU for $500,000 and places a lien on my house for $500,000. I cannot then just sell the house and run off with the proceeds, since the bank has a lien on the house.”

But now you’re being deliberately ambiguous. Is the IOU a claim on the house? Or is it a future claim to $500,000 in gold or Fed notes? If the former, then any attempt by the bank to lend it out to anyone else as a claim to money is flat-out fraud. If the latter, then the IOU will trade at a discount. That is, if you found somebody willing to accept the IOU in place of money, they won’t accept it at face value.

In practice, with the help of legal tender laws, the bank will lend it out as if it were money. This is fraud. Period.

As for Benjamin Franklin, the United States Constitution makes it pretty clear that not all the founders were as confused (or dishonest) about the nature of money as he was. Not that it seems to have mattered in the long run.