A Review of Rudy Fritsch’s Beyond Mises — Part 2
[Editor’s Note: Any comments about fiat money reformers are solely the author’s. Mr. Fritsch does not mention them in his book. He only refers to the Keynesians and Friedmanites. The author has used remarks that Mr. Fritsch makes to expose the irrationalities, absurdities, and frauds of fiat money reformers. Unless the author specifically mention Mr. Fritsch making the comment, the reader should assume that the comment is the author’s.]
Mr. Fritsch’s inflation discussion set me to pondering. He argues that the quality of money is the underlying cause of inflation instead of the commonly held belief that its quantity is. He also shows that the velocity of money can be as important, if not more so, as its quantity. This suggests that velocity is connected to demand. Although he does not discuss the demand for money in this context, it seems that quality is connected to demand, especially secular demand as opposed to cyclical or seasonal demand like harvest time and Christmas.
His explanation of the quality of money, i.e., the lack of it, causing inflation tells me that a decline in the demand for money causes inflation. I am not sure if that is his intent.
As the demand for money declines, its value, purchasing power, declines. Or as the purchasing power of money declines, the demand for money declines. Is the decline in purchasing power, quality, caused by a decline in the demand for money, or is it the result of a decline in the demand for money? I am not sure which is cause and which is effect.
For fiat money, its supply affects its purchasing power. As Mr. Fritsch shows, so does its velocity, which is related to demand. Higher the velocity of money is; the lower is the demand for money. In the hyperinflation stage the demand for money approached zero, and velocity of money approaches infinity.
The quantity theory focuses on the supply of money. He notes that the quantity theory of money is the dominant explanation of inflation. According to the quantity theory of money, the value of money is inversely proportional to the quantity of goods in the market — the more money and less goods, the lower the value of the money. Considering the succinctness of his explanation, he does a good job of exposing the weakness in relying on the quantity theory to explain inflation.
He argues that the quality of money offers a better explanation. The quality theory focuses on purchasing power of a unit of money and how long it will retain that purchasing power. The value of money depends on material of which it is made. High valued material, such as gold, results in high quality money. Low valued material, such as irredeemable paper, results in low quality money.
As these two theories of money are interrelated if quality is related to demand as I surmise, both should be considered. Although I have no statistical studies to support my conclusion, at least for fiat money, demand or quality seems to dominate at the beginning when people realize their money has lost its quality and at the end when they begin to lose confidence in their money. Supply seems to dominate most other times. Supply probably also dominates when the rate of inflation, i.e., currency depreciation, is low. At least in the United States, that seems true. In the 1970s when the dollar had obviously lost any pretense to quality with the closing of the gold window, inflation, currency depreciation, erupted. In the early 1980s, the rate of currency depreciation subsided. It even appreciated against gold. The quantity of money appeared to dominate as much of the money’s poor quality had been discounted. Now we are probably entering an era when people are again recognizing the massive loss of quality that has occurred during the last 25 years. Soon quality will again dominate. If the U.S. dollar hyperinflates, as it may do, quality will become the sole determiner of inflation.
The greenback, U.S. note, supports quality theory of inflation. The U.S. government issued the greenback as irredeemable paper money. It was low quality money. Its value quickly fell. After the enactment of the Resumption Act in 1875, the value of the greenback rose rapidly in 1877 and 1878. By January 1, 1879, it was at par with gold when redemption began.
It also adds some support to the quantity theory of inflation. When Congress froze the quantity of greenbacks and began reducing the supply, the greenback rose in value.
If Mr. Dale is correct, this argument about quantity and quality is irrelevant. According to Mr. Dale, interest causes inflation. The quantity and quality of money are immaterial, or so he seems to imply.
Other fiat money reformers also present arguments that make the quantity and quality of money irrelevant. According to them, inflation, or its lack, depends on who issues the money, and not on its quantity or quality. If private banks, and by inference other private parties, issue the money, then inflation occurs — apparently even if all that they issue are full-weight gold and silver coins whose excess can be melted and used for other purposes. If the government issues the money, then inflation, currency depreciation, is impossible regardless of the quantity issued or the quality of the money. They argue that money issued by government is of the highest quality, especially if it is irredeemable paper money.
The quality theory of inflation is new to most people. Mr. Fritsch should add more explanation and examples. As he ties the quality of paper money to gold, he provides a weakness that the quantity theory folks, the antigold folks, and the fiat money reformers can use to attack his argument. For example, by 1980 when the dollar price of gold peaked, it was obvious to all that the dollar would never again be redeemed in gold and would never again be officially backed by gold. Yet the dollar price of gold declined for the next 20 years. The quality theory would have predicted a continuous increase in the dollar price of gold because the quality the paper dollar was in a state of decline.
The example that he gives about the debasement of coins is true. A loss of quality does lead to a loss of purchasing power, inflation. However, the quantity folks can and have argued that debasement leads to an excessive increase in the money supply and that the increase causes the inflation. Which is it? Does quality or quantity cause the inflation? I suspect both contributed. However, even the quantity folks use quality to judge if inflation is occurring. In the final analysis, one can only determine if inflation, currency depreciation, is occurring by observing a loss in the money’s purchasing power, that is a loss in the money’s quality.
For coin debasement, reasoning supports the quality theory over the quantity theory as the cause of inflation. For example, the coin of the realm is, say, the banco, which contains 20 pennyweights (dwt.) of silver. This is the standard money. The emperor calls in all the 20-dwt. bancos and mints them into new bancos containing 10 dwt. of silver. The new bancos are denominated the same as the old banco, but they contain half the silver. Now the empire has twice as many coins as before. Yet the silver in circulation remains the same. Quantity theory folks would say doubling the number of coins in circulation causes the inflation, but they are wrong. True, prices have risen in bancos. However, prices have not risen in silver. Under metallic standards, people make exchanges based on the weight of the monetary metal, in this case silver, in the coin. Their exchanges are not based on words engraved in the coin. Consequently, they require two new bancos (two 10-dwt. coins) to buy what one old banco (one 20-dwt. coin) bought. Although the prices in bancos have doubled, the prices in silver remain the same. Thus, a loss of quality causes the inflation instead of the increase the quantity of coins. In his discussion of seigniorage, Mr. Fritsch notes this outcome.
Coin debasement does result in one major loser: creditors or lenders. Lenders suffer a lost if their contracts are written in terms of bancos. For this example, they lose half of their loans. They only receive half of the silver due them. When the borrowers pay back the number of bancos borrowed, they pay only half the silver borrowed.
For fiat paper money, quantity may have a more important relationship to inflation than its quality as the money has extremely little quality. Only when people began to lose confidence in the currency does its quality become highly important. Their loss of confidence leads to a loss of demand. A loss of demand leads to an increase in velocity as people spend money at a much higher rate to get rid if it.
Gresham’s law reveals the relationship between quality and demand. When irredeemable paper money and gold coins circulated and the government prohibits accepting gold coins at a premium or paper money at a discount, the low quality paper money will circulate. It will be used to pay debts. High quality gold coins will be hoarded. People are demanding gold coins more than paper money. People demand high quality money more than they demand low quality money. They spend paper money and keep the gold coins.
Mr. Fritsch does a good job of describing the ultimate debasement of corrupting precious metal money into irredeemable paper money. Evidence of this debasement is seen in the federal reserve note. Originally, federal reserve notes promised the bearer its equivalent in dollars of gold, each dollar of gold equaled to 23.22 grains of fine gold. Now the federal reserve notes declare themselves to be so many dollars, which now equals some unknown depreciating abstraction.
Ultimately, supply and demand fixes the value of money. Commodity money like gold or silver has two utilities: one as money and one as a commodity. Supply and demand of these utilities fixes its monetary value. Fiat money like federal reserve notes or greenbacks has only one utility: money. Its supply and demand as money fixes its monetary value.
Mr. Fritsch identifies a major problem with fiat paper money — at least for people who value liberty. Its value depends on how much wealth the government can steal from the people. In the government’s mind, it owns everything and condescends to allow individuals to posses and use some of its wealth — hence, a tax cut is the government giving the people some of its money.
Some fiat money reformers realize this outcome and rejoice in it. They believe that the government should own everything. Others seem ignorant of or want to ignore this outcome.
I have one major, but unimportant, disagreement with Mr. Fritsch. I disagree with his definition of money.
Mr. Fritsch defines money as “that which extinguishes all debt.” He claims that money functioning as a medium of exchange is use of money. Why is not extinguishing debt as much of a use of money as its use as a medium of exchange? One can just as easily defined money as “that which is used to extinguish all debt.” Mr. Hawtrey and Prof. Klien have defined it as such. Others, such as Prof. Walker and Dr. Ely, include such use as part of their definition of money. (Their definitions in my article “What Is Money.”)
The only difference that I see between the two is that when money is used as a medium of exchange, the action of the buyer and seller occur in the present. With extinguishing debt, money or an item is borrowed in the present, and the debt is paid, extinguished, in the future.
Could not one just as easily define money, as Prof. Mises and many other economists do, to be that which is used to make nonbarter exchanges. Money can be used to make all nonbarter exchanges.
Prof. Dusenberry has one of the best definitions that I have come across. He defines money as “something that people are willing to accept in exchanges, even if they have no use for the thing themselves. . . . [M]oney is something people accept in exchange for goods, in the expectation of passing it on to someone else in a further exchange.”
Mr. Fritsch somewhat contradicts himself with his sugar example. If I borrow a pound of sugar from my neighbor with the understanding that I will repay the debt with a pound of sugar next week, I am obligated to pay with sugar and not money. If my neighbor insists that I keep my promise to repay my debt with sugar, I cannot extinguish this debt with money (assuming no legal tender laws). I must extinguish this debt with sugar. Thus, money cannot extinguish this debt.
He states that sugar is not money because it does not extinguish all debt. However, debts must be paid in whatever the lender and borrower agree to use (again assuming no legal tender law). Thus, I find his definition of money questionable.
Actually, he does sort of support money as that which is used as a medium of exchange. However, he does so by claiming that a debt has occurred even with cash payment. That is an unusual claim. If I hand the store clerk a 10-dwt. gold coin for an item priced at 10 dwt. of gold, where is the debt? If a debt is occurring, I as the buyer am the lender, and the store as the seller is the debtor. The store gets my 10-dwt. gold coin before I get the item. Thus, the item has extinguished the debt instead of money.
His description of buying with credit cards is correct. If more people realized that a purchase with a credit card merely transfers debt and does not extinguish it, perhaps most would use their credit cards more judiciously.
He implies that only money that is universally acceptable as money can extinguish all debt. Any money or thing that claims to be money that cannot extinguish all debt is not real money. Does this mean that gold did not become real money until all the most primitive tribes on the planet accepted it as extinguishing debt? As I have shown, even gold cannot extinguish all debts — at least not without violation of contracts or being forced on people via legal tender laws.
He states that a debt contracted in U.S. dollars cannot be paid off with Swiss francs. With that I cannot argue. However, he implies that a debt contracted in U.S. gold dollars could be paid off with Swiss gold francs. In his discussion on money, Henry George, who wrote during the era of the gold standard, disagrees with Mr. Fritsch. Mr. George contends that most people would not recognize the Swiss gold franc as money for payment of a U.S. gold dollar debt or transaction. They would insist on payment in gold dollars. Does this mean that gold is not money? When stamped as a Swiss franc, it does not extinguish all debt.
Mr. Fritsch is correct that fiat money fails to extinguish debt. As he remarks, it is an obligation, a debt itself. Being a debt itself, it cannot extinguish debt. It can only transfer debt. A debt can only be extinguished by something, such as gold or silver, that is no one else’s obligation. This is an important point that fiat money folks fail to recognize or acknowledge.
He gives a good concise description of fractional reserve banking. Unfortunately, many people, including most Austrians, consider issuing bank notes to buy real bills as fractional reserve banking. He correctly distinguishes between issuing bank notes to buy real bills, which is not fractional reserve banking, and issuing bank notes in excess of unobligated gold (or under our present system, unobligated federal reserve notes) for loans, which is fractional reserve banking.
He provides a good and simple description of the pernicious effects for bond sellers in particular and the economy in general of governments or their central banks forcing interest rates downward. As he observes, only bond speculators who are long benefit. New bond sellers benefit if interest rates stabilize.
As they drive interest rates lower, fiat money folks refuse to acknowledge the power of the markets. (The government’s other market manipulations also attempt to defeat the power of the markets.) No government or banking system has ever defeated the markets. Markets are too powerful. They are more powerful than the combined political weight of the world. They brought down the Roman empire, the British Empire, and the Soviet empire and are now bringing down the American empire. They will bring down the emerging Chinese empire if China does not cease fighting them.
In summary, Mr. Fritsch has written an excellent and simple book on money. Anyone with an interest in monetary science should read it.
More articles on money.