6. CASH INDUCED AND GOODS INDUCED CHANGES IN PURCHASING POWER
Changes in the purchasing power of money, that is, in the exchange ratio between money
and the vendable goods and commodities, can originate either from the side of money or
from the side of the vendable goods and commodities. The change in the data which provokes them
can either occur in the demand for and supply of money, or in the demand for and supply
of the other goods and services.
We may accordingly distinguish between cash-induced and goods-induced changes in purchasing power.
Goods-induced changes in purchasing power can be brought about by changes in the supply
Let us now scrutinize the social and economic consequences of changes in the purchasing power of money under the following three assumptions.
1. That the money in question can only be used as money, that is, as a medium of exchange, and can serve no other purpose.
2. That there is only exchange of present goods, and no exchange of present goods against future goods.
3. That we disregard the effects of changes in purchasing power on monetary calculation.
Under these assumptions, all that cash-induced changes in purchasing power bring about are shifts in the disposition of wealth among different individuals.
Some get richer, others poorer. Some are better supplied, others less.
What some people gain is paid for by the loss of others.
It would, however, be impermissible to interpret this fact by saying that total satisfaction
remained unchanged, or that, while no changes have occurred in total supply, the state of
total satisfaction, or of the sum of happiness, has been increased or decreased by changes
in the distribution of wealth.
The notions of total satisfaction, or total happiness, are empty.
It is impossible to discover a standard for comparing the different degrees of satisfaction
or happiness attained by various individuals.
Cash-induced changes in purchasing power indirectly generate further changes by favoring
either the accumulation of additional capital or the consumption of capital available.
Whether and in what direction such secondary effects are brought about depends on the specific
Data of each case.
We shall deal with these important problems at a later point.
Goods-induced changes in purchasing power are sometimes nothing else but consequences
of a shift of demand from some goods to others.
If they are brought about by an increase or a decrease in the supply of goods, they are
not merely transfers from some people to other people.
They do not mean that Peter gains what Paul has lost.
Some people may become richer, although nobody is impoverished, and vice versa.
We may describe this fact in the following way.
Let A and B be two independent systems, which are in no way connected with each other.
In both systems, the same kind of money is used, a money which cannot be used for any
Money Non-Monetary Purpose.
Now we assume, as case one, that A and B differ from each other only insofar as in B the total
supply of money is N, M, M being the total supply of money in A, and that to every cash
holding of C, and to every claim in terms of money, D, in A there corresponds a cash
Push-holding of NC and a claim of ND in B. In every other respect, A equals B. Then we
assume, as case 2, that A and B differ from each other only insofar as in B the total
supply of a certain commodity R is NP, P being the total supply of this commodity in A, and
In both cases, N is greater than 1. If we ask every individual of A whether he is ready to make the slightest sacrifice in order to exchange his position for the corresponding place in B, the answer will be unanimously in the negative, in case 1.
But in case, too, all owners of R, and all those who do not own any R but are eager to
acquire a quantity of it, that is, at least one individual, will answer in the affirmative.
The services money renders are conditioned by the height of its purchasing power.
Nobody wants to have in his cash holding a definite number of pieces of money, or a definite
weight of money.
He wants to keep a cash holding of a definite amount of purchasing power.
As the operation of the market tends to determine the final state of money's purchasing power
at a height at which the supply of and the demand for money coincide, there can never
be an excess or a deficiency of money.
Each individual and all individuals together always enjoy fully the advantages which they
They can derive from indirect exchange and the use of money, no matter whether the total
quantity of money is great or small.
Changes in money's purchasing power generate changes in the disposition of wealth among
the various members of society.
From the point of view of people eager to be enriched by such changes, the supply of
of Money may be called insufficient or excessive, and the appetite for such gains may result
in policies designed to bring about cash-induced alterations in purchasing power.
However, the services which money renders can be neither improved nor impaired by changing
the supply of money.
There may appear an excess or a deficiency of money in an individual's cash holding,
But such a condition can be remedied by increasing or decreasing consumption or investment.
Of course, one must not fall prey to the popular confusion between the demand for money for
cash holding and the appetite for more wealth.
The quantity of money available in the whole economy is always sufficient to secure for
everybody all that money does and can do.
From the point of view of this insight, one may call wasteful all expenditures incurred
for increasing the quantity of money.
The fact that things which could render some other useful services are employed as money,
and thus withheld from these other employments, appears as a superfluous curtailment of limited
opportunities for want satisfaction.
It was this idea that led Adam Smith and Ricardo to the opinion that it was very beneficial
to reduce the cost of producing money by resorting to the use of paper printed currency.
However, things appear in a different light to the students of monetary history.
If one looks at the catastrophic consequences of the great paper money inflations, one must
should admit that the expensiveness of gold production is the minor evil.
It would be futile to retort that these catastrophes were brought about by the improper use which
the governments made of the powers that credit money and fiat money placed in their hands,
and that wiser governments would have adopted sounder policies.
As money can never be neutral and stable in purchasing power, a government's plans concerning
Having the determination of the quantity of money can never be impartial and fair to all
members of society.
Whatever a government does in the pursuit of aims to influence the height of purchasing
power depends necessarily upon the ruler's personal value judgments.
It always furthers the interests of some groups of people at the expense of other groups.
It never serves what is called the common wheel or the public welfare.
In the field of monetary policies, too, there is no such thing as a scientific ought.
The choice of the good to be employed as a medium of exchange and as money is never indifferent.
It determines the course of the cash-induced changes in purchasing power.
The question is only, who should make the choice?
The People Buying and Selling on the Market or the Government?
It was the market which, in a selective process going on for ages, finally assigned to the
precious metals gold and silver the character of money.
For 200 years the governments have interfered with the market's choice of the money medium.
Even the most bigoted etatists do not venture to assert that this interference has proved
Inflation and Deflation, Inflationism and Deflationism
The notions of inflation and deflation are not praxeological concepts.
They were not created by economists, but by the mundane speech of the public and of politicians.
They implied the popular fallacy that there is such a thing as neutral money, or money
Money of Stable Purchasing Power, and that sound money should be neutral and stable in
purchasing power.
From this point of view, the term inflation was applied to signify cash-induced changes
resulting in a drop in purchasing power, and the term deflation to signify cash-induced
changes resulting in a rise in purchasing power.
However, those applying these terms are not aware of the fact that purchasing power never remains unchanged, and that consequently there is always either inflation or deflation.
They ignore these necessarily perpetual fluctuations as far as they are only small and inconspicuous, and reserve the use of the terms to big changes in purchasing power.
Since the question as to at what point a change in purchasing power begins to deserve being called big depends on personal relevance judgments, it becomes manifest that inflation and deflation are terms lacking the categorical precision required for praxeological, economic and catallactic concepts.
Their application is appropriate for history and politics.
Catallactics is free to resort to them only when applying its theorems to the interpretation of events of economic history and of political programs.
Moreover, it is very expedient even in rigid catallactic disquisitions to make use of these two terms whenever no misinterpretation can possibly result
and pedantic heaviness of expression can be avoided, but it is necessary never to forget that all that catallactic says with regard to inflation and deflation, that is, big cash-induced changes in purchasing power, is valid also with regard to small changes, although, of course, the consequences of smaller changes are less conspicuous than those of big changes.
The terms inflationism and deflationism, inflationist and deflationist, signify the political programs aiming at inflation and deflation in the sense of big cash-induced changes in purchasing power.
The Semantic Revolution, which is one of the characteristic features of our day, has also changed the traditional connotation of the terms inflation and deflation.
What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money,
but its inexorable consequences, the general tendency toward a rise or a fall in commodity prices and wage rates.
This innovation is by no means harmless.
It plays an important role in fomenting the popular tendencies toward inflationism.
First of all, there is no longer any term available to signify what inflation used to signify.
It is impossible to fight a policy which you cannot name.
Statesmen and writers no longer have the opportunity of resorting to a terminology accepted and understood by the public
when they want to question the expediency of issuing huge amounts of additional money.
They must enter into a detailed analysis and description of this policy with full particulars and minute accounts whenever they want to refer to it, and they must repeat this bothersome procedure in every sentence in which they deal with the subject.
As this policy has no name, it becomes self-understood and a matter of fact. It goes on luxuriantly.
The second mischief is that those engaged in futile and hopeless attempts to fight the inevitable consequences of inflation, the rise in prices, are disguising their endeavors as a fight against inflation.
While merely fighting symptoms, they pretend to fight the root causes of the evil.
Because they do not comprehend the causal relation between the increase in the quantity of money on the one hand and the rise in prices on the other, they practically make things worse.
The best example was provided by the subsidies granted on the part of the governments of the United States, Canada and Great Britain to farmers.
Price ceilings reduce the supply of the commodities concerned because production involves a loss for the marginal producers.
To prevent this outcome, the governments granted subsidies to the farmers producing at the highest costs.
These subsidies were financed out of additional increases in the quantity of money.
If the consumers had had to pay higher prices for the products concerned,
No further inflationary effects would have emerged.
The consumers would have had to use for such surplus expenditure only money which had already
been issued previously.
Thus, the confusion of inflation and its consequences, in fact, can directly bring about more inflation.
It is obvious that this new-fangled connotation of the terms inflation and deflation is utterly
7. Monetary Calculation and Changes in Purchasing Power
Monetary calculation reckons with the prices of commodities and services as they were determined
or would have been determined or presumably will be determined on the market. It is eager
are here to detect price discrepancies and to draw conclusions from such a detection.
Cash-induced changes in purchasing power cannot be taken into account in such calculations.
It is possible to put in the place of calculation based on a definite kind of money, A, a mode
of calculating based on another kind of money, B. Then, the result of the calculation is
is made safe against adulteration on the part of changes affected in the purchasing power
of A. But it can still be adulterated by changes affected in the purchasing power of B. There
is no means of freeing any mode of economic calculation from the influence of changes
in the purchasing power of the definite kind of money on which it is based. All results
Parts of economic calculation, and all conclusions derived from them, are conditioned by the
vicissitudes of cash-induced changes in purchasing power.
In accordance with the rise or fall in purchasing power, there emerge between items reflecting
earlier prices, and those reflecting later prices, specific differences.
The calculus shows profits or losses, which are merely produced by cash-induced changes
affected in the purchasing power of money.
If we compare such profits or losses with the result of a calculation accomplished on
the basis of a kind of money whose purchasing power had been subject to less vehement changes,
we can call them imaginary or apparent only.
But one must not forget that such statements are only possible as a result of the comparison
and of calculations carried out in different kinds of money.
As there is no such thing as a money with stable purchasing power, such apparent profits
and losses are present with every mode of economic calculation, no matter on what kind
of money it may be based.
It is impossible to distinguish precisely between genuine profits and losses and merely
Apparent Profits and Losses.
It is therefore possible to maintain that economic calculation is not perfect.
However, nobody can suggest a method which could free economic calculation from these
defects or design a monetary system which could remove this source of error entirely.
It is an undeniable fact that the free market has succeeded in developing a currency system
which well served all the requirements both of indirect exchange and of economic calculation.
The aims of monetary calculation are such that they cannot be frustrated by the inaccuracies
which stem from slow and comparatively slight movements in purchasing power.
Cash-induced changes in purchasing power of the extent to which they occurred in the last
In the last two centuries, with metallic money, especially with gold money, cannot influence the result of the businessman's economic calculations so considerably as to render such calculations useless.
Historical experience shows that one could, for all practical purposes of the conduct of business, manage very well with these methods of calculation.
Theoretical consideration shows that it is impossible to design, still less to realize, a better method.
In view of these facts, it is vain to call monetary calculation imperfect.
Man has not the power to change the categories of human action.
He must adjust his conduct to them.
Businessmen never deemed it necessary to free economic calculation in terms of gold from its dependence on the fluctuations in purchasing power.
The proposals to improve the currency system by adopting a tabular standard based on index numbers or by adopting various methods of commodity standards
were not advanced with regard to business transactions and to monetary calculation.
Their aim was to provide a less fluctuating standard for long-run loan contracts.
Businessmen did not even consider it expedient to modify their accounting methods in those regards in which it would have been easy to narrow down certain errors induced by fluctuations in purchasing power.
It would, for instance, have been possible to discard the practice of writing off durable equipment by means of yearly depreciation quotas, invariably fixed in a percentage of the cost of its acquisition.
In its place, one could resort to the device of laying aside in renewal funds as much as seems necessary to provide the full costs of the replacement at the time when it is required.
8. The Anticipation of Expected Changes in Purchasing Power
Banking Power.
The deliberations of the individuals which determine their conduct with regard to money
are based on their knowledge concerning the prices of the immediate past.
If they lacked this knowledge, they would not be in a position to decide what the appropriate
height of their cash holdings should be, and how much they should spend for the acquisition
of various goods.
A medium of exchange without a past is unthinkable.
Nothing can enter into the function of a medium of exchange which was not already previously
an economic good, and to which people assigned exchange value already, before it was demanded
as such a medium.
But the purchasing power handed down from the immediate past is modified by today's
demand for and supply of money.
Human action is always providing for the future, be it sometimes only the future of the impending
hour.
He who buys, buys for future consumption and production.
As far as he believes that the future will differ from the present and the past, he modifies
his valuation and appraisement.
This is no less true with regard to money than it is with regard to all vendible goods.
In this sense we may say that today's exchange value of money is an anticipation of tomorrow's
exchange value.
The basis of all judgments concerning money is its purchasing power, as it was in the
immediate past.
But as far as cash-induced changes in purchasing power are expected, a second factor enters
the scene, the anticipation of these changes.
He who believes that the prices of the goods in which he takes an interest will rise, buys
more of them than he would have bought in the absence of this belief.
Accordingly, he restricts his cash holding.
He who believes that prices will drop restricts his purchases, and thus enlarges his cash
holding.
As long as such speculative anticipations are limited to some commodities, they do not
bring about a general tendency toward changes in cash holding.
But it is different if people believe that they are on the eve of big, cash-induced changes
in purchasing power.
When they expect that the money prices of all goods will rise or fall, they expand or
restrict their purchases.
These attitudes strengthen and accelerate the expected tendencies considerably.
This goes on until the point is reached beyond which no further changes in the purchasing
power of money are expected.
Only then does the inclination to buy or to sell stop, and do people begin again to increase
or to decrease their cash holdings.
But if once public opinion is convinced that the increase in the quantity of money will
will continue and never come to an end, and that consequently the prices of all commodities
and services will not cease to rise.
Everybody becomes eager to buy as much as possible and to restrict his cash holding
to a minimum size.
For under these circumstances, the regular costs incurred by holding cash are increased
by the losses caused by the progressive fall in purchasing power.
The advantages of holding cash must be paid for by sacrifices which are deemed unreasonably
burdensome.
This phenomenon was, in the great European inflations of the 20s, called flight into
real goods, or crack-up boom.
The mathematical economists are at a loss to comprehend the causal relation between the
The Increase in the Quantity of Money and what they call Velocity of Circulation
The characteristic mark of the phenomenon is that the increase in the quantity of money
causes a fall in the demand for money.
The tendency toward a fall in purchasing power as generated by the increased supply of money
is intensified by the general propensity to restrict cash holdings which it brings about.
Eventually, a point is reached where the prices at which people would be prepared to part
with real goods discount to such an extent the expected progress in the fall of purchasing
power that nobody has a sufficient amount of cash at hand to pay them.
The monetary system breaks down. All transactions in the money concerned cease. A panic makes
its purchasing power vanish altogether. People return either to barter or to the use of another
kind of money.
The course of a progressing inflation is this. At the beginning, the inflow of additional
Financial money makes the prices of some commodities and services rise.
Other prices rise later.
The price rise affects the various commodities and services, as has been shown, at different
dates and to a different extent.
This first stage of the inflationary process may last for many years.
While it lasts, the prices of many goods and services are not yet adjusted to the altered
Money Relation.
There are still people in the country who have not yet become aware of the fact that
they are confronted with a price revolution which will finally result in a considerable
rise of all prices, although the extent of this rise will not be the same in the various
commodities and services.
These people still believe that prices one day will drop.
Waiting for this day they restrict their purchases and concomitantly increase their cash holdings.
As long as such ideas are still held by public opinion, it is not yet too late for the government
to abandon its inflationary policy.
But then, finally, the masses wake up.
They become suddenly aware of the fact that inflation is a deliberate policy and will
go on endlessly.
A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against
real goods, no matter whether he needs them or not, no matter how much money he has to
pay for them. Within a very short time, within a few weeks or even days, the things which
were used as money are no longer used as media of exchange. They become scrap paper. Nobody
He wants to give away anything against them.
It was this that happened with the Continental Currency in America in 1781, with the French
Monda Territorio in 1796, and with the German Mark in 1923.
It will happen again whenever the same conditions appear.
If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity
9.
The Specific Value of Money
As far as a good used as money is valued and appraised on account of the services it renders
for non-monetary purposes, no problems are raised which would require special treatment.
The task of the theory of money consists merely in dealing with that component in the valuation
of money which is conditioned by its function as a medium of exchange.
In the course of history, various commodities have been employed as media of exchange.
A long evolution eliminated the greater part of these commodities from the monetary function.
Only two, the precious metals, gold and silver, remained.
In the second part of the nineteenth century, more and more governments deliberately turned
toward the demonetization of silver.
In all these cases, what is employed as money is a commodity which is used also for non-monetary
purposes.
Under the gold standard, gold is money, and money is gold.
It is immaterial whether or not the laws assign legal tender quality only to gold coins minted
by the government.
What counts is that these coins really contain a fixed weight of gold, and every quantity
of bullion can freely be transformed into coins.
Under the gold standard, the dollar and the pound sterling were merely names for a definite
weight of gold within very narrow margins precisely determined by the laws.
We may call such a sort of money commodity money.
A second sort of money is credit money.
Credit money evolved out of the use of money substitutes.
It was customary to use claims, payable on demand and absolutely secure, as substitutes
for the Sum of Money to which they gave a claim.
We shall deal with the features and problems of money substitutes in the next section.
The market did not stop using such claims when one day their prompt redemption was suspended
and thereby doubts about their safety and the solvency of the obligi were raised.
As long as these claims had been daily maturing claims against a debtor of undisputed solvency
and could be collected without notice and free of expense, their exchange value was
equal to their face value.
It was this perfect equivalence which assigned to them the character of money substitutes.
Now, as redemption was suspended, the maturity date postponed to an undetermined day, and
consequently doubts about the solvency of the debtor, or at least about his willingness
Money could remain in use as a medium of exchange even if it were to lose its character as a
claim against a bank or a treasury and thus would become fiat money.
Fiat money is a money consisting of mere tokens which can neither be employed for any industrial
purposes nor convey a claim against anybody.
It is not a task of catallactics but of economic history to investigate whether there appeared
in the past, specimens of fiat money, or whether all the sorts of money which were not commodity
money were credit money.
The only thing that catallactics has to establish is that the possibility of the existence of
fiat money must be admitted.
The important thing to be remembered is that with every sort of money, demonetization,
That is, the abandonment of its use as a medium of exchange must result in a serious fall
of its exchange value.
What this practically means has become manifest when, in the last 80 years, the use of silver
as commodity money has been progressively restricted.
There are specimens of credit money and fiat money which are embodied in metallic coins.
Such money is printed, as it were, on silver, nickel or copper.
If such a piece of fiat money is demonetized, it still retains exchange value as a piece
of metal.
But this is only a very small indemnification of the owner.
It has no practical importance.
The keeping of cash holding requires sacrifices.
To the extent that a man keeps money in his pockets or in his balance with a bank, he
forsakes the instantaneous acquisition of goods he could consume or employ for production.
In the market economy, these sacrifices can be precisely determined by calculation.
They are equal to the amount of originary interest he would have earned by investing
the sum.
The fact that a man takes this falling off into account is proof that he prefers the
advantages of cash holding to the loss in interest yield.
It is possible to specify the advantages which people expect from keeping a definite amount
of cash.
But it is a delusion to assume that an analysis of these motives could provide us with a theory
Theory of the Determination of Purchasing Power, which could do without the notions
of cash holding and demand for and supply of money.
The advantages and disadvantages derived from cash holding are not objective factors which
could directly influence the size of cash holdings.
They are put on the scales by each individual and weighed against one another.
The result is a subjective judgment of value, colored by the individual's personality.
Different people and the same people at different times value the same objective facts in a
different way.
Just as knowledge of a man's wealth and his physical condition does not tell us how much
he would be prepared to spend for food of a certain nutritive power, so knowledge about
Data concerning a man's material situation does not enable us to make definite assertions
with regard to the size of his cash holding.
10.
The Import of the Money Relation.
The money relation, that is, the relation between demand for and supply of money, uniquely
determines the price structure as far as the reciprocal exchange ratio between money and
If the money relation remains unchanged, neither an inflationary expansionist nor a deflationary
contractionist pressure on trade, business, production, consumption and employment can
emerge.
The assertions to the contrary reflect the grievances of people reluctant to adjust their
and their activities to the demands of their fellow men as manifested on the market.
However, it is not an account of an alleged scarcity of money that prices of agricultural products are too low to secure to the sub-marginal farmers proceeds of the amount they would like to earn.
The cause of these farmers' distress is that other farmers are producing at lower costs.
What is wrong with British manufacturing is not that the level of prices is too low, but the fact that they did not succeed in raising the productivity of the capital invested and the men employed to a height that would provide all the goods the British want to consume.
An increase in the quantity of goods produced, other things being unchanged, must bring about an improvement in people's conditions.
Its consequence is a fall in the money prices of the goods the production of which has been increased.
But such a fall in money prices does not in the least impair the benefits derived from the additional wealth produced.
One may consider as unfair the increase in the share of the additional wealth which goes to the creditors,
Although such criticisms are questionable as far as the rise in purchasing power has been correctly anticipated and adequately taken into account by a negative price premium.
But one must not say that a fall in prices caused by an increase in the production of the goods concerned is the proof of some disequilibrium which cannot be eliminated otherwise than by increasing the quantity of money.
Of course, as a rule, every increase in production of some or of all commodities requires a new
allocation of factors of production to the various branches of business.
If the quantity of money remains unchanged, the necessity of such a reallocation becomes
visible in the price structure.
Some lines of production become more profitable, while in others profits drop or losses appear.
Thus, the operation of the market tends to eliminate these much discussed disequilibria.
It is possible by means of an increase in the quantity of money to delay or to interrupt
this process of adjustment.
It is impossible either to make it superfluous or less painful for those concerned.
If the government made cash-induced changes in the purchasing power of money resulted
only in shifts of wealth from some people to other people, it would not be permissible
to condemn them from the point of view of catalactics' scientific neutrality.
It is obviously fraudulent to justify them under the pretext of the common-wheel or public
welfare, but one could still consider them as political measures suitable to promote
the interests of some groups of people at the expense of others without further detriment.
However, there are still other things involved.
It is not necessary to point out the consequences to which a continued deflationary policy must lead.
Nobody advocates such a policy.
The favor of the masses and of the writers and politicians eager for applause goes to inflation.
With regard to these endeavors, we must emphasize three points.
First, inflationary or expansionist policy must result in overconsumption on the one hand and in malinvestment on the other.
It thus squanders capital and impairs the future state of want satisfaction.
Second, the inflationary process does not remove the necessity of adjusting production and reallocating resources.
3. Inflation cannot be employed as a permanent policy because it must, when continued, finally result in a breakdown of the monetary system.
A retailer or innkeeper can easily fall prey to the illusion that all that is needed to make him and his colleagues more prosperous is more spending on the part of the public.
In his eyes, the main thing is to impel people to spend more.
But it is amazing that this belief could be presented to the world as a new social philosophy.
Lord Keynes and his disciples make the lack of the propensity to consume responsible for
what they deem unsatisfactory in economic conditions.
What is needed in their eyes to make men more prosperous is not an increase in production,
and Increase in Spending. In order to make it possible for people to spend more, an expansionist
policy is recommended. This doctrine is as old as it is bad. Its analysis and refutation
will be undertaken in the chapter dealing with the trade cycle.
11. The Money Substitutes
is to a definite amount of money, payable and redeemable on demand, against a debtor
about whose solvency and willingness to pay there does not prevail the slightest doubt,
render to the individual all the services money can render, provided that all parties
with whom he could possibly transact business are perfectly familiar with these essential
qualities of the claims concerned.
Fully maturity and undoubted solvency and willingness to pay on the part of the debtor.
We may call such claims money substitutes as they can fully replace money in an individual's
or a firm's cash holding.
The technical and legal features of the money substitutes do not concern catallactics.
A money substitute can be embodied either in a bank note or in a demand deposit with
The Bank, subject to check, checkbook money or deposit currency, provided the bank is
prepared to exchange the note or the deposit daily free of charge against money proper.
Token coins are also money substitutes, provided the owner is in a position to exchange them
at need against money free of expense and without delay.
To achieve this, it is not required that the government be bound by law to redeem them.
What counts is the fact that these tokens can be really converted free of expense and
without delay.
If the total amount of token coins issued is kept within reasonable limits, no special
provisions on the part of the government are necessary to keep their exchange value at
par with their face value.
The demand of the public for small change gives everybody the opportunity to exchange
them easily against pieces of money.
The main thing is that every owner of a money substitute is perfectly certain that it can,
at every instant and free of expense, be exchanged against money.
If the debtor, the government or a bank, keeps against the whole amount of money substitutes
A Reserve of Money Proper We call the money substitute a money certificate.
The individual money certificate is, not necessarily in a legal sense, but always in the catallactic
sense, a representative of a corresponding amount of money kept in the reserve.
The issuing of money certificates does not increase the quantity of things suitable to
satisfy the demand for money for cash holding.
Those in the quantity of money certificates therefore do not alter the supply of money
and the money relation.
They do not play any role in the determination of the purchasing power of money.
If the money reserve kept by the debtor against the money substitutes issued is less than
the total amount of such substitutes, we call that amount of substitutes which exceeds the
reserve fiduciary media.
As a rule, it is not possible to ascertain whether a concrete specimen of money substitutes
is a money certificate or a fiduciary medium.
A part of the total amount of money substitutes issued is usually covered by a money reserve
held.
Thus, a part of the total amount of money substitutes issued is money certificates,
the rest fiduciary media.
But this fact can only be recognized by those familiar with the bank's balance sheets.
The individual banknote, deposit or token coin does not indicate its catalactic character.
The issue of money certificates does not increase the funds which the bank can employ in the
conduct of its lending business.
A bank which does not issue fiduciary media can only grant commodity credit, that is,
Credit can only lend its own funds and the amount of money which its customers have entrusted
to it.
The issue of fiduciary media enlarges the bank's funds available for lending beyond
these limits.
It can now not only grant commodity credit but also circulation credit, that is, credit
granted out of the issue of fiduciary media.
While the quantity of money certificates is indifferent, the quantity of fiduciary media
is not.
The fiduciary media affect the market phenomena in the same way as money does.
Changes in their quantity influence the determination of money's purchasing power, and of prices,
and temporarily also of the rate of interest.
Earlier economists applied a different terminology.
Many were prepared to call the money substitutes simply money, as they are fit to render the
services money renders.
However, this terminology is not expedient.
The first purpose of a scientific terminology is to facilitate the analysis of the problems
involved.
The task of the catalactic theory of money, as differentiated from the legal theory and
from the technical disciplines of bank management and accountancy is the study of the problems
of the determination of prices and interest rates. This task requires a sharp distinction
between money certificates and fiduciary media. The term credit expansion has often been misinterpreted.
It is important to realize that commodity credit cannot be expanded. The only vehicle
One example of credit expansion is circulation credit.
But the granting of circulation credit does not always mean credit expansion.
If the amount of fiduciary media previously issued has consummated all its effects upon
the market, if prices, wage rates and interest rates have been adjusted to the total supply
of money proper plus fiduciary media, supply of money in the broader sense, granting of
Of circulation credit without a further increase in the quantity of fiduciary media is no longer
credit expansion.
Credit expansion is present only if credit is granted by the issue of an additional amount
of fiduciary media, not if banks lend a new fiduciary media paid back to them by the old
debtors.
12.
The Limitation on the Issuance of Fiduciary Media
People deal with money substitutes as if they were money because they are fully confident
that it will be possible to exchange them at any time without delay and without cost
against money.
We may call those who share in this confidence and are therefore ready to deal with money
Money Substitutes as if they were money, the clients of the issuing banker, bank or authority.
It does not matter whether or not this issuing establishment is operated according to the
patterns of conduct customary in the banking business.
Token coins issued by a country's treasury are money substitutes too, although the treasury
as a rule does not enter the amount issued into its accounts as a liability and does
does not consider this amount a part of the national debt.
It is no less immaterial whether or not the owner of a money substitute has an actionable
claim to redemption.
What counts is whether the money substitute can really be exchanged against money without
delay and cost.
It is furthermore immaterial whether or not the laws assigned to the money substitute's
legal tender quality.
If these things are really dealt with by people as money substitutes, and are therefore money
substitutes and equal in purchasing power to the respective amount of money, the only
effect of the legal tender quality is to prevent malicious people from resorting to chicanery
for the mere sake of annoying their fellow men.
If, however, the things concerned are not money substitutes, and are traded at a discount
below their face value, the assignment of legal tender quality is tantamount to an authoritarian
price ceiling, the fixing of a maximum price for gold and for an exchange, and of a minimum
price for the things which are no longer money substitutes, but either credit money or fiat
money.
Then the effects appear, which Gresham's law describes.
Cheating money certificates is an expensive venture. The banknotes must be printed, the
token coins minted, a complicated accounting system for the deposits must be organized,
the reserves must be kept in safety. Then there is the risk of being cheated by counterfeit
banknotes and checks. Against all these expenses stands only the slight chance that some of
of the banknotes issued may be destroyed, and the still slighter chance that some depositors
may forget their deposits.
Issuing money certificates is a ruinous business, if not connected with issuing fiduciary media.
In the early history of banking, there were banks whose only operation consisted in issuing
money certificates.
But these banks were indemnified by their clients for the costs incurred.
At any rate, catallactics is not interested in the purely technical problems of banks
not issuing fiduciary media.
The only interest that catallactics takes in money certificates is the connection between
issuing them and the issuing of fiduciary media.
While the quantity of money certificates is catallactically unimportant, an increase or
or decrease in the quantity of fiduciary media affects the determination of money's purchasing
power in the same way as do changes in the quantity of money.
Hence the question of whether there are or are not limits to the increase in the quantity
of fiduciary media has fundamental importance.
If the clientele of the bank includes all members of the market economy, the limit to
to the issue of fiduciary media is the same as that drawn to the increase in the quantity
of money.
A bank which is, in an isolated country or in the whole world, the only institution issuing
fiduciary media, and the clientele of which comprises all individuals and firms, is bound
to comply in its conduct of affairs with two rules.
First, it must avoid any action which could make the clients, that is, the public, suspicious.
As soon as the clients begin to lose confidence, they will ask for the redemption of the bank
notes and withdraw their deposits.
How far the bank can go on increasing its issues of fiduciary media without arousing
distrust depends on psychological conditions.
Second, it must not increase the amount of fiduciary media at such a rate and with such speed that the clients get the conviction that the rise in prices will continue endlessly at an accelerated pace.
For if the public believes that this is the case, they will reduce their cash holdings, flee into real values and bring about the crack-up boom.
It is impossible to imagine the approach of this catastrophe without assuming that its first manifestation consists in the evanescence of confidence.
The public will certainly prefer exchanging the fiduciary media against money to fleeing into real values, that is, to the indiscriminate buying of various commodities.
Then, the bank must go bankrupt. If the government interferes by freeing the bank from the obligation
of redeeming its banknotes and of paying back the deposits in compliance with the terms
of the contract, the fiduciary media become either credit money or fiat money. The suspension
of specie payments entirely changes the state of affairs. There is no longer any question
In addition of fiduciary media, of money certificates and of money substitutes, the government enters
the scene with its government-made legal tender laws.
The bank loses its independent existence.
It becomes a tool of government policies, a subordinate office of the Treasury.
The catallactically most important problems of the issuance of fiduciary media on the
are part of a single bank, or of banks acting in concert, the clientele of which comprehends
all individuals, are not those of the limitations drawn to the amount of their issuance.
We will deal with them in Chapter 20, devoted to the relations between the quantity of money
and the rate of interest.
At this point of our investigations, we have to scrutinize the problem of the coexistence
Coexistence of a Multiplicity of Independent Banks
Independence means that every bank in issuing fiduciary media follows its own course and
does not act in concert with other banks.
Coexistence means that every bank has a clientele which does not include all members of the
market system.
For the sake of simplicity, we will assume that no individual or firm is a client of
of More Than One Bank.
It would not affect the result of our demonstration if we were to assume that there are also people
who are clients of more than one bank, and people who are not clients of any bank.
The question to be raised is not whether or not there are limits to the issuance of fiduciary
media on the part of such independently coexisting banks, as there are even limits to the issuance
The limits of fiduciary media on the part of a unique bank, the clientele of which comprises
all people, it is obvious that there are such limits for a multiplicity of independently
coexisting banks too.
What we want to show is that for such a multiplicity of independently coexisting banks, the limits
are narrower than those drawn for a single bank with an unlimited clientele.
We assume that within a market system several independent banks have been established in
the past.
While previously only money was in use, these banks have introduced the use of money substitutes,
a part of which are fiduciary media.
Each bank has a clientele and has issued a certain quantity of fiduciary media which
are kept as money substitutes in the cash holdings of various clients.
The total quantity of the fiduciary media, as issued by the banks and absorbed by the
cash holdings of their clients, has altered the structure of prices and the monetary unit's
purchasing power.
But these effects have already been consummated, and at present, the market is no longer stirred
by any movements generated from this past credit expansion.
But now, we assume further, one bank alone embarks upon an additional issue of fiduciary
media while the other banks do not follow suit.
The clients of the expanding bank, whether its old clients or new ones acquired on account
of the expansion, receive additional credits.
They expand their business activities.
They appear on the market with an additional demand for goods and services.
They bid up prices.
Those people who are not clients of the expanding bank are not in a position to afford these
higher prices.
They are forced to restrict their purchases.
Thus there prevails on the market a shifting of goods from the non-clients to the clients
of the expanding bank.
The clients buy more from the non-clients than they sell to them.
They have more to pay to the non-clients than they receive from them.
Fiat money substitutes issued by the expanding bank are not suitable for payments to non-clients,
as these people do not assign to them the character of money substitutes.
In order to settle the payments due to non-clients, the clients must first exchange the money
substitutes issued by their own, namely the expanding bank, against money.
The expanding bank must redeem its banknotes and pay out its deposits.
Its reserve, we suppose that only a part of the money substitutes it had issued had the
character of fiduciary media, dwindles.
The instant approaches in which the bank will, after the exhaustion of its money reserve,
no longer be in a position to redeem the money substitutes still current.
In order to avoid insolvency, it must as soon as possible return to a policy of strengthening
its money reserve.
It must abandon its expansionist methods.
This reaction of the market to a credit expansion on the part of a bank with a limited clientele
has been brilliantly described by the currency school.
The special case dealt with by the currency school referred to the coincidence of credit
Expansion on the part of one country's privileged central bank, or of all banks of one country,
and of a non-expansionist policy on the part of the banks of other countries.
Our demonstration covers the more general case of the coexistence of a multiplicity
of banks with different clientele, as well as the most general case of the existence
of one bank with a limited clientele, in a system in which the rest of the people do
do not patronize any bank and do not consider any claims as money substitutes.
It does not matter, of course, whether one assumes that the clients of a bank live neatly
separated from those of the other banks in a definite district or country, or whether
they live together with those of the other banks.
These are merely differences in the data not affecting the catallactic problems involved.
A bank can never issue more money substitutes than its clients can keep in their cash holdings.
The individual client can never keep a larger portion of his total cash holding in money
substitutes than that corresponding to the proportion of his turnover with other clients
of his bank to his total turnover.
For considerations of convenience, he will, as a rule, remain far below this maximum proportion.
Thus a limit is drawn to the issue of fiduciary media.
We may admit that everybody is ready to accept in his current transactions, indiscriminately,
banknotes issued by any bank, and checks drawn upon any bank.
But he deposits without delay with his own bank not only the checks, but also the banknotes
of banks of which he is not himself a client.
In the further course, his bank settles its accounts with the bank engaged, thus the process
described above comes into motion.
A lot of nonsense has been written about a perverse predilection of the public for bank
notes issued by dubious banks.
The truth is that except for small groups of businessmen who were able to distinguish
Banknotes were always looked upon with distrust.
It was the special charters which the governments granted to privileged banks that slowly made
these suspicions disappear.
The often advanced argument that small banknotes come into the hands of poor and ignorant people
who cannot distinguish between good and bad notes cannot be taken seriously.
The poorer the recipient of a bank note is, and the less familiar he is with bank affairs,
the more quickly will he spend the note, and the more quickly will it return, by way of
retail and wholesale trade, to the issuing bank, or to people conversant with banking
conditions.
It is very easy for a bank to increase the number of people who are ready to accept loans
granted by credit expansion, and paid out in an amount of money substitutes.
But it is very difficult for any bank to enlarge its clientele, that is, the number of people
who are ready to consider these claims as money substitutes and to keep them as such
in their cash holdings.
To enlarge this clientele is a troublesome and slow process, as is the acquisition of
any kind of goodwill.
On the other hand, a bank can lose its clientele very quickly.
If it wants to preserve it, it must never permit any doubt about its ability and readiness
to discharge all its liabilities in due compliance with the terms of the contract.
A reserve must be kept large enough to redeem all banknotes which a holder may submit for
redemption.
Therefore, no bank can content itself with issuing fiduciary media only.
must keep a reserve against the total amount of money substitutes issued, and thus combine
issuing fiduciary media and money certificates.
It was a serious blunder to believe that the reserve's task is to provide the means for
the redemption of those banknotes, the holders of which have lost confidence in the bank.
The confidence which a bank and the money substitutes it has issued enjoy is indivisible.
It is either present with all its clients or it vanishes entirely.
If some of the clients lose confidence, the rest of them lose it too.
No bank issuing fiduciary media and granting circulation credit can fulfill the obligations
which it has taken over in issuing money substitutes if all clients are losing confidence and want
to have their banknotes redeemed and their deposits paid back.
This is an essential feature or weakness of the business of issuing fiduciary media and
granting circulation credit.
No system of reserve policy and no reserve requirements as enforced by the laws can remedy
it.
All that a reserve can do is to make it possible for the bank to withdraw from the market an
excessive amount of fiduciary media issued.
If the bank has issued more banknotes than its clients can use in doing business with
other clients, it must redeem such an excess.
The laws which compelled the banks to keep a reserve in a definite ratio of the total
amount of deposits and of banknotes issued were effective insofar as they restricted
the increase in the amount of fiduciary media and of circulation credit.
They were futile, as far as they aimed at safeguarding in the event of a loss of confidence,
the prompt redemption of the banknotes and the prompt payment of deposits.
The banking school failed entirely in dealing with these problems.
It was confused by a spurious idea according to which the requirements of business rigidly
limit the maximum amount of convertible banknotes that a bank can issue.
They did not see that the demand of the public for credit is a magnitude dependent on the
bank's readiness to lend, and that banks which do not bother about their own solvency are
in a position to expand circulation credit by lowering the rate of interest below the
market rate.
It is not true that the maximum amount which a bank can lend if it limits its lending to
to discounting short-term bills of exchange resulting from the sale and purchase of raw
materials and half-manufactured goods is a quantity uniquely determined by the state
of business and independent of the bank's policies.
This quantity expands or shrinks with the lowering or raising of the rate of discount.
Lowering the rate of interest is tantamount to increasing the quantity of what is mistakenly
be considered as the fair and normal requirements of business.
The currency school gave a quite correct explanation of the recurring crises as they upset English
business conditions in the 30s and 40s of the 19th century.
There was credit expansion on the part of the Bank of England and the other British
banks and bankers, while there was no credit expansion, or at least not to the same degree,
in the countries with which Great Britain traded.
The external drain occurred as the necessary consequence of this state of affairs.
Everything that the banking school advanced in order to refute this theory was vain.
Unfortunately, the currency school erred in two respects.
It never realized that the remedy it suggested, namely strict legal limitation of the amount
of Banknotes issued beyond the specie reserve was not the only one. It never gave a thought
to the idea of free banking. The second fault of the currency school was that it failed
to recognize that deposits subject to check are money substitutes, and as far as their
amount exceeds the reserve kept, fiduciary media, and consequently no less a vehicle
of Credit Expansion than our banknotes.
It was the only merit of the banking school that it recognized that what is called deposit
currency is a money substitute, no less than banknotes.
But except for this point, all the doctrines of the banking school were spurious.
It was guided by contradictory ideas concerning money's neutrality.
It tried to refute the quantity theory of money by referring to a deus ex machina, the
much talked about hordes, and it misconstrued entirely the problems of the rate of interest.
It must be emphasized that the problem of legal restrictions upon the issue of fiduciary
media could emerge only because governments had granted special privileges to one or several
Banks, and had thus prevented the free evolution of banking.
If the governments had never interfered for the benefit of special banks, if they had
never released some banks from the obligation incumbent upon all individuals and firms in
the market economy to settle their liabilities in full compliance with the terms of the contract,
no bank problem would have come into being.
The limits which are drawn to credit expansion would have worked effectively.
Considerations of its own solvency would have forced every bank to cautious restraint in
issuing fiduciary media.
Those banks which would not have observed these indispensable rules would have gone
bankrupt, and the public, warned through damage, would have become doubly suspicious and reserved.
The attitudes of the European governments and their satellites with regard to banking were
from the beginning insincere and mendacious.
The pretended solicitude for the nation's welfare, for the public in general, and for
the poor ignorant masses in particular, was a mere blind.
The governments wanted inflation and credit expansion.
They wanted booms and easy money.
Those Americans who twice succeeded in doing away with a central bank were aware of the
dangers of such institutions.
It was only too bad that they failed to see that the evils they fought were present in
every kind of government interference with banking.
Today, even the most bigoted etatists cannot deny that all the alleged evils of free banking
Banking count little when compared with the disastrous effects of the tremendous inflations
which the privileged and government-controlled banks have brought about.
It is a fable that governments interfered with banking in order to restrict the issue
of fiduciary media and to prevent credit expansion.
The idea that guided governments was, on the contrary, the lust for inflation and credit
expansion.
They privileged banks because they wanted to widen the limits drawn to credit expansion
by conditions prevailing on the unhampered market, or because they were eager to open
to the Treasury a source of revenue.
For the most part, both of these considerations motivated the authorities.
They were convinced that the fiduciary media are an efficient means of lowering the rate
of Interest, and asked the banks to expand credit for the benefit of both business and
the treasury.
Only when the undesired effects of credit expansion became visible were laws enacted
to restrict the issue of banknotes, and sometimes also of deposits, not covered by specie.
The establishment of free banking was never seriously considered, precisely because it
would have been too efficient in restricting credit expansion.
For rulers, writers and the public were unanimous in the belief that business has a fair claim
to a normal and necessary amount of circulation credit, and that this amount could not be
attained under free banking.
The notion of normal credit expansion is absurd.
The use of additional fiduciary media, no matter what its quantity may be, always sets
in motion those changes in the price structure, the description of which is the task of the
theory of the trade cycle.
Of course, if the additional amount issued is not large, neither are the inevitable effects
of the expansion.
Many governments never looked upon the issuance of fiduciary media from a point of view other
than that of fiscal concerns.
In their eyes, the foremost task of the banks was to lend money to the Treasury.
The money substitutes were pacemakers for government-issued paper money.
The convertible banknote was merely a first step on the way to the non-redeemable banknote.
With the progress of statolatry and the policy of interventionism, these ideas have become
general and are no longer questioned by anybody.
No government is willing today to give any thought to the program of free banking, because
no government wants to renounce what it considers a handy source of revenue.
What is called today financial war preparedness is merely the ability to procure by means
of privileged and government-controlled banks all the money a warring nation may need.
Financial inflationism, although not admitted explicitly, is an essential feature of the
economic ideology of our age.
But even at the time liberalism enjoyed its highest prestige, and governments were more
eager to preserve peace and well-being than to foment war, death, destruction and misery,
people were biased in dealing with the problems of banking.
State of the Anglo-Saxon countries, public opinion was convinced that it is one of the
main tasks of good government to lower the rate of interest, and that credit expansion
is the appropriate means for the attainment of this end.
Great Britain was free from these errors when in 1844 it reformed its bank laws.
But the two shortcomings of the currency school vitiated this famous act.
On one hand, the system of government interference with banking was preserved.
On the other hand, limits were placed only on the issuance of banknotes not covered by
specie.
The fiduciary media were suppressed only in the shape of banknotes.
They could thrive as deposit currency.
In carrying the idea implied in the currency theory to its full logical conclusion, one
One could suggest that all banks be forced by law to keep against the total amount of
money substitutes, banknotes plus demand deposits, a 100% money reserve.
This is the core of Professor Irving Fisher's 100% plan.
But Professor Fisher combined his plan with his proposals concerning the adoption of an
index number standard.
It has been pointed out already why such a scheme is illusory and tantamount to open
approval of the government's power to manipulate purchasing power according to the appetites
of powerful pressure groups.
But even if the 100% reserve plan were to be adopted on the basis of the unadulterated
gold standard, it would not entirely remove the drawbacks inherent in every kind of government
interference with banking.
What is needed to prevent any further credit expansion is to place the banking business
under the general rules of commercial and civil laws, compelling every individual and
firm to fulfill all obligations in full compliance with the terms of the contract.
If banks are preserved as privileged establishments, subject to special legislative provisions,
The tool remains that governments can use for fiscal purposes.
Then every restriction imposed upon the issuance of fiduciary media depends upon the government's
and the parliament's good intentions.
They may limit the issuance for periods which are called normal.
The restriction will be withdrawn whenever a government deems that an emergency justifies
resorting to extraordinary measures.
If an administration and the party backing it want to increase expenditure without jeopardizing
their popularity through the imposition of higher taxes, they will always be ready to
call their impasse an emergency.
Recourse to the printing press and to the obsequiousness of bank managers willing to
oblige the authorities regulating their conduct of affairs is the foremost means of governments
Free banking is the only method available for the prevention of the dangers inherent
in credit expansion.
It would, it is true, not hinder a slow credit expansion, kept within very narrow limits
on the part of cautious banks which provide the public with all information required about
without their financial status.
But under free banking, it would have been impossible for credit expansion, with all
its inevitable consequences, to have developed into a regular, one is tempted to say, normal
feature of the economic system.
Only free banking would have rendered the market economy secure against crises and depressions.
Looking backward upon the history of the last hundred years, one cannot help realizing that
But the blunders committed by liberalism in handling the problems of banking were a deadly
blow to the market economy.
There was no reason whatever to abandon the principle of free enterprise in the field
of banking.
The majority of liberal politicians simply surrendered to the popular hostility against
money lending and interest taking.
They failed to realize that the rate of interest is a market phenomenon which cannot be manipulated
Ad Libitum by the authorities or by any other agency. They adopted the superstition that
lowering the rate of interest is beneficial and that credit expansion is the right means
of attaining such cheap money. Nothing harmed the cause of liberalism more than the almost
regular return of feverish booms and of the dramatic breakdown of bull markets followed
by Lingering Slumps.
Public opinion has become convinced that such happenings are inevitable in the unhampered
market economy.
People did not conceive that what they lamented was the necessary outcome of policies directed
toward a lowering of the rate of interest by means of credit expansion.
They stubbornly kept to these policies and tried in vain to fight their undesired consequences
by more and more government interference.