Study Guide to the Theory of Money and Credit

Chapter Outline

1.   The Two Ways of Issuing Fiduciary Media

Fiduciary media may be issued by banks or by non-banks (primarily the government). Banks can issue fiduciary media either through banknotes or by granting deposits in a current account (i.e., a modern-day checking account). Banks treat their outstanding fiduciary media as liabilities on their balance sheets, and must loan or directly invest them wisely.

Governments may also issue fiduciary media such as convertible Treasury notes and token coins. Governments often do not set aside a credit fund out of their capital to “cover” the increased obligations. Instead governments will pocket the seigniorage as income just as surely as tax revenue.

2.   Fiduciary Media and the Clearing System

The use of fiduciary media can reduce the demand for money in the narrower sense. For example, in the modern United States, the demand to hold actual Federal Reserve notes (green pieces of paper with pictures of dead presidents) is much lower, because people can open checking accounts with commercial banks and write checks or use debit cards (where these deposits are partly fiduciary media, because they are not fully backed up by cash in the vault).

However, an entirely different phenomenon is the reduction in the demand for money in the broader sense—including money proper and even money substitutes (including fiduciary media)—brought about by the development of credit and the clearing system. If one party to a transaction is willing to defer receiving payment, he has thus granted credit. If the other party later delivers goods or performs services such that the original debt is partially or fully offset, only the difference needs to be settled by actual money or money substitutes. As more such transactions are incorporated into such arrangements, the community’s demand for money in the broader sense falls below what it otherwise would have been.

3.   Fiduciary Media in Domestic Trade

So long as a country has a stable legal framework that permits the building of trust in issuers, the use of clearing operations and fiduciary media can grow to dominate transactions and almost completely displace the use of money in the narrower sense.

4.   Fiduciary Media in International Trade

The practice of using claims and counter-claims in clearing operations to reduce the need to transport money was of particular benefit in international trade, because of the longer distances and time involved. However, fiduciary media themselves are still limited by national boundaries. For example, a particular supplier in the United States might grant credit to a merchant in France, but the claim on the French merchant would not circulate from hand to hand in the same way that a banknote in the United States (or in France) could. Only with the development of a world bank, with clientele drawn from every country, could fiduciary media transcend national boundaries.

Technical Notes

•   On page 278 Mises writes, “[Bank fiduciary media] are entered as liabilities, and the issuing body does not regard the sum issued as an increase of its income or capital, but as an increase on the debit side of its account, which must be balanced by a corresponding increase on the credit side if the whole transaction is not to figure as a loss. This way of dealing with fiduciary media makes it necessary for the issuing body to regard them as part of its trading capital and never to spend them on consumption but always to invest them in business.” This is a crucial point that newcomers to fractional-reserve banking often miss. Even though such bankers in a sense “create money out of thin air,” they can’t simply open up a new account for $100,000 and then write checks to buy themselves sports cars and designer clothes. The reason is that the merchants in the community would then have $100,000 in claims on the actual cash reserves of the bank, and ultimately the bank’s vault would run out of the genuine money. What fractional bankers do instead is loan out the $100,000 to a productive business at (say) 5 percent interest. When the $105,000 is repaid in a year, the $100,000 that was initially created can be “destroyed” (through bookkeeping) and the $5,000 in interest income can be safely spent without draining the bank’s cash reserves. Thus fractional-reserve bankers create money out of thin air not to directly spend it—which would be incredibly reckless and short-lived—but instead to earn interest income from it.

•   On page 291 Mises rejects the claim that India and other Asiatic countries used gold as a “measure of prices” while retaining silver as a medium of exchange. For one thing, the modern subjective value theory explodes the very notion of money as a measure, since value is not an objective property like length or weight that can be measured. Yet of more relevance to this passage, Mises is pointing out that even in the classical gold standard countries, people rarely used actual gold when buying goods and services. Instead, they employed claims to gold. But this is precisely what happened in India, which retained silver coins in circulation that could be redeemed for the official money, gold, at a certain exchange rate.

New Terminology

Convertible Treasury notes: Paper notes issued by the government that entitle the bearer to redemption in money upon demand.

Seigniorage: The difference between the market value of money and the cost to produce it.

Credit: The ability to receive present goods in exchange for the promise of delivering (typically a greater number of) future goods.

Study Questions

1.   Explain: “To complete [a] transaction ... by full or partial cancellation of counter-claims offers important advantages in comparison with direct exchange: all the freedom connected with the use of money is combined with the technical simplicity that characterizes direct exchange transactions.” (p. 282)

2.   What does Mises think is the importance of credit for the monetary system? (p. 282)

3.   Explain: “Money in these cases [of international clearing operations] is still a medium of exchange, but its employment in this capacity is independent of its physical existence. Use is made of money, but not physical use of actually existing money or money substitutes. Money which is not present performs an economic function; it has its effect solely by reason of the possibility of its being able to be present.” (p. 283)

4.   Does Mises classify bills of exchange as fiduciary media? (pp. 285-86)

5.   If a hypothetical world bank had deposits and notes that were backed up 100 percent by money on reserve, could it economize on money payments? (p. 294)