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Chapter 11—Money and Its Purchasing Power (continued)

6. The Supply of Money

A. The Stock of the Money Commodity

     The total stock of money in a society is the total number of ounces of the money commodity available. Throughout this volume we have deliberately used “gold ounces” instead of “dol­lars” or any other name for money, precisely because on the free market the latter would only be a confusing term for units of weight of gold or silver.

     The total stock, from one period to another, will increase from new production and decrease from being used up—either in in­dustrial production as a nonmonetary factor or from the wear and tear of coins. Since one of the qualities of the money com­modity is its durability, the usual tendency is a long-run increase in the money supply and a resulting gradual long-run decline in the PPM. This furthers social utility only in so far as more gold or silver is made available for nonmonetary purposes.

     We saw in chapter 3 that the physical form of the monetary commodity makes no difference. It can be in nonmonetary use as jewelry, in the form of bars of bullion, or in the form of coins. On the free market, transforming gold from one shape to another would be a business like any other business, charging a market price for its service and earning a pure interest return in the ERE. Since gold begins as bullion and ends as coin, it would seem that the latter would command a small premium over the equivalent weight of the former, the bullion often being a capital good for coin. Sometimes, however, coins are remelted back into bullion for larger transactions, so that a premium for coin over bullion is not a certainty. If, as generally happens, mint­ing coins costs more than melting, coins will command the equiva­lent premium over bullion. This premium is called brassage.

     It is impossible for economics to predict the details of the structure of any market. The market for privately issued gold bars or coins might develop as homogeneous, like the market for wheat, or the coins might be stamped and branded by the coin­makers to certify to the quality of their product. Probably the public would buy only branded coins to ensure accurate quality.

     One argument against permitting free private coinage is that compulsory standardization of the denominations of coins is more convenient than the diversity of coins that would ensue under a free system. But if the market finds it more convenient, private mints will be led by consumer demand to mint certain standard denominations. On the other hand, if greater variety is preferred, consumers will demand and obtain a more varied number of coins.[29]

B. Claims to Money: The Money Warehouse

     Chapter 2 described the difference between “claims to present goods” and “claims to future goods.” The same analysis applies to money as to barter. A claim to future money is a bill of ex­change—an evidence of a credit transaction. The holder of the bill—the creditor—redeems it at the date of redemption in ex­change for money paid by the debtor. A claim to present money, however, is a completely different good. It is not the evidence of an uncompleted transaction, an exchange of a present for a future good, as is the bill; it is a simple evidence of ownership of a present good. It is not uncompleted, or an exchange on the time market. Therefore, to present this evidence for redemption is not the completion of a transaction or equivalent to a creditor’s calling his loan; it is a simple repossessing of a man’s own good. In chapter 2 we gave as examples of a claim to present goods warehouse receipts and shares of stock. Shares of stock, however, cannot be redeemed in parts of a company’s fixed assets because of the rules of ownership that the companies themselves set up in their co-operative venture. Furthermore, there is no guarantee that such assets will have a fixed money value. We shall therefore confine ourselves to warehouse receipts, which are also more rele­vant to the supply of money.

     When a man deposits goods at a warehouse, he is given a receipt and pays the owner of the warehouse a certain sum for the service of storage. He still retains ownership of the property; the owner of the warehouse is simply guarding it for him. When the warehouse receipt is presented, the owner is obligated to re­store the good deposited. A warehouse specializing in money is known as a “bank.”

     Claims to goods are often treated on the market as equivalent to the goods themselves. If no fraud or theft is suspected, then evidence of ownership of a good in a warehouse is considered as equivalent to the good itself. In many cases, individuals will find it advantageous to exchange the claims or evidences—the goods-substitutes—rather than the goods themselves. Paper is more convenient to transfer from person to person, and the expense of moving the goods is eliminated. When Jones sells Smith his wheat, therefore, instead of moving the wheat from one place to another, they may well agree simply to transfer the warehouse receipt itself from Jones to Smith. The goods remain in the same warehouse until Smith needs them or until the receipt is transferred to someone else. Of course, Smith may prefer, for one reason or another, to keep the goods in his own warehouse, in which case they are moved from one to the other.

     Let us take the case of a warehouse owned by the Trustee Ware­house Company. It holds various goods in its vaults for safe­keeping. Suppose that this company has developed a reputation for being very reliable and theft-free. Consequently, people tend to leave their goods in the Trustee Warehouse for a considerable length of time and, in the case of goods that they do not use frequently, will even tend to transfer the goods-certificates (the warehouse receipts, or evidences of ownership of the goods) and not redeem the goods themselves. Thus, the goods-certificates act as goods-substitutes in exchange. Suppose that the Trustee Company sees this happening. It realizes that a good opportunity for fraud presents itself. It can take the depositors’ goods, the goods that it holds for safekeeping, and lend them out to people on the market. It can earn interest on these loans, and as long as only a small percentage of depositors ask to redeem their certifi­cates at any one time, no one is the wiser. Or, alternatively, it can issue pseudo warehouse receipts for goods that are not there and lend these on the market. This is the more subtle practice. The pseudo receipts will be exchanged on the market on the same basis as the true receipts, since there is no indication on their face whether they are legitimate or not.

     It should be clear that this practice is outright fraud. Someone else’s property is taken by the warehouse and used for its own money-making purposes. It is not borrowed, since no interest is paid for the use of the money. Or, if spurious warehouse receipts are printed, evidences of goods are issued and sold or loaned without any such goods being in existence.

     Money is the good most susceptible to these practices. For money, as we have seen, is generally not used directly at all, but only for exchanges. It is, furthermore, a widely homogeneous good, and therefore one ounce of gold is interchangeable with any other. Since it is convenient to transfer paper in exchange rather than carry gold, money warehouses (or banks) that build up public confidence will find that few people redeem their certificates. The banks will be particularly subject to the tempta­tion to commit fraud and issue pseudo money certificates to cir­culate side by side with genuine money certificates as acceptable money-substitutes. The fact that money is a homogeneous good means that people do not care whether the money they redeem is the original money they deposited. This makes bank frauds easier to accomplish.

     “Fraud” is a harsh term, but an accurate one to describe this practice, even if not recognized as such in the law, or by those committing it. It is, in fact, difficult to see the economic or moral difference between the issuance of pseudo receipts and the ap­propriation of someone else’s property or outright embezzlement or, more directly, counterfeiting. Most present legal systems do not outlaw this practice; in fact, it is considered basic banking procedure. Yet the libertarian law of the free market would have to prohibit it. The purely free market is, by definition, one where theft and fraud (implicit theft) are illegal and do not exist.

     To part with goods or money held in trust or to issue spurious warehouse receipts is, of course, a dangerous business, even when the law permits it. If the warehouse once failed to meet its con­tractual obligations, its fraud would be discovered, and a general panic “run” on the warehouse or bank would ensue. It would then be quickly plunged into bankruptcy. Such a bankruptcy, however, would not be similar to the failure of an ordinary speculative business enterprise. It is rather similar to the ab­sconder who gets caught before he has returned the funds he has “borrowed.”

     Even if the receipt does not say on its face that the warehouse guarantees to keep it in its vaults, such an agreement is implicit in the very issuance of the receipt. For it is obvious that if any pseudo receipts are issued, it immediately becomes impossible for the bank to redeem all of them, and therefore fraud is immedi­ately being committed. If a bank has 20 pounds of gold in its vaults, owned by depositors, and gold certificates redeemable on demand for 30 pounds, then notes to the value of 10 pounds are fraudulent. Which particular receipts are fraudulent can be determined only after a run on the bank has occurred and the later claimants are left unsatisfied.

     In a purely free market where fraud cannot, by definition, occur, all bank receipts will be genuine, i.e., will represent only actual gold or silver in the vaults. In that case, all the bank’s money-substitutes (warehouse receipts) will also be money certifi­cates, i.e., each receipt genuinely certifies the actual existence of the money in its vaults. The amount of gold kept in bank vaults for redemption purposes is called its “reserves,” and the policy of issuing only genuine receipts is therefore a policy of “100-percent reserves” of cash to demand liabilities (liabilities that must be paid on demand).[30] However, the term “reserve” is a misleading one, because it assumes that the bank owns the gold and inde­pendently decides how much of it to keep on hand. Actually, it is not the bank that owns the gold, but its depositors.[31]

     An enormous literature has developed dealing with the physi­cal form of the money receipts, and yet the physical form is of no economic importance. It may be in the form of a paper note, a token coin (essentially a note stamped on coin instead of paper), or a book credit (demand deposit) in the bank. The demand de­posit is not tangibly held by the owner, but can be transferred to anyone he desires by written order to the bank. This order is called a check. The depositor has a choice of which form of receipt to take, according to his convenience. Which form he chooses makes no economic difference.

C. Money-Substitutes and the Supply of Money

     Since money-substitutes exchange as money on the market, we must consider them as part of the supply of money. It then becomes necessary to distinguish between money (in the broader sense)—the common medium of exchange—and money proper. Money proper is the ultimate medium of exchange or standard money—here the money commodity—while the supply of money (in a broader sense) includes all the standard money plus the money-substitutes that are held in individuals’ cash balances. In the cases cited above, gold was the money proper or standard money, while the receipts—the demand claims to gold—were the money-substitutes.

     The relation between these elements may be illustrated as follows: Assume a community of three persons, A, B, C, and three money warehouses, X, Y, Z. Suppose that each person has 100 ounces of gold in his possession and none on deposit at a warehouse. For the community, then:

The total supply of money is here identical with the total supply of money proper.

Now assume that A and B each deposits his 100 ounces of gold at warehouses X and Y respectively, while C keeps his gold on hand. The total supply of money is always equal to the total of individual cash balances. Its composition now is:

A—100 ounces of X-Money-Substitute
B—100 ounces of Y-Money-Substitute
C—100 ounces of Gold Money Proper

     Total supply of money (in the broader sense) = Total cash bal­ances = 200 ounces of money-substitutes + 100 ounces of money proper.

     The effect of the deposit of money proper in the warehouses or banks is to change the composition of the total supply of money in cash balances; the total amount, however, remains unchanged at 300 ounces. Money-substitutes of various banks have replaced most of the standard money in individual cash holdings. Similarly, if A and B were to redeem their deposits, the total amount would remain unchanged, while the composition would revert to the original pattern.

     What of the 200 ounces of gold deposited in the vaults of the banks? These are no longer part of the money supply; they are held in reserve against the outstanding money-substitutes. While in reserve, they form no part of any individual’s cash balance; the cash balances consist not of the gold, but of evidences of ownership of the gold. Only the money proper outside of bank reserves forms part of individuals’ cash balances and hence part of the community’s supply of money.

     Thus, as long as all money-substitutes are full money certifi­cates, an increase or decrease in the money-substitutes outstanding can have no effect on the total supply of money. Only the composi­tion of that supply is affected, and such changes in composition are of no economic importance.

     However, when banks are legally permitted to abandon a 100-percent reserve and to issue pseudo receipts, the economic effects are quite different. We may call the money-substitutes that are not genuine money certificates, uncovered money-substitutes, since they do not genuinely represent money. The issue of un­covered money-substitutes adds to individuals’ cash balances and hence to the total supply of money. Uncovered money-substitutes are not offset by new money deposits and so constitute net addi­tions to the total supply. Any increase or decrease in the supply of uncovered money-substitutes increases or decreases to the same extent the total supply of money (in the broader sense).

     Thus, the total supply of money is composed of the following elements: supply of money proper outside reserves + supply of money certificates + supply of uncovered money-substitutes. The supply of money certificates has no effect on the size of the supply of money; an increase in this factor only decreases the size of the first factor. The supply of money proper and the factors determining its size have already been discussed. It depends on annual production compared to annual wear and tear, and thus, on the unhampered market, the supply of money-proper changes only slowly. As for uncovered money-substitutes, since they are essentially a phenomenon of the hampered rather than the free market, factors governing their supply will be further discussed below, in chapter 12.

     In the meanwhile, however, let us analyze a little further the difference between a 100-percent-reserve and a fractional- reserve bank. The Star Bank, let us suppose, is a 100-percent-reserve bank; it is estab­lished with 100 gold ounces of capital invested by its stockholders in building and equipment. In the familiar balance sheet, with assets on the left-hand side and liabilities and capital on the right-hand side, the condition of the bank now appears as follows:

     The Star Bank is ready to begin operations. Several people now come and deposit gold in the bank, which in return issues ware­house receipts giving the depositors (the true owners of the gold) the right to redeem their property on demand at any time. Let us assume that after a few months 5,000 gold ounces have been deposited and stored in the bank’s vaults. Its balance sheet now appears as follows:

     The warehouse receipts function and exchange as money-substi­tutes, replacing, not adding to, the gold stored in the bank. All the warehouse receipts are money certificates, 100-percent reserve has been maintained, and no invasion of the free market has occurred. The warehouse receipts may take the form of printed tickets (notes) or book credit (demand deposits) transferable by written order or “check.” The two are economically identical.

     But now suppose that law enforcement is lax and the bank sees that it can make money easily by engaging in fraud, i.e., by lending some of the depositors’ gold (or, rather, issuing pseudo warehouse receipts for nonexistent gold and lending them) to people who wish to borrow it.[32] Let us say that the Star Bank, chafing at the mere interest return earned on its fees for ware­house service, prints 1,000 ounces of pseudo warehouse receipts and lends them on the credit market to businesses and consumers who desire to borrow money. The balance sheet of the Star Bank is now as follows:

     The warehouse receipts still function as money-substitutes on the market. And we see that new money has been created by the bank out of thin air, as if by magic. This process of money crea­tion has also been called the “monetization of debt,” an apt term since it describes the only instance where a liability can be trans­formed into money—the supreme asset. It is obvious that the more money the bank creates, the more profits it will earn, for any income earned on newly created money is a pure unalloyed gain. The bank has been able to alter the conditions of the free mar­ket system, in which money can be obtained only by purchase, mining, or gift. In each of these routes, productive service—either one’s own or one’s ancestor’s or benefactor’s—was necessary in order to obtain money. The bank’s inflationary intervention has created another route to money: the creation of new money out of thin air, by issuing receipts for nonexistent gold.[33] [34]

D. A Note on Some Criticisms of 100-Percent Reserve

     One popular criticism of 100-percent bank reserves charges that the bank could not then earn any income or cover costs of storage, printing, etc. On the contrary, a bank is perfectly capable of operating like any goods warehouse, i.e., by charging its cus­tomers for its services to them and reaping the usual interest return on its operations.

     Another popular objection is that a 100-percent-reserve policy would eliminate all credit. How would businessmen be able to borrow funds for short-term investment? The answer is that businessmen can still borrow saved funds from any individual or institution. “Banks” may still lend their own saved funds (capital stock and accumulated surplus) or they may borrow funds from individuals and relend them to business firms, earning the interest differ­ential.[35] Borrowing money (e g., floating a bond) is a credit trans­action; an individual exchanges his present money for a bond—a claim on future money. The borrowing bank pays him interest for this loan and in turn exchanges the money thus gathered for promises by business borrowers to pay money in the future. This is a further credit transaction, in this case the bank acting as the lender and businesses as the borrowers. The bank’s income is the interest differential between the two types of credit transactions; the payment is for the services of the bank as an intermediary, channeling the savings of the public into investment. There is, furthermore, no particular reason why the short-term, more than any other, credit market should be subsidized by money creation.

     Finally, an important criticism of a governmentally enforced policy of 100-percent reserves is that this measure, though beneficial in itself, would establish a precedent for other governmental in­tervention in the monetary system, including a change in this very requirement by government edict. These critics advocate “free banking,” i.e., no governmental interference with banking apart from enforcing payment of obligations, the banks to be permitted to engage in any fictitious issues they desire. Yet the free market does not mean freedom to commit fraud or any other form of theft. Quite the contrary. The criticism may be obviated by imposing a 100-percent-reserve requirement, not as an arbitrary administrative fiat of the government, but as part of the general legal defense of property against fraud. As Jevons stated: “It used to be held as a general rule of law, that any present grant or as­signment of goods not in existence is without operation,”[36] and this general rule need only be revived and enforced to outlaw fictitious money-substitutes. Then banking could be left perfectly free and yet be without departure from 100-percent reserves.[37]

7. Gains and Losses During a Change in the Money Relation

     A change in the money relation necessarily involves gains and losses because money is not neutral and price changes do not take place simultaneously. Let us assume—and this will rarely hold in practice—that the final equilibrium position resulting from a change in the money relation is the same in all respects (includ­ing relative prices, individual values, etc.) as the previous equilib­rium, except for the change in the purchasing power of money. Actually, as we shall see, there will almost undoubtedly be many changes in these factors in the new equilibrium situation. But even if there are not, the movement of prices from one equilibrium position to the next will not take place smoothly and simultane­ously. It will not take place according to the famous example of David Hume and John Stuart Mill, where everyone awakens to find his money supply doubled overnight. Changes in the demand for money or the stock of money occur in step-by-step fashion, first having their effect in one area of the economy and then in the next. Because the market is a complex interacting network, and because some people react more quickly than others, move­ments of prices will differ in the speed of reaction to the changed situation.

     As we have intimated above, the following law can be enun­ciated: When a change in the money relation causes prices to rise, the man whose selling price rises before his buying prices gains, and the man whose buying prices rise first, loses. The one who gains the most from the transition period is the one whose selling price rises first and buying prices last. Conversely, when prices fall, the man whose buying prices fall before his selling price gains, and the man whose selling price falls before his buying prices, loses.

     It should be evident, in the first place, that there is nothing about rising prices that causes gains or about falling prices that causes losses. In either situation, some people gain and some people lose from the change, the gainers being the ones with the greatest and lengthiest positive differential between their sell­ing and their buying prices, and the losers the ones with the greatest and longest negative differential in these movements. Which people gain and which lose from any given change is an empirical question, dependent on the location of changes in ele­ments of the money relation, institutional conditions, anticipa­tions, speeds of reaction, etc.

     Let us consider the gains and losses from an increase in money stock. Suppose that we start from a position of monetary equilibrium. Every person’s money relation is in equilibrium, with his stock of and demand for money being equal. Now suppose that Mr. Jones finds some new gold never known before. A change in Jones’ data has taken place. He now has an excess stock of gold in his cash balance compared with his demand for it. Jones acts to spend his excess cash balance. This new money is spent, let us say, on the products of Smith. Smith now finds that his cash balance exceeds his demand for money, and he spends his excess on the products of someone else.

     Jones’ increased supply also increases Smith’s selling price and income. Smith’s selling price has increased before his buying price. He spends the money on the products of Robinson, thus raising the latter’s selling prices while most buying prices have not risen. As the money is transferred from hand to hand, buying prices rise more and more. Robinson’s selling price increases, for ex­ample, but already one of the products he buys—Smith’s—has gone up. As the process continues, more and more buying prices rise. The individuals who are far down “on the list” to receive the new money, therefore, find that their buying prices have increased while their selling prices have not yet done so.

     Of course, the changes in the money supply and in prices may well be insignificant. But this process occurs, however large or small the change in the money stock. Obviously, the larger the increase in money stock, the greater, ceteris paribus, will be its impact on prices.

     We have seen above that an increase in the stock of money leads to a fall in the PPM, and a decrease in the stock of money leads to a rise in the PPM. However, there is no simple and un­eventful rise and fall in the PPM. For a change in the stock of money is not automatically simultaneous. New money enters the system at some specific point and then becomes diffused in this way throughout the economy. The individuals who receive the new money first are the greatest gainers from the increased money; those who receive it last are the greatest losers, since all their buying prices have increased before their selling prices. Mone­tarily, it is clear that the gains of the approximate first half of the recipients of new money are exactly counterbalanced by the losses of the second half. Conversely, if money should somehow disap­pear from the system, say through wear and tear or through being misplaced, the initial loser cuts his spending and suffers most, while the last who feel the impact of a decreased money supply gain the most. For a decrease in the money supply results in losses for the first owners, who suffer a cut in selling price before their buying prices are lowered, and gains for the last, who see their buying prices fall before their income is cut.[38]

     This analysis bears out our assertion above that there is no social utility in an increased supply, nor any social disutility in a decreased supply, of money. This is true for the transition period as well. An increase in gold is socially useful (i.e., beneficial to some without demonstrably injuring others) only to the extent that it makes possible an increase in the nonmonetary, direct use of gold.

     If, as we have been assuming, relative prices and valuations remain the same for all throughout, the new equilibrium will be identical with the old except for an all-round price change. In that case, the gains and losses will be temporary, disappearing upon the advent of the new equilibrium. Actually, however, this will almost never occur. For even if people’s values remain frozen, the shift in relative money income during the transition itself changes the structure of demand. The gainers of wealth during the transition period will have a structure of preferences and demand different from that of the losers. As a result, demand itself will shift in structure, and the new equilibrium will have a dif­ferent set of relative prices. Similarly, the change will probably not be neutral to time preferences. The permanent gainers will undoubtedly have a different structure of time preferences from that of the permanent losers, and, as a result, there may be a per­manent shift in general time preferences. What the shift will be or in which direction, it is of course impossible for economics to say.

     Money changes have this “driving force,” it may be noted, even in the fanciful case of the automatic overnight doubling of the supply of everyone’s cash balance. For the fact that everyone’s money stock doubles does not at all mean that all prices will automatically double! Each individual has a differently shaped demand-for-money schedule, and it is impossible to predict how each will be shaped. Some will spend proportionately more of their new money, and others will keep proportionately more in their cash balance. Many people will tend to spend their new cash balances on different goods from those they had bought with their old money. As a result, the structure of demand will change, and a decreased PPM will not double all prices; some will increase by more and some by less than double.[39]

8. The Determination of Prices: The Goods Side and the Money Side

     We are now in a position to draw together all the strands determining the prices of goods. In chapters 4 through 9 we an­alyzed all the determinants of the prices of particular goods. In this chapter we have analyzed the determination of the purchas­ing power of money. Now we can see how both sets of determi­nants blend together.

     A particular price, as we have seen, is determined by the total demand for the good (exchange and reservation) and the stock of the good, increasing as the former increases and decreasing as the latter increases. We may therefore call the demand a “factor of increase” of the price, and the stock a “factor of decrease.” The exchange demand for each good—the amount of money that will be spent in exchange for the good—equals the stock of money in the society minus the following: the exchange demands for all other goods and the reservation demand for money. In short, the amount spent on X good equals the total money supply minus the amount spent on other goods and the amount kept in cash balances.

     Suppose we overlook the difficulties involved and now consider the price of “all goods,” i.e., the reciprocal of the purchasing power of money. The price of goods-in-general will now be de­termined by the monetary demand for all goods (factor of in­crease) and the stock of all goods (factor of decrease). Now, when all goods are considered, the exchange demand for goods equals the stock of money minus the reservation demand for money. (In contrast to any specific good, there is no need to subtract people’s expenditures on other goods.) The total demand for goods, then, equals the stock of money minus the reservation demand for money, plus the reservation demand for all goods.

     The ultimate determinants of the price of all goods are: the stock of money and the reservation demand for goods (factors of increase), and the stock of all goods and the reservation demand for money (factors of decrease). Now let us consider the obverse side: the PPM. The PPM, as we have seen, is determined by the demand for money (factor of increase) and the stock of money (factor of decrease). The exchange demand for money equals the stock of all goods minus the reservation demand for all goods. Therefore, the ultimate determinants of the PPM are: the stock of all goods and the reservation demand for money (factors of in­crease), and the stock of money and the reservation demand for goods (factors of decrease). We see that this is the exact obverse of the determinants of the price of all goods, which, in turn, is the reciprocal of the PPM.

     Thus, the analysis of the money side and the goods side of prices is completely harmonious. No longer is there need for an arbitrary division between a barter-type analysis of relative goods-­prices and a holistic analysis of the PPM. Whether we treat one good or all goods, the price or prices will increase, ceteris paribus, if the stock of money increases; decrease when the stock of the good or goods increases; decrease when the reservation demand for money increases; and increase when the reservation demand for the good or goods increases. For each individual good, the price will also increase when the specific demand for that good increases; but unless this is a reflection of a drop in the social reservation demand for money, this changed demand will also signify a decreased demand for some other good, and a consequent fall in the price of the latter. Hence, changes in specific demands will not change the value of the PPM.

     In a progressing economy, the secular trend for the four de­termining factors is likely to be: the money stock increasing gradually as gold production adds to the previous total; the stock of goods increasing as capital investment accumulates; the reserva­tion demand for goods disappearing because short-run speculations disappear over the long run, and this is the main reason for such a demand; the reservation demand for money unknown, with clearing, for example, working to reduce this demand over a period of time, and the greater number of transactions tending to increase it. The result is that we cannot precisely say how the PPM will move in a progressing economy, though the best sum­mary guess would be that it declines as a result of the influence of the increased stock of goods. Certainly, the influence of the goods side is in the direction of falling prices; the money side we cannot predict.

     Thus, the ultimate determinants of the PPM as well as of specific prices are the subjective utilities of individuals (the determinants of demand) and the given objective stocks of goods—thereby vindicating the Austrian-Wicksteedian theory of price for all aspects of the economic system.

     A final note of warning: It is necessary to remember that money can never be neutral. One set of conditions tending to raise the PPM can never precisely offset another set of factors tending to lower it. Thus, suppose that an increase in the stock of goods tends to raise the PPM, while at the same time, an increase in the money supply tends to lower it. One change can never offset the other; for one change will lower one set of prices more than others, while the other will raise a different set within the whole array of prices. The degrees of change in the two cases will depend on the particular goods and individuals affected and on their concrete valuations. Thus, even if we can make an historical (not an economic-scientific) judgment that the PPM has remained roughly the same, the price relations have shifted within the array, and therefore the judgment can never be exact.

9. Interlocal Exchange

A. Uniformity of the Geographic Purchasing Power of Money

     The price of any commodity tends to be the same through­out the entire area using it. We have seen that this rule is not violated by the fact that cotton in Georgia, for example, is priced lower than cotton in New York. When cotton in New York is a consumers’ good, cotton in Georgia is a capital good in relation to the former. Cotton in Georgia is not the same commodity as cotton in New York because goods must first be processed in one location and then transported to the places where they are consumed.

     Money is no exception to the rule that the price of every com­modity will tend to be uniform throughout the entire area in which it is used. In fact, the scope for the money commodity is broader. Other commodities are produced in certain centers and must then be transported to other centers where they are con­sumed. They are therefore not the same “good” in different geographical locations; in the producing centers they are capital goods. Money, it is true, must first be mined and then shipped to places of use. But, once mined, the money commodity is used only for exchange. For these purposes, it is from then on shipped back and forth throughout the world market. Therefore, there is no really important capital-good location for money separate from a consumers’-good location. Whereas all other goods are first produced and then moved to the place where they are used and consumed, money is used interchangeably throughout the entire market area, moving back and forth. Therefore, the tend­ency toward geographical uniformity in the purchasing power of money holds true for the physical commodity gold or silver, and there is no need for that commodity to be treated as a different good in one place or another.

     The purchasing power of money will therefore be identical over the entire area. Should the PPM be lower in New York than in Detroit, the supply of money for the exchange of goods will diminish in New York and increase in Detroit. Prices of goods being higher in New York than in Detroit, people will spend less in New York and more in Detroit than heretofore, this shift being reflected in the movement of money. This action will tend to raise the purchasing power of money in New York and lower it in Detroit, until its purchasing power in the two places is equal. The purchasing power of money will, in this way, tend to remain equal in all places where the money is used, whether or not na­tional boundaries happen to intervene.

     Some people contend that, on the contrary, there do exist per­manent differences in the purchasing power of money from place to place. For example, they point to the fact that prices for food in restaurants are higher in New York City than in Peoria. For most people, however, New York has certain definite advantages over Peoria. It has a vastly wider range of goods and services available to the consumer, including theaters, concerts, colleges, high-quality jewelry and clothing, and stockbrokerage houses. There is a great difference between the commodity “restaurant service in New York” and the commodity “restaurant service in Peoria.” The former allows the purchaser to remain in New York and to enjoy its various advantages. Thus, the two are distinct goods, and the fact that the price of restaurant service is greater in New York signifies that the preponderance of individuals on the market value the former more highly and consider it a com­modity of higher quality.[40]

     Costs of transport, however, do introduce a qualification into this analysis. Suppose that the PPM in Detroit is slightly higher than in Rochester. We would expect gold to flow from Rochester to Detroit, spending relatively more on goods in the latter place, until the PPM’s are equalized. If, however, the PPM in Detroit is higher by an amount smaller than the transport cost of shipping the gold from Rochester, then relative PPM’s have a leeway to differ within the zone of shipping costs of gold. It would then be too expensive to ship gold to Detroit to take advantage of the higher PPM. The interspatial PPM’s may vary in either direction within this cost-of-transport margin.[41]

     Many critics allege that the PPM cannot be uniform throughout the world because some goods are not transferable from one locale to another. Times Square or Niagara Falls, for example, cannot be transferred from one region to another; they are specific to their locale. Therefore, it is alleged, the equalization process can take place only for those goods which “enter into interregional trade”; it does not apply to the general PPM.

     Plausible as it seems, this objection is completely fallacious. In the first place, disparate goods like Times Square and other main streets are different goods, so that there is no reason to ex­pect them to have the same price. Secondly, so long as one com­modity can be traded, the PPM can be equalized. The composi­tion of the PPM may well be changed, but this does not refute the fact of equalization. The process of equalization can be de­duced from the fact of human action, even though, as we shall see, the PPM cannot be measured, since its composition does not remain the same.

     Finally, since any good can be traded, what is there to prevent, for example, Oshkosh capital from buying a building on Times Square? The Oshkosh capitalists need not literally transport a good back to Oshkosh in order to buy it and make money from their investment. Every good, then, “enters into interregional trade”; no distinction between “domestic” and “interregional” (or “international”) goods can be made.

     Thus, suppose the PPM is higher in Oshkosh than in New York. New Yorkers tend to buy more in Oshkosh, and Oshkoshians will buy less in New York. This does not only mean that New York will buy more Oshkosh wheat, or that Oshkosh will buy less New York clothing. It also means that New Yorkers will invest in real estate or theaters in Oshkosh, while Oshkoshians will sell some of their New York holdings.

B. Clearing in Interlocal Exchange

     Clearing is particularly appropriate for interlocal transac­tions, since costs of transporting money from one locale to another are likely to be heavy. Bills of exchange on each town (i.e., I.O.U.’s owed by each town) can be reciprocally canceled. Suppose that there are two traders, A and B, in Detroit, and two in Rochester, C and D. A sells C a refrigerator for 200 gold grams, and D sells B a TV set for 200 grams. The two debts can be cleared, and no money need be shipped from one place to the other. On the other hand, D’s sale of a TV set may total 120 grams. Suppose for a moment that these are the only traders in the two com­munities. Then 80 grams will have to be shipped from Rochester to Detroit. In the latter case, the citizens of Detroit have, on net balance, decided to add to their cash holdings, while the Rochesterites have decided to diminish their cash holdings.

     Economists have often described interlocal trade in terms of “gold export points” and “gold import points.” The use of such expressions assumes, however, that even though two localities both use gold money, it makes sense to talk of an “exchange rate” of the money of one locality for that of another. This exchange rate is set between the margins fixed by the cost of transporting money—the “gold import” and “gold export” points. This does not hold true on the free market, however. On such a market, all coins and bullion are expressed in terms of weight of gold, and it makes no sense whatever to speak of an “exchange rate” of the money of one place for the same money in another. How can there be an “exchange rate” of an ounce of gold for an ounce of gold? There will be no legal tender or other laws to separate the value of the coins of one area from those of another. There­fore, there may be slight variations in the PPM in each locale, within the limits of the cost of transporting gold, but there could never be deviations from par in interlocal “exchange rates.” For there are no exchange rates on the free market, except for two or more coexisting money commodities.

10. Balances of Payments

     In chapter 3 above, we engaged in an extensive analysis of the individual’s balance of payments. We saw there that an in­dividual’s income can be called his exports, and the physical sources of his income his goods exported; while his expenditures can be termed his imports, and the goods purchased his goods imported.[42] We also saw that it is nonsensical to call a man’s balance of trade “favorable” if he chooses to use some of his in­come to add to his cash balance, or “unfavorable” if he decides to draw down his cash balance, so that expenditures are greater than income. Every action and exchange is favorable from the point of view of the person performing the action or exchange; otherwise he would not have engaged in it. A further conclu­sion is that there is no need for anyone to worry about anyone else’s balance of trade.

     A person’s income and expenditure constitute his “balance of trade,” while his credit transactions, added to this balance, com­prise his “balance of payment.” Credit transactions may compli­cate the balance, but they do not alter its essentials. When a creditor makes a loan, he adds to his “money paid” column to the extent of the loan—for purchase of a promise to pay in the future. He has purchased the debtor’s promise to pay in exchange for transferring part of his present cash balance to the debtor. The debtor adds to his “money receipts” column—from the sale of a promise to pay in the future. These promises to pay may fall due at any future date decided upon by the creditor and the debtor; generally they range from a day to many years. On that date the debtor repays the loan and transfers part of his cash balance to the creditor. This will appear in the debtor’s “money paid” column—for repayment of debt—and in the cred­itor’s “money received” column—from repayment of debt. In­terest payments made by the debtor to the creditor will be simi­larly reflected in the respective balances of payments.

     More nonsense has been written about balances of payments than about virtually any other aspect of economics. This has been caused by the failure of economists to ground and build their analysis on individual balances of payments. Instead they have employed such cloudy, holistic concepts as the “national” bal­ance of payment without basing them on individual actions and balances.

     Balances of payments may be consolidated for many individ­uals, and any number of groupings may be made. In these cases, the balances of payments only record the monetary transactions between individuals of the group and other individuals, but fail to record the exchanges of individuals within the group.

     For example, suppose that we take the consolidated balance of payments for the Antlers Lodge of Jonesville for a certain pe­riod of time. There are three lodge members A, B, and C. Sup­pose their individual balances of payments are as indicated in Table 16.

In the consolidated balance sheet of the Antlers Lodge, the money payments between the members must of necessity cancel out. Thus,

     The consolidated balance tells less about the activities of the members of the group than do the individual balances, since the exchanges within the group are not revealed. This discrepancy grows as the number of people grouped in the consolidated bal­ance increases. The consolidated balance of the citizens of a large nation such as the United States conveys less information about their economic activities than is revealed by the consolidated bal­ance of the citizens of Cuba. Finally, if we lump together all the citizens of the world engaged in exchange, their consolidated bal­ance of payments is precisely zero. All the exchanges are internal within the group, and the consolidated balance conveys no in­formation whatever about them. Taken together, the people of the world have zero income from “outside” and zero expendi­tures on “outside goods.”[43]


     Fallacies in thinking about foreign trade will disappear if we understand that balances of payment are merely built upon con­solidated individual transactions and that national balances are merely an arbitrary stopping point between individual balances on the one hand and the simple zeros of a world balance of pay­ments on the other. There is, for example, the perennial worry that a balance of trade will be permanently “unfavorable” so that gold will drain out of the region in question until none is left. Drains of gold, however, are not mysterious acts of God. They are willed by people, who, on net balance, wish for one reason or another to reduce their cash balances of gold. The state of the balance is simply the visible manifestation of a voluntary re­duction in the cash balance in a certain region or among a cer­tain group.

     Worries about national balances of payment are the fallacious residue of the accident that statistics of exchange are far more available across national boundaries than elsewhere. It should be clear that the principles applying to the balance of payment of the United States are the same for one region of the country, for one state, for one city, for one block, one house, or one per­son. Obviously no person or group can suffer because of an “un­favorable” balance; he or the group can suffer only because of a low level of income or assets. Seemingly plausible cries that money “be kept in” the United States, that Americans not be flooded with the “products of cheap foreign labor,” etc., take on a new perspective when we apply it, say, to a family of three Jones brothers. Imagine each brother exhorting the others to “buy Jones,” to “keep the money circulating within the Jones family,” to abstain from buying products made by others who earn less than the Jones family! Yet the principle of the argument is pre­cisely the same in both cases.

     Another popular argument is that a debtor group or nation cannot possibly repay its debt because its “balance of trade is in fundamental disequilibrium, being inherently unfavorable.” This is taken seriously in international affairs; yet how would we re­gard the individual debtor who used this excuse for defaulting on his loan? The creditor would be justified in bluntly telling the debtor that all he is saying is that he would much rather spend his money income and assets on enjoyable goods and serv­ices than on repayment of his debt. Except for the usual holistic analysis, we would see that the same holds true for an interna­tional debt.

[29] For an exposition of the feasibility of private coinage, see Spencer, Social Statics, pp. 438–39; Charles A. Conant, The Principles of Money and Banking (New York: Harper & Bros., 1905), I, 127–32; Lysander Spooner, A Letter to Grover Cleveland (Boston: B.R. Tucker, 1886), p. 79; B.W. Barnard, “The Use of Private Tokens for Money in the United States,” The Quarterly Journal of Economics, 1916–17, pp. 617–26.

     Recent writers favorable to private coinage include: Everett Ridley Taylor, Progress Report on a New Bill of Rights (Diablo, Calif.: the author, 1954); Oscar B. Johannsen, “Advocates Unrestricted Private Con­trol over Money and Banking,” The Commercial and Financial Chronicle, June 12, 1958, pp. 2622f.; and Leonard E. Read, Government—An Ideal Concept (Irvington-on-Hudson, N.Y.: Foundation for Economic Education, 1954), pp. 82ff. An economist hostile to market-controlled commodity money has recently conceded the feasibility of private coinage under a commodity standard. Milton Friedman, A Program for Monetary Stability (New York: Fordham University Press, 1960), p. 5.

[30]Time deposits are, legally, future claims, since banks have a legal right to delay payment 30 days. Moreover, they do not pass as final media of exchange. The latter fact is not determining, however, since a se­cure claim to a money-substitute is itself part of the money supply. “Idle” cash balances are kept as “time deposits,” just as gold bullion is a more “idle” form of money than coins. The deciding factor, perhaps, is that the 30-day limit is virtually a dead letter, for if a “savings” bank should impose it, a bankrupting “run” on the bank would ensue. Furthermore, actual payments are sometimes made by “cashiers’ checks” on time deposits. Thus, “time” deposits now function as demand de­posits and should be treated as part of the money supply. If banks wished to act as genuine savings banks, borrowing and lending credit, they could issue I.O.U’s for specified lengths of time, due at definite future dates. Then no confusion or possible “counterfeiting” could arise.

[31]Such items as bills of lading, pawn tickets, and dock warrants have been warehouse receipts rooted in the specific objects deposited, in contrast to the loose “general deposits” where a homogeneous good can be returned. See W. Stanley Jevons, Money and the Mechanism of Exchange (16th ed.; London: Kegan Paul, Trench, Trübner & Co., 1907), pp. 201–11.

[32]We might ask why the owners of the bank do not really reap the spoils and lend the money to themselves. The answer is that they once did so profusely, as the history of early American banking shows. Legal regulations forced the banks to abandon this practice.

[33]This discussion is not meant to imply that bankers, particularly at the present time, are always knowingly engaged in fraudulent practices. So embedded, indeed, have these practices become, and always with the sanction of law as well as of sophisticated but fallacious economic doc­trines, that it is undoubtedly a rare banker who regards his standard occupational procedure as fraudulent.

[34]For a brilliant discussion of fractional-reserve banking, see Amasa Walker, The Science of Wealth (3rd ed.; Boston: Little, Brown & Co., 1867), pp. 138–68, 184–232.

[35]Swiss banks have successfully and for a long time been issuing debentures to the public at varying maturities, and banks in Belgium and Holland have recently followed suit. On the purely free market, such practices would undoubtedly be greatly extended. Cf. Benjamin H. Beckhart, “To Finance Term Loans,” The New York Times, May 31, 1960.

[36]Jevons, Money and the Mechanism of Exchange, pp. 211–12.

[37]Jevons stated:

If pecuniary promises were always of a special character, there could be no possible harm in allowing perfect freedom in the issue of promissory notes. The issuer would merely constitute himself a warehouse keeper and would be bound to hold each special lot of coin ready to pay each corresponding note. (Ibid., p. 208)

[38]See Mises, Theory of Money and Credit, pp. 131–45.

[39]See Mises Human Action, pp. 413–16.

[40]For an appreciation of Mises’ achievement in clarifying this problem, see Wu, An Outline of International Price Theories, pp. 127, 232–34.

[41]As we shall see below, however, interlocal clearing can greatly narrow these limits.

[42]To say that “exports pay for imports” is simply to say that income pays for expenditures.

[43]For an excellent and original analysis of balances of payments along these lines, see Mises, Human Action, pp. 447–49.

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