Chapter 2. Money in a Free Society
1. The Value of Exchange
How did money begin? Clearly, Robinson Crusoe had no need for money. He could not have eaten gold coins. Neither would Crusoe and Friday, perhaps exchanging fish for lumber, need to bother about money.
Money. But when society expands beyond a few families, the stage is already set for the
emergence of money. To explain the role of money we must go even further back and ask,
why do men exchange at all? Exchange is the prime basis of our economic life. Without
exchanges there would be no real economy and, practically, no society. Clearly, a voluntary
The exchange occurs because both parties expect to benefit.
An exchange is an agreement between A and B to transfer the goods or services of one
man for the goods and services of the other.
Obviously, both benefit because each values what he receives in exchange more than what
he gives up.
When Crusoe, say, exchanges some fish for lumber, he values the lumber he buys more
than the fish he sells.
How Friday, on the contrary, values the fish more than the lumber.
From Aristotle to Marx, men have mistakenly believed that an exchange records some sort
of equality of value, that if one barrel of fish is exchanged for ten logs, there is some
sort of underlying equality between them.
Actually, the exchange was made only because each party valued the two products in different
order.
Why should exchange be so universal among mankind? Fundamentally, because of the great
variety in nature, the variety in man, and the diversity of location of natural resources.
Every man has a different set of skills and aptitudes, and every plot of ground has its
own unique features, its own distinctive resources. From this external natural fact of variety
come exchanges. Wheat in Kansas for iron in Minnesota, one man's medical services for
another's playing of the violin. Specialization permits each man to develop his best skill
and allows each region to develop its own particular resources. If no one could exchange,
if every man were forced to be completely self-sufficient, it is obvious that most of
Two of us would starve to death, and the rest would barely remain alive.
Exchange is the life blood, not only of our economy, but of civilization itself.
2. Barter
Yet direct exchange of useful goods and services would barely suffice to keep an economy going above the primitive level.
Such direct exchange, or barter, is hardly better than pure self-sufficiency.
Why is this?
For one thing, it is clear that very little production could be carried on.
If Jones hires some laborers to build a house, with what will he pay them?
With parts of the house, or with building materials they could not use?
The two basic problems are indivisibility and lack of coincidence of wants.
Thus, if Smith has a plow, which he would like to exchange for several different things,
say eggs, bread and a suit of clothes, how can he do so?
How can he break up the plow and give part of it to a farmer and another part to a tailor?
Even where the goods are divisible, it is generally impossible for two exchangers to find each
other at the same time.
If A has a supply of eggs for sale and B has a pair of shoes, how can they get together
if A wants a suit?
And think of the plight of an economics teacher who has to find an egg producer who wants
to purchase a few economics lessons in return for his eggs.
Clearly, any sort of civilized economy is impossible under direct exchange.
3.
Indirect Exchange
What man discovered in the process of trial and error, the route that permits a greatly
expanding economy, indirect exchange.
Under indirect exchange, you sell your product not for a good which you need directly, but
for another good which you then in turn sell for the good you want.
At first glance, this seems like a clumsy and roundabout operation, but it is actually
the marvelous instrument that permits civilization to develop.
Consider the case of A, the farmer, who wants to buy the shoes made by B. Since B doesn't
want his eggs, he finds what B does want, let's say, butter. A then exchanges his eggs
for C's butter and sells the butter to B for shoes. He first buys the butter not because
Because he wants it directly, but because it will permit him to get his shoes.
Similarly, Smith, a plow owner, will sell his plow for one commodity which he can more
readily divide and sell, say, butter, and will then exchange parts of the butter for
eggs, bread, clothes, etc.
In both cases, the superiority of butter, the reason there is extra demand for it beyond
and Simple Consumption is its greater marketability.
If one good is more marketable than another, if everyone is confident that it will be more
readily sold, then it will come into greater demand because it will be used as a medium
of exchange.
It will be the medium through which one specialist can exchange his product for the goods of
other specialists.
Now just as in nature there is a great variety of skills and resources, so there is a variety
in the marketability of goods.
Some goods are more widely demanded than others, some are more divisible into smaller units
without loss of value, some more durable over long periods of time, some more transportable
over large distances.
All of these advantages make for greater marketability.
It is clear that in every society the most marketable goods will be gradually selected
as the media for exchange.
As they are more and more selected as media, the demand for them increases because of this
use, and so they become even more marketable.
The result is a reinforcing spiral.
More marketability causes wider use as a medium, which causes more marketability, etc.
Historically one or two commodities are used as general media in almost all exchanges,
and these are called money.
Historically many different goods have been used as media, tobacco in colonial Virginia,
sugar in the West Indies, salt in Abyssinia, cattle in ancient Greece, nails in Scotland,
Silver in Ancient Egypt and Grain, Beads, Tea, Cowrie Shells and Fish Hooks.
Through the centuries two commodities, gold and silver, have emerged as money in the free
competition of the market and have displaced the other commodities.
Both are uniquely marketable, are in great demand as ornaments and excel in the other
necessary qualities.
In recent times, silver, being relatively more abundant than gold, has been found more
useful for smaller exchanges.
At any rate, the important thing is that whatever the reason, the free market has found gold
and silver to be the mobility development of a medium of exchange on the free market
is the only way money can become established.
Money cannot originate in any other way, neither by everyone suddenly deciding to create money
Money out of useless material, nor by government calling bits of paper money.
For embedded in the demand for money is knowledge of the money prices of the immediate past.
In contrast to directly used consumers' or producers' goods, money must have pre-existing
prices on which to ground a demand.
But the only way this can happen is by beginning with a useful commodity under barter, and
and then adding demand for a medium for exchange to the previous demand for direct use, that
is, for ornaments, in the case of gold.
Thus, government is powerless to create money for the economy.
It can only be developed by the processes of the free market.
A most important truth about money now emerges from our discussion.
Money is a commodity.
Learning this simple lesson is one of the world's most important tasks.
So often have people talked about money as something much more or less than this.
Money is not an abstract unit of account, divorcible from a concrete good.
It is not a useless token, only good for exchanging.
It is not a claim on society.
It is not a guarantee of a fixed price level.
It is simply a commodity.
It differs from other commodities in being demanded mainly as a medium of exchange.
But aside from this, it is a commodity, and like all commodities, it has an existing stock,
it faces demands by people to buy and hold it, etc.
Like all commodities, its price, in terms of other goods, is determined by the interaction
The emergence of money was a great boon to the human race.
Without money, without a general medium of exchange, there could be no real specialization
1, no advancement of the economy above a bare primitive level.
With money, the problems of indivisibility and coincidence of wants that plagued the barter
society all vanish.
Now Jones can hire laborers and pay them in money.
Smith can sell his plow in exchange for units of money.
The money commodity is divisible into small units, and it is generally acceptable by all.
So, all goods and services are sold for money, and then money is used to buy other goods
and services that people desire.
Because of money, an elaborate structure of production can be formed, with land, labor
services and capital goods cooperating to advance production at each stage and receiving
payment in money.
The establishment of money conveys another great benefit.
Because all exchanges are made in money, all the exchange ratios are expressed in money,
and so people can now compare the market worth of each good to that of every other good.
If a TV set exchanges for 3 ounces of gold and an automobile exchanges for 60 ounces
of gold, then everyone can see that one automobile is worth 20 TV sets on the market.
These exchange ratios are prices, and the money commodity serves as a common denominator
for all prices.
Only the establishment of money prices on the market allows the development of a civilized
economy, for only they permit businessmen to calculate economically.
Businessmen can now judge how well they are satisfying consumer demands by seeing how
How the selling prices of their products compare with the prices they have to pay productive
factors, their costs.
Since all these prices are expressed in terms of money, the businessmen can determine whether
they are making profits or losses.
Such calculations guide businessmen, laborers and landowners in their search for monetary
income on the market.
Many such calculations can allocate resources to their most productive uses, to those uses
that will most satisfy the demands of consumers.
Many textbooks say that money has several functions, a medium of exchange, unit of account,
or measure of values, a store of value, etc.
But it should be clear that all of these functions are simply corollaries of the one great function,
The Medium of Exchange
Because gold is a general medium, it is most marketable.
It can be stored to serve as a medium in the future as well as the present, and all prices
are expressed in its terms.
Money does not measure prices or values.
It is the common denominator for their expression.
In short, prices are expressed in money.
They are not measured by it.
As gold is a commodity medium for all exchanges, it can serve as a unit of account for present
and expected future prices.
It is important to realize that money cannot be an abstract unit of account or claim, except
in so far as it serves as a medium of exchange.
5.
The Monetary Unit
Now that we have seen how money emerged and what it does, we may ask, how is the money
commodity used?
Specifically, what is the stock or supply of money in society, and how is it exchanged?
In the first place, most tanite is the distinctive unit of a tangible commodity, and so trading
takes place in terms of units like tons, pounds, ounces, grains, grams, etc.
Even those goods nominally exchanging in terms of volume, bale, bushel, etc., tacitly assume
a standard weight per unit volume.
Gold is no exception.
Gold like other commodities will be traded in units of weight.
One of the cardinal virtues of gold as money is its homogeneity.
Unlike many other commodities, it has no differences in quality.
An ounce of pure gold equals any other ounce of pure gold the world over.
It is obvious that the size of the common unit chosen in trading makes no difference
to the economist.
One country on the metric system may prefer to figure in grams.
England or America may prefer to reckon in grains or ounces.
All units of weight are convertible into each other.
One pound equals 16 ounces, one ounce equals 437.5 grains or 28.35 grams, etc.
Assuming gold is chosen as the money, the size of the gold unit used in reckoning is
immaterial to us.
Jones may sell a coat for one gold ounce in America or for 28.35 grams in France.
Both prices are identical.
All this might seem like laboring the obvious, except that a great deal of misery in the
world would have been avoided if people had fully realized these things as abstract units
for something or other, each cleaving uniquely to a certain country.
Even when countries were on the gold standard, people thought in similar terms.
American money was dollars, French was francs, German marks, etc.
All these were admittedly tied to gold, but all were considered sovereign and independent,
and hence it was easy for countries to go off the gold standard.
Yet all of these names were simply names for units of weight of gold or silver.
The British pound sterling originally signified a pound weight of silver.
And what of the dollar?
The dollar began as the generally applied name of an ounce weight of silver coined by
by a Bohemian Count named Schlick in the 16th century.
The Count of Schlick lived in Joachim's Valley or Joachimstal.
The Count's coins earned a great reputation for their uniformity and fineness, and they
were widely called Joachim's Taller's or, finally, Taller's.
The name Dollar eventually emerged from Taller.
In the free market, then, the various names that units may have are simply definitions
of units of weight.
When we were on the gold standard before 1933, people liked to say that the price of gold
was fixed at $20 per ounce of gold.
But this was a dangerously misleading way of looking at our money.
Actually, the dollar was defined as the name for approximately one twentieth of an ounce
of gold.
It was therefore misleading to talk about exchange rates of one country's currency for another.
The pound sterling did not really exchange for $5. Actually, the pound sterling exchanged
for $4.87, but we are using $5 for greater convenience of calculation. The dollar was
defined as 1 twentieth of a gold ounce, and the pound sterling was, at that time, defined
as the name for one-fourth of a gold ounce, simply traded for five-twentieths of a gold
ounce.
Clearly, such exchanges and such a welter of names were confusing and misleading.
How they arose is shown below in the chapter on government meddling with money.
In a purely free market, gold would simply be exchanged directly as grams, grains or
and such confusing names as dollars, francs, etc. would be superfluous.
Therefore, in this section, we will treat money as exchanging directly in terms of ounces or grams.
Clearly, the free market will choose as the common unit whatever size of the money commodity is most convenient.
If platinum were the money, it would likely be traded in terms of fractions of an ounce.
6. The Shape of Money
If the size or the name of the money unit makes little economic difference, neither
does the shape of the monetary metal. Since the commodity is the money, it follows that
But the entire stock of the metal, so long as it is available to man, constitutes the
world's stock of money.
It makes no real difference what shape any of the metal is at any time.
If iron is the money, then all the iron is money, whether it is in the form of bars,
chunks, or embodied in specialized machinery.
Iron hoes have been used extensively as money, both in Asia and Africa.
Gold has been traded as money in the raw form of nuggets, as gold dust in sacks and even
as jewelry.
It should not be surprising that gold or other monies can be traded in many forms, since
their important feature is their weight.
It is true, however, that some shapes are often more convenient than others.
In recent centuries, gold and silver have been broken down into coins for smaller day-to-day
Transactions and into larger bars for bigger transactions.
Other gold is transformed into jewelry and other ornaments.
Now any kind of transformation from one shape to another costs time, effort and other resources.
Doing this work will be a business like any other, and prices for this service will be
set in the usual manner.
Most people agree that it is legitimate for jewelers to make ornaments out of raw gold,
But they often deny that the same applies to the manufacture of coins.
Yet on the free market, coinage is essentially a business, like any other.
Many people believed in the days of the gold standard that coins were somehow more really
money than plain uncoined gold bullion, bars, ingots or any other shape.
It is true that coins commanded a premium over bullion, but this was not caused by any
7. Private Coinage
The idea of private coinage seems so strange today that it is worth examining carefully.
We are used to thinking of coinage as a necessity of sovereignty, yet after all we are not wedded
to a royal prerogative, and it is the American concept that sovereignty rests not in government
but in the people.
How would private coinage work?
In the same way we have said as any other business.
Each minter would produce whatever size or shape of coin is most pleasing to his customers.
The price would be set by the free competition of the market.
The standard objection is that it would be too much trouble to weigh or assay bits of
gold at every transaction.
But what is there to prevent private minters from stamping the coin and guaranteeing its
weight and fineness?
Private minters can guarantee a coin at least as well as a government mint.
Abraded bits of metal would not be accepted as coin.
People would use the coins of those minters with the best reputation for good quality
of product.
We have seen that this is precisely how the dollar became prominent, as a competitive
silver coin.
Opponents of private coinage charge that fraud would run rampant, yet these same opponents
would trust government to provide the coinage.
But if government is to be trusted at all, then surely, with private coinage, government
could at least be trusted to prevent or punish fraud.
It is usually assumed that the prevention or punishment of fraud, theft or other crimes
is the real justification for government.
But if government cannot apprehend the criminal when private coinage is relied upon, what
hope is there for a reliable coinage when the integrity of the private market place
operators is discarded in favor of a government monopoly of coinage?
If government cannot be trusted to ferret out the occasional villain in the free market
in coin, why can government be trusted when it finds itself in a position of total control
over money, and may debase coin, counterfeit coin, or otherwise with full legal sanction
perform as the sole villain in the marketplace?
It is surely folly to say that government must socialize all property in order to prevent
anyone from stealing property. Yet the reasoning behind abolition of private coinage is the same.
Moreover, all modern business is built on guarantees of standards. The drug store sells
an eight ounce bottle of medicine, the meat packer sells a pound of beef. The buyer expects these
guarantees to be accurate, and they are. And think of the thousands upon thousands of specialized
have vital industrial products that must meet very narrow standards and specifications.
The buyer of a half-inch bolt must get a half-inch bolt and not a mere three-eighths inch.
Yet business has not broken down.
Few people suggest that the government must nationalize the machine tool industry as part
of its job of defending standards against fraud.
The modern market economy contains an infinite number of intricate exchanges, most depending
on definite standards of quantity and quality.
But fraud is at a minimum, and that minimum, at least in theory, may be prosecuted.
So it would be if there were private coinage.
We can be sure that a midter's customers and his competitors would be keenly alert
to any possible fraud in the weight or fineness of his coins.
Champions of the government's coinage monopoly have claimed that money is different from
all other commodities, because Gresham's law proves that bad money drives out good from
circulation. Hence the free market cannot be trusted to serve the public in supplying
good money. But this formulation rests on a misinterpretation of Gresham's famous law.
The law really says that money overvalued artificially by government will drive out
of circulation artificially undervalued money.
Suppose for example there are one ounce gold coins in circulation.
After a few years of wear and tear let us say that some coins weigh only 0.9 ounces.
Obviously on the free market the worn coins would circulate at only 90% of the value of
of the full-bodied coins and the nominal face value of the former would have to be repudiated.
To meet the problem of wear and tear, private coiners might either set a time limit on their
stamped guarantees of weight or agree to re-coin anew either at the original or at the lower
weight.
We may note that in the free economy there will not be the compulsory standardization
One of the coins that prevails when government monopolies direct the coinage.
If anything, it will be the bad coins that will be driven from the market.
But suppose the government decrees that everyone must treat the worn coins as equal to new
fresh coins and must accept them equally in payment of debts.
What has the government really done?
It has imposed price control by coercion on the exchange rate between the two types of
By insisting on the par ratio when the worn coins should exchange at 10% discount, it
artificially overvalues the worn coins and undervalues new coins.
Consequently, everyone will circulate the worn coins and hoard or export the new.
Bad money drives out good money then, not on the free market, but as the direct result
of Governmental Intervention in the Market.
Despite never-ending harassment by governments, making conditions highly precarious, private
coins have flourished many times in history.
True to the virtual law that all innovations come from free individuals and not the state,
the first coins were minted by private individuals and goldsmiths.
In fact, when the government first began to monopolize the coinage, the royal coins bore
were the guarantees of private bankers, whom the public trusted far more, apparently, than
they did the government. Privately minted gold coins circulated in California as late
as 1848.
8. The Proper Supply of Money
Now we may ask, what is the supply of money in society, and how is that supply used? In
In particular, we may raise the perennial question, how much money do we need?
Must the money supply be regulated by some sort of criterion, or can it be left alone
to the free market?
First, the total stock or supply of money in society at any one time is the total weight
of the existing money stuff.
Let us assume for the time being that only one commodity is established on the free market
as money.
Let us further assume that gold is that commodity, although we could have taken silver or even
iron.
It is up to the market, and not to us, to decide the best commodity to use as money.
Since money is gold, the total supply of money is the total weight of gold existing in society.
The shape of gold does not matter, except if the cost of changing shapes in certain
ways is greater than in others.
For example, minting coins costing more than melting them.
In that case, one of the shapes will be chosen by the market as the money of a count, and
the other shapes will have a premium or discount in accordance with their relative costs on
the market.
Changes in the total gold stock will be governed by the same causes as changes in other goods.
Increases will stem from greater production from mines.
Changes from being used up in wear and tear in industry, etc.
Because the market will choose a durable commodity as money, and because money is not used up
at the rate of other commodities but is employed as a medium of exchange, the proportion of
new annual production to its total stock will tend to be quite small.
Changes in total gold stock, then, generally take place very slowly.
What should the supply of money be?
All sorts of criteria have been put forward, that money should move in accordance with
population, with the volume of trade, with the amounts of goods produced, so as to keep
the price level constant, etc.
Few indeed have suggested leaving the decision to the market.
But money differs from other commodities in one essential fact, and grasping this difference
furnishes a key to understanding monetary matters.
When the supply of any other good increases, this increase confers a social benefit.
It is a matter for general rejoicing.
More consumer goods mean a higher standard of living for the public.
More capital goods mean sustained and increased living standards in the future.
The discovery of new fertile land or natural resources also promises to add to living standards,
present and future.
But what about money?
Does an addition to the money supply also benefit the public at large?
Consumer goods are used up by consumers.
Capital goods and natural resources are used up in the process of producing consumer goods.
But money is not used up.
Its function is to act as a medium of exchanges, to enable goods and services to travel more
are expeditiously from one person to another. These exchanges are all made in terms of money
prices. Thus, if a television set exchanges for three gold ounces, we say that the price
of the television set is three ounces. At any one time, all goods in the economy will
exchange at certain gold ratios, or prices. As we have said, money, or gold, is the common
One denominator of all prices. But what of money itself? Does it have a price? Since
a price is simply an exchange ratio, it clearly does. But in this case, the price of money
is an array of the infinite number of exchange ratios for all the various goods on the market.
Thus, suppose that a television set costs 3 gold ounces, an auto 60 ounces, a loaf of
The price of bread one hundredth of an ounce, and an hour of Mr. Jones' legal services,
one ounce.
The price of money will then be an array of alternative exchanges.
One ounce of gold will be worth either one-third of a television set, one-sixtieth of an auto,
one hundred loaves of bread, or one hour of Jones' legal service.
And so on down the line.
The price of money, then, is the purchasing power of the monetary unit.
in this case of the gold ounce. It tells what that ounce can purchase in exchange, just
as the money price of a television set tells how much money a television set can bring
in exchange. What determines the price of money? The same forces that determine all
prices on the market, that venerable but eternally true law, supply and demand. We all know that
And if the supply of eggs increases, the price will tend to fall.
If the buyer's demand for eggs increases, the price will tend to rise.
The same is true for money.
An increase in the supply of money will tend to lower its price.
An increase in the demand for money will raise it.
But what is the demand for money?
In the case of eggs, we know what demand means.
Demand is the amount of money consumers are willing to spend on eggs, plus eggs retained
and not sold by suppliers.
Similarly, in the case of money, demand means the various goods offered in exchange for
money, plus the money retained in cash and not spent over a certain time period.
In both cases, supply may refer to the total stock of the good on the market.
What happens then if the supply of gold increases, demand for money remaining the same?
The price of money falls, that is, the purchasing power of the money unit will fall all along
the line.
An ounce of gold will now be worth less than one hundred loaves of bread, one third of
a television set, etc.
Conversely, if the supply of gold falls, the purchasing power of the gold ounce rises.
What is the effect of a change in the money supply?
Following the example of David Hume, one of the first economists, we may ask ourselves
what would happen if, overnight, some good fairy slipped into pockets, purses and bank
vaults and doubled our supply of money.
In our example, she magically doubled our supply of gold.
Would we be twice as rich?
Obviously not.
What makes us rich is an abundance of goods, and what limits that abundance is a scarcity
of resources, namely land, labor, and capital.
Multiplying coin will not whisk these resources into being.
We may feel twice as rich for the moment, but clearly all we are doing is diluting the
money supply.
As the public rushes out to spend its newfound wealth, prices will very roughly double, or
or at least rise until the demand is satisfied and money no longer bids against itself for
the existing goods.
Thus we see that while an increase in the money supply, like an increase in the supply
of any good, lowers its price, the change does not, unlike other goods, confer a social
benefit.
The public at large is not made richer.
As new consumer or capital goods add to standards of living, new money only raises prices, that
is, dilutes its own purchasing power.
The reason for this puzzle is that money is only useful for its exchange value.
Other goods have various real utilities, so that an increase in their supply satisfies
more consumer wants.
Money has utility only for prospective exchange.
Its utility lies in its exchange value, or purchasing power.
Our law, that an increase in money does not confer a social benefit, stems from its unique
use as a medium of exchange.
An increase in the money supply, then, only dilutes the effectiveness of each gold ounce.
On the other hand, a fall in the supply of money raises the power of each gold ounce
to do its work.
We come to the startling truth that it doesn't matter what the supply of money is.
Any supply will do as well as any other supply.
The free market will simply adjust by changing the purchasing power or effectiveness of the
gold unit.
There is no need to tamper with the market in order to alter the money supply that it
determines.
At this point, the monetary planner might object, all right, granting that it is pointless
As to increase the money supply, isn't gold mining a waste of resources?
Shouldn't the government keep the money supply constant and prohibit new mining?
This argument might be plausible to those who hold no principled objections to government
meddling, though it would not convince the determined advocate of liberty.
But the objection overlooks an important point, that gold is not only money but is also, inevitably,
a commodity.
An increased supply of gold may not confer any monetary benefit, but it does confer a
non-monetary benefit.
That is, it does increase the supply of gold used in consumption, ornaments, dental work
and the like, and in production, industrial work.
Gold mining, therefore, is not a social waste at all.
We conclude, therefore, that determining the supply of money, like all other goods, is
are best left to the free market.
Aside from the general moral and economic advantages of freedom over coercion,
no dictated quantity of money will do the work better,
and the free market will set the production of gold in accordance with its relative ability
to satisfy the needs of consumers as compared with all other productive goods.
Gold mining is, of course, no more profitable than any other business.
In the long run, its rate of return will be equal to the net rate of return in any other industry.
9. The Problem of Hoarding
The critic of monetary freedom is not so easily silenced, however.
There is in particular the ancient bugbear of hoarding.
The image is conjured up of the selfish old miser who, perhaps irrationally, perhaps from evil motives,
In the first place, what has simply happened is an increased demand for money on the part
of the miser.
As a result, prices of goods fall, and the purchasing power of the gold ounce rises.
There has been no loss to society, which simply carries on with a lower active supply of more
powerful gold ounces.
Even in the worst possible view of the matter, then, nothing has gone wrong, and monetary
freedom creates no difficulties.
But there is more to the problem than that, for it is by no means irrational for people
to desire more or less money in their cash balances.
Let us at this point study cash balances further.
Why do people keep any cash balances at all?
Suppose that all of us were able to foretell the future with absolute certainty.
In that case, no one would have to keep cash balances on hand.
Everyone would know exactly how much he will spend and how much income he will receive
at all future dates.
He need not keep any money at hand, but will lend out his gold so as to receive his payments
and the needed amounts on the very days he makes his expenditures.
But of course, we necessarily live in a world of uncertainty.
People do not precisely know what will happen to them or what their future incomes or costs
will be.
The more uncertain and fearful they are, the more cash balances they will want to hold.
The more secure, the less cash they will wish to keep on hand.
Another reason for keeping cash is also a function of the real world of uncertainty.
If people expect the price of money to fall in the near future, they will spend their
money now while money is more valuable, thus dishorting and reducing their demand for money.
Conversely, if they expect the price of money to rise, they will wait to spend money later
when it is more valuable, and their demand for cash will increase.
People's demands for cash balances, then, rise and fall for good and sound reasons.
Economists err if they believe something is wrong when money is not in constant, active
circulation. Money is only useful for exchange value, true. But it is not. This truth has
been often overlooked. Money is just as useful when lying idle in somebody's cash balance,
in a Miser's Horde. At what point does a man's cash balance become a faintly disreputable
horde or the prudent man a miser? It is impossible to fix any definite criterion. Generally the
charge of hoarding means that A is keeping more cash than B thinks is appropriate for
A. For that money is being held now in weight for possible future exchange. It supplies
is to its owner, right now, the usefulness of permitting exchanges at any time, present
or future, the owner might desire.
It should be remembered that all gold must be owned by someone, and therefore that all
gold must be held in people's cash balances.
If there are 3,000 tons of gold in society, all 3,000 tons must be owned and held at any
one time in the cash balances of individual people.
The total sum of cash balances is always identical with the total supply of money in the society.
Thus, ironically, if it were not for the uncertainty of the real world, there could be no monetary
system at all.
In a certain world, no one would be willing to hold cash, so the demand for money in society
would fall infinitely, prices would skyrocket without end, and any monetary system would
break down.
Instead of the existence of cash balances being an annoying and troublesome factor, interfering
with monetary exchange, it is absolutely necessary to any monetary economy.
It is misleading, furthermore, to say that money circulates.
Like all metaphors taken from the physical sciences, it connotes some sort of mechanical
process, independent of human will, which moves at a certain speed of flow or velocity.
Actually, money does not circulate. It is, from time to time, transferred from one person's cash balance to another's.
The existence of money, once again, depends upon people's willingness to hold cash balances.
At the beginning of this section, we saw that hoarding never brings any loss to society.
Now we will see that movement in the price of money caused by changes in the demand for money yields a positive social benefit, as positive as any conferred by increased supplies of goods and services.
We have seen that the total sum of cash balances in society is equal and identical with the total supply of money.
Let us assume the supply remains constant, say at 3,000 tons.
Now suppose, for whatever reason, perhaps growing apprehension, people's demand for cash balances increases.
Surely it is a positive social benefit to satisfy this demand.
But how can it be satisfied when the total sum of cash must remain the same?
Simply as follows.
With people valuing cash balances more highly, the demand for money increases, and prices fall.
As a result, the same total sum of cash balances now confers a higher real balance, that is, it is higher in proportion to the prices of goods, to the work that money has to perform.
In short, the effective cash balances of the public have increased.
Conversely, a fall in the demand for cash will cause increased spending at higher prices.
The public's desire for lower effective cash balances will be satisfied by the necessity for given total cash to perform more work.
Therefore, while a change in the price of money stemming from changes in supply merely alters the effectiveness of the money unit and confers no social benefit,
benefit.
A fall or rise caused by a change in the demand for cash balances does yield a social benefit,
for it satisfies a public desire for either a higher or lower proportion of cash balances
to the work done by cash.
On the other hand, an increased supply of money will frustrate public demand for a more
effective sum total of cash, more effective in terms of purchasing power.
People will almost always say, if asked, that they want as much money as they can get.
But what they really want is not more units of money, more gold ounces or dollars, but
more effective units, that is, greater command of goods and services bought by money.
We have seen that society cannot satisfy its demand for more money by increasing its supply,
For an increased supply will simply dilute the effectiveness of each ounce, and the money
will be no more really plentiful than before.
People's standard of living, except in the non-monetary uses of gold, cannot increase
by mining more gold.
If people want more effective gold ounces in their cash balances, they can get them
Only Through a Fall in Prices and a Rise in the Effectiveness of Each Ounce
10.
Stabilize the Price Level?
Some theorists charge that a free monetary system would be unwise because it would not
stabilize the price level, that is, the price of the money unit.
Money, they say, is supposed to be a fixed yardstick that never changes.
Therefore its value or purchasing power should be stabilized.
Since the price of money would admittedly fluctuate on the free market,
freedom must be overruled by government management to ensure stability.
How the government would go about this is unimportant at this point.
Basically it would involve governmentally managed changes in the money supply.
Stability would provide justice, for example, to debtors and creditors
who will be sure of paying back dollars or gold ounces of the same purchasing power as
they lent out.
Yet if creditors and debtors want to hedge against future changes in purchasing power,
they can do so easily on the free market.
When they make their contracts, they can agree that repayment will be made in a sum of money
adjusted by some agreed-upon index number of changes in the value of money.
The stabilizers have long advocated such measures, but strangely enough, the very lenders and
borrowers who are supposed to benefit most from stability have rarely availed themselves
of the opportunity.
Must the government then force certain benefits on people who have already freely rejected
them?
Apparently, businessmen would rather take their chances in this world of irremediable
uncertainty on their ability to anticipate the conditions of the market.
After all, the price of money is no different from any other free price on the market.
They can change in response to changes in demand of individuals.
Why not the monetary price?
Artificial stabilization would in fact seriously distort and hamper the workings of the market.
As we have indicated, people would be unavoidably frustrated in their desires to alter their
real proportion of cash balances.
There would be no opportunity to change cash balances in proportion to prices. Furthermore,
improved standards of living come to the public from the fruits of capital investment. Increased
productivity tends to lower prices and costs, and thereby distribute the fruits of free
enterprise to all the public, raising the standard of living of all consumers. Forcible
propping up of the price level prevents this spread of higher living standards.
Money in short is not a fixed yardstick, it is a commodity serving as a medium for exchanges.
Flexibility in its value in response to consumer demands is just as important and just as beneficial
as any other free pricing on the market.
11. Coexisting Monies
So far we have obtained the following picture of money in a purely free economy. Gold or
for Silver coming to be used as a medium of exchange, gold minted by competitive private
firms circulating by weight, prices fluctuating freely on the market in response to consumer
demands and supplies of productive resources. Freedom of prices necessarily implies freedom
of movement for the purchasing power of the money unit. It would be impossible to use
force and interfere with movements in the value of money without simultaneously crippling
Thus far we have simplified the problem by assuming only one monetary metal, say gold.
Suppose that two or more monies continue to circulate on the world market, say gold and
silver. Possibly gold will be the money in one area and silver in another, or else they
both may circulate side by side. Gold, for example, being ounce for ounce more valuable
on the market than silver, may be used for larger transactions and silver for smaller.
Would not two monies be impossibly chaotic? Wouldn't the government have to step in and
and impose a fixed ration between the two, bimetallism, or in some way demonetize one
or the other metal, impose a single standard?
It is very possible that the market, given free rein, might eventually establish one
single metal as money.
But in recent centuries silver stubbornly remained to challenge gold.
It is not necessary, however, for the government to step in and save the market from its own
and Folly in Maintaining Two Monies. Silver remained in circulation precisely because
it was convenient, for small change, for example. Silver and gold could easily circulate side
by side, and have done so in the past. The relative supplies of and demands for the two
metals will determine the exchange rate between the two, and this rate, like any other price,
will continually fluctuate in response to these changing forces.
At one time, for example, silver and gold ounces might exchange at 16 to 1, another
time at 15 to 1, etc.
Which metal will serve as a unit of account depends on the concrete circumstances of the
market.
If gold is the money of account, then most transactions will be reckoned in gold ounces,
And silver ounces will exchange at a freely fluctuating price in terms of the gold.
It should be clear that the exchange rate and the purchasing powers of the units of
the two metals will always tend to be proportional.
If prices of goods are fifteen times as much in silver as they are in gold, then the exchange
rate will tend to be set at fifteen to one.
If not, it will pay to exchange from one to the other until parity is reached.
Suppose if prices are 15 times as much in terms of silver as gold, while silver to gold
is 20 to 1, people will rush to sell their goods for gold, buy silver and then re-buy
the goods with silver, reaping a handsome gain in the process.
This will quickly restore the purchasing power parity of the exchange rate.
As gold gets cheaper in terms of silver, silver prices of goods go up and gold prices of goods
go down.
The free market, in short, is eminently orderly, not only when money is free, but even when
there is more than one money circulating.
What kind of standard will a free money provide?
The important thing is that the standard not be imposed by government decree.
If left to itself, the market may establish gold as a single money, gold standard, silver
as a Single Money, Silver Standard, or, perhaps most likely, both as monies, with freely fluctuating
exchange rates, parallel standards.
12.
Money Warehouses
Suppose then that the free market has established gold as money, forgetting again about silver
for the sake of simplicity.
Even in the convenient shape of coins, gold is often cumbersome and awkward to carry and
used directly in exchange. For larger transactions, it is awkward and expensive to transport several
hundred pounds of gold. But the free market, ever ready to satisfy social needs, comes
to the rescue. Gold, in the first place, must be stored somewhere. And just as specialization
is most efficient in other lines of business, so it will be most efficient in the warehousing
business. Certain firms, then, will be successful on the market in providing warehousing services.
Some will be gold warehouses and will store gold for its myriad owners.
As in the case of all warehouses, the owner's right to the stored goods is established by a warehouse receipt which he receives in exchange for storing the goods.
The receipt entitles the owner to claim his goods at any time he desires.
This warehouse will earn profit no differently from any other, that is, by charging a price for its storage services.
There is every reason to believe that gold warehouses or money warehouses will flourish on the free market in the same way that other warehouses will prosper.
In fact, warehousing plays an even more important role in the case of money, for all other goods pass into consumption and so must leave the warehouse after a while to be used up in production or consumption.
But money, as we have seen, is mainly not used in the physical sense, instead it is used to exchange for other goods, and to lie and wait for such exchanges in the future.
In short, money is not so much used up as simply transferred from one person to another.
In such a situation, convenience inevitably leads to transfer of the warehouse receipt, instead of the physical gold itself.
Suppose, for example, that Smith and Jones both store their gold in the same warehouse.
Jones sells Smith an automobile for 100 gold ounces.
They could go through the expensive process of Smith's redeeming his receipt and moving
their gold to Jones' office, with Jones turning right around and redepositing the gold again,
but they will undoubtedly choose a far more convenient course.
Roth simply gives Jones a warehouse receipt for 100 ounces of gold.
In this way, warehouse receipts for money come more and more to function as money substitutes.
Fewer and fewer transactions move the actual gold.
In more and more cases, paper titles to the gold are used instead.
As the market develops, there will be three limits on the advance of this substitution
process.
One is the extent that people use these money warehouses, called banks, instead of cash.
Clearly, if Jones, for some reason, didn't like to use a bank, Smith would have to transport
the actual gold.
The second limit is the extent of the clientele of each bank.
In other words, the more transactions taking place between clients of different banks,
the more gold will have to be transported.
The more exchanges are made by clients of the same bank, the less need to transport
the gold.
If Jones and Smith were clients of different warehouses, Smith's Bank, or Smith himself,
would have to transport the gold to Jones' Bank.
Third, the clientele must have confidence in the trustworthiness of their banks.
If they suddenly find out, for example, that the bank officials have had criminal records,
The bank will likely lose its business in short order. In this respect, all warehouses
and all businesses resting on good will are alike.
As banks grow and confidence in them develops, their clients may find it more convenient
in many cases to waive their right to paper receipts, called bank notes, and instead to
keep their titles as open book accounts. In the monetary realm, these have been called
Bank Deposits
Instead of transferring paper receipts, the client has a book claim at the bank. He makes
exchanges by writing an order to his warehouse to transfer a portion of this account to someone
else. Thus, in our example, Smith will order the bank to transfer book title to his one
hundred gold ounces to Jones. This written order is called a check.
It should be clear that economically there is no difference whatever between a bank note
and a bank deposit.
Both are claims to ownership of stored gold.
Both are transferred similarly as money substitutes, and both have the identical three limits on
their extent of use.
The client can choose, according to his convenience, whether he wishes to keep his title in note
or deposit form.
A third form of money substitute will be token coins for very small change.
These are, in effect, equivalent to banknotes, but printed on base metal rather than on paper.
Now what has happened to their money supply as a result of all these operations?
If paper notes or bank deposits are used as money substitutes, does this mean that the
effective money supply in the economy has increased even though the stock of gold has
remained the same?
For the money substitutes are simply warehouse receipts for actually deposited gold.
If Jones deposits 100 ounces of gold in his warehouse and gets a receipt for it,
the receipt can be used on the market as money but only as a convenient stand-in for the gold, not as an increment.
The gold in the vault is then no longer a part of the effective money supply
Supply, but is held as a reserve for its receipt to be claimed whenever desired by its owner.
An increase or decrease in the use of substitutes, then, exerts no change on the money supply.
Only the form of the supply is changed, not the total.
Thus the money supply of a community may begin as ten million gold ounces.
Then six million may be deposited in banks in return for gold notes, whereupon the effective
Reserve supply will now be 4 million ounces of gold, 6 million ounces of gold claims in
paper notes.
The total money supply has remained the same.
Curiously, many people have argued that it would be impossible for banks to make money
if they were to operate on this 100% reserve basis, gold always represented by its receipt.
Yet there is no real problem, any more than for any warehouse.
Almost all warehouses keep all the goods for their owners 100% reserve as a matter of course.
In fact, it would be considered fraud or theft to do otherwise.
Their profits are earned from service charges to their customers.
The banks can charge for their services in the same way.
If it is objected that customers will not pay the high service charges, this means that
the bank's services are not in very great demand, and the use of their services will
will fall to the levels that consumers find worthwhile.
We come now to perhaps the thorniest problem facing the monetary economist, an evaluation
of fractional reserve banking.
We must ask the question, would fractional reserve banking be permitted in a free market,
or would it be proscribed as fraud?
It is well known that banks have rarely stayed on a 100% basis very long, since money can
If the bank can remain in the warehouse for a long period of time, the bank is tempted to use some of the money for its own account, tempted also because people do not ordinarily care whether the gold coins they receive back from the warehouse are the identical gold coins they deposited.
The bank is tempted then to use other people's money to earn a profit for itself.
If the banks lend out the gold directly, the receipts, of course, are now partially invalidated.
There are now some receipts with no gold behind them.
In short, the bank is effectively insolvent, since it cannot possibly meet its own obligations
if called upon to do so.
It cannot possibly hand over its customers' property should they also desire.
Generally, banks, instead of taking the gold directly, print uncovered or pseudo warehouse receipts, that is, warehouse receipts for gold that is not and cannot be there.
These are then loaned at a profit.
Clearly, the economic effect is the same. More warehouse receipts are printed than gold exists in the vaults.
What the bank has done is to issue gold warehouse receipts which represent nothing, but are supposed to represent 100% of their face value in gold.
The pseudo-receipts pour forth on the trusting market in the same way as the true receipts, and thus add to the effective money supply of the country.
In the above example, if the banks now issue 2 million ounces of false receipts with no gold behind them, the money supply of the country will rise from 10 to 12 million gold ounces, at least until the hocus-pocus has been discovered and corrected.
There are now, in addition to 4 million ounces of gold held by the public, 8 million ounces of money substitutes, only 6 million of which are covered by gold.
Issue of pseudo receipts, like counterfeiting of coin, is an example of inflation, which will be studied further below.
Inflation may be defined as any increase in the economy's supply of money, not consisting of an increase in the stock of the money metal.
Fractional reserve banks, therefore, are inherently inflationary institutions.
Defenders of banks reply as follows. The banks are simply functioning like other businesses. They take risks. Admittedly, if all the depositors presented their claims, the banks would be bankrupt, since outstanding receipts exceed gold in their vaults.
But banks simply take the chance, usually justified, that not everyone will ask for his gold.
The great difference, however, between the fractional reserve bank and all other businesses
is this. Other businessmen use their own or borrowed capital in ventures, and if they borrow
credit, they promise to pay at a future date, taking care to have enough money at hand on that
date to meet their obligation. If Smith borrows 100 gold ounces for a year, he will arrange to
to have 100 gold ounces available on that future date.
But the bank isn't borrowing from its depositors.
It doesn't pledge to pay back gold at a certain date in the future.
Instead, it pledges to pay the receipt in gold at any time on demand.
In short, the banknote or deposit is not an IOU or debt.
It is a warehouse receipt for other people's property.
Further, when a businessman borrows or lends money, he does not add to the money supply.
The loaned funds are saved funds, part of the existing money supply being transferred
from saver to borrower.
Bank issues, on the other hand, artificially increase the money supply, since pseudo-receipts
are injected into the market.
A bank, then, is not taking the usual business risk.
It does not, like all businessmen, arrange the time pattern of its assets proportionately
to the time pattern of liabilities.
That is, see to it that it will have enough money on due dates to pay its bills.
Instead, most of its liabilities are instantaneous, but its assets are not.
The bank creates new money out of thin air, and does not, like everyone else, have to
acquire money by producing and selling its services.
In short, the bank is already, and at all times, bankrupt.
But its bankruptcy is only revealed when customers get suspicious and precipitate bank runs.
No other business experiences a phenomenon like a run.
No other business can be plunged into bankruptcy overnight simply because its customers decide
to repossess their own property.
No other business creates fictitious new money which will evaporate when truly gauged.
The dire economic effects of fractional bank money will be explored in the next chapter.
Here we conclude that morally such banking would have no more right to exist in a truly
free market than any other form of implicit theft.
It is true that the note or deposit does not actually say on its face that the warehouse
The US guarantees to keep a full backing of gold on hand at all times, but the bank does promise to redeem on demand, and so when it issues any fake receipts, it is already committing fraud, since it immediately becomes impossible for the bank to keep its pledge and redeem all of its notes and deposits.
Fraud, therefore, is immediately being committed when the act of issuing pseudo receipts takes place.
Which particular receipts are fraudulent can only be discovered after a run on the bank has occurred, since all the receipts look alike, and the late-coming claimants are left high and dry.
Perhaps a libertarian system would consider general warrant deposits, which allow the warehouse to return any homogeneous good to the depositor, as specific warrant deposits,
which, like bills of lading, pawn tickets, dock warrants, etc., establish ownership to
certain specific earmarked objects.
For in the case of a general deposit warrant, the warehouse is tempted to treat the goods
as its own property, instead of being the property of its customers.
This is precisely what the banks have been doing.
If fraud is to be proscribed in a free society, then fractional reserve banking would have
have to meet the same fate.
Fraud is implicit theft, since it means that a contract has not been completed after the
value has been received.
In short, if A sells B a box labeled cornflakes and it turns out to be straw upon opening,
A's fraud is really theft of B's property.
Similarly, the issue of warehouse receipts for non-existent goods, identical with genuine
Receipts is fraud upon those who possess claims to non-existent property.
Suppose however that fraud and fractional reserve banking are permitted, with the banks
only required to fulfill their obligations to redeem in gold on demand.
Any failure to do so would mean instant bankruptcy.
Such a system has come to be known as free banking.
Would there then be a heavy fraudulent issue of money substitutes with resulting artificial
creation of new money?
Many people have assumed so, and believed that wild-cat banking would then simply inflate
the money supply astronomically, but on the contrary, free banking would lead to a far
harder monetary system than we have today.
The banks would be checked by the same three limits that we noted above, and checked rather
rigorously.
In the first place, each bank's expansion will be limited by a loss of gold to another
bank.
For a bank can only expand money within the limits of its own clientele.
Suppose for example that Bank A, with 10,000 ounces of gold deposited, now issues 2,000
ounces of false warehouse receipts to gold and lends them to various enterprises, or
invests them in securities.
The borrower or former holder of securities will spend the new money on various goods
and services.
Eventually, the money going the rounds will reach an owner who is a client of another
bank, B.
At that point, Bank B will call upon Bank A to redeem its receipt in gold, so that the
gold can be transferred to Bank B's vaults.
Clearly, the wider the extent of each bank's clientele and the more the clients trade with
with one another, the more scope there is for each bank to expand its credit and money
supply.
For if the bank's clientele is narrow, then soon after its issue of created money it will
be called upon to redeem, and, as we have seen, it doesn't have the wherewithal to redeem
more than a fraction of its obligations.
To avoid the threat of bankruptcy from this quarter, then, the narrower the scope of a
bank's clientele, the greater the fraction of gold it must keep in reserve, and the less
it can expand. If there is one bank in each country, there will be far more scope for
expansion than if there is one bank for every two persons in the community. Other things
being equal then, the more banks there are and the tinier their size, the harder and
better the monetary supply will be. Similarly, a bank's clientele will also be limited by
those who don't use a bank at all. The more people use actual gold instead of bank money,
and the less room there is for bank inflation.
Suppose, however, that the banks form a cartel and agree to pay out each other's receipts
and not call for redemption, and suppose further that bank money is in universal use.
Are there any limits left on bank expansion?
Yes, there remains the check of client confidence in the banks.
As bank credit and the money supply expand further and further, more and more clients
will get worried over the lowering of the reserve fraction, and in a truly free society
those who know the truth about the real insolvency of the banking system will be able to form
anti-bank leagues to urge clients to get their money out before it is too late.
In short, leagues to urge bank runs or the threat of their formation will be able to
stop and reverse the monetary expansion.
None of this discussion is meant to impugn the general practice of credit, which has
an important and vital function on the free market.
In a credit transaction, the possessor of money, a good useful in the present, exchanges
it for an IOU payable at some future date, the IOU being a future good, and the interest
charge reflects the higher valuation of present goods over future goods on the market.
Banknotes or deposits are not credit. They are warehouse receipts, instantaneous claims
to cash, that is, gold, in the bank vaults. The debtor makes sure that he pays his debt
when payment becomes due. The fractional reserve banker can never pay more than a small fraction
of his outstanding liabilities.
We turn in the next chapter to a study of the various forms of governmental interference
13. Summary.
What have we learned about money in a free society? We have learned that all money has
originated and must originate in a useful commodity chosen by the free market as a medium
System of Exchange.
The unit of money is simply a unit of weight of the monetary commodity, usually a metal
such as gold or silver.
Under freedom, the commodities chosen as money, their shape and form, are left to the voluntary
decisions of free individuals.
Private coinage, therefore, is just as legitimate and worthwhile as any business activity.
The price of money is its purchasing power in terms of all goods in the economy, and
This is determined by its supply and by every individual's demand for money.
Any attempt by government to fix the price will interfere with the satisfaction of people's
demands for money.
If people find it more convenient to use more than one metal as money, the exchange rate
between them on the market will be determined by the relative demands and supplies and will
tend to equal the ratios of their respective purchasing power.
Since there is enough supply of a metal to permit the market to choose it as money, no
increase in supply can improve its monetary function. An increase in money supply will
then merely dilute the effectiveness of each ounce of money without helping the economy.
An increased stock of gold or silver, however, fulfills more non-monetary wants—ornament,
industrial purposes, etc. served by the metal, and is therefore socially useful.
Inflation, an increase in money substitutes not covered by an increase in the metal stock,
is never socially useful, but merely benefits one set of people at the expense of another.
Inflation, being a fraudulent invasion of property, could not take place on the free
market.
In sum, freedom can run a monetary system as superbly as it runs the rest of the economy.
Contrary to many writers, there is nothing special about money that requires extensive
governmental dictation.
Here too, free men will best and most smoothly supply all their economic wants.
For money, as for all other activities of man, liberty is the mother, not the daughter,
of order.