Comments (214)

• hayesy

  Frank, you really are a refreshing voice of sanity amidst all the sagely prognosticating economic talking heads on Australian TV who tut-tut about CPI/credit crunch this and long-term/short-term that, dazzling the viewers with terminology without really saying anything substantial. They remind me of those cold-reading psychic charlatans like John Edward who attempt to remain as vague as possible to convince people that they can actually talk to people's dead relatives. I wish the ABC would interview you instead.

  Published: July 1, 2008 9:03 AM

• Michael A. Clem

  Good article separating "inflation" (general increase in prices) from inflation (increase in money supply). I especially appreciated the scenario of the increased production of goods, because that one had been bugging me. When there is increased productivity, what should happen is a general decrease in prices, not steady prices.

  Published: July 1, 2008 11:16 AM

• Jake

  Great article Mr. Shostak. Thank you.

  Hayesy's "refreshing" comment sums it up.

  I add you to my list of favourite commentators like Mike Shedlock and Gary North. You've got gray hair, experience, practice Austrian Economics and are involved in the "real" world.

  It's not just academic chatter.

  Published: July 1, 2008 11:45 AM

• Richard Cummings

  
  What a great article. Isn't the money supply also affected by the deficit and the balance of payments deficit? It's amazing to me that
  no one at the Fed ever talks about all of this.
  

  Published: July 1, 2008 12:07 PM

• Stephen Cicero

  It never ceases to amaze me how people just cannot or will not see the reality of inflation. I can talk until I am blue in the face, but most do not get it.

  Here is one example of the problem:

  In a recent conversation, the subject arose concerning the Austrian insight that value is relative. One participant went from this to the notion that a gold standard would be meaningless because “money is worth whatever people think its worth” – in a single statement dismissing inflation as even a passing concern.

  Published: July 1, 2008 1:39 PM

• Walt D.

  Frank
  
  You might want to comment on the Phillips Curve, another artifact of an incorrect definition of inflation.
  "Low unemployment is inflationary since labor shortages leads to higher wages and higher prices!"

  Published: July 1, 2008 1:59 PM

• Kevin T.

  Over all this was a good piece, however, I believe your analysis is lacking in a particular area. This is in response to the following paragraph:

  “So irrespective what people's expectations are, if the money supply hasn't increased, then people's monetary expenditure on goods cannot increase either. This means that no general strengthening in price increases can take place without an increase in the pace of monetary pumping.”

  It is true that the overall money supply would be unchanged unless the “pace of monetary pumping” changed. However, you are assuming that 100% of money supply is in circulation. If for example, consumers who are expecting inflation have a reserve of money supply currently not in circulation, they could put it into circulation to purchase goods. Therefore Frank, the amount of money spent per unit of goods will CHANGE.

  Then again I am 25 and do not know what I am talking about.
  

  Published: July 1, 2008 2:29 PM

• Matt

  Excellent Article.
  However it should be noted that The FED and Congress to a very large extent DO KNOW what Frank is talking about is true. Do they ever look in the mirror and see thievery being perpetrated and what this eventually leads to? The public education system has created economic morons for the most part, but the Federal Reserve Folks do know what they are propagating...in one word.. INJUSTICE.

  Published: July 1, 2008 3:06 PM

• C. Evans

  I have a question for the Mises community. Mr. Shostak wrote:
  "If the price of oil goes up, and if people continue to use the same amount of oil as before, people will be forced to allocate more money to oil. If people's money stock remains unchanged, less money is available for other goods and services, all other things being equal."
  My question is that if oil is used in the production of other goods and the price of oil goes up, shouldn't this increase the prices of other goods dependent on oil as an input? Or does the decrease in demand due to less money being available equal or outweigh the rise in the cost of a factor of production? Or does something else happen?
  

  Published: July 1, 2008 3:36 PM

• Joe Stoutenburg

  I'm a little surprised to not find our friend Mike Sproul here peddling his real bills doctrine (RBD). While not as devoted as he is, I'll offer my own RBD-lite theory:

  Writers here at mises.org tend to insist upon a relatively stable supply of money such as gold or silver (of course, even the supply of precious metals is not fixed -- but it's more predictable). They correctly point out that, for a fixed amount of goods, prices will be higher per unit of money if the supply of money increases. To them, increases to the money supply by any means other than the normal mining of gold or silver is to create money "out of thin air". While I am a strict advocate for the gold standard, I think that such language is inaccurate.

  Without going into the painful details, I'll explain it simply this way: Money may be backed by anything that we choose to back it with. There may be strong reasons to advocate a strict gold standard, but I can find no compelling reason for an Austrian economist to reject the ability of a bank and an individual to voluntarily contract to create (illustrating) $200,000 in new money in exchange for your home as collateral. Figuring out the value of the collateral is the tricky part. Such an arrangement works best if there is both financial convertibility (the IOU on the home) and physical convertibility (a certain amount of silver, for instance). If $200,000 of the bank notes are exchangeable for a certain amount of silver and the home may be exchanged for at least that much silver, then there is no reason to find the bank insolvent as long as it makes provisions for liquidity (supposing there is a run on the bank, it would be wise to stipulate in its contracts the ability to delay payment so that it could sell the IOU). There is also no reason to say that the money is created "out of thin air". The home is the backing. You have effectively monetized the home.

  Exercises could be followed to consider what would happen to the money in cases of default or in cases in which it is put to productive use. There is no question that in dollar terms, goods would cost more after the collateralization. But that simply reflects the increased demand of the home owner to obtain the goods. Under a strict gold standard, the new demand would have been seen not in price increases but in interest rate increases.

  Without a doubt, the arrangements I described are more complicated than a 100% gold standard. Don't take this as an endorsement of such a system. I'll also offer a disclaimer that I am not convinced that our banking system is so sound. Even if it has full backing (both financial and physical as Mr. Sproul claims), I think that the value of the collateral is questionable at best.

  What is egregious is that the majority of the assets held by the Federal Reserve are government bonds -- essentially promises to rob in the future. It is the taxation that ought to be condemned, not the absence of a gold standard. In like manner, the king who clipped the coins was guilty of fraud and violence (or at least its threat). Absent those elements, the mere act of clipping the coins was no crime. It could have been a voluntary exchange whereby the holders of the larger coins were paying for services rendered by the king.

  In any case, it is always violence and fraud that should be opposed. Absent those crimes, we should not criticize.

  Published: July 1, 2008 3:40 PM

• Joe Stoutenburg

  C. Evans:

  I was thinking about the same matter. Because oil is often a factor of production, its price and availability will certainly impact the quantity and price of other goods. To the extent that less oil becomes available, production may decrease. Inflation would then result not because the supply of money increased but because the same supply of money would be chasing a decreased amount of goods.

  Published: July 1, 2008 3:47 PM

• fundamentalist

  C. Evans: “My question is that if oil is used in the production of other goods and the price of oil goes up, shouldn't this increase the prices of other goods dependent on oil as an input? Or does the decrease in demand due to less money being available equal or outweigh the rise in the cost of a factor of production?”

  I think you answered your question. Higher oil prices do affect transportation costs of all goods, but the effect is much smaller than most economists think. And as you pointed out, a fixed supply of money means that consumers must take money from other areas in order to pay for higher fuel prices and that lowers demand for other goods.
  

  Published: July 1, 2008 4:19 PM

• fundamentalist

  Joe: "increases to the money supply by any means other than the normal mining of gold or silver is to create money "out of thin air".

  That's not quite accurate. Things besides gold and silver can be money. In the US, paper is money, but it's not the real problem. Checking account money is roughly 20 times the value of paper money in circulation. The checking account money that is in excess of the paper money is what was created out of thin air.

  Joe: "To the extent that less oil becomes available, production may decrease. Inflation would then result not because the supply of money increased but because the same supply of money would be chasing a decreased amount of goods."

  Good point. Price inflation will not result if the increase in the money supply matches the growth in production of goods. One way of describing the current increase in oil prices is to say that oil production slowed to a rate below the increase in the money supply.

  Published: July 1, 2008 4:31 PM

• Eric Spiess

  My question is not identical, but is along the lines of C. Evans...

  While I am persuaded that an increase in the supply of money (the true definition of inflation) can lead to a general increase in prices, I am wondering whether it is required.

  Suppose there is a "shock" to the oil market and the supply curve shifts up/left. The new equilibrium price will be higher and the quantity purchased will be lower, all else equal.

  Now, consider an individual consumer. His consumption of oil at the higher price will be lower. He will pay more for that unit of oil but it is possible that he will spend less of his income on oil overall (he'll get less bang for his buck so to speak, getting a smaller quantity at a higher price). Then, if he spends less on oil, and assuming he doesn't curtail his total consumption, he will have more money to spend on other goods and he will bid up the price of socks, movie tickets, etc. Thus, it seems that the supply shock in the oil market could lead to a higher price for oil AS WELL AS higher prices on other goods. Presumably, this could all happen without any increase in money.

  Any thoughts?

  Published: July 1, 2008 4:53 PM

• Brent

  C. Evans: “My question is that if oil is used in the production of other goods and the price of oil goes up, shouldn't this increase the prices of other goods dependent on oil as an input? Or does the decrease in demand due to less money being available equal or outweigh the rise in the cost of a factor of production?”

  The lower demand for other goods, assuming more money is spent on oil, leads to lower prices for "All Other Goods". It is true that an increased price for oil will lead to some goods increasing in price, but "on average" the price of other goods must go down.

  Published: July 1, 2008 5:56 PM

• Brent

  Eric Spiess,

  You question assumes that the supply of oil decreases. This is entirely possible and at least some of your observations logically follow from such a scenario, but it is not consistent with what we typically observe. In fact, the supply of oil has actually increased. See:

  http://mappingthefuture.csis.org/08oilconsumption.html

  Published: July 1, 2008 6:03 PM

• Duncan

  If an economy is going to grow but the money supply stay constant, will this not result in deflation as the same amount of money purchases a larger amount of goods? To have stable prices wouldn't the money supply, by mathematic proof, need to grow at the same rate as the production is growing?

  Can we conclude that inflation to match economic growth is a good thing?

  Thanks for the article, and I appreciate any enlightenment on the above.

  Published: July 1, 2008 6:07 PM

• Brent

  Duncan: "If an economy is going to grow but the money supply stay constant, will this not result in deflation as the same amount of money purchases a larger amount of goods? To have stable prices wouldn't the money supply, by mathematic proof, need to grow at the same rate as the production is growing?

  Can we conclude that inflation to match economic growth is a good thing?"

  This is the simple version of Milton Friedman's argument.

  The general response you'll find here is that price deflation is not a bad thing and, because of the manner in which the central bank inflates the money supply (the money goes to some people first, at the expense of everyone else), any such scheme is not economically efficient (for many of the same reasons that all wealth redistribution is inefficient).

  Published: July 1, 2008 6:14 PM

• C. Evans

  Brent:"The lower demand for other goods, assuming more money is spent on oil, leads to lower prices for "All Other Goods". It is true that an increased price for oil will lead to some goods increasing in price, but "on average" the price of other goods must go down."

  Thanks for your reply and to everyone else who helped guide my thinking on this question.
  

  Published: July 1, 2008 6:16 PM

• Joe

  Duncan:

  Why would falling prices be a bad thing? If capitalism is the great source of wealth creation that we all believe it to be, then it should work absent inflation. And it does. Prices should fall.

  Another interesting aspect of inflation is the link to wealth inequality that modern liberals are so concerned about.

  "Likewise, it is monetary inflation, and not increases in prices, that erodes the real incomes of pensioners and low-income earners. As a rule, they are the last receivers of money — often called the "fixed-income groups." "

  The rich get richer because they are the first receivers of new money and as such are the beneficiaries of inflation. If that is true, raising taxes on the rich will not solve the problem. In fact, I suspect it will make inequality worse. The only way to solve the inequality problem (and so many of our other economic problems) is to define properly and stop inflation. Great job Mr. Shostak!

  Published: July 1, 2008 6:40 PM

• Jonathan

  Thanks for the insightful article on the connection of Commodity Prices and the Inflation. I am a toddler when it comes to Austrian Economics, so seeing real world application of Austrian Theory is extremely helpful. The contrast with other economic schools of thought proved insightful:

  "Please note we don't say, as monetarists do, that the increase in the money supply causes inflation. What we are saying is that inflation is the increase in the money supply."

  I look forward to reading more of your articles.

  Published: July 1, 2008 7:20 PM

• Mike Sproul

  Frank Shostak:

  You present the quantity theory of money--the belief that more money causes higher prices--as if there were no other theory worth considering. You do not even mention the real bills doctrine, which states that the issue of new money is not inflationary, provided that the issuer acquires adequate additional backing for the money issued. The real bills doctrine has been logically and empirically supported, in preference to the quantity theory, by the research of Cunningham, Smith, Sargent, Calomiris, Bomberger, Makinen, and other reputable economists. This issue has been discussed on many Mises threads, and several readers, myself included, would like to see it addressed.

  Published: July 1, 2008 8:12 PM

• Frank Shostak

  Hi Mr Sproul,
  As far as I know the real bill doctrine was recently discussed by Austrian economists. If I am not mistaken by Robert Blumen and Sean Corrigan. If I will have the time I promise to provide my side of the story on this issue. With respect to your comment regarding my article all that I can suggest at this stage that in the present world of fiat standard printing money is always bad news.
  All the best,
  Frank Shostak

  Published: July 1, 2008 8:30 PM

• Mike Sproul

  Frank Shostak:

  "all that I can suggest at this stage that in the present world of fiat standard printing money is always bad news."

  If you do get time, and I hope you do, one point that needs to be addressed is the real bills claim that there is no such thing as fiat money.
  

  Published: July 1, 2008 9:43 PM

• hayesy

  "Low unemployment is inflationary since labor shortages leads to higher wages and higher prices!"

  Don't forget the politician's favourite canard, that tax cuts are "inflationary", and hence undesirable.

  Published: July 1, 2008 10:34 PM

• Robert C.

  When it comes to RBD, I don't really see what the problem is with the creation of money backed by securities, per se.

  The fact that our currency is backed by the "full faith and credit" in the Treasury's ability to tax people in the future (bonds) means that there need not be a physical asset. If we actually lived in a free market, people would be allowed to decide if that was sufficient credit with which to back a currency, and even if people believed in the Treasury's ability to raise enough money by later taxation, they still could reject the currency if they were uncomfortable with the moral implications.

  From here, the problem seems to lie more in the fact that we live in a society of legal tender laws in which a particular "brand" of currency (Federal Reserve Notes in the US) is forced upon the populace. Since all sellers are forced to accept these notes, their supply can be expanded ad infinitum without the threat of rejection. The fact that there are no physical assets directly backing these notes means that the supply can be expanded as quickly as is desired, but this is possible only because their legal tender status is what makes them non-rejectable.

  Again, I know little about RBD, and I'll be looking over Prof. Sproul's literature to expand on it. Given my current knowledge, however, I don't see what the problem is with RBD per se, since legal tender laws (the force that turns our FRB notes into "fiat money") are not necessarily implied by the doctrine.

  Published: July 2, 2008 2:47 AM

• Jonny

  Expectations matter in the extent they affect credit expansion.
  In the example Frank uses, there is no expansion of credit but take a contemporary example, expectations of house price increases. If people expect house price gains to outpace the cost of servicing the related debt, the consequence of these expectations will lead to house purchases, creating credit.. hey presto, no?

  Published: July 2, 2008 3:10 AM

• Miklos Hollender

  Some additional info:

  http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&width=1000&height=600&preserve_ratio=true&s[1][id]=BORROW

  Published: July 2, 2008 3:34 AM

• Miklos Hollender

  BTW I think the mainstream attaches a different meaning to the word inflation, than Austrians. The mainstream thinks inflation is the increase of the price of the "consumer basket" so if there would be a fixed money supply and bread and fuel and trousers are more expensive but loans and excavators cheaper, the mainstream would see it as inflation while Austrians would see as simply different preferences. Thus there is an implicit value judgement in the mainstream view: inflation is whatever hurts the "little guy".

  Published: July 2, 2008 3:40 AM

• flix

  Miklos,
  "bread and fuel and trousers are more expensive but loans and excavators cheaper"

  Totally agree. When did you hear anyone complain about "house price inflation" or "stock price inflation"?

  Published: July 2, 2008 4:33 AM

• flix

  Miklos,
  "bread and fuel and trousers are more expensive but loans and excavators cheaper"

  Totally agree. When did you hear anyone complain about "house price inflation" or "stock price inflation"?

  Published: July 2, 2008 4:35 AM

• DS

  "Isn't the money supply also affected by the deficit and the balance of payments deficit? It's amazing to me that
  no one at the Fed ever talks about all of this."

  In my mind these are minor pieces of the puzzle - effects as opposed to causes. While the budget deficit is the method the Fed uses to get more debt with which to inflate the currency, there is so much government debt already in circulation that a budget deficit is not required to create more money and credit.

  The "trade deficit" is a symptom, not a cause of excess money creation and inflation.

  My real problem with putting these issues front and ceter is that they divert attention from the real issues. For instance you could reduce the trade deficit by limiting trade and the budget deficit by raising taxes - both of which will actually make the situation worse, not better.

  I prefer to focus on the fundamental issue: fiat currency and it's devasting long term effects on the global economy.

  "If an economy is going to grow but the money supply stay constant, will this not result in deflation as the same amount of money purchases a larger amount of goods? To have stable prices wouldn't the money supply, by mathematic proof, need to grow at the same rate as the production is growing?

  Can we conclude that inflation to match economic growth is a good thing?"

  An economy that is experiencing REAL growth - increased productivity - SHOULD have price deflation and that is a good thing. In such an environment goods become more affordable to consumers and businesses make higher profits because input costs are also declining. The constant lowering of prices motivates businesses to continue to innovate to increase productivity, because failure to do so would result in decreasing profits. When the mirage of increasing profits through inflation is removed - if prices and costs go up by the same percentage nominal (though not real) profits go up - there is no real incentive for producers to increase productivity.

  Monetary inflation creates malinvestments, distortions and inequalities (for those Jacobites concerned with those things) in any economic environment. Forcing an increase in prices on an economy where the productive forces of capitalism are trying to lower prices through productivity is as disasterous as increasing the money supply into an environment where price inflation is 10% or 50% - the effects are just less obvious in the short run.

  Supposedly the 1920's and 1990's were times of productivity growth that SHOULD have lead to mild price deflation - a boon to mankind. Instead, the Fed in both cases looked at mild deflation as a curse to be avoided at all costs and inflated the money supply to keep consumer price inflation in the low single digits. The results are now plain to see, but few mainstream economists, especially one Ben Bernanke, are completely oblivious to this idea.

  Of course the Fed doesn;t actually exist for the purpose of keeping price inflation contained, stimulating economic growth, or providing a stable dollar. The Fed exits to maintain the profits of the banking cartel - the rest is jsut what they tell the politicians so that they won't take away their unique privilige.

  Published: July 2, 2008 6:40 AM

• Joe Stoutenburg

  fundamentalist:

  Things besides gold and silver can be money. In the US, paper is money, but it's not the real problem. Checking account money is roughly 20 times the value of paper money in circulation. The checking account money that is in excess of the paper money is what was created out of thin air.

  The point that I have conceded to Mike Sproul is that both the paper money and the checking account money may have backing. Typically, checking account money comes into existence via loans. When you build a new home and fund it by a loan of newly issued checking account dollars, I am saying that it is inaccurate to claim that those dollars were created "out of thin air". They are backed by the home. Similarly, if I understand correctly, the dollars at the Fed are also backed primarily by real assets represented by the wealth that may be acquired through taxation. The backing is real. The problem is that it is stolen.

  Again, I'll stress that I am not endorsing our banking system. Even ignoring the theft, I think that it is very challenging to keep track of the value of the collateral especially given the lack of physical convertibility. Mike downplays this, but I think that the link to a stable commodity would be key to giving objective value to the currency.

  Published: July 2, 2008 8:10 AM

• Michael A. Clem

  All in all, what bothers me the most about RBD is its lack of explanatory power. Austrian economics provides logical and reasonable explanations of money, inflation, the business cycle, interest, business productivity, and more. RBD doesn't seem to explain much of anything.
  
  Money may be backed by anything that we choose to back it with.
  
  I'll go you one step further, Joe. Money doesn't have to be backed by anything. The only thing that truly matters is that people accept money because other people accept money. The value of money is subjective, like any other commodity. Asset backing's main purpose is to control the amount of money issued by banks. As such, our current system of backing based on debt provides little or no controls.
  
  I agree that commodity backing is most likely the best form of backing, and in a true free market, would probably be the most likely choice of banks and consumers for currency stability. But I don't see that it's a necessary and essential requirement for the existence and workings of money. Gold and silver have simply been the customary historical standards for money.
  
  Last, but not least, I don't see how the backing of money really affects the value of money. It may provide a psychological comfort to consumers to "know" that the pieces of paper or credits in their account are "worth" so much in gold or other assets (assuming that it's true), but again, the real value of money comes not from its backing, but from the fact that other people are willing to accept them in exchange for goods and services. If Americans lose trust in the "full faith and credit" of the U.S. government, our Federal Reserve Notes will become as valueless as a piece of paper with Robert Mugabe's picture on it.
  

  Published: July 2, 2008 9:12 AM

• DS

  "I don't see how the backing of money really affects the value of money. It may provide a psychological comfort to consumers to "know" that the pieces of paper or credits in their account are "worth" so much in gold or other assets (assuming that it's true), but again, the real value of money comes not from its backing, but from the fact that other people are willing to accept them in exchange for goods and services."

  It's not psychological - gold (or some other valuable commodity) backing is not a psychological effect. When the dollar was backed by gold anybody could demand exchange of paper dollars for gold at any time - the issuer was contractually required to exchange a dollar for a fixed amount of gold - it was illegal for him not to (although the government has on numerous occaisions let issuers violate their contractual agreements when they get themselves into a bind). That meant that no matter how many paper dollars were printed and how much value they lost as a result you could still trade them in for a fixed amount of gold. This was not just a tremendous restraint on currency issue by banks it was an insurance policy that the currency you accepted from your employer or from other citizens in payment would hold its value regardless of the actions of banks (including the Fed) that you could not control.

  In contrast, today if the currency you hold depreciates due to over-issue you have no recourse. The only backing of the dollar is other depreciated dollars or treasury notes denomenated in the same depreciated dollars. Even if you choose to buy gold with your depreciated dollars the value is already lost - the gold just insures against further loss in the future.

  The result is that TODAY in a pure fiat currency world with no backing (or precisely the backing of the "full faith and credit" of the United States government) the value of a currency IS based on faith and nothing else - the faith that the government can take equally depreciated dollars from other citizens and give them to the holder on demand.

  That is not the case with REAL physical backing by a scarce commodity.

  Published: July 2, 2008 9:47 AM

• fundamentalist

  Joe: "The point that I have conceded to Mike Sproul is that both the paper money and the checking account money may have backing."

  I think some confusion is caused by the way the term "backing" is used. When RBD says money is backed by something, it means the loan has collateral. But when quantity theoryg (QT) talks about backing, they mean that paper money, or checking account money, has a one-to-one correspondence with something tangible. "Backing" as used by the QT limits the amount of money that can exist by what "backs" it. But "backing" as used by the RBD places no limit on the amount of money issued.

  Also, I think a distinction should be made between backing for money and for the loan. In fractional banking, FRB, and RBD, the backing is for the loan, not the money, technically. With 100% reserve banking, money issued from loans must come from reserves, which are the savings of depositors. So no money gets created; it's just exchanged. The RBD is just a justification for FRB, and in FRB, the bank is not limited to loaning out the savings of other people; it can create new money that never existed before and doesn't represent savings. That's why people call it created out of thin air. It's not derived from something else as were gold/silver certificates. Then that newly created money is exchanged for something of value, an IOU with the backing of collateral such as land.

  Published: July 2, 2008 11:32 AM

• fundamentalist

  For an educational comparison of Mr. Shostak's excellent article with the nonsense of mainstream econ, check out Jeffry Sach's article "Saving Resources to Save Growth" at project-syndicate.org/commentary/sachs142. He calls for state intervention in the marketplace world wide because of the following:

  "First, history has already shown how resource constraints can hinder global economic growth. After the upward jump in energy prices in 1973, annual global growth fell from roughly 5% between 1960 and 1973 to around 3% between 1973 and 1989.

  "Second, the world economy is vastly larger than in the past, so that demand for key commodities and energy inputs is also vastly larger.

  "Third, we have already used up many of the low-cost options that were once available. Low-cost oil is rapidly being depleted. The same is true for ground water. Land is also increasingly scarce.

  "Finally, our past technological triumphs did not actually conserve natural resources, but instead enabled humanity to mine and use these resources at a lower overall cost, thereby hastening their depletion. "
  

  Published: July 2, 2008 11:41 AM

• Joe Stoutenburg

  Michael Clem:

  All in all, what bothers me the most about RBD is its lack of explanatory power. Austrian economics provides logical and reasonable explanations of money, inflation, the business cycle, interest, business productivity, and more. RBD doesn't seem to explain much of anything.

  I haven't spent much time considering RBD to be frank. While the subject deserves more than what I could reasonably ask you to read in a blog comment, I'll give a shot at some of my initial thoughts.

  Money: I'm not sure exactly what you mean by wanting an explanation for money. I don't think that RBD and Austrian economics necessarily explain money differently. It's just that someone following Austrian thinking is likely to call for commodity backing while an RBD advocate is more likely to accept financial backing.

  Inflation: In my opinion, Mike Sproul has done himself no favor by adamantly denying that financial backing causes inflation. Relative to 100% commodity backing, prices in currency backed by an expanding base of financial assets will have higher prices per unit of currency. This follows from simple algebra - no economic theory is needed. The way I understand it, RBD claims though that as long as backing is adequate (very important later), the supply of money will match the level of production. So overall, on an absolute basis, there need not necessarily be inflation even though there is inflation relative to 100% commodity money.

  The business cycle: This is the interesting one. According to Austrian theory, the business cycle is caused by an increase of money that goes into projects that are not backed by actual capital. The boom spawned by the new projects is followed by a bust when the it is discovered that the projects are unrealizable for lack of capital.

  I think that RBD would claim that the business cycle is caused by inadequate backing. In theory, there would be no cycles as long as the backing was adequate. When you stop to think of it, even under a gold standard, a bank could print more dollars than it had gold to back it. A boom/bust cycle would ensue. The problem with financial backing, my opinion, is the greater difficulty to judge backing adequacy. I suspect also that there are strong psychological factors artificially inflating the value of collateral. For instance, a great deal of bank collateral is wrapped up in real estate. How dollars may be exchanged for property is entirely subjective. And in our mortgaged society, everyone has incentive to avoid admitting that the values we're assigning to our homes are out of line with other values. But until the bust, those values may be monetized and are to a great extent.

  I remain a gold standard advocate from a pragmatic standpoint.

  Interest: This one is also interesting though I haven't thought it out entirely. It's clear to me that in a 100% commodity currency, greater demand for loans will result in higher interest rates. When the currency is backed by financial assets, the demand for loans will result not in higher interest rates but in higher prices of the goods purchased with the new money. I believe that there is an inflation/interest rate trade-off here depending upon how you back the currency.

  Business productivity: I'm not sure that I understand what you mean by this. A few comments about the results of production levels are in order. Under a 100% commodity currency, increased productivity should result in lower prices generally. With financial backing, we may assume that many projects will be financed using prior production as collateral. If the projects are productive, price levels will tend to be stable. If they fail to produce, I think that the question of what happens is less clear. It seems that the currency base might just contract. Otherwise, inflation would certainly result.

  Conclusion: I'm sure that my analysis has not been completely thorough in every way. As I've said, I'm still thinking about this. I still do remain convinced that a 100% gold standard would be the best practice. However, I oppose first and foremost the practices of taxation and legal tender laws. Absent those crimes, monetary systems return to matters of preference.

  Published: July 2, 2008 11:50 AM

• fundamentalist

  Joe: "The way I understand it, RBD claims though that as long as backing is adequate (very important later), the supply of money will match the level of production. So overall, on an absolute basis, there need not necessarily be inflation even though there is inflation relative to 100% commodity money."

  Based on Mike's previous posts, I think he would say that the supply of money relative to the level of production is a concern for the QT, not the RBD. In the RBD, inflation results purely from banks making loans on poor collateral. The collateral for the loan (which is the backing for the money exchanged for the loan) loses value which caused the money loaned to lose value.

  Joe: "I think that RBD would claim that the business cycle is caused by inadequate backing. In theory, there would be no cycles as long as the backing was adequate."

  Based on previous posts from Mike, the RBD doesn't have an opinion on business cycles because they're not related to money. In this regard RBD is very similar to mainstream econ in that business cycles result from mysterious shocks that come from nowhere. RBD is concerned with providing adequate flows of money when businesses need it, such as during a boom or the Christmas rush, and reducing the money supply when business doesn't need it, such as during a bust. So the RBD would be procyclical and make the highs and lows of a business cycle higher and lower than they would be under a fixed money supply. But RBD isn't concerned with business cycles because it sees money as having no effect on inflation or the business cycle.

  Published: July 2, 2008 12:33 PM

• Joe Stoutenburg

  fundamentalist:

  I think some confusion is caused by the way the term "backing" is used. When RBD says money is backed by something, it means the loan has collateral. But when quantity theoryg (QT) talks about backing, they mean that paper money, or checking account money, has a one-to-one correspondence with something tangible. "Backing" as used by the QT limits the amount of money that can exist by what "backs" it. But "backing" as used by the RBD places no limit on the amount of money issued.

  I agree with everything you wrote. Financial backing places no practical limits on the amount of money that may be issued. In the absence of physical convertibility, a currency is furthermore dominated by the subjective valuations of the value of the collateral. That those valuations are made in terms of the currency being expanded leaves me wondering how we could ever truly keep track of the backing.

  I do disagree with one statement in your second paragraph:

  The RBD is just a justification for FRB, and in FRB, the bank is not limited to loaning out the savings of other people; it can create new money that never existed before and doesn't represent savings.

  First, allow me to offer a disclaimer. I have never been convinced that our banking system can even in principle claim to be fully backed. I am arguing for an abstraction (as are all of us - few people here, if any, will argue for the reality of current day banking).

  I don't think that you can categorically say that money backed by financial assets does not represent savings. If money is created through issuance of a mortage on your home, that money didn't come out of thin air. It was created through the monetization of a real asset that required actual savings and real capital to produce.

  The problem, of course, is in the subjective valuation of your home. You'll get no resistance from me that currency backed by a 100% commodity standard will be more objective and stable than one backed by financial assets. I am encouraging you to back off statements such as "out of thin air". I don't believe that they are accurate. Furthermore, they distract from the real sources of wealth transfers -- taxation and legal tender laws. I think that we would all be united in opposing those crimes. Once abolished, what sort of backing we allow for our money may be matters of preference. At that point, I'll certainly recommend that financial backing is much more prone to fraud. However, it is benign in itself.

  Published: July 2, 2008 12:56 PM

• Joe Stoutenburg

  I'm sure that Mike and I don't agree on alot. That's why I initially called my ideas "RBD-lite". Since then, I've usually tried to make distinctions between physical and financial convertibility rather than appealing to RBD as any appeal to dogma.

  Mike has gotten me thinking simply that money backed by financial assets may be legitimate (meaning the result of voluntary exchanges). Whether it is wise is another question.

  fundamentalist: Based on previous posts from Mike, the RBD doesn't have an opinion on business cycles because they're not related to money.

  If so, I disagree with RBD. In this, I probably remain more Austrian. But RBD has prompted me to change my stance somewhat. Previously in my mind, business cycles were caused by any changes to the money supply. What was needed to avert them was stable money. Now, I am claiming that they are caused by unbacked money. I've already proposed that money may be unbacked in a gold standard by banks fraudulently printing more money than what may be backed by their gold. I also concede that a system of full financial convertibility will be hard pressed to objectively keep track of the value of its collateral. I could approve of a system of mixed convertibility in which (for example) your home, a certain number of dollars and a certain amount of gold are all interchangeable. In such a system, I do not have a fundamental problem if new dollars are printed with your home as backing.

  Published: July 2, 2008 1:22 PM

• Joe Stoutenburg

  I'm sure that Mike and I don't agree on alot. That's why I initially called my ideas "RBD-lite". Since then, I've usually tried to make distinctions between physical and financial convertibility rather than appealing to RBD as any appeal to dogma.

  Mike has gotten me thinking simply that money backed by financial assets may be legitimate (meaning the result of voluntary exchanges). Whether it is wise is another question.

  fundamentalist: Based on previous posts from Mike, the RBD doesn't have an opinion on business cycles because they're not related to money.

  If so, I disagree with RBD. In this, I probably remain more Austrian. But RBD has prompted me to change my stance somewhat. Previously in my mind, business cycles were caused by any changes to the money supply. What was needed to avert them was stable money. Now, I am claiming that they are caused by unbacked money. I've already proposed that money may be unbacked in a gold standard by banks fraudulently printing more money than what may be backed by their gold. I also concede that a system of full financial convertibility will be hard pressed to objectively keep track of the value of its collateral. I could approve of a system of mixed convertibility in which (for example) your home, a certain number of dollars and a certain amount of gold are all interchangeable. In such a system, I do not have a fundamental problem if new dollars are printed with your home as backing.

  Published: July 2, 2008 1:26 PM

• Joe Stoutenburg

  Sorry about the double post - not sure how that happened...

  Published: July 2, 2008 1:29 PM

• Michael A. Clem

  Here's a fundamental question: Austrians generally agree that most any amount of currency will work (within reasonable divisibility limits), and the problems are related to the changes in currency, usually inflation (increases in the money supply). RBD seems to say that changing the money supply has no effect on pricing, as long as the backing or collateral stays in lock-step with those changes.
  
  Obviously, if you have a certain ratio of money to commodities, and they change to the same degree, the ratio hasn't changed, and prices are stable. But as has been noted, Austrian inflation has still occurred (or deflation, in cases of reducing the money supply), because normally, increased productivity should be a boon to consumers that results in lower prices. RBD thus seems to be aimed towards stable prices, and not towards "accurate" prices.
  
  RBD cannot deny that absolute changes to the money supply have occurred, no matter how solid the backing asset is. So the question is which is more important: absolute changes to the money supply, or the ratio of money to commodities?

  Published: July 2, 2008 2:01 PM

• fundamentalist

  Michael: "RBD thus seems to be aimed towards stable prices, and not towards "accurate" prices."

  I don't want to pretend to be an expert on RBD. All I know is what I've read from Mike's posts. Based on that, I think it's not quite accurate to say that RBD aims at stable prices because RBD sees almost no connection between money and prices, except in the rare occasion when the value of the asset "backing" money falls. RBD sees many other things as being more important in determining prices with money having the least, almost insignificant, role. The goal of RBD appears to be nothing more than to guarantee the supply of loanable funds when businessmen request them. Of course, the businesses should be sound and they should provide sound collateral. In that way, interest rates would never rise to choke off a boom. In addition, when the inevitable bust happens, then the money supply automatically contracts. If anything, I would say the RBD aims for steady, low interest rates.

  Michael: "So the question is which is more important: absolute changes to the money supply, or the ratio of money to commodities?"

  According to Austrian theory, the absolute changes are the most important because they cause the business cycle, in which there is a great amount of wasted wealth, and absolute changes increase inequality by transferring wealth from late to early receivers of the new money.

  Published: July 2, 2008 2:36 PM

• Joe Stoutenburg

  I challenge the idea that wealth transfers occur simply because the money supply increases. Allow me to illustrate by the following scenarios. In each, suppose that you wish to acquire $50,000 and own a home worth at least $200,000.

  1) You request a loan and receive gold (or claims to gold) worth $50,000. Whether or not you post your home as security on repaying the loan is immaterial to the outcomes though it will certainly impact the interest rate you pay.

  2) You request a loan and receive $50,000 of newly created money. You place a lien upon your home to back it.

  3) You request a loan and receive $50,000 of new money. The only security on that loan is an IOU on your future income based upon your fine credit.

  4) You steal $50,000 worth of assets.

  5) You request and receive a $50,000 grant from the government.

  I began to provide my own outcomes but would not be able to finish until tomorrow. Rather than leaving this half finished, I think that I'll allow any interested readers to comment on which cases involve wealth transfers. We can use 1) as the base case in which we all will certainly agree that no wealth transfer has occured. In order to prove a wealth transfer, you must demonstrate how you would be better off than pursuing 1).

  Published: July 2, 2008 4:01 PM

• jp

  Joe said:
  "I don't think that you can categorically say that money backed by financial assets does not represent savings. If money is created through issuance of a mortage on your home, that money didn't come out of thin air. It was created through the monetization of a real asset that required actual savings and real capital to produce."

  I agree with that. Same with a new chequing account created with IBM shares as collateral. Those IBM shares had to come from savings at some point. And if the shares are already standing as collateral for another loan, no bank would accept them for a new loan. So even with FRB the amount of chequing account dollars is limited by the pool of prior savings, whatever collateralizable form these savings may take.

  Poor standards for collateralization cause booms and bust. Government monopolies ie. central banks are protected from competition, allowing standards to deteriorate. Banking guarantees such as FDIC help relax standards even more by engendering moral hazard. As long as their is no banking monopoly and banks try to maximize profits, collateralization standards should stay strong.

  It seems to me that the whole "money out of thin air" meme is a useful expository tool used by Austrians to convert those new to economics to the Austrian fold. After all, when you first hear about a group that can create money from nothing you can't help but be a bit angry, given the fact that everyone else has to work for their cash. But once you spend some time reading Mike and looking underneath the hood of banking it's hard to continue supporting the "out of thin air" critique. I'd encourage people to back off it too.

  Published: July 2, 2008 4:03 PM

• fundamentalist

  Mike’s use of the term “backing” has got some of you confused about money creation. So let’s look at the real economy without money. Suppose a construction company needed potatoes to feed its crew until they finished a building and got paid. The company owner can put up his equipment as collateral for the loan. There are no banks because there is no money, but what would be equivalent to a bank? A food storage company. Potato farmers who grew more potatoes than they consumed put their excess potatoes (their savings) in the storage facility for sale later. The construction company owner might be able to go to the storage facility and borrow potatoes to feed his crew in exchange for returning an equivalent amount of potatoes later plus extra potatoes as interest.

  This scenario is roughly equivalent to 100% reserve banking. But suppose that the storage facility held just 100 lbs of potatoes when the contractor needs 200 lbs.? In the real world, the contractor is out of luck. He will have to settle for 100 lbs of potatoes. In the case of 100% reserve banking, borrowers are limited to the actual savings out of production of other people. This is the part of Austrian monetary theory that RBD objects to. It says that loans should not be limited to savings.

  Now in the FRB/RBD world, the storage facility isn’t limited to loaning out the 100 lbs of potatoes that it keeps in reserve. It has a machine that can create food like those replicators on Star Trek. So the storage guys replicate 100 lbs of potatoes to add to the 100 lbs. in storage and make the loan to the contractor.

  As you can see, both scenarios have the loans backed by the collateral of the construction equipment. But in the FRB/RBD world, potatoes are loaned that didn’t come from savings. They were created out of thin air. The case is the same if you add money to the scenario. The money is created out of thin air because it didn’t exist in the bank’s vault before the loan was made. The new money is created at the conclusion of the loan; it did not exist before the loan transaction was completed.
  

  Published: July 2, 2008 4:30 PM

• Michael A. Clem

  Okay, I agree that #1 is not a wealth transfer, assuming that the $50,000 (or gold) was from the bank's deposits. I think we can also safely assume that #4 and #5 are wealth transfers. Theft involves taking something from someone against their will and providing nothing in exchange. Likewise, for #5, the government takes money in the form of taxes and then redistributed it in the $50,000 grant. The grantee may pay taxes, but his share of the $50,000 that he paid in is going to be so small as to be insignificant.
  
  But as for #2 and #3, in both cases, new money has been created, increasing the money supply. The receiver of the loan has money that didn't exist before to bid up prices in whatever industries he spends the money on. In #5, wealth was transferred from taxpayers to the receiver. In 2 and 3, wealth was transferred from everyone who uses the currency to those who receive the new currency, until the prices are readjusted to account for the new currency.
  True, $50,000 is pretty small when compared to the trillions of dollars already in circulation, but that just means the wealth transfer was proportionally smaller, than, say, #4, where the victim of the thief bears the entire loss of $50,000, or even #5, where, while there are many taxpayers, they are still fewer than the total number of people using the currency.
  
  Whether or not some collateral was put up is irrelevant to the fact that new money was created, although if the receiver is unable to pay back the loan, the bank may end up the big winner instead of the receiver--the bank may get a home for the cost of printing the currency, instead of just receiving the interest on the loan.
  
  You may want to say that the receiver is no better off than he would be in #1, since he received the same amount of money, but this ignores a simple fact: if the bank had to loan him the money from deposits instead of creating new money, would they have been able to? Receiving the loan from newly created money makes him better off than not receiving the loan because the bank can't cover it. And the bank is certainly better off, even if he doesn't default on the loan.
  

  Published: July 2, 2008 4:58 PM

• DS

  "Same with a new chequing account created with IBM shares as collateral. Those IBM shares had to come from savings at some point. "

  Really? Do 100% of the value of those shares represent real savings or only some fraction?

  That's the problem with fractional reserve banking - even if it's based on gold only a portion of it represents real wealth, the rest of it is out of thin air. The fact that the "real" portion once came from savings doesn't stop the whole amount from being used as collateral to pyramid even more money creation on top.

  Is it really fundametally different to say that money is created "mostly" out of thin air versus "entirely" out of thin air?

  "So even with FRB the amount of chequing account dollars is limited by the pool of prior savings, whatever collateralizable form these savings may take. "

  The fact that some portion of the value at the bottom of the pyramid represents real savings doesn't really make much difference - it's like being somewhat pregnant.

  Monetizing assets that were not previously monetized is creating money by it's very definition, and it IS inflationary. So is digging gold out of the ground. The difference is that there is a finite rate at which new gold can be found. There is very little limit to the amount of assets that can be collateralized - government bonds can be created at extremely high rates, though not infinite. The limit is the point where creation of government debt as collateral and the money it spawns causes the system to collapse. This is a minor distinction and the technicality that I believe RBD uses to claim that there is no such thing as fiat currency. Austrian Business Cycle theory explains this point succinctly.

  Published: July 2, 2008 5:28 PM

• Alex

  Fundamentalist: In your potato storage and potato lending example, farmers X, Y and Z deposit their 100 potatoes with the storage facility. At that point, the storage facility is operating on a 100% reserve system. However, when the storage operator lends the 100 potatoes to the contractor for his I.O.U., the storage facility has zero potatoes left in reserve for X, Y and Z, who may now want their potatoes back. In what sense then do you regard this as a 100% reserve system.

  Published: July 2, 2008 5:42 PM

• fundamentalist

  Alex: "In what sense then do you regard this as a 100% reserve system."

  That's a good point. For the system to involve 100% reserves, the farmers who stored their potatoes would have to agree to give up use of the potatoes for a certain period of time. Fractional potatoe storage would result if the farmers withdrew potatoes as they needed them while the storage facility was lending most of them out at interest. In that case, both the farmers and the borrowers would have claim to the same potatoes.

  Published: July 2, 2008 8:06 PM

• jimc

  Joe's five cases above illustrate how RBD (and FRB for that matter) hinges on semantic confusion between real money (a commodity generally accepted as a medium of exchange), money substitutes (accounting claims on a physically specified quantity of real money), and shares of ownership in some other real good. Cases 2 and 3 are wealth tranfers (and inflationary) because (fraudulent) claims to real money, which are actually claims to something else, are created without a corresponding increase in the stock of the actual commodity money.

  While savings can take many physical forms, only that form which constitutes the actual physical commodity that is generally accepted in exchange transaction is in fact money. Calling a house "money" does not make it money, any more than calling a calling a cat a "dog" makes it a dog. A claim to a share of ownership in a house (or the future income of the borrower) is not the same as a claim to a specified quantity of real money. Anyone ever tried buying groceries by offering the clerk shares to your house? Of course not, but the clerk will accept a note that is indistinguishable from a claim to real money (despite the fact that it is actully a claim on some other good). Sellers who accept the new (fraudulent) notes from the borrower in exchange for real goods are decieved by the borrower and the lender into believing that they represent claims to real money as opposed to claims to a share of the house.

  In both cases 2 and 3, the supply of circulating claims to money is increased without a corresponding increase in the supply of real commodity money (inflation) and wealth is redistributed toward the point of origin of the new, fraudulent notes. All of this is made possible by confusion on the part of market participants between money, money substitutes, and the fake notes which the issuers claim to be something they are not.

  If the new notes were printed and issued in good faith (cleary stating that they not claims to money but to some other good) market participants would shun them in favor of claims to real money for the reasons Mises describes in his theory of the origin of money. In the case where the issuance and acceptance of notes that are claims to goods other than money as if they were money is condoned and enforced by government we see that what we essentially have is a return to barter, and it becomes clear that RBD/FRB is really an attack on one of the key foundations of the market society.

  Published: July 3, 2008 8:50 AM

• Joe Stoutenburg

  fundamentalist:

  Here's a counter example. Let's suppose that the construction company needs 100 lbs of potatoes to feed its workers. Assume further that this is an economy in which gold is used as money. The construction company currently lacks enough money to pay for the potatoes. However, the owner is able to convince the potato farmer to accept in exchange the promise to do some minor construction work on the farmer's property in exchange for the potatoes.

  Is there anything objectionable in this arrangement?

  Now, suppose that we introduce a banking intermediary. Instead of transacting by barter, the construction company goes to a bank. While it is short on cash, it is able to convince the bank that its future prospects are good. The bank issues new money in exchange for an IOU to repay the loan plus interest. The construction company uses this new money to purchase the potatoes. The farmer then pays the money to the construction company in exchange for the work he wanted done on his farm. The construction company pays the loan back. Along with the principal, it must produce enough additional money (gold or an equivalent) to pay the interest. Having repaid the loan, the IOU is gone. In order to remain solvent, the bank must take the now unbacked money out of circulation. It keeps the interest as its compensation for doing business.

  Replace the new money with an actual gold reserve, and the exchanges are the same. The amount of money the bank has earned is also the same.

  You might now wonder what will happen if the construction company defaults on its loan. Its IOU will have been found to be worthless. However, no money was returned to the bank for it to destroy. In order to remain solvent, it must take gold out of its own earnings to back the money that it put into circulation. If you follow through the chain of events under a 100% gold standard, you'll find that every immediate participant is in the same position. No wealth transfer has been made at least for those immediately involved.

  Being the good economists that we are, we should now turn our attention to the broader picture. I don't have the time to continue my thought experiment at the moment. But the question that I leave for all of you to ponder is what happens in each case to the broader economy. My hypothesis is that there is a trade-off between inflation and interest rates. When new money is created, prices will rise upon default. That is generally okay because there is more money in circulation now to follow the higher prices. The people hurt are the ones holding the empty bag after default. When existing money is loaned, prices won't rise upon default. But I think that banks may tend to raise their rates to compensate for their losses. Again, this isn't well thought-out, and I welcome commentary.

  Published: July 3, 2008 9:01 AM

• fundamentalist

  Joe: “Replace the new money with an actual gold reserve, and the exchanges are the same.”

  Adding money to the scenario doesn’t change the situation; it just makes it more complex. In my scenario I kept money out in order to show that the storage company would have to “replicate” potatoes in order to make the loan to the contractor. When you add money, whether gold or paper, the bank still must “replicate” it in order to make the loan to the contractor.

  Actually, the exchanges can’t be the same. You wrote that “The bank issues new money in exchange for an IOU…” This is an example of “replication” of potatoes. Money that did not exist before the transaction exists after it. So the money supply increases and sets in motion the business cycle boom and bust.

  Joe: “However, no money was returned to the bank for it to destroy….No wealth transfer has been made at least for those immediately involved.”

  However, if the contractor defaults on his IOU, the bank then gets his collateral, so the bank is better off; it exchanged money that it created from nothing for real property. But that’s not where Austrian econ places the transfer of wealth. It happens when the monetary inflation causes price inflation. The rise in wealth of the financial sector of the past decade is a good example. When the Feds lower interest rates, hedge funds and investment banks are among the first to borrow. They invest in assets, such as housing, before prices rise. It takes 12-18 months for new money to affect prices. After prices have risen, they sell those assets for a considerble profit. Wage earners, particularly in retail, receive the new money last, after prices have risen. They purchase assets (such as houses) from those who received the new money first. So the transfer of wealth takes place after prices have risen and goes from the late receivers of money to the early receivers.
  

  Published: July 3, 2008 9:36 AM

• newson

  jp says:
  "Poor standards for collateralization cause booms and bust."

  that glosses over the most important weakness with rbd - that the very collateralization of a particular asset causes a price bubble in that very same asset.
  the ascent of prices sucks in more and more punters, until the market is saturated, and then the bankruptcy of the marginal players drags down even the more conservative players. many deals that appeared relatively sane in the nasdaq mania turned out to be duds when the bubble popped.

  besides, mike has been unable to explain the existence of legal tender laws in all countries. indeed these would be superfluous if fiat money did not exist, as he posits.

  Published: July 3, 2008 9:50 AM

• Michael A. Clem

  The bank issues new money in exchange for an IOU to repay the loan plus interest.
  
  Once again, it doesn't matter what the collateral is, the simple fact is that new money has been issued. This is inflationary, per Austrian econ. Now, here's the fun part. If we replace the IOU with gold, that is, the bank is creating new money to buy gold, we STILL have new money, and thus, Austrian inflation. The only real difference is that the gold can't be created on demand ("with the stroke of a pen" or a computer entry) whenever the bank wants to create new money--it has to be mined and available. Thus, commodity banking (with 100% reserves) provides strong limits on inflation and the creation of new money in a way that debt-backed money cannot.
  
  No wealth transfer has been made at least for those immediately involved.
  
  But a wealth transfer did occur. The bank is earning interest on money that didn't exist before, as well as the fact that the people getting the new money can now use it to bid up prices, something that couldn't be done without the newly created money. The proof is in the fact that if the borrower defaults the bank has to scramble to cover the losses--it's a shell game. The bank is "floating" the new money, just like a person writing a hot check hopes to cover it with his next paycheck before it hits the bank. Everything seems fine as long as nothing goes wrong, but purchases have still been made with money that didn't really exist, purchases that couldn't have been made otherwise.

  Published: July 3, 2008 10:09 AM

• Joe Stoutenburg

  fundamentalist:

  Actually, the exchanges can’t be the same.

  Go back and read my narrative carefully. When all obligations are honored, the following exchanges are made:

  1) The construction company receives the potatoes.

  2) The farmer gets the construction work done.

  3) Except in the case of straight barter, the bank earns interest.

  Whether existing gold reserves are used or new money is issued, after all transactions are completed (including repayment of the loan and cancelling of the IOU), the money supply is the same as it was originally. The money supply may only increase without bound if the new production (for instance, the improvements on the farmers property) are then mortgaged for new money. I stress that this is true only when all obligations are honored and no fraud is committed by either the bank or by borrowers.

  I arrive at these conclusions by simple applications of logic. We really can't proceed until we reach agreement on this.

  Obviously, matters are complicated when one or more of the following occurs:

  1) Default

  2) Intentional fraud by the bank

  3) Introduction of legal tender laws

  4) Violence or coercion forcing collateral to be posted

  We can proceed on these points after we get agreement on the base case.

  Published: July 3, 2008 11:40 AM

• Mike Sproul

  Newson:
  "the most important weakness with rbd - that the very collateralization of a particular asset causes a price bubble in that very same asset."

  I don't think you'd make that claim if all paper dollars were physically convertible into 1 oz. of silver, and backed by assets worth at least 1 oz. of silver. If the issue of new dollars did cause the market value of the dollar to fall to .99 oz., then the superfluous dollars would simply reflux to the bank to be exchanged for 1 oz., so the value of the dollar never could fall below 1 oz. I wonder if you'd admit to the validity of the RBD in this simple case, because it's a short step to admitting its validity for our so-called 'fiat' system.

  "esides, mike has been unable to explain the existence of legal tender laws in all countries. indeed these would be superfluous if fiat money did not exist, as he posits."

  What's to explain? If 'legal tender' means that the government is obligated to accept paper dollars for taxes, then the government is using taxes to back dollars. If it means that private traders are obligated to accept dollars, then the government is using traders' weath to back dollars (a form of robbery). But in most cases, legal tender laws are meaningless. People in Mexico, for example, can insist on being paid in dollars, regardless of any legal tender inscriptions that might be printed on the paper peso.

  Published: July 3, 2008 11:47 AM

• fundamentalist

  Joe: "We can proceed on these points after we get agreement on the base case."

  I'll agree that the money supply ends up the same after the loans have been paid in each scenario. But the devil is in what happens in between taking out the loan and paying it back. The money supply increases when the bank creates new money, but not when reserves are used to supply the contractor with money. Then when the contractor pays back the loan, the money supply contracts back to the original level (ignoring interest) with the new money scenario. But the money supply is not affected when gold/reserves are repaid; they just return to the bank.

  Now if you apply the new money creation scenario to the whole economy, you have the business cycle. It's true that the money supply returns to a level close to what is was before the money creation, but a lot of time has passed during which the business cycle took place.

  It's true that a version of the RBD insists on making short term loans so that the period of money creation doesn't have time to initiate the business cycle. But that ignores the fungible nature of money. Short term loans may do nothing but free up internal funds of companies for them to use in long term projects. In that way, even short-term money creation/destruction via the RBD can cause the business cycle.

  Published: July 3, 2008 12:24 PM

• jp

  "If we replace the IOU with gold, that is, the bank is creating new money to buy gold, we STILL have new money, and thus, Austrian inflation. The only real difference is that the gold can't be created on demand ("with the stroke of a pen" or a computer entry) whenever the bank wants to create new money--it has to be mined and available."

  Wait a moment. If gold is the only money in circulation, and then banks start to issue 1 oz reedemable money certificates (IOUs) for 1 oz gold, eventually replacing all the gold in circulation with money certificates, than no Austrian inflation is occurring. Its a 1 for 1 trade.

  Money depreciation only occurs when more gold is mined, this increased supply pushing down the value of gold and therefore the value of the certificates. But the actual creation of certificates, as long as it is done on a one to one basis and reedemable, doesn't cause any problems.

  "that glosses over the most important weakness with rbd - that the very collateralization of a particular asset causes a price bubble in that very same asset."

  Not if it is done at market prices and interest rates. If a bank provides financing to a home owner based on the same price that the owner could sell it on the open market, then there will be no mass movement to collateralize houses.

  Only when government institutions like the Fed, Fannie Mae and Freddie Mac get involved do interest rates get out of whack and collateralization standards deteriorate. People who normally wouldn't be able buy a house suddenly find themselves capable of getting a mortgage. Enough of them and house prices will start to rise. This is a clearly a case of the very collateralization of an asset causing a bubble in the same asset.

  To further show why collateralization of a particular asset needn't cause a price bubble, take a bank that starts to collateralize assets but does so too stringently. Say it provides loans on bicyles as security at 25% of their value, charging 100% interest per annum. That doesn't mean a bubble is going to start in the collateralizable asset; bicycles. Who would take a loan on such poor terms? The point of this extreme example is that the introduction of collateralization does not necessarily cause asset bubbles. Only bad collateralization does.

  "Monetizing assets that were not previously monetized is creating money by it's very definition, and it IS inflationary. So is digging gold out of the ground. The difference is that there is a finite rate at which new gold can be found."

  There is also a finite rate at which land can be pledged as collateral for loans. An untouched piece of land homesteaded by a new owner is worth little and can only stand as collateral for a small loan, if at all.

  As the owner invests in their property by foregoing consumption and thereby saving, the land is improved. Buildings are added, a few fields, maybe a road. All through the owner's sweat and blood. The property can now stand as collateral for a larger loan since it is more valuable. But this only comes about through the owner's foregoing of consumption. This is done at a finite rate, much like gold mining.

  Stocks and bonds are the same. The owner of those securities had to forego consumption to buy them.

  Published: July 3, 2008 2:27 PM

• DS

  "But the devil is in what happens in between taking out the loan and paying it back."

  Exactly - just because a loan will be paid back in the future doesn't mean that there is no net money created (inflation), just the chance that it may be contracted at some later date. But that's a very simplistic view anyway because:

  "Then when the contractor pays back the loan, the money supply contracts back to the original level (ignoring interest) with the new money scenario."

  That's true for an individual loan, but as soon as the bank lends those re-paid funds back out the money suppply increases again. The bank's portfolio of loans will be large enough that the effect will be negligible. The overall money supply will increase by the amount of net loans outstanding.

  Banks make money by collecting interest on loaned funds. Their revenue would disappear if each principal repayment on their outstanding loans were put in the vault (or more precisely disappear into thin air, because that was how it was created in the first place). Being re-paid is the worst thing that could happen to a bank because 1) their interest revenue is gone and 2) they have to spend effort (money) trying to find somebody else to loan those funds to in order to start up the revenue stream. The best thing that could happen to a bank is a client who is perpetually in debt but is solvent enough to make interest payments, but not pay any principal. If that sounds like credit cards, interest only mortgages and perpetual government debt (last paid off in 1836) then you're starting to understand how the game works.

  The moral of the story is that no bank would ever voluntarily behave in a way that would shrink the money supply in the manner that the RBD theorizes - although sometimes they have that situation forced upon them. The RBD explanation falls apart in light of how banks actually work.

  But we've had these discussions before on this site, over and over......

  Published: July 3, 2008 2:59 PM

• Mike Sproul

  It's clear that making a loan creates money, and paying back the loan retires money. What matters is that the assets of the lender move in step with the amount of money created. More money, more assets. Less money, less assets. The amount of assets per unit of money is the same throughout, so the value of money is unaffected.

  There is also the matter of the Law of the Reflux: If some bank creates 50 new dollars, and as a result, 50 existing dollars reflux to their issuer, there is no increase in the money supply.

  Published: July 3, 2008 3:10 PM

• Michael A. Clem

  If gold is the only money in circulation, and then banks start to issue 1 oz reedemable money certificates (IOUs) for 1 oz gold, eventually replacing all the gold in circulation with money certificates, than no Austrian inflation is occurring. Its a 1 for 1 trade.
  
  True, IF gold is the money in circulation. I didn't see that the scenario was supposed to be that limiting. If gold is simply the backing asset, though, and the certificate itself is the money, then creating new money to buy gold causes inflation.
  

  Published: July 3, 2008 3:14 PM

• gene berman

  Kevin T:

  You've asked a perfectly straightforward question; I'm very surprised that not a single one of the knowledgeable Misesians has jumped forward to explain what seems to you a discrepancy.

  Though it is true that the entry of previously-saved money into the general pool of money utilized for the purchase of goods has the effect of damping or retarding the rise in the prices of goods and services, this is not a process that in any way changes the picture (already painted).

  The price structure (or what might be called "the data of the market") at any given time determines precisely how people will use whatever money they possess, including how much they will save and in what form. (The word "save" is commonly used to cover a multiplicity, including investments in securities, time deposits (CDs), savings accounts, and even cash under the mattress.). You could, if you wished, even view any of these forms of saving as "spending" of a special type--just a different method of achieving what one wants with what one's got.

  In other words, in the absence of monetary inflation, the decision (by some or all) to spend part (or all) of what they've saved will affect the prices of virtually everything else in the market; on that, you've seen correctly. But, if you include "savings" in the general price level (as should be done), no increase in the general price level will have taken place. Folks will merely have rearranged how they've chosen to use whatever they've got.

  It should also be borne in mind that, in the first place, the "lowness" of the general level of consumer prices is, in part, directly due to the fact that some have chosen to save rather than to buy something else. Further, this description is somewhat simplified: those who had formerly had money saved in bank accounts and CDs will have already enabled (through the magic of the fractional reserve system) other to borrow some multiple of that amount, which will be spent on many things tending to raise the level of other prices; conversely, when they withdraw and spend those funds, they will have reduced the "reserve" necessary to support that former spending level. But even if everyone kept their savings under the mattress (referred to as "hoarding") and then spent it into the economy, no "inflation" would have taken place--the rise in the level of prices in general is directly offset by the reduction which has taken place in the amount spent on "saving." This is one of the chiefest of the evils of the system of never-ending inflation: it makes saving far less attractive because it virtually assure the saver that, in terms of goods and services, his money will NEVER be as well-spent as RIGHT NOW. Whatever the normal propensity to save, doing so will make progressively less sense as inflation proceeds.

  Under conditions such that there is no increase in the quantity of money (or even only a very slight change in either direction), the prevailing tendency is for the prices of goods and services to decrease, due to two factors. One is that, whatever the savings rate, a certain amount of those savings will be lent (or invested) in industries intent on increasing the "roundaboutness" of their productive processes--lengthening the period necessary for realizing the end-product, whose aim is the reduction of cost per unit, which in most cases is translated into a similar reduction in price (the intention being to achieve competitive edge by such efficiency and reap a larger unit profit at the same price to the same-sized market or to enlarge the market or the market share at some lower price and, in so doing, to enlarge net profits to the degree that the increase in net represents satisfactory return on investment for whatever's been sunk on the cost of the newer equipment or processes.

  The problem with inflation is that it's never a single or occasional iteration, as would be the case with an instance of counterfeiting. The inflation always has a goal--the achievment of a "good" level of general business activity, production, employment, and savings. This can be achieved but the rise in the fortunes of some will be directly offset by the misfortune of those further from the source at which the money is introduced: as a very general matter, all those on fixed incomes whose purchasing power is reduced; technically this will include even employees of the government--their automatic raises (other than cost-of living adjustments) will be nullified. Only continued introduction of new money will even suffice to keep the former beneficiaries at their previous level (of purchasing power) and the rate of the introduction will have to be at some multiple of the old rate to have even the effect of "maintenance." In other words, if the rate of inflation has been at 2% for a year, the rate in the second year will need to be 2% higher than 2% and so on--each succeeding year. The advantage that accrues to those first to receive is that they're spending into a price structure not yet adjusted and, therefore, tricking those further from the source. But these aren't fooled for long and soon demand adjustments (COLA), which means that those without the COLAs are cheated even worse and, since there are now fewer people being deprived to the advantage of others, the pressure to increase the rate of money-creation is yet increased even more than the simplistic arithmetic I suggested immediately previous. At some point, the only alternative to hyperinflation (runaway inflation) is to surrender to recession.

  The US (and the entire world) has been very fortunate over the last 40 years or so. The most amazing development, a before-unheard-of increase in human productivity due to the fortuitous, combined advent of computers, component miniaturization, and communications (internet, telephony, D-photo) has allowed us to keep ahead of the reckoning and even become somewhat better off. No lesson has been learned. There's an old saying about it being impossible to design something that a fool cannot screw up. I'm afraid we're going to learn that "the hard way" but the survivors won't be any smarter because they won't understand what made them fools in the first place.

  I hope that gives you a clearer insight, Kevin. But reading Mises is much better; you won't even be able to think of a question of a question that's not answered fully--and then some. You owe it to yourself.

  Published: July 3, 2008 3:16 PM

• newson

  jp says:
  "Only when government institutions like the Fed, Fannie Mae and Freddie Mac get involved do interest rates get out of whack and collateralization standards deteriorate."

  central banks only convert isolated bank runs into systemic crises. the boom bust cycle did not start with central banks. the latter have changed the cycle by making it less frequent, but of greater amplitude. the dynamics remain the same. central banks only came into being on the back of public distaste for bank collapses.

  whilst there is a finite amount of land available in the us for collateralization, this is an irrelevant argument. much of the land is unencumbered, and so is readily available for mortgaging. the rate of growth in real estate lending in the last decade attests to this.

  the absence of the fed/freddie/fannie only means that the boom/busts would have been more localized, with the damage confined to the interested bank(s). the bank(s) shareholders and creditors would have borne the damage. with the government agencies in the picture, the damage has been borne by the dollar. everybody pays through eroding purchasing power of the currency.
  

  Published: July 3, 2008 8:44 PM

• newson

  to mike sproul:
  yet where we part company is not on the backing of the currency (in your silver example), but on the convertibility aspect. for me it's necessary, you're not stuck on it.

  mexico: sure, dollars are freely transacted, but you cannot oblige someone to accept them as satisfaction for a debt, and as you say, the government insists that imposts be paid in pesos. this is an order, or a fiat. even if the currency were 100% backed in gold but inconvertible, it would still be fiat currency. it's not the backing that counts, but rather the presence of regulations or fiats.

  Published: July 3, 2008 9:10 PM

• newson

  fiat: from the latin "let it be done".

  Published: July 3, 2008 9:22 PM

• P.M.Lawrence

  DS, you appear to have confused Jacobites and Jacobins.

  Published: July 3, 2008 10:00 PM

• DS

  "central banks only came into being on the back of public distaste for bank collapses. "

  The history of central banking shows very few of them coming into existence to meet some overwhelming need of the public. Most have been created rather stealthily (if that's a word) and not one citizen in a thousand understand what they do, how they do it or what purpose they really serve.

  I think the reality of the situation is almost precisely the opposite.

  Published: July 4, 2008 6:50 AM

• David C

  Newson said:
  central banks only convert isolated bank runs into systemic crises. the boom bust cycle did not start with central banks. the latter have changed the cycle by making it less frequent, but of greater amplitude. the dynamics remain the same. central banks only came into being on the back of public distaste for bank collapses.

  Albeit on the right track, this statement misrepresents the story a bit: Its not only about BANKS - its about the entire business sector.

  Absent a cental bank and with a properly free market interest rate ( established by borrowing and lending activities in turn driven by activities in the real sector), businesses, (including banks), do their respective things. Some will make mistakes that cause them to be overshoot their expectations and perform surprisingly well, some will 'get it right' as it were, and some will make mistakes and incur unexpected losses, and some of those will fail altogether. There is no cycle as such - you merely have business at large continuing, with some inevitable failures occurring from time to time, and some astonishing successes also occurring from time to time.

  INtroduce a central bank with the power to set artificially-low market rates. Now ALL market participants are responding to an incorrect pricing signal that has no causal influence from real-sector activity. The effect of this incorrect pricing signal is to firstly increase the likelihood of businesses making mistakes in planning investment and production, and secondly it will SYNCHRONISE most of the mistakes made in one particular direction. Ergo, when rates are set low, we get mini-boom of investment activity against a false expectation of successful deployment of that investnemt, which evaporates when the expectation is shown to have been false (viz. the investments' output fails to realise the expected returns envisaged at the outset). Around about this point, the central bank starts to fret about the economy 'overheating' ( 'we're here to control inflation, remember?), and beefs up interest rates, and new investment slows down in response and fresh borrowing eases. Meanwhile, the marginal (worst-performing/most vulnerable) of the mistake-makers who (Mises's word) 'mal-invested' during the cheap money stage, now fail in the high-cost debt environment. Thus do central bank activities both exacerbate the 'natural' rate of mistake making, and synchronise it - voila, a high-amplitude cycle is born.

  Thus the Orwellian nature of the main Central Bank mandate: An agency whose mission is said to be aimed at providing 'stability', is in practice a profoundly destabilising influence. This is not the only instance of the Orwellian lexicon being applicable to government - other examples are legion and whole books could be written about them.

  Published: July 4, 2008 9:44 AM

• newson

  ds says:
  "There is no cycle as such - you merely have business at large continuing, with some inevitable failures occurring from time to time, and some astonishing successes also occurring from time to time."

  that's not at all the case. the business cycle was in existence long before the central bank was instituted, not courtesy of business, but rather of fractional reserve banking.

  and yes, public disaffection following periodic bank collapses and recession wasn't the real motivation for setting up a central bank, but this was how it was propagandized.

  Published: July 4, 2008 10:39 AM

• newson

  sorry for the quote that belongs to david c, and not to ds.

  to ds, the second part of my comment.

  Published: July 4, 2008 10:43 AM

• Alex

  Fundamentalist or anyone else: Darn, after my post of 2 days ago I haven't been able to return to the discussion till now. Happy July 4 everyone!

  With 100% reserve banking, why would banks exist at all? Whether fiat money exists, or instead money is 100% gold backed, $100 of deposits would have to be matched by $100 of "non-revenue earning" gold or fiat currency assets. How would the banks earn any revenue to pay the tellers and the all the costs associated with accepting deposits in the first place, and so why would they be willing to accept deposits? Lendable funds could still be raised by issuing bonds or equity, but you don't have to be a bank to do that.

  Published: July 4, 2008 10:52 AM

• jp

  "whilst there is a finite amount of land available in the us for collateralization, this is an irrelevant argument. much of the land is unencumbered, and so is readily available for mortgaging. the rate of growth in real estate lending in the last decade attests to this."

  Not irrelevant, since the point has been made several times in previous comments that gold is finite and takes effort to mine, therefore it alone should back money. I was pointing out that the same applies to land.

  Even if most of the land in the US is unencumbered, it doesn't proceed that a land boom will occur. Only if banks lend with land as security at below market prices and rates will a land boom occur. If lending practices are stringent it doesn't matter how much collateralizable land is available since no one will seek such loans.
  

  Published: July 4, 2008 12:09 PM

• Mike Sproul

  JP: "Even if most of the land in the US is unencumbered, it doesn't proceed that a land boom will occur. Only if banks lend with land as security at below market prices and rates will a land boom occur. If lending practices are stringent it doesn't matter how much collateralizable land is available since no one will seek such loans."

  Exactly right, and well put.

  Newson: The mainstream definition of fiat money, and the definition I use, is that it is UNBACKED. Textbooks start their discussion of paper money by saying "The Fed won't give you gold for your dollar, so it is unbacked. The fact that dollars have value even without backing results from the fact that the government limits their supply, and people demand them for liquidity." The real bills response is that the dollar is not unbacked, it is merely physically inconvertible, while still financially convertible. The mainstream view that the dollar is unbacked would leave one wondering why central banks bother to hold any assets at all, if the only thing determining the value of the dollar is supply and demand. The mainstream view also leaves one wondering how currencies like the peso manage to have any value at all in the face of competition from the dollar. The real bills view does not have these defects. It says that the reason central banks hold assets is that backing matters, and the reason the peso has any value at all is that the mexican central bank holds assets to back the peso.

  Published: July 4, 2008 2:12 PM

• Alex

  Mike Sproul said "The mainstream view that the dollar is unbacked would leave one wondering why central banks bother to hold any assets at all..."

  Mike, as I have explained before (in the blog with regards to another daily article), the entire significance of a central bank recording the vast majority of the government bonds it holds as "assets" is simply to make its balance sheet balance, nothing more. Apart from a small amount that it may need for open market sales from time to time, central banks could simply burn their government bonds and nothing of economic significance would happen -absolutely nothing. While government bonds are on the balance sheets of central banks they represent government I.O.U.s to the government itself. The government pays interest semiannually to the central bank and the central bank remits it (usually after deducting the cost of operating the central bank, a minor amount, which amount represents taxes paid each year to operate the central bank). Also, as long as the central bank's portfolio of government bonds continues to expand, year in and year out, no government bonds are redeemed on net, and therefore to say that these government bonds are somehow "backed" by the ability of the government pay off via taxation is a fiction.

  By the way, I'm still waiting for anyone who believes in 100% reserve banking to explain how banking would be profitable under such a scheme. There must be an explanaton, because I see people at this site continually advocating such a proposal.

  Published: July 4, 2008 5:04 PM

• Alex

  "The government pays interest semiannually to the central bank and the central bank remits it (usually after deducting the cost of operating the central bank, a minor amount, which amount represents taxes paid each year to operate the central bank)." Sorry, the words "to the government" should be inserted after the words "remits it" in the above sentence.

  Published: July 4, 2008 5:09 PM

• newson

  jp says:
  "If lending practices are stringent it doesn't matter how much collateralizable land is available since no one will seek such loans."

  well, i'm assuming that we're talking about a real world situation, where competitive forces will mean that customers are attracted to seek loans. what sort of bank would offer a product priced out of the market? there will always be marginal loans.

  the amount of land available for collateralization is vastly more than the amount of unencumbered gold, for that reason (amongst others) it is a preferable backing.
  

  Published: July 4, 2008 8:58 PM

• newson

  to mike sproul:
  i don't know how economics textbooks define fiat money, and if what you say is correct then my beef is with them, too.
  my point is purely etymological - the "fiat" or order really doesn't touch on the backing of the currency, but the legal tender aspect.

  of course, one naturally concentrates on the backing issue, because otherwise why would governments have very precise money prescriptions?

  i know your counterargument - why not do away with all pretense of backing, if it's a sham? i think the answer is that what central banks do is not to manage inflation, but to manage inflation expectations.

  and this confidence game can go on for a very long time. ultimately the public calls the reserve bank's bluff, and then it's monetary collapse. i imagine that scenario is still years away.

  Published: July 4, 2008 9:13 PM

• newson

  alex says:
  "By the way, I'm still waiting for anyone who believes in 100% reserve banking to explain how banking would be profitable under such a scheme."

  it would be a reversion to the moneylender of yore. depositors would be charged for the convenience and security of using electronic or paper. banks would make money only on intermediation.

  even if 100% reserve banking were made a legal stipulation, it's a given that the temptation to under-reserve will still tempt many. there is no possible remedy for this, legislation cannot prevent fraud, but it can convict transgressors after the fact.

  Published: July 4, 2008 9:31 PM

• jp

  "central banks could simply burn their government bonds and nothing of economic significance would happen -absolutely nothing."

  You are right that if bonds were to be destroyed this wouldn't affect the interest income component of the Fed's income statement as it remits this all back to the treasury anyway. But the destruction of the bond also removes the Fed's ability to get its original principle back, or roll it over. Furthermore, the Fed is audited by KPMG in addition to several gov't watchdogs. I'm sure a burning of the bonds would be caught. This information would be made public and the Fed would lose credibility, the effect on the dollar being pretty significant.
  

  Published: July 4, 2008 9:33 PM

• Alex

  Newson: Eg. Assets=$100 (gold or fiat currency); Liabils=$100 deposits. Where's the financial intermediation in this? It is a pure storage function. In this case depositors would have to pay interest (or storage costs), rather than receive it, to pay for the costs of the storage operation. If banks do lend out deposits, then there would, of course, be an intermediary function carried out, but this would mean fractional reserve banking.

  So, am I to understand that those who wish 100% reserve banking really do not want banks to be involved in lending at all, that is, they want them purely to be storage facilities for gold or currency?

  Published: July 5, 2008 3:25 PM

• Alex

  Jp: Yes, I know the pretense that the gov bonds on the central bank's balance sheet really are some kind of backing for the monetary base is useful for accountants (as I said earlier, it keeps the balance sheet balanced). But that's all it's useful for. If there is any financial market "credibility" in a central bank having its own federal government's bonds on its balance sheet, that credibility is grossly missplaced.

  A simple thought experiment shows the above. Suppose the U.S. Treasury printed up a $10 trillion U.S. bond and "sold" it to the Fed for $10 trillion. Or, to be more realistic, suppose the government of Zimbabwe did it (since this is exactly the stuff Mugabe does to finance his regime's spending). Does anyone feel any better knowing that Zimbawe's central bank has enough Zimbabwe government bonds on its balance sheet to match its liabilities? There is absolutely no economic meaning in such a fiction.

  Published: July 5, 2008 5:48 PM

• Mike Sproul

  Newson:
  "this confidence game can go on for a very long time. ultimately the public calls the reserve bank's bluff, and then it's monetary collapse. i imagine that scenario is still years away."

  Alex:
  ""central banks could simply burn their government bonds and nothing of economic significance would happen -absolutely nothing."

  I don't suppose either of you would claim that a private bank could get away for long with issuing unbacked money. As soon as people find out, the bank would collapse.

  Suppose some great new kind of money were introduced, and nobody wanted federal reserve notes (frn's) anymore. The Fed, if it does its duty, would use its bonds to buy back the unwanted dollars. Once the bonds were gone, the only way the fed could buy back the remaining frn's would be to sell its gold for the remaining dollars. (i.e., to finally restore physical convertibility) Naturally, if the fed had no bonds, and no gold, it could not buy back the unwanted frn's. I conclude that the bonds and the gold matter for the fed, just as they matter for private banks.
  

  Published: July 5, 2008 8:07 PM

• newson

  alex says:
  "If banks do lend out deposits, then there would, of course, be an intermediary function carried out, but this would mean fractional reserve banking."

  no it wouldn't. if i, 100% reserved bank, match up term deposits with loans of the same duration and size, i'm not exposed to any run. my only risk is that individual loans are not honored when falling due, and in that case my shareholders take a hit. presumably if my owners' equity is too slim, and my lending standards lax, then i will go out of business. i don't contribute to the business cycle.

  current accounts are charged fees, as you acknowledge, and there is no chance of a devastating run, simply because cheque account monies aren't loaned out, and so are effortlessly redeemed on demand.

  Published: July 5, 2008 9:49 PM

• newson

  mike sproul says:
  "Suppose some great new kind of money were introduced, and nobody wanted federal reserve notes (frn's) anymore."

  this scenario flies in the face of mises regression theory, ie that money ultimately must derive it's value from a real commodity, and cannot merely be willed into existence.

  Published: July 5, 2008 9:54 PM

• Mike Sproul

  Newson:

  By "some great new kind of money", I had in mind, for example, cash cards issued by banks, better credit cards, or foreign currency that is superior to the domestic currency--sort of like the dollar invading mexico and displacing pesos. That doesn't fly in the face of any sensible theory.
  

  Published: July 5, 2008 10:24 PM

• newson

  mike sproul says:
  "cash cards issued by banks, better credit cards, or foreign currency that is superior to the domestic currency--sort of like the dollar invading mexico and displacing pesos."

  all the above are derived currencies, linked back to the usd, which in turn had been linked backed to gold. so the above don't qualify as "new", and therefore satisfy mises' money regression theorem.

  Published: July 5, 2008 10:37 PM

• Bruce Koerber

  It is a fallacy that prices are sticky downwards (especially a prominent element in Keynesianism).

  If some institutional rigidity exists that causes prices to be sticky downward that enterprise is subject to being driven out of business in a free market economy.

  All stickiness resulting from economic intervention can be viewed as obsolescence which the market quickly casts aside. Of course the interventionists object to this and want to find a coercive means to guarantee stickiness.

  Economic fallacies promulgated by Keynesians and empirical economists is one of the means used by the interventionists. But to speak frankly about these fallacies - they are lies.

  Published: July 5, 2008 11:31 PM

• Alex

  Mike Sproul and Newson:

  Newson: Okay, so those who wish a 100% reserves banking system only want 100% reserves on demand deposits. Thanks for the explanation.

  Mike Sproul: The liability side of a central bank consists almost entirely of the liability for issued currency and bank's deposits at the central bank. There is no obligation for the Fed to re-purchase the currency and the bank deposits at the Fed represent bank reserves, which must legally be held. The liabilities of central banks rise and fall at the will of the central banks themselves, so there is no need for the Fed to ever "buy back the unwanted dollars." And, of course, the bonds the Fed holds are denominated in U.S. dollars, and, if held by the public will pay U.S. dollar interest and principal.

  I notice there's no comment on my Zimbabwe example. Mike, are you at all comforted by the fact that when Mugabe's boys want another $1 trillion in spending money that they print up a new $1 trillion government bond, which is held as "backing" at the Zimbabwean central bank???

  Published: July 6, 2008 8:05 AM

• Mike proul

  Newson:
  "There is no obligation for the Fed to re-purchase the currency "

  I said that the fed will buy back its dollars IF IT DOES ITS DUTY. If people trust the central bank to buy back its currency when the time comes, people will value that currency highly. If they don't trust the central bank (like in Zimbabwe) then they will place a low value on the currency.

  Published: July 6, 2008 11:59 AM

• jp

  "Does anyone feel any better knowing that Zimbawe's central bank has enough Zimbabwe government bonds on its balance sheet to match its liabilities? There is absolutely no economic meaning in such a fiction."

  The issue in Zimbabwe is that government assets are being monetized by the central bank at ridiculously inflated prices (or at unrealistically low interest rates). Inflation rates in Zimbabwe are around 1 000 000% a year. Commercial banks will lend to each other overnight for 1200%. That's not an annualized number, by the way. It costs 1200% for a 24 hour loan.

  Yet the government is able to issue debt at 340% per annum. The central bank ensures this rate stays low by constantly buying the debt. Commercial banks are also strong-armed into purchasing new issues on threat of de-licensing. With such high inflation, this is like giving a negative interest rate loan to the government. No private institution operating in an uncoercive environment would ever embark on such a money losing enterprise.

  I'm with you in being skeptical of government banking monopolies. Not because the assets they buy are worthless or irrelevant, but because the incentives to misprice them are massive. How do you feel about private banks holding private debt as assets? For instance, do you think a bank operating in a system of competing private banks issuing gold-backed notes could get away with destroying a significant percentage of the short term debt it holds as backing assets? If you think the public would laugh this off you are gravely mistaken. Clients of that bank would start lining up to redeem their notes for gold the very day the event was discovered. Assets are important.

  
  

  Published: July 6, 2008 12:18 PM

• fundamentalist

  Alex: "With 100% reserve banking, why would banks exist at all?"

  As newson has pointed out, banks would charge a fee to keep cash for checking accounts, as they used to do. And they could take term deposits in which the owner could not withdraw funds without penalty for the duration of the period. The bank would then loan out those deposits for periods matching the deposit period. Banks could also become mutual funds. But you're right that without fractional banking, the banking industry is much, much less lucrative.

  Published: July 6, 2008 3:11 PM

• Alex

  Mike Sproul: you said: "I said that the fed will buy back its dollars IF IT DOES ITS DUTY. If people trust the central bank to buy back its currency when the time comes.." There is no duty for the central banks (Fed included) to re-purchase their issued currency. "When the time comes." What time? Who in the public thinks that the Fed is ever going to redeem its currency for government bonds?

  
  JP: you said: "do you think a bank operating in a system of competing private banks issuing gold-backed notes could get away with destroying a significant percentage of the short term debt it holds as backing assets?"

  No, absolutely not! The assets of a private bank, including standard loans of various types and including government bonds are all economically meaningful backing for the bank's liabilities. But in the case of central banking, the little pieces of paper (currency (which directly represent government debt in the case of most central banks, and effectively represent government debt in the case of the Fed)) are "backed" on the asset side of the balance sheet of the central bank by big pieces of paper (government bonds). So, we have little government I.O.U.s in the form of currency backed by big government I.O.U.s in the form of bonds. The small I.O.U.s (currency) are not redeemable, and the big pieces of paper (the central bank held government bonds) don't get redeemed either. Both sets of paper are government debt fictions.

  Published: July 6, 2008 4:29 PM

• fundamentalist

  Mike: "If they don't trust the central bank (like in Zimbabwe) then they will place a low value on the currency."

  You sound like an Austrian quoting the subjective value theory. I thought that the RBD claimed that the value of currency was determined by the value of the asset backing it and subjective valuation of the currency didn't matter. Which is it? Does subjective valuation determine the value of currency, or does the value of the asset backing it?

  Published: July 6, 2008 9:57 PM

• Mike Sproul

  Alex:
  "What time? Who in the public thinks that the Fed is ever going to redeem its currency for government bonds?"
  The time for the fed to redeem currency for bonds is whenever the economy is overstocked with cash. For example, every Christmas, the fed buys about $10 billion in bonds to provide extra cash during the shopping season. After Christmas, the bonds are sold back to the public and the cash returns to the fed. In the 1950's, the fed used to watch the level of free reserves in the banking system, and issue money when free reserves were low, and retire money when free reserves were high. Nowadays the fed does the same thing by targeting the federal funds rate. When free reserves are low, the fed funds rate rises, and the fed reacts by buying bonds. Vice versa when reserves are high. This, at least, is the fed's duty. Whether the imperfect people in charge perform that duty is open to question, but to the extent that they do their duty, the dollar will hold its value.

  In my scenario of a superior substitute money being introduced, the fed would see free reserves rising (fed funds rate falling) and would react by retiring currency until the fed funds rate returned to its target level. Thus the ordinary operation of the fed would in fact lead the fed to buy back its currency.
  

  Published: July 6, 2008 10:06 PM

• newson

  mike sproul says:
  "In my scenario of a superior substitute money being introduced, the fed would see free reserves rising (fed funds rate falling) and would react by retiring currency until the fed funds rate returned to its target level."

  but mike, unless mises' regression theorem is incorrect, then any new currency must be a commodity, or its derivative.
  if a commodity-based currency were to find favour (ie. superior, as you say), there would be no room for the usd, assuming there are no legal tender laws. the dollar would be worthless, and by inference, so would the treasuries held as backing.

  Published: July 7, 2008 12:30 AM

• TLWP Sam

  I agree with what you said before Alex - it's confusing! If someone going keep saying "I don't like paper money, it can be easily both counterfeited and hyperinflated". The solution then is precious metal coinage. Use silver for everyday purchases, gold for the more expensive purchases, platinum for really expensive purchases and, perhaps, bronze, for small purchases. I don't see the point of a gold standard - governments have had a history of dropping the gold standard like a hot potato at times of war. Not to mention if gold is redeemable what's stopping a counterfeiter with a scanner/printer copy a note, go to the bank, redeem the gold with a false note and leave real note-holders high&dry? Perhaps the inconvenience of a water-displacement test to disqualify false precious metal coinage would be worth the bother compared to potential counterfeiting and hyperinflation of paper money? And, yes, banks wouldn't exist in a precious metal coinage world - there'd be storage houses (for which the despositor would pay a rental fee) and investment houses (to get savers and business startup folk in contact with each other). Otherwise the arguments seem rather circular to me.

  Published: July 7, 2008 2:00 AM

• newson

  tlwp sam says:
  "Use silver for everyday purchases, gold for the more expensive purchases, platinum for freally expensive purchases and, perhaps, bronze, for small purchases."

  most money would still probably transact electronically, or via paper, even in a future, hypothetical, free market for money. as long as there is convertibility, the actual money configuration will conform to whatever people want.

  regarding your point as to the veracity of gold weights - nowadays numbered ingots from trusted refiners are accepted and paid out against on the trustworthiness of their assays. it's hard to imagine the same not developing in coins, as it did in the days of yore. (the bezant lasted ten centuries, so it is doable).

  Published: July 7, 2008 3:34 AM

• TLWP Sam

  Not so much 'weight' as 'density'.

  Published: July 7, 2008 8:04 AM

• Alex

  Mike Sproul: You said, "The time for the fed to redeem currency for bonds is whenever the economy is overstocked with cash. For example, every Christmas, the fed buys about $10 billion in bonds to provide extra cash during the shopping season. After Christmas, the bonds are sold back to the public and the cash returns to the fed. In the 1950's, the fed used to watch the level of free reserves in the banking system, and issue money when free reserves were low, and retire money when free reserves were high. Nowadays the fed does the same thing by targeting the federal funds rate. When free reserves are low, the fed funds rate rises, and the fed reacts by buying bonds. Vice versa when reserves are high. This, at least, is the fed's duty. Whether the imperfect people in charge perform that duty is open to question, but to the extent that they do their duty, the dollar will hold its value."

  Yes, as I've acknowledged before, central banks occasionally engage in open market sales of government bonds, but this is small potatoes. Over the long run, the volume of government fiat money (small government I.O.U.s) increases as does the volume of big government I.O.U.s held on the central banks as fictitious "backing." And there is absolutely no obligation for the central banks ever to reduce either the volume of fiat money or the big government I.O.U.s held on the asset side of their balance sheets. Government small I.O.U.s "backed" by government big I.O.U.s is what a central bank's balance sheet is all about.

  Here's one more point A central bank (including the Fed) could simply transfer its liability for currency outstanding to the federal government along with handing over an equivalent dollar amount of the government bonds it is holding. Let's deal with $100 worth. The federal government now would have $100 of its own big I.O.U.s (bonds) (an asset, if you want to call it that) and $100 liability for the currency. So, the government could then cancel both its liability for the $100 of currency and burn the $100 of its bonds, and everything is even. No one would be upset. The money supply is unaffected, etc.

  Published: July 7, 2008 10:03 AM

• Joe Stoutenburg

  After a long July 4th holiday during which I didn't get to a computer, I see that the discussion proceeded on. In the interests of not derailing the thread, I will only make a few comments:

  Alex said:

  A simple thought experiment shows the above. Suppose the U.S. Treasury printed up a $10 trillion U.S. bond and "sold" it to the Fed for $10 trillion. Or, to be more realistic, suppose the government of Zimbabwe did it (since this is exactly the stuff Mugabe does to finance his regime's spending). Does anyone feel any better knowing that Zimbawe's central bank has enough Zimbabwe government bonds on its balance sheet to match its liabilities? There is absolutely no economic meaning in such a fiction.

  jp gave a great response for which he did not get credit:

  I'm with you in being skeptical of government banking monopolies. Not because the assets they buy are worthless or irrelevant, but because the incentives to misprice them are massive.

  I'll add that central bank monopolies do allow the banking system to cover up mis-pricing. Many of you act as if the primary crime is to not use commodity money as backing. To me, the crimes consist primarily of backing money with stolen assets (taxes) and passing laws to require people to use that money.

  In the case of Zimbabwe, it's not that the new money had no backing. Mugabe is able and willing to rob his citizens to place real backing to his money. The problem (aside from the theft) is that no one believe that he is able to squeeze that much out of his nation. So the money loses value. The discussion would change significantly if only voluntary collateralization were offered and if banking were allowed a free market.

  to newson's quotations of "mises regression theory":

  that money ultimately must derive it's value from a real commodity, and cannot merely be willed into existence.

  I haven't read Mises on that. But would he deny that land and other property consists of real commodities? I'll agree that we may seem to get on slippery slopes when the backing asset consists only of a promise to pay from real commodities that will be developed in the future. As I've said before, I favor more straight-forward banking institutions that have some ties to commodity money. But that doesn't mean that backing with assets other than precious metals is invalid. What is invalid is that central bank monopolies allow the banking industry to get away with under-valuing their collateral (not to mention taxes posted as collateral).

  Published: July 7, 2008 1:43 PM

• Alex

  Joe Stoutenburg: Joe, do you have any comment on my 10:03 AM post?

  Joe, you said: "Many of you act as if the primary crime is to not use commodity money as backing. To me, the crimes consist primarily of backing money with stolen assets (taxes) and passing laws to require people to use that money."

  Once more, there is zero backing for our fiat currency. Consider $100 of government bonds purchased by a central bank (the Fed or any other country's central bank). The Fed increases the government's deposit account (a Fed liability) by $100. The Treasury spends the $100 by writing cheques on its account at the Fed and thus acquires $100 of goods and services from the public. THIS is the point in time at which the taxation takes place. By this process the government has extracted from the public $100 of goods and services with absolutely no promise of future payment. Ther is NO BACKING of the money base of the central bank by the ability to tax. The fact that there are government bonds on the asset side of a central bank's balance sheet means that the taxation has already taken place.

  To carry the example one step further, the public deposits the $100 of government checks drawn on the Fed in their banks. The public then withdraws, say, $40 in currency. The Fed will then have on the liability side of its balance sheet $40 in liability for currency and a liability for $60 of commercial bank deposits, replacing the liability of $100 to the government as the government checks come in (to the Fed).

  As I say, none of the $100 of government bonds held as assets on the Fed's balance sheet will be redeemed in the long run (since the above process goes on, and on, and on over time). The bonds a central bank holds are not backed by the ability to tax, they are a fictional backing and the taxation has already taken place.

  Published: July 7, 2008 5:08 PM

• newson

  joe stoutenberg says:
  "I haven't read Mises on that. But would he deny that land and other property consists of real commodities?"

  obviously land has real value, but fails the money test because of its lack of fungibility and divisibility. different peoples chose different monies over time, but none chose land as money. try buying cigarettes with land!

  mike sproul often uses "sproul" dollars for illustrative purposes in his examples. this flies in the face of the mises regression theorem.

  Published: July 7, 2008 7:33 PM

• newson

  joe stoutenberg:

  see "human action" pages 408-10 and 610-11, for the full mises treatment.

  Published: July 7, 2008 8:40 PM

• Mike Sproul

  Newson:
  "but mike, unless mises' regression theorem is incorrect, then any new currency must be a commodity, or its derivative."

  There are many examples of currencies from various countries circulating side-by-side. Mises was wrong about real bills. I have no problem with his being wrong about other things.

  
  Alex:
  "The federal government now would have $100 of its own big I.O.U.s (bonds) (an asset, if you want to call it that) and $100 liability for the currency. So, the government could then cancel both its liability for the $100 of currency and burn the $100 of its bonds, and everything is even. No one would be upset. The money supply is unaffected, etc"

  Before this happened, the dollars were backed by the bonds, which were backed by the government's ability to tax. After, the dollars are backed directly by the government's ability to tax. The dollars were backed before and they are backed after. You just eliminated the bonds. I have a section on "Tax Backing" in my "No Fiat Money" paper that explains this.
  

  Published: July 7, 2008 9:03 PM

• newson

  joe:
  in "man, economy and state", rothbard also treats the regression theorem. see p. 268-276 (the page numbers are from the pdf versions on this site).

  Published: July 7, 2008 9:17 PM

• newson

  mike sproul says:
  "There are many examples of currencies from various countries circulating side-by-side."

  the difficulty in trying to disprove the regression theorem will be finding a currency that did not originally spring directly from a commodity, or indirectly from another currency that did.

  bottom line: currency, whether sproul dollars or newson pesos cannot be just conjured up and acquire money status.

  Published: July 7, 2008 9:42 PM

• fundamentalist

  Mike is right that the Fed can issue and absorb currency by buying and selling bonds, but that is not where the real expansion/contraction in the money supply comes from. The great expansion comes from individual banks through credit expansion and fractional reserves. The Feds make it possible for individual banks to expand the money supply far beyond what a free market in banking would allow. The amount of money that the Fed itself creates by buying bonds is small in comparison to what individual banks create when the Fed lowers it's rate.

  Published: July 8, 2008 8:05 AM

• Joe Stoutenburg

  Alex, regarding your 10:03AM post:

  Over the long run, the volume of government fiat money (small government I.O.U.s) increases as does the volume of big government I.O.U.s held on the central banks as fictitious "backing."

  It is the word "fictitious" with which I take exception. The backing is certainly illegitimate (representing the power of the government to tax). And given the many interventions the government places on the banking system, its value is questionable. But there can be no question that real (i.e. not fictitious) wealth may be acquired with tax dollars.

  Consider $100 of government bonds purchased by a central bank (the Fed or any other country's central bank).

  Okay.

  The Fed increases the government's deposit account (a Fed liability) by $100. The Treasury spends the $100 by writing cheques on its account at the Fed and thus acquires $100 of goods and services from the public. THIS is the point in time at which the taxation takes place.

  I agree. By monetizing its promise to tax in the future, it is able to spend those tax dollars today. I am insisting on a number of things:

  1) The $100 is only "out of thin air" to the extent that the government decides on a whim that it will be able to tax in the future. If the government is able to make good (bad) on its nefarious promise the $100 will be backed by real assets.

  2) It should be no suprise that the market value of the future ability to steal is questionable. For this reason, the valuation of the new money is very subjective. I am beginning to believe that absolute inflation (in contrast to inflation relative to a more fixed money) arises because of the inherent deficiencies in the "market" for stolen wealth.

  3) There is a fundamental difference between placing a stolen asset for collateral to back new money and placing an asset legitimately owned.

  4) Fiat does not mean "unbacked". While our money is indeed fiat (by virtue of laws requiring its use), it is not unbacked - simply poorly backed.

  Published: July 8, 2008 8:43 AM

• Joe Stoutenburg

  newson:

  I'll check out your references and get back to you. Thanks!

  Published: July 8, 2008 9:06 AM

• Mike Sproul

  Fundamentalist:
  "The great expansion comes from individual banks through credit expansion and fractional reserves."

  Every dollar created by private banks is backed by at least a dollar's worth of assets acquired by those banks. Furthermore, the actions of the private banks do not affect the fed's assets or liabilities. Are you advocating that great Austrian inconsistency: Forbidding willing banks from issuing a checking account dollar to customers who willingly give the bank a $1 lien on their property?
  

  Published: July 8, 2008 9:17 AM

• fundamentalist

  Mike: "Are you advocating that great Austrian inconsistency: Forbidding willing banks from issuing a checking account dollar to customers who willingly give the bank a $1 lien on their property?"

  Yep!

  Published: July 8, 2008 9:46 AM

• newson

  mike sproul says:
  "Mike: "Are you advocating that great Austrian inconsistency: Forbidding willing banks from issuing a checking account dollar to customers who willingly give the bank a $1 lien on their property?"

  two parties willingly conspiring to the detriment of a third party doesn't strike me as defensible under any austrian (or other) framework.

  Published: July 8, 2008 10:10 AM

• Joe Stoutenburg

  fundamentalist:

  I admire your unequivacable response. However, are you sure that you don't want to challenge any part of Mike's statement? By "inconsistency", I take him to mean that you violate a central tenet of Austrian economics - that exchange is guided by the subjective valuation of two or more willing parties. By forbidding a voluntary exchange in which two parties change the ownership status of property legitimately acquired, you go against the core of Austrian economics - not to mention a fundamental principle of liberty.

  In a free market (absent legal tender laws), you could reject a currency with backing not to your liking (whether you prefer gold in the vault or you believe that the backing is inadequate). If enough people rejected a currency, its value would drop. Holders of the currency would return to the lender demanding settlement. We would then discover whether the backing was good.

  Published: July 8, 2008 10:18 AM

• Alex

  Joe Stoutenburg.

  You said, "By monetizing its promise to tax in the future, it is able to spend those tax dollars today. I am insisting on a number of things:

  1) The $100 is only "out of thin air" to the extent that the government decides on a whim that it will be able to tax in the future. If the government is able to make good (bad) on its nefarious promise the $100 will be backed by real assets."

  There is no promise to pay off the government bonds held by the Fed. The Fed is ultimately controlled by the federal government. The fact that it is owned by the commercial banks has no impact on the fact that the government bonds on the balance sheet of the Fed will never be paid off. The reason is that there is no promise to ever redeem the currency for anything!

  With regard to the government bonds held by the Fed there is therefore NO promise to raise taxes in the future to service this debt. As I said earlier no taxes need be raised for the interest on the bonds, since it is remitted to the Treasury and no taxes need ever be collected to redeem the bonds. The maturing bonds are simply replaced with new ones.

  The taxation has occured the moment the currency is issued and the government spends the proceeds. There are no further tax considerations.

  With regard to your "nefarious promise," what promise?! There is no promise of anything! No promise to ever "pay off the Fed," no promise to ever pay interest on the bonds the Fed holds.

  I don't know if the Fed's balance sheet is published but if it is I would like a reference. The balance sheet of the Bank of Canada is published, however. For Dec 31, 2007, this is what it looked like (including the detail of only the major items).

  Assets: Government bonds $50 billion. Liabilities: currency in circulation $50.6 billion. Tot assets=Tot liabils=$53.9 billion.

  In 1996, the numbers were about $29.3 bill gov bonds. currency in circ. $29.1 billion. Tot assets=Tot liabils=$30.6 bill. And that's how it goes, a central bank's balance sheet grows and grows over time. It doesn't shrink but for the short run, through temporary open market bond sales.

  The Fed's balance sheet would be similar, except the numbers would be about 10 times larger.

  Published: July 8, 2008 10:31 AM

• Joe Stoutenburg

  newson:

  I read your Mises references on the regression theorem. It seems to me that you're reading much more into than is there.

  From chapter XXI:

  The regression theorem establishes the fact that no good can be employed for the function of a medium of exchange which at the very beginning of its use for this purpose did not have exchange value on account of other employments. This fact does not substantially affect the daily determination of money's purchasing power as it is produced by the interplay of the supply of and the demand for money on the part of people intent upon keeping cash. The regression theorem does not assert that any actual exchange ratio between money on the one hand and commodities and services on the other hand is a historical datum not dependent on today's market situation. It merely explains how a new kind of media of exchange can come into use and remain in use. In this sense it says that there is a historical component in money's purchasing power.

  I don't doubt that elsewhere he opines on the desirability of divisible and fungible money, but it just isn't here. All that I get out of this is that the value of money must be traceable back to non-money uses. This does apply to precious metals. It also applies to real estate, stock and even (though more of a strecth, I admit) on the good credit of a person known to repay his debts. It also places a restriction on so-called financial assets that they ultimately derive their value from real assets that have value outside of their use as a medium of exchange. I agree with this restriction.

  I have a few critiques about Mises:

  1) Within the sections that you asked me to read, the only reference to the creation of paper money was that the government created it. He never broaches the possibility that a private bank could create paper money.

  2) To him, it seems to be the paper money that is created "out of thin air" (though he doesn't use that term). Rather, I say that it is the bonds that are created out of nothing. They are decreed into existence by the government's promise to plunder wealth. The money that is created on their backs may have real value if the government follows through on its promises. I condemn the creation of the bonds and the ensuing taxation. While I might reject money created on the back of financial assets, I do not condemn it.

  3) He doesn't consider the impact of repaying the bonds that back the money. Those future taxes will force people to reduce spending at that time just as current taxes would cause people to reduce current spending with the same kind of impact of reducing some prices. I admit that the practice of monetizing the bonds changes the timing of the price changes. It is also clear that coercive wealth transfers are occuring. But I now strongly claim that the wealth transfers are primarily the result of taxation.

  4) According to Mises, events other than government-created money lead to price changes that unequally harm or benefit different people. From chapter XVII:

  Changes in the money relation are not only caused by governments issuing additional paper money. An increase in the production of the precious metals employed as money has the same effects although, of course, other classes of the population may be favored or hurt by it. Prices also rise in the same way if, without a corresponding reduction in the quantity of money available, the demand for money falls because of a general tendency toward a diminution of cash holdings. The money expended additionally by such a "dishoarding" brings about a tendency toward higher prices in the same way as that flowing from the gold mines or from the printing press. Conversely, prices drop when the supply of money falls (e.g., through a withdrawal of paper money) or the demand for money increases (e.g., through a tendency toward "hoarding," the keeping of greater cash balances). The process is always uneven and by steps, disproportionate and asymmetrical.

  When the quantity of money or the tendency to hold cash changes are prompted by voluntary, legitimate exchange, the ensuing impacts on prices are manifestations of supply and demand. If you would restrict voluntary exchanges affecting the quantity of money on the grounds that it hurts some third party (I agree that it may), you should also consider other instances in which third parties are harmed by other kinds of exchanges. If you do, you must ask yourself how far down the road to socialism you want to go - keeping in mind what Mises had to say on the subject.

  Published: July 8, 2008 11:00 AM

• Joe Stoutenburg

  Alex:

  There is no promise to pay off the government bonds held by the Fed.

  What do you mean that there is no promise to pay off the bonds? The bonds are paid off all the time. The fact that maturing bonds are replaced by new ones reflects the fact that taxation is on-going. As I explained above, this allows the government to accelerate its expenditures. Also, making reliance on the Regression Theorem, I posit that manner of monetizing wealth obscures its initial value. Market values depend upon subjective, voluntary valuations. That does not describe the transactions used by the Federal government to create new money. Also add to all of this that myriad laws are on the books inducing people to offer more and more assets to back money. It's plain to see that government has made a mess of our money. But this does not preclude a free market institution of monetizing legitimately owned assets.

  With regard to your "nefarious promise," what promise?! There is no promise of anything! No promise to ever "pay off the Fed," no promise to ever pay interest on the bonds the Fed holds.

  Given that you admit in the next paragraph that you have not seen the financial statements of the Fed, I can't see how you can make those statements with certainty. I'll give you a point though. To the degree that maturing bonds are replaced with new ones, I agree that the Federal government may not ever need to pay them off. In effect, it issues a bond with the "nefarious promise" of raising taxes. It doesn't raise taxes but then says, "but I'll do it this time!" and pays off the old bonds by issuing new ones. In effect, it may indefinitely put off raising taxes yet continue to increase the "value" of the collateral.

  Hopefully, I have made clear that I do not defend the cozy relationship between the Federal Reserve and the Federal government. Indeed, in a free market, I can not conceive of a need for a central bank.

  Reviewing my message, I see that I changed direction just a bit mid-course. That's okay. I'm still adjusting my position, and most of what I write is still spot on (I have only started to question whether the Federal government must ever redeem the bonds it places with the Fed). While I think that I'll still get the point at which I'll insist that the government must be able to back its bonds, I am not surprised to continue to find criticisms of the workings of the Fed. As I've written several times though, I don't see any crimes in backing new money loans with valuable assets as long as they are rightfully obtained.

  Published: July 8, 2008 11:31 AM

• fundamentalist

  Joe: "By "inconsistency", I take him to mean that you violate a central tenet of Austrian economics..."

  I'm not sure what he meant by "inconsistency," but I took it to mean that it's inconsistent with RBD. However, he could have meant that it's inconsistent with freedom. It's not inconsistent with freedom if you define fractional banking as fraud.

  I really don't have a dog in the fight between 100% reserve banking and free banking with fractional reserves. I would only add one condition on free banking: you can't allow regional or national banks. If you allow regional, but especially national banks, you end up with a situation no different from having a central bank. So free banking can't be totally free as advocates assume. Either you limit banking to 100% reserve lending or you must limit the size of banks.

  Published: July 8, 2008 11:46 AM

• Joe Stoutenburg

  fundamentalist:

  That's a fair answer. I'm satisfied but with a clarification. We must consider what methods are appropriate to limit the size of banks. If you wish to limit their size because you believe that they will tend to hold inadequate backing, the solution is to have a population and a banking system that is willing to challenge their solvency. Runs on the bank are healthy in that they provide restraint on the money. If a run reveals fraud, then it should be dealth with at that point. Not prior.

  If you advocate any form of coercion to fashion banking into the form that you think it should be, I believe that you advocate the mechanisms by which you will be ruled.

  Published: July 8, 2008 11:57 AM

• fundamentalist

  Joe: "If you wish to limit their size because you believe that they will tend to hold inadequate backing, the solution is to have a population and a banking system that is willing to challenge their solvency."

  That's true. Mises illustrates the benefits of free banking at restraining money creation. But as de Soto points out in his book the restraints illustrated by Mises disappear as banks get larger and encompass more people as customers. It's hard to say at what point restraints would disappear completely. A single private bank that served the entire nation would be no different than a central bank in its money creating ability. At least two banks would be necessary to provide some limit. A huge number of banks, each one serving just once town, would provide the greatest restraint.

  Published: July 8, 2008 12:17 PM

• Joe Stoutenburg

  If large banks tend to misbehave and if the populace is diligent, they will be pared down before they can become problems. At some point, we really have to blame our current banking problems on a gullible public. As is often the case, the first step in finding a solution is education.

  Published: July 8, 2008 12:38 PM

• Mike Sproul

  Joe:

  It seems like you clearly see the inconsistency of Austrians opposing fractional reserve banking while simultaneously calling themselves advocates of freedom. They justify this position by claiming that fractional reserve banking causes inflation and thus robs third parties, but I think you also see that fractional reserve banking is not inflationary as long as the assets backing that money are of adequate value, so the real bills opponents are left opposing liberty on the basis of their incorrect view of money.

  So I'm wondering why you don't go whole hog in favor of liberty and put yourself in the real bills camp?
  

  Published: July 8, 2008 12:58 PM

• fundamentalist

  Joe: "At some point, we really have to blame our current banking problems on a gullible public."

  If I remember Mises's account correctly, it's not so much a "wise" public that restrains money creation by banks as the fact that people must exchange currencies between banks, especially if there are multiple banks issuing currency in a town. However, if banks consolidate so that you end up with just two or three banks for the whole country, then there is much less exchange of currency between banks because more transactions take place within the same bank. That allows each bank to create more money. De Soto provides an excellent explanation of how that works.

  Published: July 8, 2008 1:41 PM

• Joe Stoutenburg

  Mike:

  I think that liberty stands as its own camp though its tent is wide enough to include elements of both Austrian and RBD. To me, liberty simply means observing the right of self-ownership. That observance implies prohibition against the initiation of violence against a person or his justly acquired property.

  If it pleases you to know, in the matter of banking, I am closer to the RBD position than the Austrian position (at least as espoused by people posting here). Still, as a matter of preference, I remain leaning toward desiring a tighter link to physical convertibility. I believe that removing current government interventions would probably achieve that. Along those lines, I do not see myself changing from a harsh critic of the Federal Reserve and its relation to the Federal government. I believe that I have made clear my opposition to both taxation (whether monetized or not) and legal tender laws (an opposition born out of the "liberty" camp).

  In effect, I do agree with your statement:

  I think you also see that fractional reserve banking is not inflationary as long as the assets backing that money are of adequate value

  But I won't agree with anyone who tries to tell me that our current day banking system even comes close to adequately valuing the backing assets.

  Published: July 8, 2008 1:57 PM

• Joe Stoutenburg

  Mike:

  I would be interested if you would opine on the plausibility (and if plausible, consequences) of the following chain of events:

  1) The Federal government creates new bonds.

  2) It sells the bonds (are the initial buyers privileged in any way?).

  3) The Federal Reserve purchases the bonds (are the purchase prices fair market?).

  4) New money is injected into the economy.

  5) When the bonds mature, the Federal government redeems them by issuing new bonds that it places directly on the Fed's balance sheet.

  6) Repeat step 1.

  This is to respond to Alex's claim that the assets of the Fed may be expanded without ever needing to actually tax. It is also reasoning like this that leaves me opposed to our present day banking system while remaining open to the idea of a free market RBD banking system in principle.

  Published: July 8, 2008 2:21 PM

• eric lansing

  Joe - that's one of the issues I have with Mike's backing theory. I keep thinking to myself: "but there is no limit on the amount of Bonds that the gov't can create and if they are AAA mostly because the Fed will always be a ready buyer, then it is those bonds that are the "fiat" to me.

  note:

  "Under a gold standard, the amount of credit that an economy can support is determined by the economy's tangible assets, since every credit instrument is ultimately a claim on some tangible asset. But government bonds are not backed by tangible wealth, only by the government's promise to pay out of future tax revenues, and cannot easily be absorbed by the financial markets.

  **A large volume of new government bonds can be sold to the public only at progressively higher interest rates.**

  Thus, government deficit spending under a gold standard is severely limited. The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. They have created paper reserves in the form of government bonds which -- through a complex series of steps -- the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods. When the economy's books are finally balanced, one finds that this loss in value represents the goods purchased by the government for welfare or other purposes with the money proceeds of the government bonds financed by bank credit expansion."

  
  http://www.usagold.com/gildedopinion/greenspan.html

  other than that, I am a big fan of Sproul.
  

  Published: July 8, 2008 3:32 PM

• eric lansing

  Joe - that's one of the issues I have with Mike's backing theory. I keep thinking to myself: "but there is no limit on the amount of Bonds that the gov't can create and if they are AAA mostly because the Fed will always be a ready buyer, then it is those bonds that are the "fiat" to me.

  note:

  "Under a gold standard, the amount of credit that an economy can support is determined by the economy's tangible assets, since every credit instrument is ultimately a claim on some tangible asset. But government bonds are not backed by tangible wealth, only by the government's promise to pay out of future tax revenues, and cannot easily be absorbed by the financial markets.

  **A large volume of new government bonds can be sold to the public only at progressively higher interest rates.**

  Thus, government deficit spending under a gold standard is severely limited. The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. They have created paper reserves in the form of government bonds which -- through a complex series of steps -- the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods. When the economy's books are finally balanced, one finds that this loss in value represents the goods purchased by the government for welfare or other purposes with the money proceeds of the government bonds financed by bank credit expansion."

  
  http://www.usagold.com/gildedopinion/greenspan.html

  other than that, I am a big fan of Sproul.
  

  Published: July 8, 2008 3:34 PM

• fundamentalist

  Joe: "I think that liberty stands as its own camp though its tent is wide enough to include elements of both Austrian and RBD."

  The issue can be simplified greatly if we realize that the RBD is nothing but fractional banking with some limits on the type of loans. RBD claims that fractional banking won't cause inflation if those limits are followed. Mike does admit that it will cause the business cycle but doesn't see a problem with that.

  Mises admitted that FRB/RBD would be fine in a free market with each bank issuing its own currency because the necessity of converting from one currency to another would limit money creation by banks. But in a world of central banks, FRB/RBD does nothing but cause inflation and make business cycles worse.

  Mike claims that RBD does not cause inflation even with a central bank. That is also the doctrine of mainstream/Keynesian economics. Mike is certainly hanging with the majority.

  The 20th century was a totally RBD experiment. According to Mises and Rothbard, the Germans practiced RBD in the 1920's and that led to their hyper-inflation. The US Fed practiced RBD in the teens and 20's which caused the US monetary inflation that led to the Great Depression. In both cases, the central banks claimed to be following the RBD and that their money creation did not cause inflation.

  The US Fed has always followed the RBD except when price inflation appears, which it then blames on speculators and shocks, but never on its money creation. It blamed the price inflation of the 1970's on the oil shock. But as Austrian have repeatedly shown an increase in the price of oil alone will not cause the prices of all other commodities to rise as well.

  Some Keynesians will admit that a rise in the prices of all commodities requires an equal expansion of the money supply at the same time, but they refuse to admit that an increase in the money supply may cause the price inflation.

  The bottom line is that we have experienced nothing but the RBD since the creation of the Federal Reserve almost 100 years ago. What do you think of its results?

  Published: July 8, 2008 4:17 PM

• Mike Sproul

  Joe:
  "1) The Federal government creates new bonds."

  Assuming the gov't has sufficient assets (probably taxes receivable) to repay the bonds, the bonds will hold their value. If not, the bonds will only sell at a discount. This sets aside the question of whether the tax itself is theft. Stolen assets are still assets

  "2) It sells the bonds (are the initial buyers privileged in any way?)."
  If the bonds are sold at open auction, there are no privileges. If there are privileges, then the gov't that sells (say) a $100 bond will only get $90 of revenue. But if the fed later buys this bond with 100 new paper dollars, the fed still has adequate assets, even though the government has thrown away $10 of its wealth.

  "3) The Federal Reserve purchases the bonds (are the purchase prices fair market?)."
  If they are purchased at a fair price, backing is adequate. If not, backing is inadequate and there will be inflationary pressure.

  "4) New money is injected into the economy."
  You didn't mention that an injection of $100 is likely to cause $100 of existing money--checking account dollars, credit card dollars, etc.--to reflux to their issuers.

  "5) When the bonds mature, the Federal government redeems them by issuing new bonds that it places directly on the Fed's balance sheet."
  As long as the government is not overextending itself, those bonds will hold their value, and the amount of backing per paper dollar is unaffected. If the government is overextended, the market value of those bonds will fall, and the dollars backed by those bonds would fall too.

  Published: July 8, 2008 5:55 PM

• Mike Sproul

  Eric:

  ""but there is no limit on the amount of Bonds that the gov't can create and if they are AAA mostly because the Fed will always be a ready buyer, then it is those bonds that are the "fiat" to me."

  As you said a few lines later, the more bonds the government tries to sell, the deeper in debt it goes, and the less valuable its bonds become. In this sense the government is no different from you or me.

  "But government bonds are not backed by tangible wealth, only by the government's promise to pay out of future tax revenues, and cannot easily be absorbed by the financial markets. "

  Taxes are limited by the amount of tangible wealth that exists in a country. Tangible wealth that is committed to taxes is that much less wealth that private people can borrow against. Thus the amount of money that can be issued in a country is limited to the total wealth of that country.

  "government deficit spending under a gold standard is severely limited. "
  The existence of a central bank can make it easier for the government to sell its bonds, but a government could sell its bonds without a central bank.

  "They have created paper reserves in the form of government bonds which -- through a complex series of steps -- the banks accept in place of tangible assets and treat as if they were an actual deposit,"

  As above, those bonds are a claim to taxes, which are a claim to tangible assets. Any tangible assets claimed by those taxes are unavailable for private use.
  

  Published: July 8, 2008 6:10 PM

• Mike Sproul

  Fundamentalist:
  "Mike does admit that it will cause the business cycle but doesn't see a problem with that. "

  No; I said that when the economy is booming, RBD banks will accommodate (not cause) that boom by issuing needed cash. When the economy is stagnant, RBD banks will accommodate (not cause) the bust by soaking up unwanted cash. I remember using an example of a hot dog vendor who accommodates the lunch rush by cooking a lot of hot dogs, and accommodates slack periods by cooking fewer hot dogs.

  "the Germans practiced RBD in the 1920's and that led to their hyper-inflation. The US Fed practiced RBD in the teens and 20's which caused the US monetary inflation that led to the Great Depression. In both cases, the central banks claimed to be following the RBD and that their money creation did not cause inflation. "

  The germans issued 1 million marks in exchange for bonds worth 1 mark. On real bills principles this would have been, and was, inflationary. The fact that those bankers claimed to be following the RBD gave the RBD an undeserved black eye.

  In the depression, the central bankers would only issue a dollar to people who handed them two dollars' worth of assets. That tight money policy was recessionary, and their claim of following the RBD gave it another undeserved black eye.

  Published: July 8, 2008 6:21 PM

• PR

  In the depression, the central bankers would only issue a dollar to people who handed them two dollars' worth of assets.

  How could the assets be worth two dollars if no one was willing to give two dollars for them? That seems to be the fundamental problem with RBD; it depends on perfect knowledge of what everything is "worth" even in the absence of any actual exchanges.

  Published: July 8, 2008 7:41 PM

• newson

  to joe stoutenburg:

  the pages i cited of rothbard (9:17pm post 7/7/08) deal with mises' regression theorem in slightly more detail, but it has nothing to do with fungibility, durability or divisibility. these are the commonsense requirements of money that you'll find mentioned in any economics text. land has never been used as money for obvious reasons. i mentioned the regression theorem only because mike keeps wheeling out the example of his "sproul dollars".

  as fundamentalist says, insofar as frb is fraudulent, libertarians should have no problem with those who favour 100% reserve banking. rothbard was in this camp, though mises favoured free banking.

  hans-hermann hoppe makes a good point in labeling frb more like a lottery - in the case of a run, only those who withdraw early receive their money, the rest are left to deal with liquidators, and may never receive a return. (see his paper "how is fiat money possible" - here's the link mises.org/journals/rae/pdf/rae7_2_3.pdf).

  again, as fundamentalist says, free banking doesn't prevent the business cycle, nor bank runs.

  Published: July 8, 2008 11:20 PM

• rtr

  RBD is just as phony as all monetary theory.

  Mike Sproul: "No; I said that when the economy is booming, RBD banks will accommodate (not cause) that boom by issuing needed cash."

  So are the cranes sitting atop buildings being literally themselves constructed out of fiat paper currency? No. Perhaps paper fiat currency is literally glued and hammered as walls in construction buildings? No.

  The money supply doesn't effect the limited supply of "real" goods and services one iota. It only effects the particular individuals who may own real goods and services in so far as any of those fiat currency notes are independently separately subjectively valued, if some people trade real goods and services for those fiat currency notes.

  All monetary theory is as silly as pretending we can magically increase the supply of diamonds and water to cause "bubble" "business cycle" "booms". But not as silly as pretending certificates of future diamonds production can cause the same thing.

  Money and Credit is fundamentally no different than Tulips. Maybe if you and the Government just planted more Tulips, you could rescue the Economy! Or maybe if we all just created our own money supplies, we would be infinitely rich!

  But unfortunately the self claimed backed by hot air wise economists and commentators like to also pretend money doesn't have a "price", and thus their "business cycle" "boom bust" *theory* is itself a house of cards devoid of a rational explanation of economic reality. RBD is just another subset of this fool's doctrine.

  Everything is independently separately subjectively valued. "Money" isn't a magical exception. Prove it to yourself with a little experiment. Tape a $100 USD fiat bill at one end of a sidewalk, and tape a $100 Parker Brothers Monopoly Game bill at the other end of a sidewalk. See which gets picked up by passer bys more often. Explain that "phenomenon".

  Published: July 9, 2008 7:10 AM

• fundamentalist

  Mike: "The germans issued 1 million marks in exchange for bonds worth 1 mark....In the depression, the central bankers would only issue a dollar to people who handed them two dollars' worth of assets."

  So you're saying that the central bankers in Germany and the US were complete idiots. Actually, they were intelligent men under the sway of a false monetary theory. Those central bankers thought they were exchanging currency for valuable assets. Can you offer any evidence that they were wrong? They were as well versed in RBD as you are, maybe better. The problem is not the men who implemented the RBD, but the doctrine itself.

  So what about the US central bank in the 1970's? Were they equally stupid? Greenspan and Bernanke, who followed and follows the RBD, are they stupid or evil? Our currency keeps falling in value.

  Mike: "I said that when the economy is booming, RBD banks will accommodate (not cause) that boom by issuing needed cash. When the economy is stagnant, RBD banks will accommodate (not cause) the bust by soaking up unwanted cash."

  I forgot. You're a Keynesian. Business cycles are acts of God. But even if the RBD doesn't cause the business cycle, it certainly makes it worse by making the booms go higher and the busts go lower than they would without the money manipulation.

  Published: July 9, 2008 7:53 AM

• Alex

  Some of you seem to think that fractional reserve banking is more inflationary than 100% reserve requirements against bank demand deposits would be. I guess the idea is that the lower the required reserve ratio, the greater the money supply, or something. But this is not the case. In the present system, the central bank alone determines the quantity of money in the economy and thus the general price level of goods and services, regardless of reserve ratios imposed on commercial banks.

  In Canada, for example, the legal required reserve ratio against deposits is zero, yet in Canada inflation is lower than in the U.S. The target CPI inflation rate of the Bank of Canada has been 2% since the early 1990s (this target is published). The measured inflation rate since that time till now has been just less than the target figure. That's not a coincidence, but determined by the Bank of Canada. (Yes, I know there are measurement problems associated with the CPI, nevertheless...)

  Regardless whether there is 100%, or zero reserve banking, or anything in between, the central bank determines the amount of liquidity in the financial system (through its control of the liability side of its balance sheet), the amount of commercial bank deposits, the money supply and thus the price level.

  Published: July 9, 2008 10:50 AM

• rtr

  Alex: "In the present system, the central bank alone determines the quantity of money in the economy and thus the general price level of goods and services, regardless of reserve ratios imposed on commercial banks."

  This is not at all correct. The Federal Reserve has nothing to do with M3, which utterly *dwarfs* M1 and M2. Ever receive an unsolicited credit card? Those things are printed off on sheets exactly like sheets of fiat currency notes. There is no limit at all to the amount of credit which can be created regardless of any fiat monetary system, regardless of any gold standard system, regardless of any system at all that uses government enforced contracts. The Federal Reserve and Central Banks generally are idiots, but they are overwhelmed in the world today by the market for privately generated credit.

  Promises are just as good as money, are just another form of money. If I promise to pay you next week for a service received today, you by definition value that promise of payment received next week more than the service you give away today (and it takes no bank for us to create that short term credit). In fact, credit promises today are indeed the most commonly exchanged things in all world-wide transactions, and are thus the de facto "money" standard. Plenty of stores and goods providers are willing and able to finance your purchases by giving you stuff now for payment later (which is epistemologically *equivalent* to promise of future payment received today), with no relationship to any bank whatsoever.

  The car dealership already has an SUV sitting on its lot, yet they will trade you that SUV for your credit promise, forming a financing arm of their dealership, creating a new "bank" with new money from your credit promise *deposit* (or you could go to a bank, get a loan, and trade those funds to the dealership). They might even trade your credit promise to other holders, including prior existing banks. There's no involvement of any bank per se in the creation of new credit. Your credit worthiness, your promise, has value equivalent to money (which is why identity thieves target credit), as long as others are willing to accept it, and they do *en mass*, from grocery stores, to car dealerships, to all manner of clothing and goods stores. Credit Promises move from Person 2 at Point 'B' to Person 1 at Point 'A', and other goods move from Person 1 at Point 'A' to Person 2 at Point 'B'. This is just another trade, epistemologically equivalent to all other exchange transactions called voluntary trade.

  None of these players borrow any money from any banks to finance your purchase; you and they create new credit (equivalent to new money) at whim. The Federal Reserve Cental Bank has nothing to do with this. This is precisely why M3 dwarfs M2 and M1. Such credit "bids" for other stuff along with fiat currency notes created by the Federal Reserve. And such credit is subject, along with fiat reserve notes, to independent subjective valuation. If credit wasn't by definition independently subjectively valued, it would never materialize in the first place as something of subjective value, to be accepted by anyone, including banks, in exchange for other goods (money included, as money is strictly just another good, the most commonly traded good). Forthcoming interest payments are still just *promises* with risk until actually received. Promises are goods, just like money, just like every other good.

  But this is a common error all economic schools, including the Austrians, commit. This error pretty much invalidates the whole of macroeconomic theory, including the Austrian "boom bust business cycle" theory.

  Any contract whatsoever, is enforced by government monopoly on violence and is just a derivative form of money and credit (but credit will still exist to a lesser degree in the absence of the government monopoly on enforcing contracts). They have permanent "bubble" value (by definition of government interference in the free market of enforcing contracts giving it, on net, starting value it would never come close to obtaining if there were no contract referee enforcer like government being involved), but even "bubble" value is not static, but just more *volatile* than other non monetary goods. If the promise is broken, intentionally or not, that promise good has basically instantaneously lost all its subjective value (in the absence of any acquired collateral).

  But we wouldn't a priori say there was a "boom bust business cycle" in the pet rock market. We would just say there was a massive change in the underlying subjective value of pet rocks. During one period of time they were worthless, then during another period of time they had positive subjective value, then during another period of time they were once again worthless. It is exactly so for fiat money and credit. One day it's equivalent to gold, the next day it's equivalent to coal or air, solely due to changing underlying subjective valuation, and *nothing but* changing subjective valuation by definition of previously occurring trade (that which is received is valued *more* than that which is given away in exchange). That's precisely what we've seen happen with both fiat currency and credit today. It's unfortunate that even early Austrian economics scholars such as Menger and Mises missed this, but the 21st century version of economics will be far more robust and scientifically accurate.

  It's also false to believe prices are determined by just money. Prices are determined by everything which exists, and which is actively traded for other things. Take an economy with just apples and oranges. Prices will be measured in either apples or oranges. Now add grapes to that economy. Grapes will by definition effect the prices of both apples and oranges. Everything which is created, not just "money" (whatever various form of which is being suggested by clueless fools), will effect the price of everything else at the margin, by definition of those who now prefer some marginal unit of grapes rather than additional marginal units of oranges or apples, whereas previously the prices were constricted to solely being spread out amongst apples and oranges.

  Published: July 9, 2008 3:19 PM

• Mike Sproul

  Fundamentalist:

  "I forgot. You're a Keynesian."

  Anyone who would call me a Keynesian is obviously not paying attention.

  Published: July 9, 2008 3:32 PM

• Michael A. Clem

  I don't understand this stuff about "increasing the supply of needed cash" and then absorbing "unwanted" cash. The demand for cash is about whether people want to hold cash reserves or spend their cash, not about people "needing" more cash for 'liquidity'. People cannot increase or decrease their cash except by controlling how they spend their earnings. Having the bank(s) increase or decrease the supply of cash doesn't change their cash holdings or their ability to spend their cash holdings, and is thus a silly thing to do during Christmas or any other time. It is clearly inflationary (or deflationary for "absorbing" cash), and thus affecting the value of their cash holdings, not the quantity of it.

  Published: July 9, 2008 3:35 PM

• fundamentalist

  Mike: "Anyone who would call me a Keynesian is obviously not paying attention."

  Maybe not in every way, but concerning business cycles and money I don't see any difference. Please enlighten me.

  Published: July 9, 2008 4:14 PM

• Michael A. Clem

  Promises are just as good as money
  
  Not sure what you're getting at, rtr. Promises are 'just as good as money', only because money is expected down the road, which is why one's reputation and credit rating are so important. It's not money, but a money substitute, and only a temporary one at that. Try buying something on credit without ever paying money on it and see how well that works. Promises can only become money when people accept promises without ever wanting dollars (or other currency) later on.
  
  It's also false to believe prices are determined by just money.
  
  I'm not sure anybody is actually saying that, although I see how easily one can think someone said that, based upon how comments usually go around here. As I myself have said, more than once, all other things being equal, more money will result in higher prices, while less money will result in lower prices. Naturally, if all other things are NOT equal, the problem becomes more complicated.
  

  Published: July 9, 2008 4:22 PM

• rtr

  Michael A. Clem: "Promises are 'just as good as money', only because money is expected down the road...It's not money, but a money substitute, and only a temporary one at that."

  Sure, individual units of credit are temporary, but aggregate outstanding credit has exploded even given minor ebbs and flows. It *dwarfs* fiat currency notes, it *dwarfs* fractional reserve bank lending. Take an economy of just apples and oranges. Apples can bid for, can be traded for oranges, and vice versa. Now add credit to the economy, and you have apples, oranges, and credit. Now apples and credit can bid for, can be traded for, oranges, and vice versa for apples.

  Even though credit is a "money substitute" it's going to immediately effect prices. And sub prime mortgage loans were packaged together as bond portfolios and traded from mortgage agencies to banks, to individual hedge funds and other institutional investors in exactly the same way stock shares of businesses would be. Debt is subjectively valued by somebody, otherwise it wouldn't come into existence in the first place.

  But everything which exists is a "money substitute" when you view economic activity correctly through the lens of trade. Two kids trading a banana for an orange at a cafeteria table is just as much economic activity as trading fiat currency for a television. Everything is independently subjectively valued. Consumable goods also are temporary. Once you eat an apple, it's gone. But the point is credit is just as real as apples, and is created at whim just like apples, independent of the Central Bank. Contracts are economic activity "credit" "money substitute" goods too. You make a cash down payment on your roof being repaired in exchange for the credit that the contractor will repair the roof as promised. And such credit can be further exchanged to various other sub-contractors.

  Fiat paper currency is easier to carry around than gold, and credit is easier to carry around than fiat paper currency. They are all subject to the economic concept of trust, or reputation.

  But the fundamental flaw in monetary theory is that it is regarded solely as a means of exchange. If it were just a means of exchange, nobody values that money in and of itself. It's pure musical chairs hot potato vapor ware. And a government enforced gold standard is inherently just as volatile as a government enforced fiat paper monetary system (of course the supply of fiat paper is much more easy to manipulate). They are both only going to continue being subjectively valued in so far as they are valued as end goods. Promises are end goods in themselves, which is why they can be traded. But they are highly volatile if the promises fail, and can instantly go from being the present value of repayment of principle plus interest payments to zero.

  Both gold and paper fiat currency can both be jewelry. It doesn't mean wearing big clocks around one's neck will forever be fashionable. Forms of money and credit are just as much subject to fashion trends (though they may play out over longer periods) as clothing styles, because money, credit, and goods are all independently subjectively valued at all times, and subjective valuations change, sometimes drastically, all by themselves.

  Michael A. Clem: "As I myself have said, more than once, all other things being equal, more money will result in higher prices, while less money will result in lower prices. Naturally, if all other things are NOT equal, the problem becomes more complicated."

  Now flip that comparison holding money constant and varying all other goods. That will effect prices too. You should be able to easier see the fundamental flaw of monetary by viewing it from this angle. Why is it "good" for the supply of all other goods to increase but it is "bad" for the supply of money to increase? This is precisely why monetary theory is a fool's doctrine. There is no a priori epistemological economic reason to regard increases in money supply as "bad". They are only regarded so because monetary theory falsely regards money as a means of exchange, a false grease between exchange of "equally valued" different goods, rather than as an element of trade, which will only occur when that which is received is by definition valued *more* than that which is given away in exchange.

  Changing money supply is no more good or bad than changing the supply of any other good. And in fact no exchange of any quantity amount of money will ever occur unless by definition that which is received is valued more than that which is given away in exchange.

  Published: July 9, 2008 7:34 PM

• newson

  rtr says:
  "Plenty of stores and goods providers are willing and able to finance your purchases by giving you stuff now for payment later (which is epistemologically *equivalent* to promise of future payment received today), with no relationship to any bank whatsoever."

  but rtr, the difference between vendor finance and the bank is that the former actually has advanced your real goods (the product of previous economizing), whilst the latter merely has made a book entry to create the loan (no previous economizing). hence the former is money supply neutral, whilst the latter is inflationary (whose addition to the money supply is gradually withdrawn as the loan is serviced and then repayed).
  

  Published: July 9, 2008 9:13 PM

• rtr

  No newson, the net price effect is the same. Without credit promise, the buyer otherwise has no goods with which to trade for the SUV. Without credit, he is out of the demand for SUVs market. With credit, he can buy away that SUV from somebody else who was only prepared to trade less cash for that SUV. To compete, at the margin, cash payers must pay higher amounts of cash to get the marginal produced SUV rather than the marginal produced SUV going to those trading newly created credit. Money PLUS credit bids for the same supply of SUVs rather than just money bidding for the supply of SUVs.

  Likewise with just creating new money out of thin air, somebody has something with which to trade for some real goods, which in the absence of that new money, might have been traded to a different person.

  Without new money or new credit, neither of those example individuals are going to have car dealerships trade them SUVs.

  Neither case is money supply neutral. Credit is a new good in the economy just as more units of money are new goods in the economy. The supply of money and the supply of credit "money substitute" increases, and both are independently subjectively valued by definition of trade.

  Because credit can be a very volatile valued good, a rash of defaults can effect the subjective valuation of remaining units of credit, severely, as well as effecting the willingness to accept, the subjective valuation of, possible new extensions of credit.

  So two trillion dollars worth of credit subjective valuation just about instantaneously vanishes in the housing market. That certainly puts a damper on housing values even if the Federal Reserve has in the meantime inflated the money supply by 100 billion units of currency and/or fractional reserve lending. That's why houses wouldn't even trade for a lot less amount of even further inflated fiat currency notes (higher supply than before the crisis). All the houses trade for 100M before the crisis. The money supply is doubled, and still all the houses would only trade for 50M in the midst of the crisis. Even though fiat money is marginally less valuable than before, houses won't even trade for the same pre-inflation amount. This is solely because of credit privately created in the free market independent of the Central Bank has lost its subjective value.

  Else wouldn't it be rationally *insane* to accept less fiat currency for a house even though the fiat currency is worth even less than before? There's nothing preventing houses from trading at lower or higher or the same nominal or real "prices". But what has happened instead, is that trade of houses has ground to a halt.

  Real economic subjective valuation has been destroyed, evaporated into thin air as quickly as (or even quicker than) it arose. Yet simultaneously the opposite phenomenon occurs in the commodities markets.

  Published: July 9, 2008 10:11 PM

• TLWP Sam

  Clear as mud! I don't know if you read what I posted a while ago, rtr. But . . . the obvious difference between a gold coin and a paper note is that should the currency be no longer supported by the issuer then the paper note is valueless whilst the gold coin is still valuable. Which in turned reminds me of the story of two guys bartering apples and oranges. Suppose the apple farmer meet with the orange farmer and the orange farmer complains the orange harvest is two weeks behind schedule, the apple farmer trusts the orange so he writes up an IOU for oranges and the orange takes the apples and brings the oranges two weeks later and they rip up the IOU. But what if the farmers didn't trust one another but both wanted the others' produce but couldn't trust that the IOU would be honoured? The answer would have been the apple farmer knowing the orange farmer might not return with the oranges and the farmer didn't want to be empty-handed with a worthless IOU asked the orange farmer to offer his gold watch as collateral, "give me the oranges and you get your watch back", hence if the orange farmer doens't return the apple farmer hasn't lost out. This, I believe, the one of the two obvious reasons for precious metal coinage over some sort of 'credit money' (the other being hyperinflation).

  Published: July 9, 2008 10:26 PM

• rtr

  Yes TLWP Sam I don't dispute that gold is less volatile than fiat currency. But credit will still arise naturally in the free market due solely to government enforcement of private contracts. There is no gold watch collateral needed in your oranges for apples farming example. The government will compel the exchange, will enforce the contract. Thus, credit generated by the private free market would similarly overwhelm a gold standard system just as it has overwhelmed the fiat currency system. Enforcing contracts causes limitless credit to be created.

  But regardless, only incorrect monetary theory deems an increase in the money supply as "bad" because it is fundamentally epistemologically and economically in error. In a gold standard monetary economy, a doubling of the gold supply would not a priori be any better or any worse than a doubling of a fiat money supply. That it is regarded as such, is just evidence of fundamentally flawed monetary theory.

  Published: July 10, 2008 12:08 AM

• newson

  to rtr:

  let me qualify what i said earlier, in the case of fractional reserve banking, the granting of a loan increases the money supply (to the extent that the money loaned doesn't come from depositors' funds).

  vendor finance has absolutely no effect on the money supply (it just an ordinary sale on deferred terms).

  so i disagree with you when you say:
  "Neither case is money supply neutral.

  the change in money supply (specifically the drop that follows the rise) is precisely what causes the "rash of defaults" that you speak of in your housing example. otherwise the business cycle becomes inexplicable except by keynes' animal spirits.
  

  Published: July 10, 2008 4:07 AM

• fundamentalist

  rtr: “Why is it "good" for the supply of all other goods to increase but it is "bad" for the supply of money to increase?”

  For all of the reasons given by every real economist from Menger to Rothbard. It’s what this web site is all about. It seems silly to have to go over it again, but here it is in a nutshell:

  When money was gold and silver only, it was a commodity produced by labor and investment. To that value as a commodity, people added the value of a medium of exchange to gold and silver, but it was still one commodity being traded for others. That is a poor summary of Mises’s regression theorem.

  But when gold merchants in the middle ages learned that they could inflate the purchasing power of the gold they held for others simply by adding and substracting numbers in accounts, they invented fractional reserve banking. Customers trusted the gold merchants and treated the numbers in their accounting books as if they were actual gold. So the bookkeeping entries became substitutes for gold, or money substitutes. By increasing the volume of money substitutes (accounting entries), gold merchants effectively increased the money supply. The increase in money created an economic boom that was unsustainable because of the shortage of capital goods. That shortage caused the bust in which many people lost huge amounts of wealth. In addition, real wealth (goods and land) were transferred from the late receivers of money to the early receivers as a result of the price inflation that accompanied the boom.

  An increase in the money supply is good if that money is a commodity, like gold and silver, resulting from increased production. But if the increase in money comes from the bookkeeping tricks of fractional banking, then it is bad because it destroys wealth and transfers some wealth unfairly.
  

  Published: July 10, 2008 8:06 AM

• rtr

  newson: "in the case of fractional reserve banking, the granting of a loan increases the money supply (to the extent that the money loaned doesn't come from depositors' funds)."

  Fractional reserve banking loans are just as "temporary" as vendor-customer created credit, are just as temporary as any promises whatsoever. People trade goods for promises. It is an economic fact. Promises have non-constant varying subjective value. Good are moved from Person 1 at Point 'A' to Person 2 at Point 'B', and Credit Promises are moved from Person 2 at Point 'B' to Person 1 at Point 'A'. Trade occurs. It doesn't matter if it's new money or if it's new credit, if that new money or new credit is traded for other stuff, it has positive economic subjective value by definition of trade. If it didn't have economic subjective value, it wouldn't be accepted by anyone in trade.

  Published: July 10, 2008 8:33 AM

• fundamentalist

  rtr: “But credit will still arise naturally in the free market due solely to government enforcement of private contracts.”

  Without fractional banking, credit can only some from savings, which places a limit on credit expansion regardless of what the state does. With fractional banking, credit expansion is only limited by the level of price inflation that causes people to reject all money. Even the Germans in the 1920’s couldn’t create infinite credit.

  Rtr: “In a gold standard monetary economy, a doubling of the gold supply would not a priori be any better or any worse than a doubling of a fiat money supply.”

  You’re exactly right, but that underscores the importance of commodity-based money: it’s impossible to double its supply in a short time. The supply of gold increases at about 3%/yr., far below the 10% + rate of money creation by fractional banking today. Other countries have doubled and quadrupled the money supply via credit expansion in one year. That’s impossible with commodity money. The value of gold as money is not in the intrinsic value of gold, but in its scarcity.
  

  Published: July 10, 2008 8:34 AM

• Michael A. Clem

  There is no a priori epistemological economic reason to regard increases in money supply as "bad". They are only regarded so because monetary theory falsely regards money as a means of exchange, a false grease between exchange of "equally valued" different goods, rather than as an element of trade, which will only occur when that which is received is by definition valued *more* than that which is given away in exchange.
  
  
  What's the point of money, then, if it's NOT a means of exchange? While a commodity-based money like gold or silver may have non-monetary uses, the value of money is precisely in the fact that people use it for exchange, and as a store of value, and that this allows indirect exchange to take place. That's not "false" grease, but real grease that greatly expanded the division of labor, productivity, and the economy in general.
  
  Increases in the money supply are obviously good for the people getting the new money, but bad for the people who don't get it, or get it last. Thus, the value of an increase in the money supply is subjective, too. But an increase is clearly bad if you want money to be a store of value, so, in that sense, it's not subjective.
  

  Published: July 10, 2008 9:36 AM

• Alex

  RTR: I loved your housing market example. I'm going to have to think about that some more. But I'm a bit busy for next day or two, so probably won't be able to answer until this blog has ended. However, there is no doubt that "money" will come again as a topic.

  Published: July 10, 2008 9:54 AM

• rtr

  fundamentalist, money, whatever form of money one were talking about, is non-constantly subjectively valued, regardless of any change in its supply.

  fundamentalist: "When money was gold and silver only, it was a commodity produced by labor and investment."

  And it is exactly similarly so for every single other
  good produced.

  fundamentalist: "To that value as a commodity, people added the value of a medium of exchange to gold and silver, but it was still one commodity being traded for others."

  And it is exactly similarly so for every single other good produced. The division of labor results in surplus specialization production of goods for TRADE, every instance of which creates positive economic wealth. Everyone who specializes in production of a particular product uses that surplus production of that particular product as his means of exchange for other stuff.

  No, it is absolutely not "one commodity being traded for others" but every commodity being traded for every other commodity, with one commodity being the most commonly traded thing in those exchanges. Even today, not every trade involves money, let alone the same form of money.

  The more money becomes just a means of exchange without subjective valuation solely as a desired end good, the more the subjective valuation of that money has declined, has vanished.

  fundamentalist: "But when gold merchants in the middle ages learned that they could inflate the purchasing power of the gold they held for others simply by adding and substracting numbers in accounts, they invented fractional reserve banking."

  They cannot inflate the purchasing power of gold. The purchasing power of gold is independently determined by the market marginal subjective valuation. You must obviously be talking about something else other than the purchasing power of gold.

  Promises result in purchasing power as well. Creating any new stuff whatsoever which is subjectively valued results in purchasing power too.

  fundamentalist: "The increase in money created an economic boom that was unsustainable because of the shortage of capital goods."

  Wrong. If that were true, doubling the supply of gold would cause the exact same thing. Changing the supply of anything, or the subjective demand valuation of anything, would cause the exact same thing. That monetary theory would only hold in a forever static economy.

  Where is this economic boom coming from? Are construction cranes being built out of fiat paper? Are walls literally constructed out of fiat paper? Changing the supply of money doesn't one iota change the supply of all other "real" goods. Those other real goods can still only be freely willingly voluntarily exchanged from one person to another person. And that will *never* occur unless what is received is valued more than what is given away in exchange, by definition of trade. It's tough luck if some famous superstar baseball player can autograph a piece of paper, creating positive subjective economic value, and then trade that autographed piece of paper for other stuff that you yourself wanted. Every new marginal unit of everything which is subjectively valued created is going to effect the trade distribution of all goods and services.

  Published: July 10, 2008 10:12 AM

• newson

  rtr says:
  "Fractional reserve banking loans are just as "temporary" as vendor-customer created credit, are just as temporary as any promises whatsoever."

  if there were no fed, frb would result in the boom/bust cycle. in the crunch part of the cycle, banks' bad loans skyrocket, devastating their balance sheets. many banks would fold, and money supply may also fall, as debtors deleverage and the remaining banks become more cautious in their loan-making.

  in a practical sense, whilst individual credits are indeed temporary, they are always rolled-over, or new clients replace old. so the aggregate effect is a rise in credit (and therefore money supply under frb) that continues until it doesn't!

  people loaning directly to other people, businesses offering purchase plans - all of these are money supply neutral, merely the temporary swapping of purchasing power.

  Published: July 10, 2008 10:14 AM

• Michael A. Clem

  And that will *never* occur unless what is received is valued more than what is given away in exchange, by definition of trade
  
  Um, wrong. That's only true in the case of free or voluntary trade. In cases where coercion or fraud is employed, a trade may occur even if one party does not value what is received more than what is given (or taken) away. And that's the whole question about new money creation: is it fraudulent or not? How are market participants made aware of changes in the money supply that may affect the value of the money they hold? The same thing as when they know there are changes in any other good or service: change in prices. But, as Mises stressed, changes in the money supply do not affect the entire economy immediately, but rather, has an effect in a certain area (where the change occurs) that eventually is felt in the rest of the economy.

  Published: July 10, 2008 10:31 AM

• newson

  fundamentalist: "The increase in money created an economic boom that was unsustainable because of the shortage of capital goods."

  rtr: "Wrong. If that were true, doubling the supply of gold would cause the exact same thing."

  but rtr, as fundamentalist said earlier, massive increments in gold supply does result in high inflation. historical examples: gold and silver pouring into the spanish economy from the new world. more recently, a massive real estate boom in "marvellous melbourne" mid-19th century, following the discovery of large goldfields in victoria).

  you seem to have skipped fundamentalist's prime point - that this bullion inflation was atypical in the past, and likely to be even more so in the future (surface deposits are less likely due to improved aerial scanning etc).

  Published: July 10, 2008 10:50 AM

• TLWP Sam

  "What's the point of money, then, if it's NOT a means of exchange? While a commodity-based money like gold or silver may have non-monetary uses, the value of money is precisely in the fact that people use it for exchange, and as a store of value, and that this allows indirect exchange to take place." M. A. Clem.

  As I inferred I do believe the point of gold and silver coins were that they were precious outside of being currency. Suppose the good ol' U.S. of A. was using gold and silver coinage and society crumbled and collapsed holders of the coins know they can take their coins elsewhere and even though other countries use paper currency the coins could be cashed in. I believe the detriment of paper money is that if something goes wrong you're holding on to nothing but a piece of paper with zilch value.

  Published: July 10, 2008 10:56 AM

• newson

  to mike sproul:
  isn't the rbd just the direct descendent of the british "banking school"?

  Published: July 10, 2008 10:58 AM

• jp

  rtr, your pure subjective theory of money is interesting. Economists do not bother to pry open the heads of people for the reason they exchange apples for oranges. ie - apples are healthier, they are sweeter, etc. Mises wrote that this was the realm of psychology, not economics.

  But when it comes to money, these same economists have built up an impressive list of reasons people trade money for other goods ie. money is a more convenient means of exchange, it is a better store of value, it serves as a precautionary asset, it has speculative properties, it represents backing, or even decorative purposes as you pointed out. This listing and prioritization of motives contradicts Mises' point about the immeasurability of the subjective use value of something.

  It seems to me that whatever subjective reason an economist prioritizes as the cause for money demand dictates the structure of their theory. Austrians and classical economists priviledge the means of exchange motive, Keynesians the store of value/speculative motive etc. If you don't prioritize anything, I guess that would put one in your camp ie without a monetary theory.

  Mises puts forth an interesting epistemological account in Part 2 Ch 1 of Theory of Money and Credit that explains why money is different from all other commodities. I guess you would disagree with all that too?

  "Nevertheless, while the utility of other goods depends on certain external facts (the objective use-value of the commodity) and certain internal facts (the hierarchy of human needs), i.e., on conditions that do not belong to the category of the
  economic at all but are partly of a technological and partly of a psychological nature, the subjective value of money is conditioned by its objective exchange-value, i.e., by a characteristic that falls
  within the scope of economics."

  Published: July 10, 2008 12:53 PM

• fundamentalist

  rtr: "The more money becomes just a means of exchange without subjective valuation solely as a desired end good, the more the subjective valuation of that money has declined, has vanished."

  That never happens. As a medium of exchange, money has value to people as it serves that purpose. The value that people place on that service doesn't change randomly or by whim; it changes according to supply and demand.

  rtr: "They cannot inflate the purchasing power of gold."

  I apologize for the lack of precision in my remark, but I think you understood what I meant. The gold merchants made the gold they stored do double duty by allowing multiple people think they had ownership of the gold.

  rtr: "Wrong. If that were true, doubling the supply of gold would cause the exact same thing."

  Doubling the supply of gold would cause the same effect. Spain experienced it in the 1500's.

  rtr: "Changing the supply of anything, or the subjective demand valuation of anything, would cause the exact same thing."

  Not true. Are you totally unfamiliar with the Austrian Business Cycle? I really don't want to repeat it here. But an increase in goods is an increase in real wealth. An increase in the money supply that does not come from increased savings destroys wealth.

  rtr: "Changing the supply of money doesn't one iota change the supply of all other "real" goods. "

  Now you're catching on. The increased supply of money causes increased demand for scarce capital goods and increases in prices. That's why the boom is not sustainable.

  I'm curious as to what you think causes business cycles. Are you like the Keynesians who think they are acts of God?

  Published: July 10, 2008 1:10 PM

• fundamentalist

  rtr: "Promises result in purchasing power as well. Creating any new stuff whatsoever which is subjectively valued results in purchasing power too."

  I realize that you would like to conflate money any other promise, but the differences are extraordinary. The promise inherent in an ounce of gold is very different from the IOU of a homeless person on the street. All promises aren't created equal. And while money may have some things in common with a promise, it is much more than a promise, too. You're trying to lure us into an extreme from of reductionism in which everything looks the same and no clear distinctions can be made.

  And there is a huge difference between mining and refining a commodity, such as gold, and creating money out of thin air, as does fractional banking. If any and all commodities could be created from air without cost, as they did on Star Trek with their replicators, then there would be no scarcity of goods and no prices. The only commodity that I'm aware of that can be created without cost out of thin air is money. As a result, the creation of money from nothing bears no resemblence whatsoever to the act of "creating" other commodities, which is not creation but the act of growing and refining something that already existed. Those who have the right to create money from nothing, banks, have an unnatural and unfair advantage.

  Published: July 10, 2008 1:21 PM

• rtr

  Michael A. Clem: "That's only true in the case of free or voluntary trade. In cases where coercion or fraud is employed, a trade may occur even if one party does not value what is received more than what is given (or taken) away. And that's the whole question about new money creation: is it fraudulent or not?"

  There is no coercion or fraud in any transaction involving any amount of money. You are free to not trade for any amount, or you are free to trade for any amount of money you wish. Money is subjectively valued. This is why Post WWI German marks are not in wide circulation anymore. It's absurd to maintain that all the transactions which occur with fiat money as one of the sides of the exchange are not free trade. Who's forcing them to accept the terms? No, they accept them voluntarily by definition of having the possible choice to decline all trades involving any amount of money.

  Michael A. Clem: "And that's the whole question about new money creation: is it fraudulent or not? How are market participants made aware of changes in the money supply that may affect the value of the money they hold?"

  How about "the whole question" about new corn creation? To ask is new corn creation fraudulent or not is ridiculous. Yet how is it that the market is perfectly able to deal with changing supplies of corn but somehow cannot deal with changing supplies of money? Relative supply and demand is signaled by free market pricing for absolutely everything, money included. If you were to allege "market failure" caused by changing money supply you'd be alleging "market failure" for absolutely every tiniest change in demand or supply for absolutely every good and service. It is obvious that the market does take account of changing money supply in *exactly* the same way the market takes account of changing supplies (and changing demands) for absolutely all goods which exist in the economy.

  Michael A. Clem: "But an increase is clearly bad if you want money to be a store of value, so, in that sense, it's not subjective."

  A "store of value"? This is another absurdity of monetary theory. Valued is stored precisely and exactly in the totality of all the diverse things which continue to exist, which continue to be subjectively valued, in the economy, whether houses, gold bars, oil barrels, diamonds, whatever. Money is just one tiny subset "store of value". This is also perhaps the reason the Keynesians and Monetarists were originally confused: they thought you had to create one dollar of currency "store of value" for "every ounce of subjective value" ever created by economic activity, as if hanging a sign in front of the house which said "store of value, no trespassing" would frighten away a tornado, and "magically" store its value. It would be careless negligence to try and store all value ever created in one form, to put all eggs in one basket. Value is stored in multiple forms, wherever subjective value continues to exist.

  It's also clearly "bad", if I want to win the Wimbledon tennis championship, to allow competition which is better than me. How else am I supposed to "store" my Wimbledon trophy?

  Michael A. Clem: "But, as Mises stressed, changes in the money supply do not affect the entire economy immediately, but rather, has an effect in a certain area (where the change occurs) that eventually is felt in the rest of the economy."

  And as rtr is stressing, it is exactly similarly so for any change in any supply or any change in any demand.

  Published: July 10, 2008 3:13 PM

• fundamentalist

  rtr: "How about "the whole question" about new corn creation? To ask is new corn creation fraudulent or not is ridiculous."

  There is no process where anyone can create corn, except in Star Trek. Growing corn requires the investment of savings, labor and time. No one can create it from nothing. Money creation requires none of the above, just a license from the state.

  rtr: "A "store of value"? This is another absurdity of monetary theory."

  If you stash $1,000 under your mattress, don't you want those dollars to be worth as much in exchange for goods when you take it out as it was worth when you put it in the mattress? That's all anyone means by money being a store of value. You're extreme reductionism is getting ridiculous. Yes everything is a store of value, but we're talking about the value of money, not the value of everything. Increasing the supply of any commodity is difficult and expensive. As a result, the value of most things change very little in relation to each other. Any form of money that is not a commodity is very easy to create from nothing. That ease of creation makes it very easy for banks and states to destroy the value of money by overproducing it.

  Published: July 10, 2008 3:52 PM

• Michael A. Clem

  There is no coercion or fraud in any transaction involving any amount of money. You are free to not trade for any amount, or you are free to trade for any amount of money you wish.
  
  Sure, just like I'm free to go to jail or leave the country if I don't want to pay my taxes (money) for all the wonderful "services" the governments provide.
  
  How about "the whole question" about new corn creation? To ask is new corn creation fraudulent or not is ridiculous
  As fundamentalist pointed out, you cannot create new corn with the stroke of a pen, or a computer entry, or by printing up pictures of corn on pieces of paper. You can buy corn that has been produced if you can get some freshly printed Federal Reserve Notes, backed by Treasury bonds (also pieces of paper with printing on them), and thus consume corn without any productive effort or value to back up those FRN's. People trade FRN's because they think they're worth something, but newly-created money without backing is fraudulent, and harms the purchasing power of people who provide productive goods and services to be paid money that they can then use to buy the goods and services of their choice.
  
  The market certainly does adapt to the changing money supply, just as it adapts to heavy and burdensome government regulation, or adapts to theft and natural disasters. That is exactly why an increase in the money supply devalues the money of hard-working people, and they don't know it until they go to the store and see higher prices.
  
  Adaptation or not, wealth transfers (theft) still occur, making the economy and most people worse off than they would be without the new money creation. The subjective value of society as a whole is reduced, the value of labor and entrepreneurship is diminished, and real production of things like corn is minimized.
  
  People still make the most valued trades that are available to them, under their circumstances, but they are better off when their circumstances give them more options rather than less.

  Published: July 10, 2008 4:27 PM

• rtr

  fundamentalist: "As a medium of exchange, money has value to people as it serves that purpose. The value that people place on that service doesn't change randomly or by whim; it changes according to supply and demand."

  Money has subjective value. Period. Obviously when you are hungry and walk into a grocery store to buy some food you by definition prefer the food to the money, and the grocery store prefers your money to the food. This is why, *the only reason why*, the trade occurs. By definition of trade, the marginal *value* of money changes for both you and the grocery store. That marginal quantity of money is worth less than the food for you, and worth more than the food for the grocery store.

  Otherwise you would be committing the infinite looping trade cycle fallacy whereby you were *indifferent*, whereby you and the grocery store valued the money and the food equally, and would just stand there at the register buying and refunding over and over. The same marginal quantity of money is valued *differently* by both you and the grocery store. This is why the trade occurs.

  This demonstrates, this *proves*, that money is subjectively valued, by the fact that it is traded for different things. Money is just the most commonly traded thing, is just a proxy measuring stick solely by custom. Read Adam Smith and the Wealth of Nations, and look how anachronistic his use of "prices" supposedly measuring value a mere few centuries ago is today. All those ancient Greek references to prices are basically senseless in today's world. The things and quantities they use to measure value no longer exist in widespread use.

  fundamentalist: "Doubling the supply of gold would cause the same effect. Spain experienced it in the 1500's."

  Then doubling the supply of anything, or changing the supply of anything in the slightest would cause the same effect. The Spain story is obviously misdiagnosed on faulty economic theory. There's plenty of such misdiagnosed stories. I find it not only hard to believe, but epistemologically impossible that a doubling of a money supply would leave people dumbfounded anymore than a halving of a wheat crop would leave people dumbfounded.

  fundamentalist: "But an increase in goods is an increase in real wealth. An increase in the money supply that does not come from increased savings destroys wealth."

  That's an absurdity. How ridiculous can theory get to anthropomorphically believe increasing another thing "destroys wealth". If money is subjectively valued, an increase in its supply increases wealth, or at best lowers its supply and demand marginal unit valuation (as long is money is still being subjectively valued by people, by evidence of it being accepted in trade). Just as if corn is subjectively valued, an increase in its supply increases wealth. If either didn't increase wealth, people wouldn't trade other things for money or corn. But such is the inescapable absurdity monetary theory logically embraces.

  fundamentalist: "The increased supply of money causes increased demand for scarce capital goods and increases in prices. That's why the boom is not sustainable.

  I'm curious as to what you think causes business cycles. Are you like the Keynesians who think they are acts of God?"

  There is no such thing as a (*cough* anthropomorphic *cough*) business cycle. Business cycles are unscientific fairy tales, believed with the same fervor that it was believed the Sun revolved around the Earth. There's no "boom" because increasing money doesn't magically increase the supply of other goods. The same other goods which exist before a change in money supply exist after a change in money supply. They can merely be moved, traded, from one person to another person.

  fundamentalist: "All promises aren't created equal."

  No they are not. That's why they are subjectively valued. That's why credit ratings agencies exist.

  fundamentalist: "You're trying to lure us into an extreme from of reductionism in which everything looks the same and no clear distinctions can be made."

  I'm trying to get you to see economic reality. Distinctions are worthless if they are false or contradictory. Monetary theory is fundamentally fatally flawed. And an entire half of a field called "macroeconomics" is built upon that error.

  fundamentalist: "And there is a huge difference between mining and refining a commodity, such as gold, and creating money out of thin air, as does fractional banking. If any and all commodities could be created from air without cost, as they did on Star Trek with their replicators, then there would be no scarcity of goods and no prices."

  Now you're getting the picture. Everything is subjectively valued. Do you pay anybody for the air you breath? Signing autographs creates value "out of thin air" too. Do you deny this? The exhibition of evidence is at the sports convention where fans are paying for autographed memorabilia. All subjective value whatsoever is "created out of thin air" by definition of it being subjective value and not Marxist intrinsic objective value with price signs independent of human actors. Why is it so hard to accept that such subjective valuation applies to money too? Because people are blinded by, are boxed in, by faulty monetary theory, which believes prices don't exist without money.

  fundamentalist: "The only commodity that I'm aware of that can be created without cost out of thin air is money"

  No, you mean fiat paper money, not necessarily all forms of money. And it doesn't matter how it's created, it only matter whether it's subjectively valued. Perhaps it's prudent to be a good entrepreneur and anticipate how the subjective valuation of various forms of money will vary through time. Ideas can be multiplied out of thin air as well. By "magic", more than one person can read these thoughts I have written at the same time.

  Published: July 10, 2008 4:38 PM

• Mike Sproul

  Newson:
  "isn't the rbd just the direct descendent of the british "banking school"?"

  Yes. You'll find Thomas Tooke and John Fullarton cited in some of my RBD papers. I think their main error was in admitting the existence of fiat money, while still claiming that the issue of derivative moneys by private banks was not inflationary.
  The banking school, in turn, repeated most of the arguments of the antibullionists of 1810. You'll also find some references to Charles Bosanquet, a leading antibullionist, in my papers.

  Published: July 10, 2008 4:40 PM

• Scott D

  rtr:

  I'm just going to pick out a little bit to critique while I digest the whole of your argument.

  "Who's forcing them to accept the terms? No, they accept them voluntarily by definition of having the possible choice to decline all trades involving any amount of money."

  This sounds to me a lot like one of the "Fairtax" arguments for why sales tax is voluntary. But you have ignored the unseen. Let's imagine that, by government decree, both parties to a transaction (or a person legally representing them) must engage in a sexual act with a government worker before the exchange is allowed to occur. This law would be violently enforced when necessary.

  Now, would you say that people subjectively value this sex act, since they submit to it whenever they make a purchase? Correct me if I'm wrong, but your reasoning would seem to indicate that they DO value it. My contention is that such thinking does not come close to human reasoning at all. Motivation for action cannot be evaluated without context, and coercion is not a contextual element that you can easily disregard.

  Yes, people do use paper dollars to trade, but that does not mean they would not mutually agree to use some other form of money, if given the choice, just as people would rather not have sex with a stranger to buy something. Your assertion would only apply if people had the option to ask for other types of money in payment, which they don't.

  Published: July 10, 2008 4:45 PM

• Mike Sproul

  Michael Clem

  "I don't understand this stuff about "increasing the supply of needed cash" and then absorbing "unwanted" cash. The demand for cash is about whether people want to hold cash reserves or spend their cash, not about people "needing" more cash for 'liquidity'. People cannot increase or decrease their cash except by controlling how they spend their earnings. "

  When my stock of cash becomes big enough that I decide I'd rather convert it to some financial security, then I have too much cash. When I have too little cash, I'll want to sell financial securities for cash. You sound like you're only thinking of cash being traded for goods.

  Published: July 10, 2008 4:48 PM

• rtr

  Scott D: "people do use paper dollars to trade, but that does not mean they would not mutually agree to use some other form of money, if given the choice,"

  Of course people would use other forms of money in the absence of fiat government interference in the market. And privately generated credit money is indeed the dominant monetary source. There's no doubt that central bank interference is inefficient, causing society to be net poorer than it otherwise would be, and the monetary system is less robust and more volatile than it would otherwise be from a free market determined money, of any and all forms. But that doesn't wipe away the laws of economics, or excuse fundamentally flawed monetary theory.

  Here's an experiment to conduct. Go to a public square and start dropping $100 bills on the ground. See if anyone picks them up. There is no compulsion whatsoever to compel anyone to pick up those $100 bills, yet they will, and they only will, because those $100 bills have positive economic subjective valuation. Let us know the results of your experiment, and how much money it takes you to learn the lesson. :P Case closed.

  Published: July 10, 2008 7:13 PM

• newson

  to mike sproul:
  thanks for the references.

  Published: July 10, 2008 7:15 PM

• rtr

  newson: "if there were no fed, frb would result in the boom/bust cycle."

  There is no "boom/bust cycle". It is an epistemological impossibility. Take the economy of apples, oranges, and fiat dollars. Triples the supply of dollars. There are still the exact same number of apples and oranges as before the supply of dollars is tripled as there is after the supply of dollars is tripled. There can be no "boom" whatsoever. If there is no "boom", there is no "bust".

  All that can occur is apples and oranges end up held in different quantities by different individuals, which will still only occur by the law of trade, that which is received is valued more than that which is given away in exchange.

  Of course it is "unfair" that the only the government has this money. Of course that monopoly is preventing the supply of dollars from approaching infinity and becoming worthless from free market competition in supplying dollars, and of course dollars would collapse as something of subjective value in a free market.

  newson: "in a practical sense, whilst individual credits are indeed temporary, they are always rolled-over, or new clients replace old. so the aggregate effect is a rise in credit (and therefore money supply under frb) that continues until it doesn't!"

  The exact same thing can and will occur in *any* monetary system, as long as the government is merely enforcing contracts. There's no limit to the number of contract promises which can be made, recorded, and traded away to others.

  newson: "people loaning directly to other people, businesses offering purchase plans - all of these are money supply neutral, merely the temporary swapping of purchasing power."

  It is not money supply neutral by definition of promises having subjective value, by definition of promises having purchasing power. Take an economy with apples and oranges. Then add promises to the economy. Now trade won't just consist of apples for oranges, and vice versa, but consist of promises bidding for, trading for, those apples and oranges. Those who create those promises get to afford apples and oranges they couldn't otherwise.

  newson: "this bullion inflation was atypical in the past, and likely to be even more so in the future (surface deposits are less likely due to improved aerial scanning etc)."

  It doesn't matter. It's immaterial. That bullion either has subjective value, or it does not have subjective value. There's no in between third way possibility. The market prices all changes in supply and demand by definition of trade. Inflation is a price change of money because it is a supply change of money, just exactly as a doubling of the corn supply is a price change of corn because it is a supply change of corn.

  Inflation of the money supply works itself unevenly and non-simultaneously through the economy, just as all supply and demand changes of all other things work themselves unevenly and non-simultaneously through the economy. They send price change *signals* which advertise "more of this, less of that" wanted.

  Published: July 10, 2008 7:41 PM

• rtr

  jp: "Economists do not bother to pry open the heads of people for the reason they exchange apples for oranges. ie - apples are healthier, they are sweeter, etc. Mises wrote that this was the realm of psychology, not economics.

  But when it comes to money, these same economists have built up an impressive list of reasons people trade money for other goods ie. money is a more convenient means of exchange, it is a better store of value, it serves as a precautionary asset, it has speculative properties, it represents backing, or even decorative purposes as you pointed out. This listing and prioritization of motives contradicts Mises' point about the immeasurability of the subjective use value of something."

  Exactly correct jp. You nailed it. Monetary theory, and this cuts across all economic schools (including the Austrian) is just a different form of the fallacious Marxist intrinsic labor theory of value. It's completely hilarious to watch Austrian economist commentators hail the "use value" of money, and not realize they have devolved backward to the pre- economic science history which was overcome by Menger. An entire sub discipline of "macroeconomics" has been constructed upon alleged intrinsic objective "use value". It would have been phenomenally fantastic to have been able to debate Mises on this topic. Knowledge sometimes continues to advance.

  jp: "It seems to me that whatever subjective reason an economist prioritizes as the cause for money demand dictates the structure of their theory. Austrians and classical economists priviledge the means of exchange motive, Keynesians the store of value/speculative motive etc."

  Bingo. You are on a roll.

  jp: "Mises puts forth an interesting epistemological account in Part 2 Ch 1 of Theory of Money and Credit that explains why money is different from all other commodities. I guess you would disagree with all that too?"

  That was the very first book I read by Mises (I think this is also the first book Mises wrote too, so his theories and epistemological demonstrations would end up being much more refined and polished through the decades). Of course he is flat out epistemologically wrong, though I certainly didn't immediately realize it (but then nor did anybody else -- "Money/Gold" is a huge Platonic "Cave" which has been perplexing people for millennia until the Menger marginal utility demonstration of *a* diamond being traded for *a* glass of water, and not all the diamonds being traded for all the water). Had to ask the right questions first, but I was disagreeing with my classmates over pitchers at Jimmy's Woodlawn Tap on monetary theory all the time. In the end, the correct definition of money is just the most commonly exchanged thing in trade (and this is more robust as it takes account of all transactions, and not just those involving "money" -- and there are huge Misean action theory demonstrations which follow and paint a clearer jigsaw puzzle picture).

  Trade is the fundamental epistemological economic activity. And it's explicitly mathematically defined as two persons valuing the exact same good differently, one strictly greater, one strictly lesser (this fits *perfectly* on the line, on the reason for which all action occurs). All economic theory must be strictly in agreement with this, tested against it. This is much more cleaner and even more powerful with regard to the condemnations of socialism and government interference in the market. The first big demonstrable conclusion which follows is that preventing free trade is actually *causing* poverty, preventing wealth from being created by trade. Libertarian Victory becomes a simpler demonstration of comparative advantage epistemological trade demonstration, losing the baggage of confusing "business cycle" "monetary theory".

  Mises: "Nevertheless, while the utility of other goods depends on certain external facts (the objective use-value of the commodity) and certain internal facts (the hierarchy of human needs), i.e., on conditions that do not belong to the category of the
  economic at all but are partly of a technological and partly of a psychological nature, the subjective value of money is conditioned by its objective exchange-value, i.e., by a characteristic that falls
  within the scope of economics."

  It would have been embarrassing, if everybody else wasn't just as wrong, or maintained even sillier theories. He's violating his own epistemological insights on action: action only occurs to go to a state of lesser dissatisfaction from a state of greater dissatisfaction. But even Mises held that the value of money was subjective. How could he not after seeing the collapse of the post WWI mark? He just wasn't able to break away from the fundamental flaws before going on to write his masterpieces, though I speculatively think he came close a couple of times and may have even suspected. But if he would have went on to such demonstrations he would have seriously discredited the work of Rothbard, and proved his Nobel Prize winning "business cycle" work was completely wrong (not that he couldn't have gotten 10 more for different advances). But we should be happy this is discovered 25 years later rather than 200 years later. It opens up a whole bunch of exciting new theory and research diagnosis possibilities. His thorough carefully laid epistemological demonstrations made it much easier to reconnect the puzzle pieces. But at the time, that *equation* of value worked nicely for "economic calculation", worked nicely for an "equation" of supply and demand "equaling" *A* price. But what would earth 20th century economists try to explain more than anything else but "value" and "money"? There was a huge intellectual race to build the best monetary theory connecting economic activity. They couldn't see that "money" was fundamentally *just another good*, a special case of "just another good". but nevertheless fundamentally just another subjectively valued good subject to changing subjective valuation and evolution of form.

  But if Mises were around today he'd probably be calling those spouting intrinsic use value theory of money "a bunch of damned socialists". :P

  Published: July 10, 2008 9:09 PM

• rtr

  Michael A. Clem: "As fundamentalist pointed out, you cannot create new corn with the stroke of a pen, or a computer entry, or by printing up pictures of corn on pieces of paper. You can buy corn that has been produced if you can get some freshly printed Federal Reserve Notes, backed by Treasury bonds (also pieces of paper with printing on them), and thus consume corn without any productive effort or value to back up those FRN's. People trade FRN's because they think they're worth something, but newly-created money without backing is fraudulent, and harms the purchasing power of people who provide productive goods and services to be paid money that they can then use to buy the goods and services of their choice."

  You are absolutely correct except for the use of the word "fraudulent". The only reason this can continue is because the government establishes a fiat monopoly on that printing of that money. In the absence of that fiat monopoly, those FRNs would lose their subjective value, would become worthless, as everybody would be free to increase their supply to infinity, and a new form of more sound money would quickly evolve to take its place.

  But it also doesn't a priori mean any of those things couldn't have subjective value. A "corn bill" might look artistically fancy hanging from a wall, or be issued by ethanol gasoline sellers. :P

  Michael A. Clem: "The market certainly does adapt to the changing money supply, just as it adapts to heavy and burdensome government regulation, or adapts to theft and natural disasters. That is exactly why an increase in the money supply devalues the money of hard-working people, and they don't know it until they go to the store and see higher prices."

  You are again absolutely correct. But that's solely because of the fiat monopoly function, and not the act of changing the supply of money. In a free money market, that would not occur, because the fiat money supply would quickly be devalued to zero and disappear.

  Michael A. Clem: "Adaptation or not, wealth transfers (theft) still occur, making the economy and most people worse off than they would be without the new money creation. The subjective value of society as a whole is reduced, the value of labor and entrepreneurship is diminished, and real production of things like corn is minimized."

  The only theft is the theft of prohibiting free market competition in supplying money. But other than that, your prognosis is again correct. Government sanctioned Banking Parasites would likely have to start performing productive work to create subjective value, rather than living off of the monopoly protectionist grant of creating new money when they feel like it from forms which can easily approach valueless infinity. Obviously, they don't want to do that. They'd rather other people were the ditch diggers.

  Michael A. Clem: "People still make the most valued trades that are available to them, under their circumstances, but they are better off when their circumstances give them more options rather than less."

  Exactly. The solution is to eliminate the government monopoly on creating money. Let a free market money evolve, and possibly compete against other various free market money forms.

  Also realize that by demonstrating the fallacies of alleged market calculation problems ("boom bust business cycles") we have simultaneously demonstrated the case against the same fallacies which are alleged against "deflation".

  Published: July 10, 2008 10:08 PM

• newson

  rtr says:
  "There is no "boom/bust cycle". It is an epistemological impossibility. Take the economy of apples, oranges, and fiat dollars. Triples the supply of dollars. There are still the exact same number of apples and oranges as before the supply of dollars is tripled as there is after the supply of dollars is tripled. There can be no "boom" whatsoever. If there is no "boom", there is no "bust".

  but you are glossing over the critical insight of the austrian school, that is the way the increased money supply works its way through the economy. it is not distributed simultaneously and in equal proportions to all money holders.
  by lowering the interest rate, using the banking system as its mechanism, the fed can influence how capital is used by businessmen. projects' npv are obviously determined by the prevailing interest rate. change that, and you change the entire complexion of the economy.

  Published: July 11, 2008 12:05 AM

• newson

  rtr says:
  "But if he would have went on to such demonstrations he would have seriously discredited the work of Rothbard, and proved his Nobel Prize winning "business cycle" work was completely wrong..."

  you mean hayek, don't you?

  Published: July 11, 2008 12:30 AM

• Scott D

  "Here's an experiment to conduct. Go to a public square and start dropping $100 bills on the ground. See if anyone picks them up. There is no compulsion whatsoever to compel anyone to pick up those $100 bills, yet they will, and they only will, because those $100 bills have positive economic subjective valuation."

  See if you can fit this into your framework: Set up a socialist state that distributes vouchers for food, clothing, furniture, etc, with all other forms of "money" illegal. Drop some of those vouchers in a public square and observe the results.

  Published: July 11, 2008 8:30 AM

• fundamentalist

  rtr: “Money has subjective value. Period.”

  No one is debating that. I agree completely. Where I disagree with you is that you want to stop with subjective value and marginal value and investigate no further. You refuse to look at what determines subjective value. Scarcity and utility go into determining subjective value. As the supply of money increases relative to goods, people subjectively value money less than they did before the increase. As a result, they will trade more money for the same goods because the marginal value of money to them has fallen.

  rtr: “Then doubling the supply of anything, or changing the supply of anything in the slightest would cause the same effect.”

  That’s true, but trivial. And you keep changing the subject. We’re talking about money, not other goods. While it’s true that shortages of goods have caused money to increase in value in the past, especially during crop failures caused by drought or during war, at no time have we seen a doubling of production of any good in a short time period. And that’s the whole point of this discussion. Is it possible to double the world’s output of corn in a year? Absolutely not. Is it possible to double the nation’s money supply in a year? That’s easy. In fact, we could increase the world’s money supply by 1,000% in a year’s time if we wanted to. Rwanda has done it.

  You simply refuse to admit that a difference exists between money and other commodities. That difference is the ease with which money can be created but other goods cannot. And when money creation exceeds the increase in goods/services, its subjective and marginal values falls.

  rtr: “How ridiculous can theory get to anthropomorphically believe increasing another thing "destroys wealth". If money is subjectively valued, an increase in its supply increases wealth, or at best lowers its supply and demand marginal unit valuation ….”

  You have to many wrong ideas in those two sentences to deal with in a blog. I recommend you read Bastiat on what constitutes real wealth. Here’s a hint: it’s not money. To understand economics, you have to get over your obsession with subjective value. There is more to economics than subjective and marginal value, a lot more. You should also read something about the Austrian Business Cycle, which shows that money created from thin air destroys wealth by causing malinvestments and transferring wealth from one group to another. It’s not the actual act of creating new money that does this, but the wealth destroying activities it tricks humans into committing.

  rtr: “Business cycles are unscientific fairy tales, believed with the same fervor that it was believed the Sun revolved around the Earth.”

  That’s what I thought. The ups and downs in the economy that even the uneducated man on the street recognizes are just figments of our imaginations. As wrong as Keynesian econ is about most things, even Keynesians don’t deny that business cycles exist. What would you call the regularly occurring periods of rapid growth in employment and sales followed by the sudden collapse in employment and sales that the rest of us idiots have been seeing in the economy for the past 200 years?

  rtr: “Perhaps it's prudent to be a good entrepreneur and anticipate how the subjective valuation of various forms of money will vary through time.”

  And that’s exactly what the Austrian Business Cycle does.

  rtr: “Go to a public square and start dropping $100 bills on the ground. See if anyone picks them up.”

  That doesn’t prove anything except that people value money, which is about as trivial as you can get. The discussion on this thread is about how people value money relative to other goods and services and your example says nothing about that.

  I don’t know what to think about you, rtr. First you trash Mises, then in your responses to Michael Clem you sound exactly like him. You claim that subjective value is everything and we should consider nothing else, then you add that increasing supplies can change subjective values. You claim that the supply of money has nothing to do with its value, then write “In the absence of that fiat monopoly, those FRNs would lose their subjective value, would become worthless, as everybody would be free to increase their supply to infinity... In a free money market, that would not occur, because the fiat money supply would quickly be devalued to zero and disappear.” The only thing you don't seem to recognize is the destructive effects of money creation.

  By the way, you appear to support free banking and so did Mises. But Mises arrived at his support for free banking as the logical conclusions of his monetary theory, which you think is so wrong.
  

  Published: July 11, 2008 9:04 AM

• rtr

  newson: "but you are glossing over the critical insight of the austrian school, that is the way the increased money supply works its way through the economy. it is not distributed simultaneously and in equal proportions to all money holders."

  It is exactly the same phenomenon for all changes in supply and demand for all other goods. Transactions are discrete. Nobody simultaneously trades all of one good for all of another good. That's the way prices signal changes to the rest of the economy. (This is the area of Hayek expertise.)

  newson: "by lowering the interest rate, using the banking system as its mechanism, the fed can influence how capital is used by businessmen. projects' npv are obviously determined by the prevailing interest rate. change that, and you change the entire complexion of the economy."

  The Fed cannot change the real capital goods which exist. The supply of real capital goods is exactly the same after Fed policy change as it is before Fed policy change. For every different project begun, another project must by definition be forsaken, by definition of trade. Somebody must trade capital goods away to holders to newly created money. At the margin, for you to secure the materials to open your Hamburger Stand, I must forsake the materials to open my Hot Dog Stand. The only thing which can change is which particular individuals control capital goods. The highest npv of capital goods before Fed policy change will still be the highest npv of capital goods after Fed policy change.

  Published: July 11, 2008 9:28 AM

• rtr

  Scott D: "See if you can fit this into your framework: Set up a socialist state that distributes vouchers for food, clothing, furniture, etc, with all other forms of "money" illegal. Drop some of those vouchers in a public square and observe the results."

  And what would those results be? People that dive for the "up for grabs" voucher coupons will be shot? Those caught trying to claim more than their "fair share" will be sent to the gulag? Or the same effect as dropping $100 bills will occur. People will pick them up and consider it a "bounty inheritance". That's correct. Economics and free trade will continue to operate in spite of socialist restrictions to the degree it can.

  Published: July 11, 2008 9:35 AM

• Michael A. Clem

  When my stock of cash becomes big enough that I decide I'd rather convert it to some financial security, then I have too much cash. When I have too little cash, I'll want to sell financial securities for cash. You sound like you're only thinking of cash being traded for goods.
  
  Okay, so what? The question is how does the bank's changes in the money supply affect your cash and demand for cash. An increase by the bank doesn't change the nominal amount of your cash, only the value of your cash, whether you're buying goods, services, commodities, securities, or whatever.

  Published: July 11, 2008 10:25 AM

• Michael A. Clem

  You refuse to look at what determines subjective value. Scarcity and utility go into determining subjective value.
  
  I agree. Subjective value doesn't mean that people value things randomly or haphazardly. There are good, rational reasons for how people determine and apply subjective value.

  Published: July 11, 2008 10:35 AM

• rtr

  fundamentalist: "You refuse to look at what determines subjective value."

  Of course I do. I'm not a psychologist. :P

  fundamentalist: "As the supply of money increases relative to goods, people subjectively value money less than they did before the increase. As a result, they will trade more money for the same goods because the marginal value of money to them has fallen."

  We agree completely.

  fundamentalist: "We’re talking about money, not other goods."

  Money behaves economically just like any other good.

  fundamentalist: "at no time have we seen a doubling of production of any good in a short time period. And that’s the whole point of this discussion. Is it possible to double the world’s output of corn in a year? Absolutely not. Is it possible to double the nation’s money supply in a year? That’s easy. In fact, we could increase the world’s money supply by 1,000% in a year’s time if we wanted to. Rwanda has done it."

  A doubling is just the inverse of a halving. The economic phenomenon effects will be the same, just in the opposite direction. We've certainly seen many farming crops fall by half. The market adjusts for any and all changes in supply and demand for any and all goods, money included.

  fundamentalist: "You simply refuse to admit that a difference exists between money and other commodities. That difference is the ease with which money can be created but other goods cannot. And when money creation exceeds the increase in goods/services, its subjective and marginal values falls."

  There is no difference between money and other commodities. They are both independently subjectively valued for whatever reasons. You are confusing one paper fiat form of money, with all other possible forms of money. It's not likely a free market would value money which is known to inflated with fractional reserve banking at the same quality and price as money which is not inflated with fractional reserve banking. The free market will sort it quickly. End the government monopoly on fiat paper money, and let everyone compete and supply to whatever extent they wish, and that fiat money will disappear as worthless in quick time.

  fundamentalist: "You should also read something about the Austrian Business Cycle, which shows that money created from thin air destroys wealth by causing malinvestments and transferring wealth from one group to another. It’s not the actual act of creating new money that does this, but the wealth destroying activities it tricks humans into committing."

  Sorry if I'm laughing, but that is completely anthropomorphic. I see "witches" and "spells" "tricking" and turning the people into sheeple. Destruction, terror, mayhem, malinvestments, robbery; all from pulling a xeroxed copy of money out of the witches brew. There's got to be some relation between alchemy, gold, money, and monetary theory.

  "Double, double, toil and trouble,
  Fire burn, and caldron bubble."

  fundamentalist: "The ups and downs in the economy that even the uneducated man on the street recognizes are just figments of our imaginations. As wrong as Keynesian econ is about most things, even Keynesians don’t deny that business cycles exist. What would you call the regularly occurring periods of rapid growth in employment and sales followed by the sudden collapse in employment and sales that the rest of us idiots have been seeing in the economy for the past 200 years?"

  I'd called those drastic changes in subjective valuation. Market stop loss orders. Subjective valuation is not constant, is always in a state of flux, sometimes significantly. Yet we don't call "pet rock" phenomenons "business cycle malinvestment". These phenomenon are not accurately epistemologically demonstrated. That's my main point.

  fundamentalist: "The discussion on this thread is about how people value money relative to other goods and services and your example says nothing about that."

  They value money *exactly* as relative to other goods and services as those other goods and services are relatively individually separately valued to each other. Money is just as relative to apples and oranges, as oranges are relatively valued to apples. The process by which relative changes of supplies and demands of other goods are worked through the economy is exactly the same as the process by which relative changes of supply and demand of money is worked through the economy.

  fundamentalist: "You claim that subjective value is everything and we should consider nothing else, then you add that increasing supplies can change subjective values."

  It all starts with subjective valuation, action, and trade.

  fundamentalist: "By the way, you appear to support free banking and so did Mises. But Mises arrived at his support for free banking as the logical conclusions of his monetary theory, which you think is so wrong."

  We disagree (if we were to disregard epistemological *demonstrations*) on methodological steps. I take a straight line rather than a roundabout journey frought with errors to get to free banking. Free banking does not necessarily imply "gold standard". Unfortunately, all monetary theory is pure junk. One can only work and advance from where one begins with time constraints. Mises priority was in demonstrating the fallacies of socialism. He didn't delve as epistemologically deeply into the the formation of money, and took too many assumptions as givens from his contemporaries. But my demonstration is a 100% pure Austrian descendant of Menger's marginal utility demonstration. Price was ingrained as "money" for millennia. Menger answered the first perplexing question of how a diamond could be more valuable than a glass of water, in terms of how much money would be traded for each separately, hence why a diamond could be more valuable than a glass of water. Now it is crystal clear that everything, money included, is relatively valued to everything else. Supply and demand free market trade will establish the price values for everything, money included. This necessarily proves business cycle malinvestments as false. This necessarily proves intrinsic use-value monetary theory as false. The End.

  Published: July 11, 2008 10:41 AM

• newson

  rtr says:
  "I find it not only hard to believe, but epistemologically impossible that a doubling of a money supply would leave people dumbfounded anymore than a halving of a wheat crop would leave people dumbfounded."

  then how to you explain the general public acceptance of the federal reserve, when you consider the massive erosion in purchasing power of the dollar since 1913? i remember in my undergraduate degree in finance very little emphasis was given to money, and i still find it a very complicated topic.

  Published: July 11, 2008 10:52 AM

• newson

  rtr says:
  "The highest npv of capital goods before Fed policy change will still be the highest npv of capital goods after Fed policy change."

  no, not necessarily. the npv will change according to the timing and size of the future returns. there is no guarantee that what was the preferred project before the interest rate change is still the most favourable one after.

  Published: July 11, 2008 10:59 AM

• Michael A. Clem

  I'd called those drastic changes in subjective valuation...These phenomenon are not accurately epistemologically demonstrated. That's my main point.
  
  Of course they're drastic changes in subjective valuation, but they, and the business cycle, occur precisely because of the money creation process. Austrians define inflation simply as an increase in the money supply. How is that not epistemologically demonstrated? It's true by definition.

  Published: July 11, 2008 11:05 AM

• newson

  to rtr:
  counterfeiters enjoy wealth taken in proportionate measure from every other member of society. small amounts are taken from many. is this not a crime? and if it's not deleterious, why did the british redesign the pound after the nazis' operation andrew (a massive warime counterfeiting exercise).

  if counterfeiting is a crime and is damaging, why is the creation of money via a central bank any less nefarious?

  Published: July 11, 2008 11:26 AM

• newson

  rtr's not jesus christ, he just a naughty boy!

  Published: July 11, 2008 11:36 AM

• fundamentalist

  rtr: "It all starts with subjective valuation, action, and trade."

  But it doesn't end there, and you again contradict yourself. Look at what you wrote to Michael Clem.

  rtr: "Mises priority was in demonstrating the fallacies of socialism. He didn't delve as epistemologically deeply into the the formation of money, and took too many assumptions as givens from his contemporaries. But my demonstration is a 100% pure Austrian descendant of Menger's marginal utility demonstration."

  You may have read Mises, but you clearly didn't understand a word he wrote. Half of "Human Action" is devoted to epistemology. Mises labored about epistemology to the point of tedium.

  rtr: "I find it not only hard to believe, but epistemologically impossible that a doubling of a money supply would leave people dumbfounded anymore than a halving of a wheat crop would leave people dumbfounded."

  I'm beginning to wonder if you know what epistemology is. It's the study of principles for determing what is true and not true. I don't think that fits with how you use it.

  As for dumbfounding people, a doubling of corn production would definately dumbfound them because it's impossible. They would recognize that they had witnessed a miracle. But a doubling of the money supply is easy, has been done repeatedly for centuries, and no miracles are involved, just fractional banking. At the same time, few people know it when the money supply doubles. All they see is the result--higher prices. What dumbfounds them is when people like you come along and tell them that the increased money supply had nothing to do with the higher prices; it's a figment of their imagination and the result of their subjective valuation.

  Published: July 11, 2008 11:38 AM

• Mike Sproul

  Michael Clem:

  "The question is how does the bank's changes in the money supply affect your cash and demand for cash. An increase by the bank doesn't change the nominal amount of your cash, only the value of your cash, whether you're buying goods, services, commodities, securities, or whatever."

  One way to understand the real bills position is to think of a mint that strikes new silver coins. If the mint strikes too many coins, people will melt them and use the silver, but the value of silver and silver coins is barely affected. The Law of the Reflux says the same is true of paper money. If some bank issues too much, then either that bank's paper will reflux to the issuing bank in exchange for bonds, or some substitute money (checks, credit cards, etc) will reflux to its issuer. If reflux channels are closed, then the money will lose value, since the closing of reflux channels is equivalent to a default by the issuer.

  Published: July 11, 2008 12:04 PM

• Michael A. Clem

  If reflux channels are closed, [as they are with the Fed?] then the money will lose value, since the closing of reflux channels is equivalent to a default by the issuer. -->as has happened since the creation of the Fed in 1913?

  Published: July 11, 2008 12:59 PM

• fusgerm

  Another brilliant guest appearance by Professor C (aka rtr). I regret I come late to the discussion. He throws a fresh perspective on Austrian economics even when making the most outrageous statements.

  "how is it that the market is perfectly able to deal with changing supplies of corn but somehow cannot deal with changing supplies of money? Relative supply and demand is signaled by free market pricing for absolutely everything, money included."

  If corn is represented by genuine warehouse-receipts, then the market will price corn correctly. If the granary manager has created a lot of fraudulent warehouse-receipts for corn backed only by farmers' promises to provide corn in future years, then the corn-market will be distorted. The present price of corn will be artificially depressed, and then one day it will shoot up asymptotically when the fraud is discovered, probably when starving peasants are thronging the warehouse.

  "credit generated by the private free market would similarly overwhelm a gold standard system just as it has overwhelmed the fiat currency system. Enforcing contracts causes limitless credit to be created."

  I agree that private credit can push up prices just as effectively as money. But there is a big difference between a credit instrument (such as a discounted bill of exchange) and a sight-draft for present gold (such as a banknote), as Mises pointed out in TMC. Merchants who accept credit do it at their own risk. But banks which create debt-backed deposits are protected by the taxpayer (e.g. through FDIC). Paper money penalizes taxpayers just as a compulsory no-fault insurance system penalizes policy-holders.

  "Fiat paper currency is easier to carry around than gold, and credit is easier to carry around than fiat paper currency. They are all subject to the economic concept of trust, or reputation."

  This is the polar opposite of Sproul's RBD. Actually, the value of gold is not dependent on trust but is ultimately derived from its non-monetary value, like any other commodity. The value of banknotes depend on trust only to the extent that it is not backed by assets. And even credit, if collateralized, is not wholly dependent on trust but on the value of the collateral.

  "Why is it "good" for the supply of all other goods to increase but it is "bad" for the supply of money to increase?"

  It is "bad" in the sense that it benefits the earliest recipients of the new money at the expense of the later recipients. In this sense the mining of gold is also bad, but gold increases at only 1-2% pa and is therefore far less pernicious than paper currencies in practice.

  "There is no such thing as a .. business cycle. The supply of real capital goods is exactly the same after Fed policy change as it is before Fed policy change."

  Depressed interest rates cause the business cycle due to a mismatch between investment and savings. Of course a greater range of capital goods will be created when interest-rates are lower, but the chance of completing all the projects will be reduced.

  Published: July 11, 2008 2:06 PM

• rtr

  newson: "then how to you explain the general public acceptance of the federal reserve, when you consider the massive erosion in purchasing power of the dollar since 1913?"

  Exactly the same way you would explain the massive erosion in purchasing power of many other goods which existed in 1913, since 1913. Changes in subjective valuation brought on by changes in supply and changes in demand. You don't see clothing manufacturers today clamoring for 1913 Singer sewing machine technology. I think it would also be highly unlikely that commodities have maintained a smooth unchanging relative pricing ratio between each other during that period, if you were to compare gold, silver, copper, zinc, diamonds, oil, etc all to each other.

  newson: "no, not necessarily. the npv will change according to the timing and size of the future returns. there is no guarantee that what was the preferred project before the interest rate change is still the most favourable one after."

  You're over complicating things too soon. Changing interest rates isn't going to effect the existence of any goods which already exist. Take an economy of apples and oranges. Now change the interest rate from 5% to 10%. That isn't going to effect the supply of anything. The same apples and oranges which exist before the interest rate change exist after the interest rate change. You're just *assuming* what you wrongly believe to be true. No business which was not going to be undertaken can subsequently be undertaken without depriving a business which was going to be undertaken from being undertaken. And a change in interest rates isn't going to change their relative ranked npv positions. By definition of free trade the highest expected returning investments will be funded by the market first with the next lowest funded last. There will always be smallest positive expected return investments which won't be funded because of limited investment capital resources. Changing the money supply isn't going to magically fund those investments. Austrian Business Cycle Theory is living in la la land. Trade of limited capital investment resources will *only* occur if what is received is subjectively valued more than what is given away in exchange.

  newson: "counterfeiters enjoy wealth taken in proportionate measure from every other member of society. small amounts are taken from many. is this not a crime? and if it's not deleterious, why did the british redesign the pound after the nazis' operation andrew (a massive warime counterfeiting exercise)."

  The fact that it could be counterfeited so easily is a sign of unstable weakness suggesting the original itself is not a scarce commodity but something which can be infinitely duplicated with ease. There's no such thing as "counterfeiting" in a dispassionate economic analysis. North Sea Brent oil isn't a "counterfeit" of West Texas Intermediate oil. Violence against "counterfeiting" is only causing supply of competing products to be less, is only causing the world to be net less wealthier. The Federal Reserve fiat currency only exists because of monopoly protectionism, because of prohibitions against "counterfeiting". This is how something of inherently unstable subjective value continues to exist for a long period of time without overnight becoming worthless because of infinite supply. If carbon dioxide were "money" would Austrians demand everyone stop breathing, would they claim breathing was causing malinvestment, poverty, etc?

  Published: July 11, 2008 2:06 PM

• rtr

  fundamentalist: "You may have read Mises, but you clearly didn't understand a word he wrote. Half of "Human Action" is devoted to epistemology. Mises labored about epistemology to the point of tedium."

  Sure he did. But he began from a faulty understanding and demonstration of money.

  fundamentalist: "As for dumbfounding people, a doubling of corn production would definately dumbfound them because it's impossible. They would recognize that they had witnessed a miracle."

  There's no market calculating market adjusting procedural difference between a doubling, a halving, or a teeny tiniest marginal change. Sure people might be shocked and awed, but market prices will nevertheless be reflecting market reality.

  fundamentalist: "At the same time, few people know it when the money supply doubles. All they see is the result--higher prices."

  There's a blatant contradiction. Assuming a constant supply of money is just as silly as assuming a constant supply (and demand) of every other good. And that's what the ABCT is doing (when you logically demonstrate by untwisting and unclouding the theory baggage). It's absurd to build a monetary and business cycle theory on an assumption that money supply remains a Constant. There's no difference between the teeny tiniest marginal change in money supply and a doubling, or any mathematical multiplier whatsoever you wish to deploy. It's ridiculous to believe that if a light a fiat dollar bill on fire I am causing "malinvestment" by changing the money supply. :P

  fundamentalist: "What dumbfounds them is when people like you come along and tell them that the increased money supply had nothing to do with the higher prices; it's a figment of their imagination and the result of their subjective valuation."

  I say no such thing. Changing supplies or changing demands of anything will effect subjective valuation. Obviously in an an economy of apples, oranges, and money, increasing the money means more money will bid for the same number of apples and oranges, by definition of trade, which will in absolutely every case whatsoever, *only* occur because that which is received is valued more than that which is given away in exchange, no matter what goods are involved, money included.

  Published: July 11, 2008 2:44 PM

• Alex

  An economy produces 100 identical perishable baskets of goods and services each year. Total real income of people is therefore also 100 baskets. Suppose some people wish to consume fewer baskets of goods and services in a given year so that they may be able to consume more baskets in the future. Others wish to consume more than their current income now and are wish to consume less in the future.

  Suppose such lending and borrowing takes place through a "bank," that issues bank notes in $1 denomination, and that each $1 may be used to buy one basket of goods and services. So, the initial price of each basket is $1.

  At any given time there are $10 of such loans made through the bank (to dissavers), supported by $10 of savers' deposits. The bank notes are also used as money. People are paid in bank notes and use bank notes to purchase baskets.

  The bank's balance sheet is: Assets ($10 loans); Liabilities ($10 deposits (bank notes)). Total desired annual consumption is 100 baskets ($100). There is no net saving. Saving by some people is simply matched by dissaving by others. So, total desired consumption=100 baskets=total production=$100

  Now suppose the bank attracts $5 of new borrowers (who want to consume 5 baskets in aggregate more than their income), and rather than go out to get $5 new savers' money (meaning getting some people to redeposit in aggregate $5 of bank notes to give, in turn, to the new borrowers), the bank simply gives the new borrowers newly created bank notes.

  The bank's balance sheet is now: Assets ($15 loans); Liabilities ($15 bank notes). The money supply has grown from $10 to $15, by creating $5 of loans that do not come from anyone's savings.

  Total demand for consumption increases by $5 to $105 (both in terms of dollars and baskets). But total supply is still only 100 baskets. The price per basket will thus rise to 105/100=1.05.

  Will it not?

  Published: July 11, 2008 2:46 PM

• rtr

  fusgerm: "If the granary manager has created a lot of fraudulent warehouse-receipts for corn backed only by farmers' promises to provide corn in future years, then the corn-market will be distorted. The present price of corn will be artificially depressed, and then one day it will shoot up asymptoticall"

  So you are saying futures, options, and various other derivatives markets are forms of fraud? That doesn't sound very Austrian. You are saying people don't recognize the difference between the actual commodity corn and the promise certificate to deliver corn in the future, and subjectively value each accordingly?

  fusgerm: "Merchants who accept credit do it at their own risk. But banks which create debt-backed deposits are protected by the taxpayer (e.g. through FDIC). Paper money penalizes taxpayers just as a compulsory no-fault insurance system penalizes policy-holders."

  Everybody who accept everything does it at their own risk. Risk, trust, reputation, effect subjective valuations. Of course all compulsion causes negative subjective valuation effects by definition of it not being voluntary forthcoming trade.

  fusgerm: "This is the polar opposite of Sproul's RBD."

  RBD is non-scientific trash just as much as every other School's monetary theory is trash.

  fusgerm: "Actually, the value of gold is not dependent on trust but is ultimately derived from its non-monetary value, like any other commodity."

  Ahh yes, the Marxist intrinsic "use-value" theory of value. How so-called Austrians come running back to thee! :P Unfortunately, Menger, the first Austrian, disagrees with you, not to mention so does mainstream economic theory disagree with you. The value of gold is determined by human subjective valuation. But the value of a particular individual's marginal quantity of gold may certainly be subject to risk if the potential traders for that gold do not trust that it is genuine. This is an extremely common market phenomenon, such as buying a bag of potatoes are a bushel of corn. People don't usually examine in detail every kernel of corn or every potato in a bag. That is a more or less conscious subjective valuation of quality being more likely than not which is by definition assigned a compartment piece valuation anywhere from some negative to some positive amount contained in the subjective valuations by definition expressed by the act of trade. If the risk were too great, assigned a negative valuation greater than what would potentially be gained by going through with the trade, the trade won't occur. This is why people give tastes, give samples, let them touch and squeeze their melons before purchasing. :P

  fusgerm: "It is "bad" in the sense that it benefits the earliest recipients of the new money at the expense of the later recipients. In this sense the mining of gold is also bad, but gold increases at only 1-2% pa and is therefore far less pernicious than paper currencies in practice."

  You heard the Austrian theory! Melt down your cell phones and computers and bury or destroy the gold content extracted. It is your Patriotic Duty to protect the queen mother money supply! :P New mined or discovered gold is "bad". It's *evil* they say. It casts trickery spells of malinvestment. If you don't obey maybe you will be turned into a sheeple, and be cast into the dungeons of poverty.

  Why isn't it also "bad" for the farmer who grows marginally more corn first? He benefits first from selling first, and denies the other farmers the ability to profit from that satiated fulfilled corn demand! He's not operating within the community declared fair production standards! He's producing more than his "fair share", flooding the market, and causing all farmers to suffer lower prices! Accuse him of the crime of causing malinvestment, confiscate his fields, and hang him! His wife and children can pay off his debt to society, if you know what I mean. :P

  fusgerm: "Depressed interest rates cause the business cycle due to a mismatch between investment and savings. Of course a greater range of capital goods will be created when interest-rates are lower, but the chance of completing all the projects will be reduced."

  No, the most productive uses of capital savings will be funded first, the second most second, and on and on, until there isn't enough capital left to fund the least productive use of capital savings. There will be no ranking change whatsoever. And those who have the biggest expected returns on capital will outbid those who have the least expected returns on capital. Interest rates have nothing do with your business plan of selling ice to the Eskimos. If you trade for capital goods savings you can do whatever you want with them, including starting your ice selling business at the North Pole.

  Published: July 11, 2008 4:19 PM

• Mike Sproul

  Michael Clem:
  "If reflux channels are closed, [as they are with the Fed?] then the money will lose value, since the closing of reflux channels is equivalent to a default by the issuer. -->as has happened since the creation of the Fed in 1913?"

  The fed's gold reflux channel was mostly closed in 1933 and further closed in 1971. In other words, the dollar is not physically convertible. The fed's bond reflux channel has always been mostly open. In other words, the dollar has always been financially convertible. Thus the Law of the Reflux is still applicable to paper money, just as it is to metallic money.

  Published: July 11, 2008 7:13 PM

• Mike Sproul

  rtr:
  "RBD is non-scientific trash just as much as every other School's monetary theory is trash."

  One of the less persuasive anti-RBD statements that I've heard.

  Published: July 11, 2008 7:22 PM

• fusgerm

  rtr says:
  "So you are saying futures, options, and various other derivatives markets are forms of fraud? That doesn't sound very Austrian. You are saying people don't recognize the difference between the actual commodity corn and the promise certificate to deliver corn in the future, and subjectively value each accordingly?"

  Strawman. There's nothing wrong with corn futures etc which are so identified. I spoke of the granary manager trying to pass off promises for future corn AS IF they were present corn. That is certainly fraud, and it will affect the price of corn in the way I described.

  The same is true of gold. The gold ETF claims to back its gold shares 100%. Investors would be peeved if the manager fraudulently substituted promises.

  It is true that fractional reserve bankers do not claim that deposits are warehouse-receipts. Since at least Carr v Carr, they have therefore been held not to be committing fraud. But the market is still in the dark. The market has no way of knowing or anticipating the reserve fraction. If a banknote is redeemeable in gold on demand, it is impossible to resolve the banknote into two components - one for the actual commodity gold and the other for the promise to pay gold in the future. The economic effect is therefore comparable to its being a fraudulent warehouse-receipt: it is treated as a gold-equivalent until the inevitable crisis causes a bank-run or statutory suspension of redeemability.

  Mises did not ask for 100% reserves. He asked for free banking. He argued that that would constrain money expansion to narrow bounds. You argue that it will simply drive credit into different forms. But the point is that those different forms are clearly identifiable as such, and thus the effect is limited to containable crises like tulipomania rather than systemic cycles.

  "RBD is non-scientific trash just as much as every other School's monetary theory is trash... Unfortunately, Menger, the first Austrian, disagrees with you, not to mention so does mainstream economic theory disagree with you."

  LOL! You disagree with EVERYONE's monetary theory, yet you cite a disagreement with mainstream economic theory against me.

  I look forward to your own treatise on economics, and I mean that seriously. Your position has certainly shifted in six months, if your current persona is expressing your real opinions.

  "the value of a particular individual's marginal quantity of gold may certainly be subject to risk if the potential traders for that gold do not trust that it is genuine. This is an extremely common market phenomenon, such as buying a bag of potatoes are a bushel of corn. People don't usually examine in detail every kernel of corn or every potato in a bag. ... If the risk were too great, assigned a negative valuation greater than what would potentially be gained by going through with the trade, the trade won't occur."

  Ad hoc counterfeiting of gold coins or gold-certificates is a small risk, yes. But its impact is nothing in comparison to the statutory protection of production of fiduciary media.

  "New mined or discovered gold is "bad". It's *evil* they say.... Why isn't it also "bad" for the farmer who grows marginally more corn first? He benefits first from selling first, and denies the other farmers the ability to profit from that satiated fulfilled corn demand!"

  The production of additional gold is "good" to the extent that it is put to non-monetary use. Corn production is "good" for the same reason: it subjectively benefits both the seller and the buyer. But newly mined gold which is put to monetary use undermines the suitability of gold as money. It's more of a zero-sum game. If gold increased at 10% pa then it would be as unsuitable as "fiat" currency. Some other commodity would be preferable. Its natural scarcity is one reason the market selected it as money.

  "No, the most productive uses of capital savings will be funded first, the second most second, and on and on, until there isn't enough capital left to fund the least productive use of capital savings. There will be no ranking change whatsoever. And those who have the biggest expected returns on capital will outbid those who have the least expected returns on capital. Interest rates have nothing do with your business plan of selling ice to the Eskimos. If you trade for capital goods savings you can do whatever you want with them, including starting your ice selling business at the North Pole."

  You ignore the fact that depressed interest rates will send false signals about the availability of savings. In Mises' words:
  The entrepreneurs employ the available supply of
  r+p1+p2
  as if they were in a position to employ a supply of
  r+p1+p2+p3+p4.
  They embark upon an expansion of investment on a scale for which the capital goods available do not suffice. Their projects are unrealizable on account of the insufficient supply of capital goods. They must fail sooner or later.

  Mises moderated his position on this between TMC and Human Action.
  

  Published: July 11, 2008 8:04 PM

• TLWP Sam

  If gold and every other commodity could be increased at a rate that it couldn't be used as money then a system of credit would have to be used.

  Published: July 11, 2008 10:05 PM

• rtr

  fusgerm: "I spoke of the granary manager trying to pass off promises for future corn AS IF they were present corn. That is certainly fraud, and it will affect the price of corn in the way I described."

  If I fraudulently sell the same house to multiple buyers that has no effect whatsoever on the price of (all) houses. It only has an effect on the imaginary prices of something which never existed (two extra copies of the same house sold -- which would be a deflationary effect on the price of houses as opposed to an inflationary effect -- or not -- more houses than actually exist are being signaled, are being temporarily perceived -- or not, it's just funneling bidding which would otherwise have occurred anyway to one particular individual committing fraud -- so it's marginally *lowering* the market value of houses -- or not, as two "extra" bidders for houses are temporarily removed from bidding on the remaining real housing market by the fraud -- there is no net effect whatsoever, as the exact number of transactions for houses which would have occurred occur anyway). The exact same amount of houses and the exact same amount of dollars exist before the fraud as exist after the fraud.

  If I sell the same $500k house to three different people simultaneously that does not change the marginal price for houses of that quality to $1.5M, it remains exactly at $500k, or likely slightly greater than $500k, as someone who really wants it more than the other two will offer something to obtain it, and they would do that as well in the absence of the transactions being fraud -- or not :P, as the other two victims of fraud would have just bid on different property houses which the act of fraud removes from occurring in the market.The effect is price neutral. Ding! Ding! Ding!

  Advertising the "greatest show on Earth" isn't fraud. If somebody subjectively after the fact values a movie they paid money to watch as bad, that isn't fraud. They traded for that possibility of post hoc valuation knowingly by definition of having the possibility (and learning by experience and inescapable changing subjective valuation of present tense risk) to not proceed with that trade transaction.

  Fraud has no effect on the pricing of real actually existing goods commodities. It merely transfers some good, usually "money", from one person to another person, which is no different than robbery (robbery doesn't change the supply and demand, it cancels the supply and demand out, merely transferring subjective value wealth from one person to another, as the exact same things which exist before the robbery exist after the robbery, merely the structural distribution of trade can change).

  Intentional fraud is equivalent to accidental failure in terms of market pricing. Intentional fraud probability will certainly be reflected in the pricing of car insurance policies, and perhaps pricing for car insurance policies will vary upon credit rating.

  Once it's declared "fraud", the market has been informed of reality, has received a signal, exactly as it does for any and all old routine changes in any and all supplies or changes in any and all demands. The market is pulled out of the "dark" that it is constantly treading water in, by definition of changing subjective valuations, signaled by all trade action. Thus, the victims of fraud will be unable to trade their previously not market wide known receipts to others. The market produces a stop loss order on continuing to accept the reputation and transactions of the person committing fraud, prevents the fraud from spreading like a plague. Just like I told you so. :P The net effect is a sucker and his money are soon departed, moved from one individual to another different individual.

  Trade transactions will signal information, will signal the number of transactions this granary manager has conducted. Why would anyone believe his promise in the first place? Why would they be unaware of his history? See drug dealers, risk, and reputation. It's always show me the stuff first, show me the money first trade (high noon) showdowns.

  People will learn credit rating lessons. People will always with various degrees be assigning a subjective valuation likelihood of the granary manager actually delivering. Quick! Find me an individual who can immediately with omniscient precision calculate the exact quantity of coffee which at this very moment exists, to the POUND! :P Does that mean if nobody, no particular individual in the whole wide world can accomplish this feat, that the price of coffee is "fraudulent", devoid of omniscient reality calculation? Of course not! Fraud or not, the exact same number and degree of pricing signals will be sent as if the transactions were not fraudulent (until the time of actual delivery inspection washes away the unknown, and perhaps signals a caution flag to be observed in the near term in the corn market, while any collateral damage on the market track is cleared, creating arbitrage profit opportunities for speculators to take risks confirming the best guessed, market *judged* supply and demand ratio, which signals any needed production corrections). (Hehe, that's some damn serious insight, if I do say so myself. You can put rtr "Strict Barter" up on the Austrian Economists poster being sold by mises.org, centered and overlapping over those other 6 guys, just as soon as the $10M advance is received :P). The person committing fraud has merely synthetically sold his neighbor's actually existing supply (or would have) to some non-synthetically actually existing (or would be) buyer of his neighbor's supply. New Demand doesn't magically jump in the pond spot temporarily displaced by the rock being tossed into the market. The prices for the goods traded would be exactly the same. No signals to increase or decrease supply of houses will be sent.

  Fraud is just a form of theft. If I steal your car, that doesn't reduce the supply of cars and cause the remaining cars to become more valuable. That would be a perfect new angle vision of the broken window fallacy. Breaking windows must certainly effect the price of windows! There's less windows after the act of breaking than there are before the act of breaking. The remaining windows are more scarce. Blah blah blah. But the effect is an immediate "bust", not in the slightest a "boom".

  But on the other hand what if Universal Car Manufacturer destroyed all the cars owned by everybody after they were sold? Would that then effect the market price for cars? The answer is:Of course it would! OR Absolutely it would not! Heh, that makes for a good paper "On the Economics of Fraud versus the Economics of Destruction". The answer is of course the former, as any remaining cars would be more valuable, would have more subjective value marginal utility, would go to serving only the most pressing needs/desires, or similarly so for the very marginally first range of newly created replacement cars.

  fusgerm: "Ad hoc counterfeiting of gold coins or gold-certificates is a small risk, yes. But its impact is nothing in comparison to the statutory protection of production of fiduciary media."

  Well yeah. Because the latter is an attack on a category action of competitive production and the former is actual market based competitive production. I could charge everybody for breathing air too if I just used violence to collect the tax.

  fusgerm: "The production of additional gold is "good" to the extent that it is put to non-monetary use. Corn production is "good" for the same reason: it subjectively benefits both the seller and the buyer. But newly mined gold which is put to monetary use undermines the suitability of gold as money."

  No. Wrong. No trade of extra newly created money occurs unless it by definition benefits the receiver of that newly created more than what he gives away in exchange. Just as this exactly occurs for every change whatsoever in any supply (previously existing or newly created categorical thing) or any demand of anything, of any other commodity good, whatsoever. Extra marginally created corn doesn't undermine the suitability of corn as food even if those marginal units were going to rot because everybody has already purchased all the corn they could ever possibly eat for the time being. It just marginally lowers the price of corn by increasing its supply. If anything, it signals to *not* increase production further, as that marginal extra supply/demand ratio has been (pretend) satisfied. No extra remaining bidders are still bidding for that transaction which is displaced by the fraud transaction. Nothing is involuntarily bid away. People don't seem to have a problem paying higher prices for the exact same quality latest technology televisions than those who later pay less as more are produced.

  People hold money for subjective reasons. People trade money for subjective reasons. People use money for subjective reasons. And people would always create money for subjective reasons, to the absolute potentially infinite limit of their capability and desire. A government monopoly on the production of money merely artificially delays the inevitable collapse, causes meantime poverty, and prevents the transfer of that artificially subjective value of money from being transferred to new different forms of money, in so far as money remains subjectively valued, supplied by other different producers. It's a medieval guild system preventing competition, not causing any malinvestment, but signaling best available returns on trade given the artificial restrictions much the same as current law and lawsuit supply is signaling an army of young lawyers to get degrees.

  fusgerm: "If gold increased at 10% pa then it would be as unsuitable as "fiat" currency. Some other commodity would be preferable. Its natural scarcity is one reason the market selected it as money."

  Wrong. That would be equivalent to saying if the supply of oil increased at 10% pa then it would be unsuitable as an energy resource. It's either subjectively valued by the market, by definition of trade, or it is not subjectively valued by the market, by definition of (non-) trade, no matter any decrees unto the wind of proper suitability. That's all that matters for all economic trade, (particular form of) money included.

  fusgerm: "You ignore the fact that depressed interest rates will send false signals about the availability of savings. In Mises' words:
  The entrepreneurs employ the available supply of
  r+p1+p2
  as if they were in a position to employ a supply of
  r+p1+p2+p3+p4.
  They embark upon an expansion of investment on a scale for which the capital goods available do not suffice. Their projects are unrealizable on account of the insufficient supply of capital goods. They must fail sooner or later."

  See the exposition on fraud above. There's no a priori reason this isn't always constantly occurring (with even constant interest rates), and in fact it is. See strip mall stores which close after a matter of weeks. See grand openings where nobody comes. See people getting bored with hula hoops. See entrepreneurs anticipating future events incorrectly. See half finished abandoned buildings and factory lines. See people changing their minds at random points in time.

  Published: July 11, 2008 11:24 PM

• newson

  rtr says:
  "a change in interest rates isn't going to change their relative ranked npv positions. By definition of free trade the highest expected returning investments will be funded by the market first with the next lowest funded last."

  this is incorrect. it may be under a high interest rate a project with a very rapid payback, but short life has a high npv with respect to a long-dated project (longer duration). changing the discount rate used for the npv calculation will necessarily alter their npv. it may also alter their ranking.
  in high inflation countries like zimbabwe, the high rate used as a discount rate in the npv calculation would favour investments with short, rather than long-term payoff streams. obviously investments made prior to the ir change are sunk capital and have no bearing on future investments.

  using fusgerm's corn analogy, the low corn prices generated by the dodgy depository receipts will have potential knock-on effects that are unpredictable. the low price may fool investors into punting on ethanol plants, whose expected returns look attractive when corn is cheap. change the price drastically (when the lack of corn becomes apparent), and we're back to begging opec for mercy. and the ethanol plants either rust, or the promoters petition their local member for help. watermelons can be grown in death valley if the cost of water is subsidized; how sustainable that is remains an open question (in this case the fed is the water company).

  i agree with you opinions on counterfeiting, but you seem to have ignored the monetary effects, dealing only with the actual material aspects.

  Published: July 12, 2008 12:19 AM

• rtr

  newson: "the low price may fool investors into punting on ethanol plants, whose expected returns look attractive when corn is cheap."

  There is no "low" price by definition of all prices always being exactly what they should be by definition of actually occurring trade. Your "fooling" is just once again the anthropomorphic magical witch trickery spell castings turning people into sheeple and causing destruction, terror, mayhem, and malinvestment.

  newson: "watermelons can be grown in death valley if the cost of water is subsidized; how sustainable that is remains an open question (in this case the fed is the water company)."

  Watermelons can be grown in death valley if anyone with the means so desires to grow watermelons in death valley, regardless of any Fed interest rate policies, for as long as one is willing and able to do so. Investment occurs for *subjective* reasons, not objective omnisciently known in advance objective reasons. Nothing in a free market prevents the rightful owner of immense capital goods savings from burning them down to the ground if he so subjectively desires for mere entertainment fireworks display purposes. The market ranking difference between p1 and p4 is purely subjective, *demonstrated* by willing and able mutually benefiting trade acquisition of means.

  If somebody begins construction of long term capital projects without having fully secured the means for which to do so, they are being out competed by somebody who does fully secure the means to complete their project, whether short term or long term. All distribution and use of capital goods occurs by voluntary trade. There is no Central Planning Commission which issues a Report of the A Priori Known Rankings of Use of Scarce Investment Capital Goods.

  NPV calculations are *subjective*, more preferred or less preferred by demonstrated trade action. Only a false monetary theory which uses intrinsic objective use-value "equations" between different goods would be so otherwise confused. NPV will always and only be signaled and undertaken by voluntary mutually beneficial trade transactions which actually put production plans into actual effect.

  newson: "you seem to have ignored the monetary effects, dealing only with the actual material aspects."

  So-called "monetary effects" are *exactly* material effects.

  Published: July 12, 2008 1:14 AM

• TLWP Sam

  Your post are interesting and fun to read, rtr. X) Your posts reminds of the Conservative saying which goes something like "you're not owed a living, period". It be nice if people in the whole world traded politely but if plenty don't, does it make sense to be a hermit until everyone does? No country in the world is not going back to a gold standard any time soon, so should we all be hermits until the world does? And so forth. A real world question is "no, the world's far from perfect and it'd be pointless to wait until it is, so how can people the deal with the world as it is?" Does buying gold and silver coins with your spare change amount to the next best thing to having gold and silver coinage currency? At least buying gold and silver coins is a real option whereas waiting for the currency to made of gold and silver coins isn't so crash hot.

  P.S. I inadvertedly got to be the 200th poster for this issue! :P

  Published: July 12, 2008 1:57 AM

• newson

  newson: "the low price may fool investors into punting on ethanol plants, whose expected returns look attractive when corn is cheap."

  rtr:
  "There is no "low" price by definition of all prices always being exactly what they should be by definition of actually occurring trade."

  by "low" i mean a price lower than it would have been, had there been no fraudulent depository receipts previously issued.

  regarding project evaluation: whether you think it has merit or not, npv calculation is the tool used by business to assess project viability, and changing the interest rate can alter projects' rankings.

  Published: July 12, 2008 2:37 AM

• Michael A. Clem

  Changing interest rates isn't going to effect the existence of any goods which already exist.
  
  Quite true, but it IS going to change how existing goods are used, because the changing interest rates changes the subjective valuation of existing goods.
  

  Assuming a constant supply of money is just as silly as assuming a constant supply (and demand) of every other good.
  
  ABCT is clearly not assuming a constant supply of money, but is explaining what happens because the money supply is not constant. Good theories explain things--they don't assume or ignore them.
  
  If I sell the same $500k house to three different people simultaneously that does not change the marginal price for houses of that quality to $1.5M, it remains exactly at $500k, or likely slightly greater than $500k,
  
  3 houses out of thousands or even hundreds of thousands is not going to have that big of an impact--nonetheless, it does have some small impact. Of course, the fact that it is so clearly a case of fraud also minimizes the impact, because it's quickly caught and corrected. The problem of new money creation is also relatively small (in the U.S., at least, but check out Zimbabwe's inflation!), but is not acknowledged and corrected, and thus has an increasing cumulative effect over the years.
  
  You recognize that we should have free banking, but you still seem to think that not having free banking isn't causing problems??

  
  

  Published: July 12, 2008 8:45 AM

• fusgerm

  rtr says:
  "If I fraudulently sell the same house to multiple buyers .. it's marginally *lowering* the market value of houses .. there is no net effect whatsoever, as the exact number of transactions for houses which would have occurred occur anyway). The exact same amount of houses and the exact same amount of dollars exist before the fraud as exist after the fraud."

  You have switched from corn, which is fungible, to houses, which are not. The sooner the fraud is revealed, the less the impact of the fraud. If I sell the same house to multiple people then the fraud will be revealed within a month (normally); fraudulent receipts for corn might well go undetected for a year, while fraudulent receipts for gold might go undetected for decades (when was Fort Knox last audited?).

  Once the fraud is discovered, prices will react at lightning speed to the new stock levels. Steady fraud produces steady inflation (of corn or gold) aborted abruptly by a deflationary implosion. That's a crude form of the Austrian business cycle.

  "fraud is equivalent to accidental failure in terms of market pricing."

  There's another possibility. The fraud might be legally reclassified as non-fraud. Is it fraud if I borrow funds which are entrusted to me? The law says no, if I am a banker and have the supposed means to repay it, or yes, if I am a trustee, regardless of my capacity to repay.

  "the victims of fraud will be unable to trade their previously not market wide known receipts to others."

  Except that if the fraud if practised on a wide enough scale, or if government is a complicit beneficiary, then laws may be passed to spread the damage uniformly. Then a run of redemptions is forestalled by forced devaluation of the paper gold or corn-receipts.

  "Wrong. That would be equivalent to saying if the supply of oil increased at 10% pa then it would be unsuitable as an energy resource. It's either subjectively valued by the market, by definition of trade, or it is not subjectively valued by the market, by definition of (non-) trade, no matter any decrees unto the wind of proper suitability. That's all that matters for all economic trade, (particular form of) money included."

  You might also say that Zimbabwean dollars are better than nothing because people still prefer to use them for transactions rather than other alternatives which are available. While true, the more interesting question is what kind of money would the market prefer in the absence of government dictat.

  "See strip mall stores which close after a matter of weeks. See grand openings where nobody comes. See people getting bored with hula hoops. See entrepreneurs anticipating future events incorrectly. See half finished abandoned buildings and factory lines. See people changing their minds at random points in time."

  No doubt most businesses which fail do so because of bad forecasting, independently of interest rates. But the point is that the PROBABILITY of failure is increased by misleading price signals.

  The modern Austrian view is perfectly expressed by Art Carden:

  First, an artificially low interest rate destroys crucial information about the intertemporal consumption preferences of savers. There is no way to know what the interest rate should be, and this increases uncertainty in financial markets. As the interest rate is supposedly the price that capitalizes all of the expected costs and benefits of a particular project, it will become difficult to distinguish profitable from unprofitable projects. To the extent that this can be done, investors will have to invest heavily in screening devices aimed at eliciting the information that would have been revealed in the free-market interest rate.

  Second, the new projects that are undertaken will have risk characteristics that are not consistent with the intertemporal consumption preferences of the saving and consuming public. Projects that were unprofitable at a free-market interest rate of 5% will be unprofitable at a distorted-market interest rate of 4%, provided that the interest rate consistent with intertemporal consumption preferences is 5%. The misallocation of resources is compounded by the fact that savers have reduced the supply of real resources available for investment.

  "Money is ..the most commonly traded good... Promises are just as good as money, are just another form of money."

  I am intrigued by your conception of money as a "means of payment" and only derivatively as a "medium of exchange" - the reverse of Mises's order.

  I agree (along with Mises) that if a promise to pay money is itself widely accepted as a medium of exchange, then it too is "money" by definition. Mises carefully distinguished the two forms of money - referring to the underlying form as "money proper" and to the promise as a "money substitute". He warned, in terms which reminded me of Russel's distinction between sets and metasets, that money could not be properly understood if the two terms were conflated. To paraphrase Kindleberger, money is like an onion whose outer layers are progressively sloughed off during a crisis.

  Published: July 12, 2008 8:46 AM

• Michael A. Clem

  "Money is ..the most commonly traded good... Promises are just as good as money, are just another form of money."
  

  I am intrigued by your conception of money as a "means of payment" and only derivatively as a "medium of exchange" - the reverse of Mises's order.
  

  What rtr is missing is that a good becomes the most commonly traded good, i.e. money, because it's being used as a medium of exchange. He's got cause and effect backwards.

  Published: July 12, 2008 9:06 AM

• rtr

  newson: "regarding project evaluation: whether you think it has merit or not, npv calculation is the tool used by business to assess project viability, and changing the interest rate can alter projects' rankings."

  Businesses don’t have omniscient information and knowledge regarding the future to such precision that they are calculating out the probabilities of success and failure to infinite decimal points to get objectively determined npv. They still nevertheless have to convince others by voluntary trade acquisition of capital goods that their plans are indeed more subjectively valuable by demonstrated motion of those plans being actually put into effect. Or do they just *gamble* on such reckless productions without democratically voted majority society will approval? Blasphemy!

  Nothing prevents anyone from "unfairly" unexpectedly "doubling down" if he has or obtains the means through trade. All voluntary trade action will by definition be reflecting positive present tense npv. There is *always* more positive npv than can be funded simultaneously because of limited capital goods savings. Nobody is ever investing in negative expected npv. Ever. By definition of the axiom of Action.

  So too can future changing subjective valuations alter a project's ranking. It's always at every moment subject to possibly receiving a market issued stop loss order, or just voluntarily turning over the project reigns to somebody new through trade.

  newson: "by "low" i mean a price lower than it would have been, had there been no fraudulent depository receipts previously issued."

  I already demonstrated in the reply to fusgerm that there is no net effect on prices from any form of fraud or robbery. Prices remain exactly as they would have otherwise been if there were no fraud or robbery because the exact same relative supply and demand for goods exists after the fraud or robbery as exists before the fraud or robbery because the exact same goods still exist in the exact same quantities after the fraud or robbery as exist before the fraud or robbery. A “boom” effect is an epistemological impossibility. There’s no such thing as artificially high economic growth.

  The victim's means of exchange is eliminated from the market price for that good; there are no extra "boom" trade transactions which can epistemologically occur. The set of possible trades is still limited by the economy of apples, oranges, houses, and money, still being that exact same economy of apples, oranges, houses, and money.

  Now it's true that government monopoly on money creation is causing net poverty. But that's because coercion is preventing wealth creating free trade. But no individual voluntary trades within that restriction are forced. No transfer of capital goods savings from one person to another person will occur except by mutually subjectively beneficial trade.

  Published: July 12, 2008 12:43 PM

• rtr

  Michael A. Clem: "changing interest rates changes the subjective valuation of existing goods."

  No subjective valuation is changed by interest rate changes except *voluntarily* by mutually beneficial trade. Savings are still limited and can only be moved from person to person, from employment to employment, by voluntary trade.

  Michael A. Clem: "ABCT is clearly not assuming a constant supply of money, but is explaining what happens because the money supply is not constant."

  ABCT fails to observe that the market adjusts to all changing supplies and demands. Any "confusion" which would allegedly be caused by changes in money supply would be exactly similarly caused by any changes in supply for any other goods.

  Michael A. Clem: "You recognize that we should have free banking, but you still seem to think that not having free banking isn't causing problems??"

  It causes problems in exactly the same way as all artificial violently enforced monopolies cause problems by eliminating competition. The world is net poorer than it otherwise would be, paying higher prices for lower quality. But by definition of trade, those higher prices for lower quality are still *better* than not trading at all.

  Michael A. Clem: "What rtr is missing is that a good becomes the most commonly traded good, i.e. money, because it's being used as a medium of exchange. He's got cause and effect backwards."

  The cause is immaterial for economic analysis purposes. All that matters is whether it's subjectively valued, as evidenced through trade. Everything which is exchanged is a "medium of exchange", not just money, by definition of trade, by definition of positive market subjective value. Money is just the "most common" medium of exchange.

  Published: July 12, 2008 1:04 PM

• rtr

  fusgerm: "Once the fraud is discovered, prices will react at lightning speed to the new stock levels. Steady fraud produces steady inflation (of corn or gold) aborted abruptly by a deflationary implosion. That's a crude form of the Austrian business cycle."

  It's epistemologically impossible to "hide" the real supply of money. It's quantity is signaled at the margin through prices exactly as the quantity for all other goods is signaled at the margin through prices.

  fusgerm: "the more interesting question is what kind of money would the market prefer in the absence of government dictat."

  Eliminate government violently established monopoly and the market will quickly answer that question.

  fusgerm: "But the point is that the PROBABILITY of failure is increased by misleading price signals."

  You sound like the Securities and Exchange Commission. There are no misleading prices or price signals. It's the responsibility of individuals to take responsibility for their own trades. Those costs of enforcement and transparency should not be imposed on the rest of society. That's forcing resources to go where they are not forthcoming through voluntary trade, or just otherwise displacing what would arise naturally in a free market. The prices still signal exactly what would otherwise occur in a free market.

  ABCT assumes people are complacent, lazy, and victims of "moral hazard" swindlers. It's the reverse side of the coin complaint socialists allege; the market can't be trusted, and needs government protection to insure consumers aren't "ripped off". Both are wrong. No voluntary trade occurs unless that which is received is valued more than that which is given away in exchange.

  Published: July 12, 2008 1:33 PM

• Alex

  Rtr, Rtr. (My hand's up.)

  An economy produces 100 identical perishable baskets of goods and services each year. Total real income of people is therefore also 100 baskets. Some people consume fewer baskets of goods and services in a given year so that they may be able to consume more baskets in the future. Others consume more than their current income now and are willing to consume less in the future, when they pay back their loans .

  Suppose such lending and borrowing takes place through a "bank," that issues bank notes in $1 denomination (as receipts for deposits of baskets by savers), and that intially each $1 may be used to buy one basket of goods and services. So, the initial price of each basket is $1.

  At any given time there are $10 of such loans made through the bank (to dissavers), supported by $10 of savers' deposits. The bank notes are also used as money. People are paid in bank notes and use bank notes to purchase baskets.

  To summarize: The bank's balance sheet is: Assets ($10 loans); Liabilities ($10 deposits (bank notes)). Total desired annual consumption is 100 baskets ($100). There is no net saving. Saving by some people is simply matched by dissaving by others. So, total desired consumption=100 baskets=total production=$100

  Now suppose the bank attracts $5 of new borrowers (who want to consume 5 baskets in aggregate more than their income), and rather than go out to get $5 new savers' money (meaning getting some people to redeposit in aggregate $5 of bank notes to give, in turn, to the new borrowers), the bank simply gives the new borrowers newly created bank notes.

  The bank's balance sheet is now: Assets ($15 loans); Liabilities ($15 bank notes). The MONEY SUPPLY has grown from $10 to $15, by creating $5 of loans that have not come from anyone's savings. What is the result?

  Total demand for consumption increases by $5 to $105 (both in terms of dollars and baskets). But total goods supply is still only 100 baskets. The price per basket will thus rise in terms of money, will it not?

  Published: July 12, 2008 5:47 PM

• newson

  rtr says:
  A “boom” effect is an epistemological impossibility. There’s no such thing as artificially high economic growth."

  as i understand it, the austrians would agree with your second point, but the "boom" doesn't refer to the pace of growth, rather to the way that changing the interest rate can also change the pattern of investment.

  i still don't see that you've adequately addressed "fusgerm's corn". why wouldn't ethanol plants seem (erroneously) profitable if the price of corn were depressed by government-sanctioned depository receipts that turn out to be unable to be honored?

  the bust is the rusting ethanol plants when the price reverts to what it would have been had the government not issued (empty) depository receipts.

  Published: July 13, 2008 12:02 AM