Sunday, June 23, 2013

Inflation and Monetary Crises Part 2: Just What the Heck IS Money, Anyway?

(Read Part 1 HERE.)
In order to understand how to avoid the consequences of large-scale monetary disasters, of which hyperinflation is one and depression is another, we have to understand in the first place exactly what money is, how it came about, what it means, how it gets corrupted, and therefore how to manage it correctly.
In order to understand money, we first need to remove it from the scene; imagine what life was like before and without money. Without money, we have a barter economy. If you want to obtain eggs, cloth, cereal and milk for your family, you have to offer a sheep, a goat and/or several pounds of carrots in exchange.
Let us ignore the obvious disadvantages of such a system for the moment. One thing we can note right away is with no money, there is no possibility of monetary fraud and the concept of counterfeiting is meaningless; assuming that all parties to the transaction are satisfied with the quality and quantity of the goats, eggs, carrots etc. involved in the exchange, there can be no such thing as inflation or monetary crisis.
So that’s it! We go back to a barter economy and live happily ever after! The End!

OK, I’m kidding. We’re just getting started here. There are distinct disadvantages to the barter economy that make an alternative highly desirable (just, without the crises). These disadvantages include:
• Granularity: If all you possess to exchange is one 3000-pound ox, whereas all you need right now is a day’s supply of various foodstuffs and clothing, then even if you could find a trading partner who had just the exact mix of items you needed (unlikely), the quantity mismatch works against the trade taking place.
• Transportability: If you live on a small farm near a bucolic village, then walking your ox to the market, permitting it to graze on grasses and contribute productive fertilizer by the side of the road, may not be too much of a problem. But if you want to exchange for some grain, silk or molasses produced hundreds or even thousands of miles away, or if you live in an apartment in a city, keeping and transporting your ox is a major inconvenience.
• Security: An ox is perishable; it can easily get sick and die. It’s too big and temperamental to keep in a cash drawer.

OK, what’s with the obsession on oxen? Well, first, Adam Smith used an ox in his example illustrating the same point about the difficulty of barter. But also, Carl Menger, the founder of the ‘Austrian’ school of economics, pointed out that cattle in the form of smaller specimens such as goats and sheep were among the earliest forms of money in agrarian and nomadic societies . That is, a man’s wealth was largely measured by how many heads of sheep, goats, cows etc. that he owned, and perhaps more importantly, people would willingly accept such cattle as payment for other goods in the market, even if they had no immediate use for them themselves, because they knew that they could easily exchange them for the other items that they did need. While retaining all of its value in use, cattle took on additional special value as the most marketable commodity in the economy and therefore highly useful in indirect exchange. Money, in the true and original sense of the word, was born.
• Fundamental definition of money (in case you missed the point): Any commodity generally accepted in a particular market in exchange for other goods, which the receiver intends not to use him/herself but to exchange for yet other goods and/or services.

Or, condensed:
• Money is the common commodity used as a medium of indirect exchange in a given market.

Note again that there is no possibility of inflation or purely monetary crisis under a commodity-money economy. It’s very difficult to ‘counterfeit’ a goat, or to ‘print’ too many of them; if you could reproduce a large number of goats, the fact that they are real, useful and valuable goods rather than pieces of paper means that their increase cannot defraud a market, even if the relative scarcity of other goods changes the exchange rate. Any banker-shepherd who issued more than one claim ticket for the same goat would soon be bankrupt and possibly lynched.
Over the generations and across cultures, hundreds of commodities having intrinsic use value have been used as the common medium of exchange in particular markets: furs (in Canada), tobacco (in Maryland and Virginia), cakes of wax (on the upper Amazon), cod (in Iceland), bolts of silk, slaves, salt, seashells, nails, dates, tea-bricks, glass beads, grains --- in short, anything which was in common or abundant supply in a given market, which people knew they could easily trade for something else if they didn’t need the particular thing themselves.

An important aspect of the emergence of money in civilization is that it occurred originally without coercion or government intervention of any kind. It was a spontaneous creation of the individuals acting in their own best interest in voluntary exchanges of the marketplace. No decrees or authorization of ‘legal tender’ was required for the origin of money.
As trading and industry evolved to become more sophisticated, highly developed, and extended over greater distances, there emerged independently in many cultures at different times in history a tendency to prefer above all other money-commodities, the precious metals: copper, tin, nickel, silver, and the king of them all, gold.
Gold is the most advantageous of all the money-commodities in the overwhelming majority of markets. Its beauty gives it aesthetic value. It has real value in use, for ornamentation, fashion accessories, art, statuary, and in an advanced civilization, electronic components. Its physical characteristics, weight and relative scarcity give it a high value relative to its bulk. As metals go, it is soft and malleable, easily minted into coins or sub-divided into small units. It isn’t perishable like livestock or foodstuffs. It is easier to carry, store and guard, especially in a city or on a long journey, as compared to a comparably valuable quantity of cattle or molasses. For these reasons gold has emerged as the closest thing to a universal standard across history and cultures for monetary currency.

So, just what are paper money and electronic bank credits? Do these represent a higher level of monetary evolution?
Paper money originated as claim receipts for a certain quantity of real commodities on deposit with another party, such as a granary or bank. Paper and electronic bank credits are entirely consistent with the principle of sound money as long as they are not counterfeit, that is, they represent real promises to redeem claims for the commodities they represent. A treasury note, such as a dollar, originally acted like a warehouse receipt, giving the owner a claim, if not to a specific identified unit, then at least to a certain specific quantity of gold (1/20 ounce) that the treasury had in it warehouse (bank vault). As long as paper money (and its modern, high-tech counterpart) retained this anchor to real goods, and the issuing agency made good on its promise to redeem the notes on demand for the promised quantity of gold, then there was no fraud and no possibility of a monetary crisis. It was when the banks succumbed to the temptation to issue more notes than it had gold to back them, in effect issuing multiple claims to the same units of real goods in the warehouse, that the trouble started. Jesus Huerta de Soto has documented the phenomenon of fractional reserve banking from the time of the ancient Greeks and Romans, though the middle ages and Renaissance up to the present day. Significantly, the Bank of Amsterdam (Holland) of the 17th and 18th centuries was the longest enduring financial establishment for as long as it maintained a strict policy of 100% gold reserves. This institution endured in spite of wars, pestilence, political upheaval and other crises that make our own modern problems seem trivial.

A private or independent bank could not and cannot long issue more claims than it has gold to back them, because sooner or later, depositors are going to attempt to redeem their claims. It doesn’t take much to trigger a panic run when customers suspect that the bank won’t be able to make good on all its promises. For this reason, the free-market failure feedback mechanism functions perfectly to correct errors and fraud in private banking. Note that by private banking, I mean banking exercised neither with interference nor (extremeley important point) with any privilege from government, such as the right not to fulfill its contracts.
Under central banking however, where the government grants a charter to one institution, giving it the exclusive privilege to originate money and/or set fractional reserve policies, requires all other banks to keep their reserves on deposit with the central bank and doesn’t redeem its notes in real commodities, then at the very least, a bias for inflation is built in to the foundation of the financial system. With virtually complete control of the total money supply of a nation, the government has an unmatched ability to conjure monetary units out of nothing.
This essentially fraudulent act is the origin of the debauchery of paper currency, the root, indeed the very definition of inflation.
• The general rising prices of commodities in the market are the symptom and end result of inflation, not inflation itself.

Inflation comes about for reasons of political corruption. It is easier for governments to inflate on the sly than to openly raise taxes. In desperate times such as wars and revolutions, kings and presidents have financed armies with counterfeit money, with disastrous consequences . Even in less-than desperate times, politician love to print money and spend it on themselves, their friends, and the constituents most likely to vote for them. The perpetual motion machine of politics works for a few cycles, until the crisis erupts.