Sunday, March 3, 2013

How is Fiat Money Possible?—or, The Devolution of Money and Credit

Fiat money is the term for a medium of exchange which is neither a commercial commodity, a consumer, a producer good, nor title to any such commodity. It is irredeemable paper money. In contrast, commodity money refers to a medium of exchange which is either a commercial commodity or a title thereto.

There is no doubt that fiat money is possible. Its theoretical possibility was recognized long ago, and since 1971, when the last remnants of a former international gold (commodity) standard were abolished, all monies have in fact been nothing but irredeemable pieces of paper.

The question to be addressed in this paper is how is a fiat money possible? More specifically, can fiat money arise as the natural outcome of the interactions between self-interested individuals; or, is it possible to introduce it without violating either principles of justice or economic efficiency?

It will be argued that the answer to the latter question must be negative, and that no fiat money can ever arise “innocently” or “immaculately.” The arguments advancing this thesis will be largely constructive and systematic. However, given the fact that the thesis has frequently been disputed, along the way various prominent counterarguments will be criticized. Specifically, the arguments of the monetarists, especially Irving Fisher and Milton Friedman, and of some Austrian “free bankers,” especially Lawrence White and George Selgin, in ethical and/or economic support of either a total or a fractional fiat money will be refuted.


Man participates in an exchange economy (instead of remaining in self-sufficient isolation) insofar as he prefers more goods over less and is capable of recognizing the higher productivity of a system of division of labor. The same narrow intelligence and self-interest is sufficient to explain the emergence of a—and ultimately only one—commodity money and a—and ultimately only one, worldwide—monetary economy. 1 Finding their markets as buyers and sellers of goods restricted to instances of double coincidence of wants (A wants what B has and B wants what A has), each person may still expand his own market and thus profit more fully from the advantages of extended division of labor if he is willing to accept not only directly useful goods in exchange, but also goods with a higher degree of marketability than those surrendered. For even if they have no direct usevalue to an actor, the ownership of relatively more marketable goods implies by definition that such goods may in turn be more easily resold for other, directly useful goods in later exchanges, and hence that their owner has come closer to reaching an ultimate goal unattainable through direct exchange.

Motivated only by self-interest and based on the observation that directly traded goods possess different degrees of marketability, some individuals begin to demand specific goods not for their own sake but for the sake of employing them as a medium of exchange. By adding a new component to the pre-existing (barter) demand for these goods, their marketability is still further enhanced. Based on their perception of this fact, other market participants increasingly choose the same goods for their inventory of exchange media, as it is in their own interest to select such commodities as media of exchange that are already employed by others for the same purpose. Initially, a variety of goods may be in demand as common media of exchange. However, since a good is demanded as a medium of exchange—rather than for consumption or production purposes—in order to facilitate future purchases of directly serviceable goods (i.e., to help one buy more cheaply) and simultaneously widen one’s market as a seller of directly useful goods and services (i.e., help one sell more dearly), the more widely a commodity is used as a medium of exchange, the better it will perform its function. Because each market participant naturally prefers the acquisition of a more marketable and, in the end, universally marketable medium of exchange to that of a less or non-universally marketable one,

there would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.

With this, and historically with the establishment of the international gold standard in the course of the nineteenth century (until 1914), the end desired through any one market participant’s demand for media of exchange is fully accomplished. With the prices of all consumer and capital goods expressed in terms of a single commodity, demand and supply can take effect on a worldwide scale, unrestricted by absences of double coincidence of wants. Because of its universal acceptability, accounting in terms of such money contains the most complete and accurate expression of any producers’ opportunity costs. At the same time, with only one universal money in use—rather than several ones of limited acceptability—the market participants’ expenditures (of directly serviceable goods) on holdings of only indirectly useful media of exchange are optimally economized; and with expenditures on indirectly useful goods so economized, real wealth (wealth in the form of stocks of producer and consumer goods) is optimized as well.

According to a long—Spanish-French-Austrian-American—tradition of monetary theory, 3 a money’s originary function—arising out of the existence of uncertainty—is that of a medium of exchange. Money must emerge as a commodity money because something can be demanded as a medium of exchange only if it has a pre-existing barter demand (indeed, it must have been a highly marketable barter commodity), and the competition between monies qua media of exchange inevitably leads to a tendency of converging toward a single money—as the most easily resold and readily accepted commodity.

In light of this, several popular notions of monetary theory are immediately revealed as misguided or fallacious.

What about the idea of a commodity reserve currency? Can bundles (baskets) of goods or titles thereto be money? 4 No, because bundles of different goods are by definition less easily salable than the most easily salable of its various components, and hence commodity baskets are uniquely unsuited to perform the function of a medium of exchange (and it thus is no mere accident that no historical examples for such money exist).

What about the—Friedmanite—idea of freely fluctuating “national monies” or of “optimal currency areas?” 5 It must be regarded as absurd, except as an intermediate step in the development of an inter-national money. Strictly speaking, a monetary system with rival monies of freely fluctuating exchange rates is still a system of partial barter, riddled with the problem of requiring double coincidence of wants in order for exchanges to take place. The lasting existence of such a system is dysfunctional of the very purpose of money: of facilitating exchange (instead of making it more difficult) and of expanding one’s market (rather than restricting it). There are no more “optimal”—local, regional, national or multinational monies or currency areas than there are “optimal trading areas.” Instead, as long as more wealth is preferred to less and under conditions of uncertainty, just as the only “optimal” trading area is the whole world market, so the only “optimal” money is one money and the only “optimal” currency area the entire globe.

What about the idea, central to monetarist thought since Irving Fisher, that money is a “measure of value” and of the notion of monetary “stabilization?” 6 It represents a tangle of confusion and falsehood. First and foremost, while there exists a motive, a purpose for actors wanting to own media of exchange, no motive, purpose or need can be discovered for wanting to possess a measure of value. Action and exchange are expressive of preferences—each person values what he acquires more highly than what he surrenders—not of identity or equivalency. No one ever needs to measure value. It is easily explained why actors would use cardinal numbers—to count—and construct measurement instruments—to measure space, weight, mass and time: In a world of quantitative determinateness, where means can only produce limited effects, counting and measuring are the prerequisite for successful action. But what imaginable technical or economic need could there possibly be for a measure of value?

Second, setting these difficulties aside for a moment and assuming that money indeed measures value (such that the money price paid for a good represents a cardinal measure of this good’s value) in the same way as a ruler measures space, another insurmountable problem results. Then the question arises “what is the value of this measure of value?” Surely it must have value just as a ruler must have value, otherwise no one would want to own either one. Yet it would obviously be absurd to answer that the value of a unit of money—one dollar—is one. One what? Such a reply would be as nonsensical as answering a question concerning the value of a yardstick by saying “one yard.” The value of a cardinal measure cannot be expressed in terms of this measure itself. Rather, its value must be expressed in ordinal terms: It is better to have cardinal numbers and measures of length or weight than merely to have ordinal measures at one’s disposal. Likewise it is better if, because of the existence of a medium of exchange, one is able to resort to cardinal numbers in one’s costaccounting, rather than having to rely solely on ordinal accounting procedures, as would be the case in a barter economy. But it is impossible to express in cardinal terms how much more valuable the former techniques are as compared with the latter. Only ordinal judgments are possible. It is precisely in this sense, then, that ordinal numbers—ranking, preferring—must be regarded as more fundamental than cardinal ones and value be considered an irreducibly subjective, nonquantifiable magnitude.

Moreover, if it were indeed the function of money to serve as a measure of value, one must wonder why the demand for such a thing should ever systematically exceed one per person. The demand for rulers, scales, and clocks, for instance, exceeds one per person only because of differences in location (handiness) or the possibility of their breaking or failing. Apart from this, at any given point in time and space, no one would want to hold more than one measurement instrument of homogeneous quality, because a single measurement instrument can render all possible measurement services. A second instrument of its kind would be useless.

Third, in any case, whatever the characteristicum specificum of money may be, money is a good. Yet if it is a good, then it falls under the law of marginal utility, and this law contradicts any notion of a stable- or constant-valued good. The law follows from the proposition that every actor, at any given point in time, acts in accordance with his subjective preference scale and chooses to do what he expects—rightly or wrongly—to satisfy him more rather than less, and that in so doing he must invariably employ quantitatively definite (limited) units of qualitatively distinct goods as means and thus, by implication, must be capable of recognizing unit-additions and -subtractions to and from his supply of means. From this incontestably true proposition it follows that an actor always prefers a larger supply of a good over a smaller one (he ranks the marginal utility of a larger sized unit of a good higher than that of a smaller sized unit of the same good) and that any increment to the supply of a good by an additional unit—of any unit-size that an actor considers and distinguishes as relevant—will be ranked lower (valued less) than any same-sized unit of this good already in one’s possession, for it can only be employed as a means for the removal of an uneasiness deemed less urgent than the least urgent one up-to-now satisfied by the same sized unit of this good. In other words, the marginal utility of a given-sized unit of a good decreases or increases as the supply of such units increases or decreases. Each change in the supply of a good therefore leads to a change in this good’s marginal utility. Any change in the supply of a good A, as perceived by an actor X, leads to X’s re-evaluation of A. X attaches a different value-rank to A now. Hence, the search for a stable or constant-valued good is obviously illusory from the outset, on a par with wanting to square the circle, for every action involves exchange, and every exchange alters the supply of some good. It either results in a diminution of the supply of a good (as in pure consumption), or it leads to a diminution of one and an incrementation of another (as in production or interpersonal exchange). In either case, as supplies are changed in the course of any action, so are the values of the goods involved. To act is to purposefully alter the value of goods. Hence, a stable-valued good—money or anything else—must be considered a constructive or praxeological impossibility.

Finally, as regards the idea of a money—a dollar—of constant purchasing power, there is the fundamental problem that the purchasing power of money cannot be measured and that the construction of price indices—any index—is scientifically arbitrary. (What goods are to be included? What relative weight should be attached to each of them? What about the problem that individual actors value the same things differently and are concerned about different commodity baskets, or that the same individual evaluates the same basket differently at different times? What is one to do with changes in the quality of goods or with entirely new products?) 7 Moreover, what is so great about “stable” purchasing power anyway (however that term maybe arbitrarily defined)? To be sure, it is obviously preferable to have a “stable” money rather than an “inflationary” one. Yet surely a money whose purchasing power per unit increased—“deflationary” money—would be preferable to a “stable” one.
What about the thesis that in the absence of any legal restrictions money—non-interest-bearing cash—would be completely replaced by interest-bearing securities? 8 Such displacement is conceivable only in equilibrium, where there is no uncertainty and hence no one could gain any satisfaction from being prepared for future contingencies as these are per assumption ruled out of existence. Under the omnipresent human condition of uncertainty, however, even if all legal restrictions on free entry were removed, a demand for non-interest-bearing cash—as distinct from a demand for equity or debt claims (stocks, bonds or mutual fund shares)—would necessarily remain in effect, for whatever the specific nature of these claims may be, they represent titles to producer goods, otherwise they cannot yield interest. Yet even the most easily convertible production factor must be less salable than the most salable one of its final products, and hence, even the most liquid security can never perform the same service of preparing its owner for future contingencies as can be provided by the most marketable final non-interest-bearing product: money. All of this could be different only if it were assumed—as Wallace in accordance with the Chicago School’s egalitarian predispositions tacitly does—that all goods are equally marketable. Then, by definition there is no difference between the salability of cash and securities. However, then all goods must be assumed to be identical to each other, and if this were the case neither division of labor nor markets would exist.

Economics and Ethics of Private Property: Studies in Political Economy and Philosophy, The

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