The great worry that hastened the establishment of the world’s central banks was that monies tended to fluctuate in value. Here, I explain how such ‘fluctuating money values’ came about and — importantly — how this attribute has since mutated. Hopefully, by the end of this article it should be clear that it is changing money, and not fluctuating money values, that one should be focussed on!
Exuberance & Regret in Redeemable Currency Systems: Unstable Money Values with by and large Stable Monies
In the redeemable currency systems of the past, paper banknotes were issued against gold at specific rates. Meaning, people held banknotes as a matter of convenience; they were free to take those notes to the issuing bank to swap their notes for gold coin (and/or bullion) at the agreed upon rate.
For anyone who’s even slightly familiar with the history of banking, the following should be unsurprising: Currency issuers (typically, banks) often noticed that large amounts of the specie in their vaults remained dormant for long periods of time. Consequently, they periodically succumbed to the temptation to issue more claims upon specie (banknotes) than could be honored given the amount of reserves in their vaults. As these inflations of banknotes were often hidden from the public eye (and didn’t endanger redeemability with immediate effect), the augmented supply of banknotes would tend to bid up the money prices of things. As the newly created banknotes most frequently entered into the economy via loans to businesses, the money prices of productive assets tended to rise first. Resultantly, established businesses would be often be surprised by the continual increases in the money values of their assets (i.e. their net asset values would surprise on the upside). The typical result would be a euphoric rise in general business conditions and a tentative euphoria among the working classes (tentative in the latter case because wages often lagged price rises).
However, all this time we must remember that the currency was unchanged in consistency (that is, the currency remained a redeemable claim upon a specific quantity of gold), it was only the excessive issuance of notes that had induced the boom. So, eventually, the outstanding stock of notes (claims upon gold) would increase to intolerable levels compared to the amount of reserves backing those notes. Resultantly, there would be a rush to redeem notes for gold, and — as banks rushed to recall their rogue excessive notes all at once — the money values of things would revert to their former levels. Thus, the cycle would complete. Although the money values of things often went on roller-coaster rides, the money itself would — usually — remain constant. The period would be characterized by exuberance and regret, but not an altogether changing money.
[Incidentally, modern-day financiers unaffectionately refer to this type of currency system as a 'currency peg'.]
Inviting Governments to Solve the Very Problems that it Created:
It should be noted that scenarios such as the one described above were only possible because of intervention by governments. In a free banking system, any given bank cannot expand its banknotes in excess of its specie without quickly being checked by other banks. For example, if a Bank A issued notes in excess of its gold with any gusto, those notes would eventually end up being exchanged among market participants and deposited into other banks. Upon the other banks receiving those notes, they would present them to bank A for redemption, thus forcing Bank A to reduce the degree of its monetary laxness. It was only by simultaneous expansion that banks were able to issue excess notes to any significant degree. Moreover, due to the fact that cartels don’t hold up without the threat of the gun, it was government intervention in the money production business that enabled long periods of inflation and deflation.
So, these periods of ‘fluctuating money values’ but ‘stable monies’ were — to be sure — by and large enabled by governmental intervention. However, governments and their democratic electors are renown for their attempts to have their cakes and eat them too. So, to combat the unpalatable circumstance where money values would fluctuate wildly, governments sought to fully cartelize their banking systems via the introductions of central banks. In this way, they pursued the folly of attempting to solve the unintended consequences of governmental intervention with governmental intervention.
Compartmentalized Thought & The Legacy of the Price Index
I find that the rudimentary problem behind this kind of thinking is the tendency to ‘compartmentalize’ various issues. In this case, governments and their pet academics honed in on what they perceived to be an undesirable thing about the former currency systems: fluctuating money values. Then they sought to attack it using any means possible but without considering anything else – meaning, without proper consideration of reality. In short, they looked at that ‘compartment’ of the world, isolated it into an imaginary vacuum, sought to ‘fix’ it (again in the vacuum scenario), and thus concluded what they thought was a suitable policy response for the real world. The misstep – if you will – was in assuming that they could apply their intellectual fantasies to the cold, hard and ontologically inflexible real world. Their great folly (that continues to this day) was to think that their intellectual convictions (derived in a vacuum) were applicable to reality. In other words, their great folly was acting on intellectual convictions that did not correspond to the objects to which they referred.
Thus came the obsession with price indices. People loathed the fluctuations in the price level. So democratically elected officials and academics, in attempts to placate the ire of the masses, sought to ‘fix’ it. For the average guy, it was ‘consumer prices’ that mattered, so their great attempt shifted towards keeping those prices stable. Nowadays, it is said that an increase in the CPI is inflation. Is there any greater indication of the legacy of compartmentalized thought in monetary affairs?
Fluctuating money values were a sign of health!
In fact, fluctuating money values were a sign of health rather than illness! The drastic fluctuations in money values were a signal that the follies of the inflation had been purged. Those fluctuations honored the fact that each person owned himself/herself in addition to the property that he/she legitimately acquired. If monies were to be debased (that is, notes to be made ‘equal to’ a lesser amount of gold), then surely property would have been taken from the prudent to pay for the mistakes of the imprudent (a dastardly philosophy indeed!).
There was something quite open about the former redeemable currency systems. As was said above, it was often the case that the stock of notes (claims upon gold) would increase well in excess of the stock of gold backing those notes. Often, when this came to be realized, the subsequent deflation of money prices would prove too onerous for people empowered with democratic votes. That is, the people would say; ‘WE DON’T LIKE THIS!’. A way to get around the deflation in prices would be to debase the notes. Meaning, decrease the amount of gold that you can get with each note. This would imply that the stock of gold would be able to meet the outstanding stock of banknotes with greater ease.
Now, to be sure, the practice of ‘revaluing’ (aka debasing) banknotes was a debauched practice. It transferred wealth from the productive people in the economy to the unproductive: – thus endorsing the notion that idiots should survive at the expense of the intelligent and prudent. However, at least it had to occur out in the open. That is, the officials had to publicly announce their stupidity and indulgence for all to see. As is to be seen below, it is quite different these days…
Periodic & Open Monetary Debauchery Turned into a Secretive & Daily Affair:
With the passing into current irredeemable fiat currency systems of the world, this property of monetary debasement being an open and embarrassing ordeal disappeared. In irredeemable fiat currency systems, there is no ‘promise’ as such. Hence, each note in existence is an irredeemable claim upon a tiny slice of the entire portfolio of assets that backs it. Therefore, as the structure of the currency issuer’s assets and liabilities change, so does the money. That is, as central banks buy and sell securities, they alter the composition and size of their assets and liabilities, thus implying that each banknote in existence changes to an irredeemable claim upon a tiny proportfion of a quantitatively and qualitatively different portfolio of assets. In this way, any change to a central bank’s balance sheet can constitute monetary debasement. Hence, there are no formal and embarassing annoucements to go along with monetary debauchery. In modern day irredeemable fiat currency systems, monetary debasement is a daily and secretive affair!
In what sense can monies be said to be ‘the same’ through time?
So, if each Federal Reserve note, Pound Sterling note and Euro note is an irredeemable claim upon a tiny slice of the Federal Reserve’s, Bank of England’s and ECB’s portfolios of assets (respectively); and if those portfolios of assets are changing on a weekly basis, then in what sense can monies be said to be ‘the same’ through time?
Well, Jim Grant’s insight immediately comes to mind: that we are currently on a ‘PhD Standard’. The dollar is only a constant in the sense that it is constantly subject to the whims of the PhD overlords. Moreover, since currencies other than the dollar are by and large backed by the dollar, we have mini ‘PhD Standards’ all over the world that all bow down to the PhD-est of all PhD’s: the PhD’s at the Fed.
There is a great intellectual legacy that pays a lot of attention to fluctuating money values. Particularly in our age, people discount things by the rate of change in the consumer price index; supposedly to get the ‘real‘ version of various calculations. Although this method has its uses, it misses the key point: in modern-day irredeemable fiat currency systems, the monies themselves are changing materially every single day! The only way that you can call – say – a dollar ‘the same through time’ is in the sense that its consistency is declared and decided by the same committee of bureaucrats!
Aftab Singh is an independent analyst. He writes about markets & political economy at http://greshams-law.com .
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