17. Fiduciary Media and the Demand for Money

CHAPTER 17 FIDUCIARY MEDIA AND THE DEMAND FOR MONEY

Summary

If labor and other resources are used to extract more gold from mines, and this additional gold goes into the cash balances of people in the community, then from a social point of view the labor and other resources have been wasted. The quantity of “real output” (pounds of steak, barrels of crude oil, etc.) produced per person doesn’t rise, but merely the prices of these items quoted in gold or silver.

The development of fiduciary media kept the objective exchange value of money lower than it otherwise would have been, and thereby avoided a large diversion of resources into mining more of the precious metals for cash holdings.

Some writers argue that the payment system in an advanced market economy is “elastic” and responds to the “needs of commerce,” rather than the actual stock of money in the narrower sense. Although the extension of the clearing system does reduce the demand for money in the broader sense, there is no reason that its development should be related to the demand for money. It is an independent phenomenon that may either strengthen or counterbalance changes in the demand for money originating from other causes.

Many writers (such as those of the Banking School) argue that the banks do not have the power to independently increase the quantity of fiduciary media. What these writers fail to understand is that the demand for loans depends on the rate of interest. It makes no sense to speak of how much money the banks’ customers wish to borrow, without specifying a rate of interest. If the banks want to issue fiduciary media, they must lower the market rate below the natural rate of interest.

Businesses seek loans from the banks because they desire capital; they simply want capital in the form of money, so that they can conveniently acquire the physical capital goods that they ultimately desire for their operations. Of course, the mere issuance of fiduciary media does not increase the amount of tractors, fertilizer, or power tools. The only way the banks can provide these goods to their clients is through redistribution of purchasing power away from members of the community who do not receive the influx of the newly created money.

Chapter Outline

1. The Influence of Fiduciary Media on the Demand for Money in the Narrower Sense

In one sense, the employment of the precious metals (or any other useful commodity) to enlarge the stock of money is wasteful. If labor and other resources are used to extract more gold from mines, and this additional gold goes not into industrial or commercial uses (such as for dental fillings or jewelry), but instead increases the cash balances of people in the community, then from a social point of view the labor and other resources have been wasted. Increasing the quantity of money may redistribute existing wealth to make some individuals richer, but only at the expense of making others (who are last to receive the new money) poorer. The community as a whole doesn’t achieve a higher standard of living, simply because people hold more gold or silver in their cash balances. The quantity of “real output” (pounds of steak, barrels of crude oil, etc.) produced per person doesn’t rise, but merely the prices of these items quoted in gold or silver.

The development of fiduciary media reduces the demand to hold money in the narrower sense. In a community using gold as commodity money, a person who holds (airtight and instantly redeemable) claims to gold, which are accepted in commerce by everyone in the community, doesn’t need to carry as much actual gold on a day-to-day basis. In this sense the widespread use of fiduciary media “economizes” on the amount of metal that must be allocated into the function of serving as the medium of exchange; more gold is freed up to be used in jewelry or industrial applications.

Were it not for the simultaneous development of fiduciary media, the intensification of the division of labor as the world became one giant integrated market would have led to a sharp increase in the objective exchange value of money. In other words, as more people around the world became part of the global market which used gold as the international money, more people would have tried to obtain gold as part of their cash holdings. If actual gold had to satisfy this huge growth in demand, prices (quoted in gold) would have fallen and the owners of gold mines would have intensified their extraction efforts. But the simultaneous development of fiduciary media counterbalanced this tendency, so that the purchasing power of a unit of gold did not rise as much as it otherwise would have.

2. The Fluctuations in the Demand for Money

Some of the fluctuations in the demand for money are quite predictable. An increase in population and the spread of the money economy increase the demand for money. The demand for money changes during boom and bust periods. And even in a typical year, there are cyclical patterns based on agriculture and the payment of workers.

3. The Elasticity of the System of Reciprocal Cancellation

Some writers argue that the payment system in an advanced market economy is “elastic” and responds to the “needs of commerce,” rather than the actual stock of money in the narrower sense. The quantity of money is said to have little influence on the objective exchange value of money, because (say) an increase in the demand for money will automatically be counterbalanced by other forces. These claims are often difficult to evaluate because they fail to make the crucial distinction between the extension of the clearing system, versus the increased use of fiduciary media. Although the extension of the clearing system does reduce the demand for money in the broader sense, there is no reason that its development should be related to the demand for money. It is an independent phenomenon that may either strengthen or counterbalance changes in the demand for money originating from other causes.

4. The Elasticity of a Credit Circulation Based on Bills, Especially on Commodity Bills

Many writers (such as those of the Banking School) argue that the banks do not have the power to independently increase the quantity of fiduciary media. If business needs require more transactions, then somehow or other, business will get it—either from banks issuing more fiduciary media, or from businesses developing techniques to economize on the use of money. On the other hand (so the argument continues), if the banks try to issue more fiduciary media than the business community desires, these excess notes will come flowing back to the banks.

What these writers fail to understand is that the demand for loans depends on the rate of interest. It makes no sense to speak of how much money the banks’ customers wish to borrow, without specifying a rate of interest. If the banks want to issue fiduciary media, they must lower the market rate below the natural rate of interest.

5. The Significance of the Exclusive Employment of Bills as Cover for Fiduciary Media

The German Bank Act of 1875 followed the famous Peel’s Act in imposing requirements on the cover that banks could accept when issuing new loans in excess of their gold deposits. The requirement was significant not because it somehow tied the expansion of credit to the desire of the community for more money. Rather, it was significant because it placed an obstacle in the issuance of fiduciary media, keeping the quantity of money in the broader sense lower than it otherwise would have been.

6. The Periodical Rise and Fall in the Extent to Which Bank Credit is Requisitioned

7. The Influence of Fiduciary Media on Fluctuations in the Objective Exchange Value of Money

As with the extension of clearing operations, there is no reason that the expansion or contraction of fiduciary media should mirror changes in the demand to hold money; there is no “automatic” mechanism by which the objective exchange value of money is stabilized. Thus the insights of the quantity theory are upheld.

Technical Notes

• An example will clarify the terminology and arguments running throughout this and earlier chapters. Suppose a man asks his bartender if he can “run a tab,” meaning that he will obtain drinks in the present but will pay money for them later (perhaps at the end of the month). The bartender agrees, saying the man can have up to $100 in drinks without having to pay for them upfront. By doing so, the bartender has extended credit to the man. However, the quantity of money in the man’s possession hasn’t increased, because the man doesn’t have any transferrable claim (issued by the bartender) that others in the community would accept. In contrast, if the man goes to his local bank and applies for a $100 loan (to be paid back at the end of the month), then in this case too the man receives an extension of credit, but he also receives an addition to his cash balances. Whether the bank loan consists of a new checking account (with $100 as the initial balance), actual money, or notes issued by the bank, these would all be classified as money in the broader sense. The man could use them to buy anything he wanted, including drinks at the bar. Finally, to see the limited role of clearing systems, revert to the original assumption, where the man’s credit consists of a “tab” issued by the bartender with a limit of $100. If the man wanted to use this credit not to buy alcoholic drinks, but rather to buy (say) a pair of shoes, he would have to find a shoe seller who also wanted to buy drinks from the particular bar in question. Then it might be possible to arrange a deal whereby the man acquires the shoes, in exchange for telling the bartender to put the shoe seller’s drinks on his own tab (rather than charging the shoe seller for them).

• Mises concludes his discussion of section 4 on page 312 by saying, “[A]ll of this is true only under the assumption that all banks issue fiduciary media according to uniform principles, or that there is only one bank that issues fiduciary media.” In the section, Mises had criticized the writers of the Banking School who argued that the banks couldn’t get the community to accept extra issues of fiduciary media, if the community didn’t want to hold them. Mises objected that the demand for the additional loans could be influenced by the rate of interest the banks charged, and hence the Banking School’s views were mistaken. So long as they are willing to sufficiently lower the rate of interest below the natural rate, the banks can convince the community to accept any amount of new fiduciary media. However, Mises does not mean that an individual bank has no checks on its issue. If any single bank unilaterally lowers its interest rate and issues more fiduciary media (compared to the policies of its competitors), then eventually those notes will fall into the hands of people who are not clients of the expanding bank. When these people deposit the bank’s newly issued notes with their own banks (which are competitors), these notes will be presented for redemption in money in the narrower sense. Thus the lone bank engaged in an expansionary policy will soon see its reserves of money proper dwindle, and will have to abandon its experiment. Yet this mechanism is not what the Banking School theorists had in mind when they said banks couldn’t issue more notes than the needs of the community warranted.

New Terminology

Banking School: An English school of thought which argued that the banks were incapable of independently altering the rate of interest or the purchasing power of money, because the market would use clearing operations, bills of exchange, and other techniques to receive the credit it demanded for business purposes.

Currency School: An English school of thought which argued that the banks caused economic crises through the expansion and contraction of credit. However, the Currency School thought the suppression of the issue of fiduciary media in the form of banknotes (which was codified in Peel’s Act) would solve the problem, because its members erroneously excluded demand (or current account) deposits from their analysis.

(Wicksellian) natural rate of interest: Developed by economist Knut Wicksell, the hypothetical rate of interest that would occur if goods were traded directly against each other without the use of money.

Peel’s Act [Bank Charter Act 1844]: An important legislative act that took the power of issuing new notes away from private banks and vested it completely with the Bank of England, which itself was required to maintain 100 percent metallic backing for any new notes that it issued. However, the Act crucially did not impose such a restriction on the extension of deposits, meaning that private banks could create more fiduciary media by granting loans (not backed by gold) to their customers.

Cover (of note issue): Assets backing the issue of new banknotes. Depending on the regulations, a bank might issue fiduciary media not backed by money itself, but backed by another asset such as a commodity bill.

Working capital: Current assets minus current liabilities. More generally, a measure of a firm’s ability to quickly turn some of its assets into cash in order to finance an expansion.

Fixed capital: Assets embodied in durable investments such as factories and specialized equipment that will be used over a long period.

Study Questions

1. What was Adam Smith’s analogy to explain the drawback of using the precious metals as money? (p. 298)

2. If fiat or credit money is employed, does it still make sense to use fiduciary media to economize on the use of money in the narrower sense? (pp. 299–300)

3. Why would population growth influence the demand to hold money? (pp. 300–01)

4. Explain: “The demand for money and money substitutes that is expressed on the loan market is in the last resort a demand for capital goods or, when consumption credit is involved, for consumption goods.” (p. 307)

5. Who bears the “cost of creating capital for borrowers of loans granted in fiduciary media”? (p. 314)

Study Guide to the Theory of Money and Credit