-Caveat Lector- Dr Shostak argues that the present monetary system cannot be fixed and that the root of the problem is the present fiat paper standard, which is fundamentally unstable. http://www.newaus.com.au/econ126frank.html The New Australian Why the present monetary system cannot be reformed? By *Frank Shostak No. 126, 5-11 July 1999 Against the background of the present world financial markets instability, most economic experts are of the view that radical reforms of the current monetary system are required. Economists however, are deeply divided about the nature of these reforms. In the one camp there are experts who regard speculative flows of money as the source of instability. It is therefore suggested to establish an institution which will exercise a control over these flows. The opposing camp argues that any intervention with the inter-country flow of money will stifle economic growth. Hence they advocate that the monetary system be kept free from intervention. It is however, overlooked by most experts that the present monetary system cannot be fixed. The root of the problem is the present fiat paper standard, which is fundamentally unstable. This raises several questions. How did this system originate? What causes people to accept pieces of paper in exchange for goods and services? Demand for a good arises from its perceived benefit. For instance people demand food because of the nourishment it offers them. With regard to money, people demand it not for direct use in consumption, but in order to exchange it for other goods and services. Money is not useful in itself, but because it has a prior exchange value, it is exchangeable in terms of other goods and services. Money is thus demanded because the benefit it offers is it's purchasing power i.e. its price. Most economic thinkers regard the acceptance or demand for money as a paradox. In other words I accept money because you accept it and vice versa. Following the view of Plato and Aristotle, economists regard money as an historical fact, that was introduced by government decree1. It is government decree, so it is argued, that makes a particular thing accepted as general medium of the exchange i.e. money. However, for something to be accepted as money, it must have a pre-existing purchasing power, a price. So how does a thing that the government proclaims will become the medium of the exchange, acquire purchasing power or a price? We know that the price of a good is the result of the inter-action between demand and supply. From this we could reach a conclusion that price of money is also set by the same law of demand-supply. Yet there is a problem with this way of thinking, since the demand for money arises because money has purchasing power i.e. money has a price. Yet if the demand for money depends on its pre-existing price or purchasing power, how can this price be explained by demand? In other words we are caught in a circular trap. The circularity seems to vindicate the view that the acceptance of money is a paradox and the result of the fact that government decree gave birth to it. In his writings Carl Menger raised doubts about the soundness of the view that the origin of money is government proclamation. According to Menger: "An event of such high and universal significance and of notoriety so inevitable, as the establishment by law or convention of a universal medium of exchange, would certainly have been retained in the memory of man, the more certainly inasmuch as it would have had to be performed in a great number of places. Yet no historical monument gives us trustworthy tidings of any transactions either conferring distinct recognition on media of exchange already in use, or referring to their adoption by peoples of comparatively recent culture, much less testifying to an initiation of the earliest ages of economic civilization in the use of money"2 Support to Menger's insight was provided by Ludwig von Mises's regression theorem. By means of this theorem Mises not only succeeded in solving the money circularity problem, but he also confirmed Carl Menger's view that money could not have originated as a result of government decree. Mises began his analysis by noting that today's demand for money is determined by yesterday's purchasing power of money. Consequently for a given supply of money, today's purchasing power of money is established. Yesterday's demand for money in turn was fixed by the prior day's purchasing power of money. For a given supply of money then, yesterday's price of money was set. The same procedure applies to past periods. However, this doesn't seem to solve the circularity problem, rather it appears to push it back to infinity. Not so, argues Mises. By regressing through time we will eventually arrive at a point in time when money was just an ordinary commodity. It's price therefore, was set by demand and supply for a commodity. Namely the commodity had an exchange value in terms of other commodities i.e. it's exchange value was established in a barter. To put it simply on the day a commodity becomes money it already has an established purchasing power or price in terms of other goods. This purchasing power enables us to establish the demand for this commodity as money. This in turn, for a given supply, sets its purchasing power on the day this commodity starts to function as money. Once the price of money is fixed, it serves as an input for the establishment of tomorrow's price of money . In plain English yesterday's price of money is required to set today's price of money. It follows then, that without yesterday's information about the price of money, today's purchasing power of money cannot be established. (With regard to other goods and services past history is not required to set present prices. As demand for these goods arises on account of the perceived benefits from consuming them. The benefit that money provides is that it can be exchanged for goods and services. Consequently, one needs to know the past purchasing power of money in order to establish today's demand for it ). Also, according to Mises: "There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money."3 Similarly Rothbard wrote that: "Just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media-in almost all exchanges-and these are called money."4 Using the Mises regression theorem we can infer that it is not possible that money could have emerged as a result of government decree. For the decree cannot bestow purchasing power upon a thing that the government proclaims will become the medium of the exchange. The theorem shows that money must emerge as a commodity. According to Hoppe: "Money must emerge a commodity because something can be demanded as a medium of exchange only if it has a pre-existing barter demand5 Once, however, a commodity becomes accepted as the medium of exchange it will continue to be accepted even if its non monetary usefulness disappears. The reason for this acceptance is the fact that people now possess the information about yesterday's purchasing power i.e. price which enables the formation of demand for money today." If money must emerge a commodity money, how then does fiat paper money become accepted? Through the ongoing selection over thousands of years people have settled on gold as money. Originally paper money was not regarded as money but just as a representative of money which was gold. Various paper certificates were claims on gold stored with the banks. Holders of paper certificates could convert them into gold whenever it was deemed necessary. Since people found it more convenient to use paper certificates to exchange for goods and services, these certificates come to be regarded as money. The introduction of paper certificates, that are accepted as the medium of exchange, opens the scope for fraudulent practice. Banks could now be tempted to boost their profits by lending certificates that are not covered by gold. In a free market economy however, a bank which over issues its paper certificate, will quickly find out that the exchange value of this certificate in terms of other banks certificates will fall. This drop will prompt people to convert the over issued bank paper certificates into gold in order to protect their purchasing power. The over issuing bank however, will not have enough gold to honour all the issued paper certificates, and therefore will be declared bankrupt. The threat of bankruptcy therefore, serves to deter banks from issuing paper certificates unbacked by gold. One can thus conclude that in a free market economy paper money cannot assume a "life" of its own and become independent of a commodity money. Within a hampered market economy, characterised by government interference with markets, paper money can be enforced. The government could by decree abolish the convertibility of paper certificates into gold, thereby preventing over issuing banks from going bankrupt. The abolition of convertibility however, does not erase yesterday's purchasing power of paper certificates. This in turn preserves the necessary link, which maintains people's demand for paper certificates today. Clearly what matters here is the fact that the past purchasing power of these certificates is known to people. Based on the past information, they can form their demand for the paper certificates today. Once however, banks are not obliged to redeem paper certificates into gold, this opens the scope for enormous profits. This in turn generates incentive for the unrestrained expansion of the supply of paper certificates. The uncurbed expansion of paper certificates could in turn produce hyperinflation and lead to the breakdown of the market economy. To prevent the emergence of hyperinflation, and the breakdown of the market economy, the enforcement of the paper money standard must be managed. The main purpose of managing the enforcement, is to prevent various competing banks from over issuing paper certificates. This can be achieved through the establishment of a monopoly bank i.e. central bank which will manage the expansion of the paper money. In order to assert its authority the central bank replaces its' paper certificates for banks certificates.( The central bank's money purchasing power is established on account of the fact that various paper certificates, which carry purchasing power, are exchanged for the central bank money at a fixed exchange rate). The central bank paper certificates, which are declared as the legal tender, also serve as the reserve money for banks . The central bank money in turn, which now employed as a reserve asset sets a limit to banks credit expansion. It would appear that by means of monetary policies the central bank can now manage and stabilise the monetary system. This however, cannot be so. For the paper standard is not a natural one i.e. it was not selected by the market, it must be constantly enforced to prevent its collapse. This means on going and ever growing monetary pumping by the central bank to keep the system "stable". This however, leads to persistent declines in the purchasing power of money to boom-bust cycles which in turn destabilises the entire monetary system. Given the fact that the current paper money standard is inherently unstable, monetary reforms cannot "fix" it. The confirmation to this is financial reforms of the early 1980's. The idea of these reforms was to free the financial system from the excessive controls of the central bank. In the early 1980's proponents of financial de-regulation held that freeing financial markets will permit a more efficient allocation of economy's scarce resources, thereby raising individuals well beings. It was argued that the overly controlled monetary system leads to more rather than less instability. Nonetheless, rather than producing more stability, the liberated system gave rise to greater instability. The 1980's financial de-regulation resulted in a reduction of the central bank supervisory powers. The weakening in the central bank controls gave impetus to a greater competition between banks . This in turn sparked the unrestrained creation of credit and thus money out of "thin air", thereby creating massive misallocation of resources and financial instability. The failure of financial de-regulation seemed to vindicate the view of interventionists and opponents of the free market economy, that the facts of reality dictate that markets must be tightly supervised. It is however, overlooked that all these reforms i.e., financial de-regulation have nothing to do with the true free market. For as we have seen in a true free market, no paper money can become independent of a commodity money which was chosen by the market. Furthermore in a free unhampered market there is no place for the central bank. It would appear that the present money paper standard could be made more stable by allowing the central bank to exercise tighter control over money flows. However, it would be almost impossible to re-regulate financial markets without causing a massive financial earth quake. Furthermore, as we have already seen, managed monetary expansion also leads to instability. It seems therefore that the chaotic state of world financial markets can only get worse, unless gold, which was chosen by the democratic process of the market, is allowed to assume its monetary role. (In the appendix of his Theory of Money and Credit, Ludwig von Mises produced a detailed plan how to make the transition back to the gold standard). 1Carl Menger, On the Origins of Money Economic Journal, volume 2 (1892) p.239-55. 2Carl Menger, ibid. 3Ludwig von Mises, Theory of Money and Credit, pp.32-33. 4Murray N. Rothbard, What Has Government Done to Our Money? 5Hans-Herman Hoppe, How is Fiat Money Possible?-or, The Devolution of Money and Credit, The Review of Austrian Economics vol. 7, Number 2, 1994. *Dr Frank Shostak is chief economist with Ord Minnett Jardine Fleming Futures, Sydney. http://www.newaus.com.au/econ126frank.html Visit: http://www.thesmokinggun.com/ Bard DECLARATION & DISCLAIMER ========== CTRL is a discussion and informational exchange list. Proselyzting propagandic screeds are not allowed. Substance�not soapboxing! 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