4. Money and the State

CHAPTER 4 MONEY AND THE STATE

Summary

Unless it resorts to outright socialism, the State must conform to the market. Its actions in the market are governed by the Laws of Price. In this respect, the State has more influence than any other entity, but this is due to the State’s enormous budget.

In economics, money is a common medium of exchange. But from the legal point of view, money is a common medium of payment or debt settlement. Money can only serve this function (as a medium of debt settlement) because it is a medium of exchange. This is clear when we consider cases where a contract cannot be fulfilled as written, and so the court specifies a monetary payment instead.

Government cannot force people to attribute a certain exchange value to a good. The legal system can certainly allow debtors to “satisfy” their contractual liabilities by paying with items at a face value higher than what the creditors actually believe they are worth, but this merely means a partial repudiation of the debt.

Originally the State’s only role in the monetary sphere was to supply recognizable coins that were hard to counterfeit and that were very similar in appearance, weight, and fineness. By producing suitable coins, the State was merely facilitating commerce, because merchants wouldn’t need chemical tests and scales to evaluate the gold or silver their customers presented in payment.

The State’s influence in the monetary sphere has grown because its size has grown, but also because of its control of the mint: The State can withdraw coins of one metal and replace them with coins of a different metal. The State also influences the monetary sphere through its ability to suspend the immediate redemption of money substitutes, converting them into credit money or even fiat money.

Chapter Outline

1. The Position of the State in the Market

Although it commands a large influence because of its power to tax, ultimately the State must conform to the market. Unless it completely abolishes private property and forms a socialist State, the government can only successfully change market prices through its own decisions to buy and sell. The same is true of money: mere government edicts cannot explain the purchasing power of a common medium of exchange.

2. The Legal Concept of Money

In economics, money is a common medium of exchange. But from the legal point of view, money is a common medium of payment or debt settlement. If a contract calls for one party to pay back a loan of “100 ounces of gold, plus 5 ounces in interest” in one year, the legal system must specify what types of goods are acceptable to satisfy the contract. (For example, must it be done in physical gold, or can a banknote or a check written on a bank account—denominated in gold—satisfy the debt? What about token coins that can be exchanged for gold?) However, money can only serve this function (as a medium of debt settlement) because it is a medium of exchange. This is clear when we consider cases where a contract cannot be fulfilled as written, and so the court specifies a monetary payment instead.

3. The Influence of the State on the Monetary System

Originally the State’s only role in the monetary sphere was to supply coins of the greatest possible degree of similarity in appearance, weight, and fineness. Furthermore, to do its task well the State would manufacture coins that were hard to counterfeit, and that bore a recognizable stamp. In this regard, the State wasn’t defining money, but was instead merely taking what the market had chosen as the money—for example, gold—and then producing hunks of the money in convenient shapes. By producing suitable coins, the State was merely facilitating commerce: if everyone recognized the State’s one-ounce gold coin, and knew that it was genuine, then merchants wouldn’t have to resort to chemical tests and scales to evaluate the yellow metal their customers presented in payment.

The State’s influence in the monetary sphere has grown because its size (relative to the economy) has grown, but also because of its control of the mint. The State can exert great power over what its subjects choose as the common medium of exchange, since it can (for example) withdraw coins of one metal and replace them with coins of a different metal. Even so, the State cannot avoid the laws of economics. The failed attempts at bimetallist legislation—where the government established a fixed ratio between the value of gold and silver—showed the operation of Gresham’s Law. That is, when the actual market values of gold and silver deviated from the legal ratio, people would hoard the undervalued metal and try to spend the overvalued metal.

The State also influences the monetary sphere through its ability to suspend the immediate redemption of money substitutes, converting them into credit money or even fiat money.

Important Contributions

• Carl Menger’s explanation of the origin of money (laid out in chapter 1) offers a satisfactory rebuttal to the “State theory of money” offered by Knapp and other theorists. (p. 73) If an Austrian economist disputes the theory that money derives its value from the State, the argument is more compelling if the Austrian can show—using Menger’s approach—how money arose spontaneously on the market.

• In this chapter we already see the benefit of Mises’s fastidious classification scheme regarding money. Armed with his categories of money substitutes, commodity money, and credit money, Mises can explain exactly how a State influences the money used by its subjects. While many others place great importance on State legislation regarding tax payments and debt contracts, Mises instead looks at the State’s role in minting coins and its power to change money substitutes into credit money (by suspending immediate redemption of the claims to money). (pp. 77–78)

New Terminology

Bimetallist legislation: Efforts by the government to establish a fixed conversion ratio between gold and silver. For example, the government might require that merchants who post a price in gold ounces, also accept payment in silver ounces at a fixed multiple of the gold price.

Gresham’s Law: Popularly summarized as “bad money drives out good,” the phenomenon by which people will hold money that is undervalued by legislation, and will spend the money that is overvalued by legislation. For example, if bimetallist legislation requires that merchants accept silver and gold at the ratio of 16–to–1, when in fact the actual market exchange rate is 20–to–1, then everyone will try to buy with silver, and no one will use gold for making purchases. Gold will seem to disappear, and only silver will be used in commerce. For a different example, if the government passes legal tender laws on all government-stamped coins, then coins with low metal value (such as U.S. quarters minted in the year 2000) will circulate in trade, whereas coins with high metal content (such as U.S. quarters minted in the year 1950) will be hoarded by people who recognize the value of the silver.

Study Questions

1. Explain: “When notes that are appraised commercially at only half their face-value are proclaimed legal tender, this amounts fundamentally to the same thing as granting debtors legal relief from half of their liabilities.” (p. 71)

2. Explain: “State declarations of legal tender affect only those monetary obligations that have already been contracted.” (p. 71)

3. What are the two mechanisms through which the “State’s influence on commercial usage, both potential and actual, has increased”? (pp. 72–73)

4. Explain: “A country that wishes to persuade its subjects to go over from one precious-metal standard to another cannot rest content with expressing this aspiration in appropriate provisions of the civil and fiscal law.” (p. 74)

5. Explain: “The parallel standard was thus turned, not into a double standard, as the legislators had intended, but into an alternative standard.” (p. 75)

Study Guide to the Theory of Money and Credit