Chapter 12. Money and Spending

CHAPTER 12

MONEY AND SPENDING

1. The Quantity Theory of Money

The quantity theory of money holds that the volume of spending in the economic system, for goods, for labor, or any other broad economic category of things, is determined primarily by the quantity of money that exists in the economic system. To state the theory in the simplest possible terms: the amount of money that is spent is determined primarily by the amount of money that exists. The quantity theory of money can be expressed in terms of the following simple equation, which relates the quantity of money to aggregate demand in the sense of the volume of spending:

M × V = D , where M is the quantity of money in the economic system, D is the aggregate demand, as manifested in a definite total expenditure of money in the economic system, and V is the average number of times a unit of the money supply is spent in the period (i.e., the socalled velocity of circulation of money).

For example, as these words are written, the money supply in the United States is approximately $1,150 billion. The socalled gross domestic product (GDP) (formerly gross national product or GNP), which is the most commonly used measure of aggregate spending, is approximately $6,700 billion. 1 The implied average number of times a dollar is spent in a way that counts in GDP is thus approximately 5.8.

The money supply embraces all directly spendable money—all commonly used means of payment. In the context of modern economic conditions, this includes paper currency, coin, and, quantitatively most important nowadays, checking-account balances (including balances transferable by telephone or computer). As of the end of 1993, the money supply of the United States amounted to $329 billion of coin and currency, including $8 billion of outstanding traveler’s checks, and $799 billion of checking account balances. The total money supply, therefore, amounted to $1,128 billion. 2

GDP currently consists almost 90 percent of consumption expenditures: $4,585 billion reported as personal consumption expenditures, $1,169 billion of government expenditures for goods and services, almost all of which is consumption, and a further substantial portion of the $284 billion reported as investment in residential structures, but which in fact is consumption. 3 Thus, out of a current GDP of approximately $6,700 billion, well over $5,700 billion represents one form or another of consumption expenditure.

Because it is comprised overwhelmingly of consumption spending, GDP can be taken as an approximate measure of aggregate consumer demand in the economic system. The velocity of circulation figure which relates GDP and the money supply could be termed GDP velocity or consumption velocity, since it reflects the number of times the average dollar of the money supply is spent in a way that counts in GDP, which essentially means: is spent for consumption. However, because of the virtual equivalence of GDP and consumption spending with national income, it happens that this measure of velocity is called income velocity. 4 In any case, for the sake of

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504 CAPITALISM greater accuracy, the above formula relating the quantity of money and aggregate demand should be rewritten as

M × V = D C , where D C is the aggregate demand for consumers’ goods, as manifested in a definite total expenditure of money to buy consumers’ goods.

For many purposes, it is necessary to use a larger measure of total spending than GDP or consumption. Total aggregate demand for all products, consumers’ goods or capital goods, is one such measure; that plus all wage payments (a concept I refer to as Gross National Revenue—GNR) is another; total spending of all kinds, including for stocks, bonds, and other securities, is yet a third. 5 When these measures of aggregate demand are used, a correspondingly different figure for velocity of circulation results. The best known is called transactions velocity, which relates the quantity of money to the total of spending of every description.

The relationship between the quantity of money and the volume of spending in the economic system (whether that volume is conceived of relatively narrowly, as consisting merely of consumption spending, or more broadly) can begin to be understood by grasping the following simple and obvious connection between more money and more demand. Namely, an increase in the quantity of money raises demand because when the new and additional money comes into existence, its owners spend it. Those upon whom the new money is spent, in turn, respend it. The additional money is spent and respent over and over again, so long as it continues in existence. And in this way it raises the amount of spending that takes place in any given year.

It is probably easiest to visualize this process in the conditions of a gold standard, in which gold coins are money. Thus imagine that we are back in the old West, and some miners discover gold. They take their gold to the mint and have it manufactured into coins. Then they spend the coins in a frontier town. The merchants on whom they spend them turn around and subsequently respend them. And so it goes, with the new coins being spent and respent over and over and thus raising the aggregate demand of any given year. 6

Nothing essential in the process is changed, except for the way that new and additional money comes into existence, if we substitute present-day paper currency and checkbook money for the gold coins of the old West. Thus, suppose that the U.S. Treasury is running short of money. It calls up its banker, the Federal Reserve System, and asks for a loan. The Federal Reserve receives some securities from the Treasury—bonds, Treasury bills, or whichever—and credits the Treasury’s checking account with the proceeds of the loan. The Federal Reserve could print currency for the Treasury and the Treasury could simply spend the currency. But under modern conditions the Treasury wants to make payments by check, not by currency. So the Federal Reserve credits the Treasury’s checking account, and new and additional money has come into existence at the stroke of a pen (or the touch of a few computer keys).

Having received a credit to its account, the Treasury can now write additional checks. It sends out, let us assume, a batch of social security checks. The recipients of these checks take them to their banks. They can either cash them or deposit them in their own checking accounts. It does not matter which they do. If they cash them, the banks will have to take the checks to the Federal Reserve System and obtain currency for the checks. Then the situation from this point on is literally a matter of the printing of money. The currency the social security recipients get they will spend, and those on whom they spend it will respend it, and so on. New and additional paper currency will pass from hand to hand, just as in our earlier example new and additional gold coins passed from hand to hand.

But suppose the social security recipients deposit the checks in their checking accounts. In this case, they are in a position to write additional checks of their own and they now spend their social security payments in this way instead of spending currency. Those to whom they write checks in turn deposit the checks in their checking accounts, and subsequently write checks of their own. In this case, checking deposits pass from hand to hand instead of currency. In all essentials, the process is identical with the spending of currency.

Of course, at any time, the recipient of a check is free to cash it and obtain currency, just as the owner of currency is free to deposit it and write checks. The point is that money is created equally by the expansion of the currency or the checking deposits of the Federal Reserve System. It circulates equally in the form of the passage of currency or the passage of checking balances from hand to hand.

Unlike gold and silver, however, the paper and checkbook money of the government can be created virtually without limit and without cost. While gold and silver are rare in nature and typically require laborious mining operations in their supply, the quantity of paper and checkbook money is not limited even by the supply of paper—additional zeros can be printed on the same paper. The cost of printing any piece of paper money, whether a dollar bill or a hundred dollar bill, is only a fraction of a cent. The cost of crediting the Treasury’s checking account with a billion dollars is not much greater. As a result, there is nothing intrinsic to paper or checkbook money that operates to preserve its value.

MONEY AND SPENDING 505

Paper and checkbook money can be created by the government in any quantity, for any purpose, for all practical purposes, effortlessly and costlessly. The power to create it constitutes an unlimited power to buy up the people’s wealth and depreciate the value of money. I will show later on to what extent the government has already used this power. (From now on, incidentally, for the sake of brevity of expression, I will generally use the words “paper money” as standing both for currency and checkbook money.)

The Quantity Theory of Money as the Explanation of Rising Prices

The quantity theory of money explains the persistent rise in prices experienced in the United States and all other countries over the last two generations or more. In the simplest possible terms, the value of money, like the value of anything else, is determined by its quantity. The greater the quantity of any good, the lower is the value of that good. The greater the quantity of money, the lower is the value of money. A lower value of money, of course, means higher prices of goods.

The same thought can be expressed more precisely by means of our equation for aggregate demand. However, we must add to that equation the further equation for expressing the general consumer price level in terms of the relationship between the aggregate demand for consumers’ goods and the aggregate supply of consumers’ goods. The demand/supply equation states that

P = D C

S C where P is the general level of consumers’ goods prices, in the sense of the weighted average of the prices at which consumers’ goods are actually sold, D C , is the aggregate demand for consumers’ goods, as manifested in a definite total expenditure of money to buy consumers’ goods, and S C is the aggregate supply of consumers’ goods, as manifested in a definite total quantity of consumers’ goods produced and sold.

As used in the above equation, and everywhere throughout this book, unless indicated otherwise, the term demand means the willingness combined with the ability to spend money, as manifested in the expenditure of a definite amount of money. Similarly, supply means the existence of goods combined with the willingness of their owners to sell them, as manifested in the sale of a definite quantity of goods. 7

The above formula shows that the general consumer price level is merely the arithmetical quotient of a numerator divided by a denominator. Demand is the numerator, and supply is the denominator. It is important to learn to think of the price level in just these terms, namely, as the arithmetical quotient of a numerator—demand—divided by a denominator—supply.

Let us use some concrete numbers in our formula, to make it more real. Thus, consider initially the price of a single good, say, the price at which packs of cigarettes are sold in a given supermarket in a given week. We want to know what is the average price at which packs of cigarettes in that supermarket were sold last week. To find the answer, we must divide the number of packs sold into the total expenditure to buy those packs, that is, the supply into the demand. If, for example, one thousand packs were sold for one thousand dollars, then the average price at which a pack was sold was one dollar. In exactly the same way, we could calculate the average price at which a pair of shoes was sold last week in a given shoe store, and similarly for any good in any period of time.

All we need do is realize that exactly the same principle applies to the general consumer price level in the sense of the weighted average of the prices at which consumers’ goods are sold in the economic system as a whole. At this level of analysis, we must conceive of cigarettes, shoes, and all other goods as representing varying quantities of an abstract unit of goods in general and thus as capable of being added up into an aggregate supply. Whatever the concrete difficulties we might encounter in attempting to implement this concept, the basic idea is very clear and we repeatedly rely on it in our thinking. For example, no one has any doubt that the aggregate production and supply of consumers’ goods in the United States today is far greater than it was a century or even a generation ago, or that it is far greater than the aggregate production and supply of consumers’ goods in contemporary Great Britain, say.

Thus let us conceive of an economic system in which the total spending for consumers’ goods during the year is a trillion (i.e., one thousand billion) dollars, and in which the abstract quantity of consumers’ goods that is sold is one billion units. In this case, it is clear that the general consumer price level must be one thousand dollars per unit. It equals the division of the demand by the supply. The essential point to grasp here is that the general consumer price level reflects the exchange of some definite overall quantity of consumers’ goods, in whatever units stated, against some definite overall expenditure of money to buy those consumers’ goods. As I stated in Chapter 7, in any given year, some definite mass of consumers’ goods—houses, cars, soap, matches, cigarettes, shoes, and everything else—exchanges against some definite overall expenditure of money. The mass of consumers’ goods goes up against the total expenditure of money to buy them, and the result, the arithmetical quotient, is the general consumer price level. 8

An expanding quantity of money operates to raise the general consumer price level by virtue of raising aggregate demand relative to aggregate supply. Aggregate demand rises while aggregate supply stays the same, or it rises more rapidly than aggregate supply. For example, while aggregate supply rises 2 percent in a year, aggregate demand rises by 6, 8, or 10 percent, with the result that the general consumer price level rises by 4, 6, or 8 percent in the year.

A system of fiat paper money, that is, a system in which the monetary unit is a mere piece of paper stamped as such by government officials—a system in which pieces of paper are not a claim to anything beyond themselves and thus themselves possess ultimate debt-paying power—such a system virtually guarantees that prices will rise. Under such a system, the increase in the quantity of money is limited only by the self-restraint of government officials. As will be shown, these officials have great incentives to increase the quantity of money and are under constant pressure to increase it. Hence, the quantity of money increases at a rate sufficient to increase aggregate demand more rapidly than aggregate supply, with the result that prices rise.

In contrast, it must be noted that under a system of commodity money, that is, for all practical purposes, a system in which the monetary unit is defined as a definite physical quantity of gold or silver, there is no inherent bias toward rising prices. The annual increase in the supply of gold and silver is always extremely limited because of the rarity of these metals in nature and the great cost of mining them. The greatest ingenuity of man has never been able to increase their supply very rapidly for very long. As a result, the use of a gold or silver money can never be accompanied by a sustained rapid rise in demand, or, therefore, in prices. Even when the New World was discovered and the accumulated treasure of the Aztecs and Incas was seized by Spain and added to the money supply of Europe, and many new discoveries of gold and silver were made, it took an entire century in most of the countries of Europe for prices to double or triple.

In normal circumstances, under a precious metals monetary system, the increase in the quantity of money is largely an accompaniment of the general increase in the ability to produce; it is the result of improvements in such fields as machinery, the means of transportation, and the sciences of engineering, metallurgy, and chemistry. Indeed, in normal circumstances a gold or silver money is accompanied by constant or even falling prices, because the limited increase in demand that larger supplies of gold and silver make possible tends to be offset, or more than offset, by equal or greater increases in the supply of other goods. The quantity of money grows, but usually not at a more rapid pace than production in general, indeed, quite possibly at a slower pace. In the latter case, the general consumer price level falls. This last fact is well illustrated by the economic history of the United States: prices actually fell in almost every year in the generation preceding the discovery of the California gold fields in 1848, and again in the generation from 1873 to 1896.

2. The Origin and Evolution of Money and the Contemporary Monetary System

It is necessary to explain how the present monetary system of paper and checkbook money, and the government’s unlimited power to create money, came into being, and, before that, how the precious metals came to be money, and, still earlier, how money of any kind originated.

Money evolved out of barter. What made it evolve was the actions of individuals in serving their self-interests. As explained in Chapter 5, in conditions of barter, exchanges are confined to situations in which a double coincidence of wants exists, that is, a situation in which each of two people holds opposite valuations with respect to goods they possess, with each valuing the good in the possession of the other more highly than the good that is in his own possession. For example, A who possesses a chocolate bar prefers the pack of cigarettes possessed by B, while B prefers A’s chocolate bar to his (B’s) pack of cigarettes. When, as was frequently the case, a double coincidence of wants was not present, no exchange could take place. 9

Some of our more intelligent ancestors who encountered the problem of the lack of a double coincidence of wants invented the practice of indirect exchange, which others soon copied. 10 What this means is that they exchanged the goods they possessed and wished to exchange, for other goods which they themselves did not desire but which the individuals whose goods they sought did desire.

For example, the owner of a boat who desired a team of horses owned by someone who did not desire a boat, exchanged the boat for goods that the owner of the horses did desire, or which people possessing such goods desired. Perhaps he would exchange his boat for an ox that the owner of the horses desired; perhaps he first had to exchange it for a quantity of iron or wheat or whatever before he could obtain the ox desired by the owner of the horses. (The complications of this example, incidentally, would be multiplied thousands of times over in the case of anyone who would attempt to live as a specialist in a barter economy. Such an individual would have to go through a comparable process of multiple exchanges in

order to obtain practically any good or service he desired, unless his own good happened to be the kind frequently sought by large numbers of people. As we have seen this is why significant division of labor is impossible in a barter economy. 11 )

Thus, people began to exchange their goods for other goods which they sought neither as articles of personal consumption nor as means of further production, but as means of effecting further exchanges. In this way, media of exchange began to develop.

In this process, certain goods naturally come to be more widely preferred as media of exchange than others. Other things being equal, the larger the number of users of a good as an ordinary commodity and the more frequent their use of it, the more it would be preferred as a medium of exchange. For once in possession of such a good, the likelihood of finding someone who possessed what one desired and who was willing to accept this good would be substantially greater than the likelihood of finding someone who possessed what one desired and who was willing to take either one’s original good or any other good.

It is on this principle that in societies of nomads, cattle emerge as a kind of money. Practically all nomads want more cattle, as the means of supporting larger families and larger numbers of servants. As a result, anyone who wants something from nomads is more likely to be able to obtain it if he can offer them cattle. It was on the same principle that in the years immediately following World War II, cigarettes emerged as a medium of exchange in the black markets of various European countries. The large number of people seeking cigarettes to smoke made cigarettes a logical good even for nonsmokers to seek in exchange for their goods. Once in possession of cigarettes, the likelihood of finding someone in possession of the goods one wanted was greatly increased.

The example of cigarettes contains a further principle. Namely, the process of certain goods being selected as media of exchange in preference to others tends to be self-reinforcing and cumulative. As soon as nonsmokers become willing to accept cigarettes, because of the large number of smokers to trade with, the effect is to increase the ability of cigarettes to serve as a medium of exchange, because now they are more widely acceptable than before. It is in this way that the acceptability of the most preferred medium or media of exchange tends to go on increasing, until it or they are universally acceptable— i.e., have developed into money. Money is merely a medium of exchange whose use has grown to the point where it is directly and readily exchangeable against all other goods in a given geographical area.

In different periods of history, in different places, a variety of goods have served as media of exchange.

Among them have been cattle, sheep, hides, furs, cocoa, tobacco, salt, sea shells, beads, iron, copper, and, of course, gold and silver. Everywhere, however, the rise of civilization was accompanied by the triumph of gold and silver over all other contenders for the office of money.

This was no accident. The rise of civilization entails fixed settlements, trade over great distances, and economic activity spanning long periods of time. Such developments make the use of animal or vegetable products as media of exchange unsuitable. Such things are all perishable and relatively expensive for dwellers in fixed settlements to transport or store. In comparison with them, practically any of the metals is superior because of its imperishability and lower costs of storage. The metals are also divisible and recombinable, something that is totally impossible in the case of animals, sea shells, beads, and the like. The precious metals have the further decisive advantage of representing a comparatively high exchange value in a small bulk. As a result, it is less costly to transport or store a given amount of exchange value in the form of gold or silver than in the form of iron, copper, tin, or any other base metal.

Furthermore, in comparison with precious stones, the precious metals have the advantage of uniformity, in that each quantity of a definite purity is perfectly substitutable for any other equal quantity of the same purity. This makes it far easier to appraise pieces of precious metal. The ability to divide and recombine units of precious metal also enormously widens the market for any given quantity. These circumstances greatly reduce the difference between the retail price, at which one must buy, and the wholesale price, at which one must sell. In the case of precious metals, this difference is relatively insignificant. In the case of precious stones, it is very considerable.

Thus, the precious metals came to be money because they are the most suitable commodities for most people to save. 12 Their desirability as a means of saving—as a socalled store of value—made them acceptable to large numbers of people as a means of payment, namely, to those who wanted to save them. A process occurred in which for some time those who held part of their savings in gold or silver originally had to buy gold or silver with an earlier existing money, such as the iron coins of the early Roman Republic, and then, when they wished to use the gold or silver to make purchases, sell the gold or silver for the existing money. But as the number of people who wished to hold precious metals as a store of value reached a certain critical proportion of the population, individuals who possessed precious metals increasingly found that they could exchange them directly with other individuals who possessed the goods they desired and who, for their part, wished to add to their own gold or

silver holdings. The willingness of a significant number of people to accept the precious metals in exchange led others, who did not wish to hold the precious metals as a store of value, also to accept them in exchange—in the knowledge that they could reexchange them with those who did. This, of course, increased the acceptability of the precious metals as media of exchange and on that basis made them still more acceptable as media of exchange.

The holding of precious metals as a store of value and their growing use as media of exchange represented an additional demand for them over and above the demand for them as ordinary commodities. This additional demand could be met only with increasing difficulty, because of the comparative rarity of these metals in nature. The result was a rise in the value of the precious metals, which further reinforced their suitability as a store of value and medium of exchange. Thus, the precious metals more and more supplanted previously existing moneys. The culmination of the process was the establishment of gold and silver as money throughout the civilized world.

The growing demand for precious metals as a store of value and as a medium of exchange operated to prevent the kind of sudden substantial changes in value to which most other commodities are subject. For now changes in the supply of the precious metals did not have to be taken out of, or added on to, merely a relatively narrow commodity usage, but the increasingly broad usage as a store of value and medium of exchange as well. The demand for these purposes tends to be more stable than an ordinary commodity demand. Furthermore, the existence of a large accumulated stock of precious metals relative to their annual production operated greatly to mitigate the effect of changes in their annual production on their overall supply. For example, a 10 percent increase or decrease in the annual production represents approximately only a 1 percent increase or decrease in the total supply if the accumulated stock is on the order of nine or ten times the annual production. In addition, the extent to which the precious metals are used as ordinary commodities relative to their use as a store of value and medium of exchange is much smaller than could ever be the case with base metals such as iron or copper, and therefore, their value is correspondingly more stable.

Because of the relative stability of their value, the precious metals came to be a preferred medium in which to write contracts and state debts. In turn, the development of a class of people with obligations payable in the precious metals made them eager to exchange their goods and services for the precious metals, so that they would have the means of meeting their obligations. This, too, obviously contributed to the development of the precious metals into money.

Coinage—the certification of the weight and fineness of specific pieces of the precious metals—followed their widespread use as a store of value and medium of exchange. Coinage performed the valuable function of sparing people the need to weigh and test individual pieces of metal. Instead, they could simply visually inspect the coins and count them out in making payment. Interestingly, the names of leading monetary units originally meant nothing other than definite weights of precious metal. For example, an English pound (in France, a livre; in Italy, a lire) meant an actual pound’s weight of pure silver on the troy scale. The original English penny contained an actual penny’s weight—one 240th of a troy pound—of pure silver.

In the Western World, gold and silver coins were money from the time of the early Roman Republic down to the twentieth century. (The period of the Dark Ages represented a hiatus, in which the economic system operated at an extremely primitive level, virtually without money and with hardly any division of labor.)

In modern times, starting very slowly, and gradually accelerating in the sixteenth and seventeenth centuries, and then more rapidly accelerating in the eighteenth and nineteenth centuries, the use of paper money developed. Paper money came into existence as transferable claims to gold and silver coins that were payable on demand to the holders of the paper. The practice developed of people leaving gold and silver on deposit with smiths, for safe keeping. In exchange, they were issued receipts. When these receipts were issued for specific sums, such as one pound, and, at the same time, were transferable, they were the ancestors of our present-day paper currency. When they were issued in a form that allowed the owner of the deposit to draw drafts on (i.e., write orders to) the smith specifying the amount to be paid to a specific individual, they were the ancestors of our present-day checking accounts. The smiths themselves, of course, were the ancestors of modern bankers.

Over the course of centuries, as the result of steadily increasing government intervention in their favor, paper currency and checks gradually displaced gold and silver in active circulation—to the point where, today, several generations of people have grown up with the experience of government paper as a universally acceptable medium of exchange. Today, everyone is willing to accept paper money in payment for his goods because he has had the constantly repeated experience, and thus has the expectation, that everyone else is willing to accept it and thus that he can use it to obtain whatever goods or services he wishes.

In the United States, a critical step in the displacement of the precious metals by paper occurred in the Civil War,

as the result of the government’s issuance of greenbacks and then the enactment of the National Bank Act of 1863. Prior to the Civil War, the federal government was held to be constitutionally prohibited from issuing paper money, as were the states. Thus, from the enactment of the Constitution down to the Civil War, the only governmentally issued money in the United States was gold and silver coin. Banknotes—that is, privately issued paper currency—as well as checkbook money, were the liability of thousands of separate private banks. Because of the vast number of different kinds of banknotes, each with a different appearance, size, and color—in other words, a variation comparable to that between the stock certificates of today’s corporations—the circulation of banknotes was strictly limited. Large manuals, comparable to today’s Moody’s or Standard and Poor’s were required to keep track of the financial condition of the various banks issuing the notes, with the result that outside of the immediate locale of the issuing bank, banknotes were accepted only by experts or at a steep discount. Only gold or silver coin were universally acceptable. These facts underlay a substantial demand for gold or silver coin as a means of exchange. 13

The greenbacks and the National Bank Act changed that. The National Bank Act placed a prohibitive tax on the issuance of private banknotes and instead made possible the issuance of national banknotes. Those banks which joined the newly created national banking system were entitled to issue national banknotes, which were backed partly by gold and partly by government securities. These notes had a uniform size, color, and appearance. Though technically issued by the separate national banks, they were actually a government paper currency. The establishment of redeemability of the greenbacks into gold in 1879 further strengthened the movement toward paper money.

The effect of a government paper currency redeemable in gold was that the demand for actual gold coin fell. People regarded the paper as equivalent to gold—as “as good as gold”—and increasingly used the paper in place of gold. Decade by decade following the Civil War, the quantity of gold coin in actual circulation steadily diminished. The gold was deposited in the banking system. The smaller banks redeposited it with the larger banks. By the time of World War I, almost all of the country’s gold supply was held by the banking system, most of it by a small number of very large banks in New York City.

The Federal Reserve System was established in 1913. During World War I, an amendment to the Federal Reserve Act required that the banks turn over their gold to the Federal Reserve Banks, in exchange for checking deposits with the Federal Reserve Banks. Thus, practically all of the country’s gold came into the possession of the government during World War I. In 1933, under the New Deal, the government seized the remaining privately held gold at the same time that it abolished the domestic redeemability of the dollar—i.e., the right of holders of paper money to redeem their paper at the rate of one dollar for approximately one-twentieth of an ounce of gold.

The government’s rationale for the seizure of privately held gold during World War I was its alleged need to be able to increase the quantity of money at a more rapid rate than would otherwise have been possible. This was held to be necessary to finance the war effort. On the basis of a mechanism to be explained shortly, and whose operation rested on government intervention, the private banking system had gained the ability to use gold in its possession—that is, its gold reserves—to support a quantity of paper-money claims to gold approximately four times as great. Substituting checking deposits with the Federal Reserve System for gold reserves left this four-to-one ratio on the part of the private banking system intact and, at the same time, made possible a vast expansion in bank reserves. Because now the Federal Reserve System could use the gold in its possession to increase the reserves of the banks in approximately a four-to-one ratio to its gold holdings. Thus, the same amount of gold was enabled to support approximately sixteen dollars of paper claims to gold instead of only four dollars of paper claims to gold. (This process is known as the pyramiding of reserves.)

In 1933, the government’s rationale for the seizure of the remaining privately held gold was that its plan to increase the official price of gold above the then-prevailing $20.67 per ounce would otherwise create a corresponding “windfall profit” for private owners of gold. The more fundamental and by far the more important motive, however, was, once again, the desire to be able to increase the supply of money more rapidly than would otherwise have been possible. At an official price of $35 per ounce—the price prevailing from 1935 to 1968—the same physical quantity of gold was made capable of supporting correspondingly more paper dollars.

Contrary to the fears of some people at the time, the paper money did not immediately become worthless, even though it was no longer redeemable in gold. This was because several decades had gone by during which people had come to think of the government’s paper as money. Two generations had grown up observing the general use and acceptability of paper money. It was the paper, not the gold, that they observed everyone being willing to accept, and which, therefore, they themselves desired as the means of making purchases. Thus, even though paper money lost its redeemability in gold, without which it could never have come into existence in the

first place, almost all of the demand for it remained, with the result that it did not go out of existence with the loss of that redeemability.

In the later thirties and during World War II, the U.S. government came into possession of a vastly larger quantity of gold, as the gold holdings of the European nations were run down by their policies of rapid inflation, their need to import vital supplies from the United States, and the desire of their citizens and governments to have a haven secure from foreign conquest. Together with the rise in the official price of gold from $20.67 to $35 per ounce, these enlarged gold holdings made it possible for a time for the U.S. government to go on increasing the quantity of paper money as rapidly as it wished. This could go on so long as the gold reserves owned by the U.S. government were larger than the gold reserves it was legally required to have—in other words, so long as it possessed excess gold reserves. For example, if the Federal Reserve System has outstanding $50 billion of currency and checking deposits (the latter category held by banks as reserves) against which it is legally required to hold, say, $15 billion in gold reserves, but it actually possesses $25 billion in gold reserves, it is in a position to expand the currency and reserves of the banks by an additional two-thirds before its gold reserve requirement becomes an effective limit on its ability to create money.

Thus, the U.S. government was in a position to create money during World War II and for approximately two decades following World War II, even though it was nominally on a form of gold standard. Finally, however, once the reserves of the banks and the paper currency were expanded sufficiently, the gold reserve requirement had to become effective. Indeed, the date of its becoming effective was accelerated by the government’s policy of trying to maintain a quasi-free-market price of gold of $35 per ounce, which it did in order to try to make good the claim that internationally the dollar was “as good as gold.” (Under the Bretton Woods agreement of 1945, the dollar was to be internationally convertible to gold and was to be the principal monetary reserve behind most other currencies.)

The U.S. government lost a major portion of its gold reserves in attempting to maintain the $35-an-ounce price in the London gold market, which was reopened in 1951. In this market, governments and private individuals from around the world were free to buy and sell gold. (American and British citizens were excluded from the market, however. It had been illegal for American citizens to own gold for monetary purposes since 1933.) Whenever the demand for gold threatened to outrun the supply at a price of $35 per ounce, the U.S. government simply dipped into its gold reserves and supplied whatever amount of gold was necessary to maintain the $35-an-ounce price. As time went on, however, it became necessary to supply ever larger amounts of gold to keep the price at the $35 level.

The policy of attempting to maintain the $35-anounce price was doomed from the beginning, because so long as the supply of money grows more rapidly than the supply of gold, a fixed price of gold means that gold tends to become cheaper and cheaper compared with other goods whose price the more rapidly growing quantity of money tends to raise. The consequence must be a steadily growing industrial demand for gold. The growing industrial demand for gold would alone have eventually absorbed the government’s gold reserves. But the process was accelerated by the fact that people recognized in advance what the ultimate result must be, and so began buying gold in anticipation of its ultimate rise in price. Such additional buying was denounced at the time as “speculative runs,” but it was nevertheless perfectly reasonable in view of the underlying circumstances.

By 1965, the government’s loss of gold had reached the point where it became necessary to abolish the gold reserve requirement that until then had been imposed on the Federal Reserve System. This became necessary in order for the expansion in the supply of dollars to continue. In 1968, the government abandoned the policy of selling gold to maintain the $35-an-ounce price on the London gold market. In 1971, it abandoned its obligation to redeem dollars held by foreign governments or central banks. Since that time, the price of gold has greatly increased, reaching a peak of approximately $800 an ounce in early 1980. As these words are written, it is approximately $400 an ounce.

Since 1975, it has once again become legal for American citizens to own gold for monetary purposes. It has also become legal once again to write contracts that make debts payable in terms of gold. (This last provision still lacks real substance, however, since it is far from certain that the courts would enforce such contracts. Also, taxes would be incurred on the dollar income resulting from a rise in the price of gold.)

The Potential Spontaneous Remonetization of the

Precious Metals

For reasons to be explained in Chapter 19, a policy of inflation destroys the real profitability of the traditional forms of investment, such as bonds, stocks, and family businesses. The monetary value of such investments tends not to keep pace with the rise in prices. This makes it necessary for people who want to preserve the buying power of their wealth to seek out assets whose price will rise in pace with prices in general and whose costs of maintenance and storage are minimal. In the circum—

stances of most people, gold and silver are the ideal candidates—for the very same reasons that made them the leading store of value in earlier periods of history.

Thus, as inflation becomes perceived as a serious problem, a growing demand for gold and silver develops as an “inflation hedge”—i.e., as a store of value. Once this demand reaches a certain level, the stage becomes set for a spontaneous remonetization of the precious metals. For, just as in the process by which the precious metals became money in the first place, once enough people want to own gold and silver as an inflation hedge and thus are willing to accept them in exchange for their own goods and services, others become willing to accept them too, even though they themselves do not wish to hold them as an inflation hedge or store of value. Conditions exist, in other words, for a growing acceptability of the precious metals, to the point at which they become universally acceptable, i.e., become money once again.

It should be realized that the remonetization of the precious metals would be greatly accelerated if they were allowed to compete with paper money freely. There exist large quantities of gold and silver coins minted both when they served as actual money and more recently as “restrikes,” that is, reproductions of the older coins.

The way the freedom of competition would accelerate the remonetization of the precious metals can perhaps best be understood by thinking back to the year 1965, when silver coins were still in actual circulation in the United States. At that time, a $10 roll of silver quarters and a $10 bill could be used interchangeably to buy a quantity of groceries, say. By the mid-1980s, that same quantity of groceries cost about $30 in paper money. But the roll of silver quarters physically contained about seven ounces of pure silver. This means that at a market price of silver of $6 per ounce, which prevailed in the mid-1980s, the $10 roll of quarters had a market value of $42 based on its silver content. Thus, the purchase price of $30 for a given quantity of groceries represented less than three-fourths of a roll of silver quarters, or, looked at in terms of the face value of the quarters, less than $7.50 in terms of silver coins. If merchants had been legally allowed to discriminate between paper money and precious-metal coins, they would have sold the same quantity of groceries either for $30 in the paper money or for less than $7.50 in the silver money.

The same principle applies even more strongly in the case of our old gold coins. Prior to 1933, the United States had gold coins, known as double eagles, which had a face value of $20 and contained just under an ounce of pure gold. At today’s price of gold of almost $400 per ounce, a new automobile that sells for $12,000 in paper money would sell for about $600 in gold coin. (At the current market price of gold bullion of almost $400 per ounce, thirty $20 gold coins, each containing an ounce of gold, simultaneously represent $600 in gold and $12,000 in paper.)

Such facts would make it very obvious to the general public precisely where the problem of rising prices lay— namely, in the paper money. And this knowledge, in turn, would operate to reduce the demand for paper money and increase the demand for precious-metal money. People would want to have their pensions payable in gold or silver. Creditors would want the money due them to be stated in gold or silver. This, of course, would further increase the demand for precious metals and decrease the demand for paper money. In an environment of prices steadily rising in paper money, but constant or, more likely, falling in precious metal-money, the demand for paper money would soon be wiped out altogether. Just as people prefer a better soup or automobile to a poorer soup or automobile, they prefer a better money to a poorer money. Under free competition, the only way paper money could stay in circulation would be by being made redeemable in the precious metals.

This discussion may appear to contradict Gresham’s Law. It shows that under free competition “good money drives out bad money,” while Gresham’s Law states that “bad money drives out good money.” There is no contradiction when it is realized that Gresham’s Law applies to circumstances in which the freedom of competition is prohibited. What drives out good money is the fact that businessmen are prohibited from accepting it at its actual value. This is the case today. Any buyer who wished to buy with gold or silver coins today would be required to use them as though they were worth no more than the paper money. To buy a $12,000 automobile with double eagles, the buyer would be required to pay six hundred such coins, for this is the quantity that is required to have a face value of $12,000. In other words, he would be required to part with gold that had a market value of $240,000, in order to buy something worth only $12,000. The buyer using silver coins in our groceries example would be required to part with three rolls of quarters, having a market value of $126, in order to buy $30 worth of goods. Under such conditions it is not difficult to understand why the better money ceases to circulate as money. People will not sacrifice what is better when it is treated equivalently to what is poorer. But when what is better can be treated as better, as when gold and silver coins can circulate at their bullion value, then, indeed, good money drives out bad.

The Government and the Banking System

It is impossible to understand the extent to which the government has increased the quantity of money without understanding how the government has encouraged the

creation of money by the private banking system.

What we must deal with here is how the government has encouraged the existence of what von Mises calls “fiduciary media.” 14 Fiduciary media are transferable claims to standard money, payable by the issuer on demand, and accepted in commerce as the equivalent of standard money, but for which no standard money actually exists. The larger part of our money supply today consists of fiduciary media in the form of checking deposits.

Standard money in contrast is money that is not itself a claim to anything further. It possesses ultimate debt-paying power, in that when it is received no further claim to be paid is present. Under a gold standard, standard money is gold. Any paper money that exists is a claim to it. Under a system of irredeemable paper money—fiat money—the irredeemable paper money is the standard money. In the present conditions of the United States, the standard money consists of the supply of Federal Reserve notes and, for all practical purposes, the checking deposit liabilities of the Federal Reserve System, which are fully equivalent to the notes. It is essentially the same as what is referred to as “the monetary base,” which is the sum of currency in circulation outside banks plus bank reserves.

An analysis of the composition of the present U.S. money supply will make the concept of fiduciary media clearer. As previously stated, the total U.S. money supply at the end of 1993 was $1,128 billion, and of this, $799 billion were in the form of checking deposits held at the various banks.

Now, checking deposits are not standard money. They are a liability—a debt—of the various banks. They are a promise of the banks to pay standard money on demand to their depositors. They circulate as the equivalent of standard money so long as no one questions the ability of the banks to meet that promise. Against these $799 billion of checking deposit liabilities the banks held on the order of $60 billion of standard money as reserves— partly in the form of currency in their actual possession, partly in the form of deposits with the Federal Reserve System. 15 Thus, $799 billion of checking deposits were backed by $60 billion of standard money. The difference—$739 billion—represents fiduciary media. Fiduciary media are the portion of checking deposit liabilities of the banks not covered by standard money.

Fiduciary media under present conditions come into existence in either of two ways. One way is the lending out of standard money that has been deposited in checking accounts. The other way is the creation of new and additional checking deposits without benefit of new and additional standard money. Let us consider an example of each, as illustrated in Figure 12–1, which shows socalled T–accounts for the public and the banking system.

Figure 12–1 shows an individual who deposits $100 of standard money into his checking account. In doing this, the individual does not part with the use of his money, because he can spend the checking deposit itself. He is minus currency in the amount of $100 but plus a checking deposit in the amount of $100, which is shown on the very next line. His action represents merely a change in the form in which he holds his money. It is equivalent in principle to exchanging a ten dollar bill for

Figure 12–1

The Creation of

Fiduciary Media

The Public

Assets Minus Currency $100 (1) Plus Checking Deposit $100 (1) Plus Currency $80 (2), or Plus Checking Deposit $80 (2a)

Liabilities

Plus IOU’S to Banks $80 (2 or 2a)

The Banking System

Assets Plus Currency $100 (1) Plus IOU’S from Public $80 (2 or 2a) Minus Currency $80 (2)

Liabilities Plus Checking Deposit $100 (1) Plus Checking Deposit $80 (2a)

two fives. This transaction is labeled (1) in the T-account of the public and in the T-account of the banking system. The banking system is simultaneously plus $100 in currency and plus a checking deposit liability of $100, which entries are shown on opposite sides of the T-account.

If the bank now lends out any part of the $100 of standard money that has been deposited, it necessarily increases the total quantity of money in circulation, because the depositor still has his $100 that he can spend by writing checks, and the borrower from the bank now has whatever it lends him. A transaction in which the bank lends out $80 is labeled (2) in the T-account of the public. The public is shown both to receive $80 of currency and to become indebted to the banking system in the amount of $80. (Again, these entries are shown on opposite sides of the T-account.) The same transaction is also shown from the point of view of the banking system, where it is also labeled (2) and describes how the banking system is plus $80 in IOUs from the public and, on the next line, minus currency in the amount of $80. The essential point is that the spendable funds of the public equal the sum of the $100 they have deposited into a checking account plus whatever part of that $100 they then borrow from the banking system. For both the funds they have deposited and the funds they borrow represent spendable money.

The second way in which fiduciary media are created arises because of the popularity of payment by check. The borrower in our example would probably not want currency; he would probably want to make payments by check. As a result, instead of lending him currency, the bank would credit his checking account with the proceeds of the loan. Observe. Here we have a new and additional checking deposit coming into existence without benefit of any additional quantity of standard money on hand. This transaction is labeled (2a) in the T-accounts. It shows the public as simultaneously plus $80 in a checking deposit and, as before, plus $80 in indebtedness to the banking system. The banking system is shown as plus $80 in IOU’s from the public, as before, and plus $80 in checking deposit liabilities instead of being minus $80 in currency. Again, just as when the bank lent currency, there are $80 of additional spendable money.

Now, the supporters of fiduciary media are quick to point out that fiduciary media are not without backing of any kind. They are backed, they say, by the loans and investments banks make in creating them and by the capitals of the banks. For example, when a bank creates a checking deposit of $80 for a borrower, the bank’s assets also grow by $80—the $80 now owed to the bank by the borrower. And the borrower may have had to put up collateral worth more than $80. In addition, the bank has its own capital that is lent out or invested, and this provides further backing, it is argued. As a result, the $733 billion of presently outstanding fiduciary media are backed by assets totaling more than $733 billion.

And, of course, an alternative way of looking at fiduciary media is that of the fractional-reserve principle. For example, instead of viewing the present $799 billion of checking deposits as representing $60 billion backed 100 percent by standard money and $733 billion backed by no standard money, one can view each dollar of checking deposits as backed by a uniform fraction of standard money—in our case, by 60 ⁄ 799 of a dollar of standard money. The remaining 733 ⁄ 799 of each dollar of checking deposits could be viewed as backed by the loans and investments of the banks. Whichever way we view them, fiduciary media are a kind of debt money. They are a debt of the banks, backed by debt, but circulating as money. 16

The great problem of fiduciary media is that they set up money and debt like a house of cards or row of dominoes that any breeze can knock over. Observe. The safety and value of the fiduciary media are supposed to depend on the value of the assets behind them. What is overlooked by the supporters of fiduciary media, however, is that the value of the assets behind them depends on the continued existence of the fiduciary media themselves. To grasp this point clearly, let us assume that there is a failure of a single large bank that has issued fiduciary media. Such a failure could result from the failure of business enterprises to which the bank had made loans. The effect of the bank failure is actually to reduce the quantity of money in the economic system by the amount of that bank’s checking deposits. Checking deposits held at a bank that has failed lose the character of money. They cease to be accepted as the equivalent of money in trade. Their status becomes that of an uncertain claim against the bank—a claim that may or may not be paid, to some unknown extent, at some future time.

Now, if the quantity of money actually falls, then, the quantity theory of money tells us, the demand for goods must fall. And as demand falls, the money revenues of businesses and the money incomes of individuals fall, because they are constituted by demand. As their revenues and incomes fall, the ability of people to pay debts falls, including, of course, their debt to banks. At the same time, the effect of a reduced quantity of money is to reduce the market value of assets that banks hold as collateral, such as stock-market collateral and the value of the property on which they hold mortgages. It is very easy, therefore, for the failure of one bank that has issued fiduciary media to cause the failure of several others— because the wiping out of its fiduciary media endangers the money value of their assets, on which their fiduciary media rest.

Indeed, once started, the process of bank failures tends to gain momentum: an initial failure wipes out money, which reduces the ability to spend money and thus to earn money and repay debts. The reduction in the ability to repay debts reduces the income and assets of banks and this in turn causes more bank failures and wipes out more money, with the effect of still greater declines in spending, sales revenues and incomes, asset values, and thus the ability to repay debts. Once begun, the process can lead, and again and again in our history has led, to periods of major deflation following periods in which the money supply was first inflated in the form of fiduciary media. The last such period of deflation was 1929 to 1933, following the expansionary period of World War I and the 1920s. In that period, the quantity of money fell by more than 25 percent and the volume of spending, as gauged by GDP, fell by almost 50 percent. Today there is even more massive deflationary potential than in 1929 because a much longer, far greater expansion of fiduciary media has occurred than in the years prior to 1929.

It must be said immediately, however, that no one should expect the deflationary potential of our day to be realized, because today, unlike 1929, the Federal Reserve System has unlimited power to expand the quantity of standard money. It will almost certainly do so to whatever extent is necessary to prevent a reduction in the quantity of money. Normally, when a bank fails nowadays, arrangements are made for it to be taken over by another bank, without loss to its depositors. In recent years there have been a few cases of losses to depositors who held over the insured amount of $100,000, but in no case has this occurred at a major bank. Indeed, when Continental Illinois National Bank, one of the country’s major banks, was in danger of failing some years ago, the Federal Reserve and FDIC (Federal Deposit Insurance Corporation) made clear their willingness to make available however many billions of dollars might be necessary to prevent the failure.

This means that the government’s policy of money creation—of inflation—will continue and almost inevitably accelerate. Nevertheless, the Continental Illinois case still confirms the existence of the domino effect I have described. It was rescued precisely in order to avoid that effect. Its failure would have precipitated runs on other financially troubled banks. A substantial volume of checking deposits would have been wiped out, correspondingly reducing the quantity of money and volume of spending in the economic system. The consequence would have been the onset of a major depression, accompanied by waves of bank failures.

Economists who have recognized the inherent danger of fiduciary media, and who believe that there is no advantage to a country in a quantity of money that expends any more rapidly than gold and silver, have come to the conclusion that the ideal monetary system would be a 100-percent-metallic-reserve system. Under this system, all paper currency and checking deposits would be 100 percent backed by gold or silver. The advantage of such a system would be that not only would it be immune from inflation, but, unlike the fractional-reserve gold standard of the nineteenth century and the first decades of this century, it would also be immune from deflation. Because once gold or silver money comes into existence, it stays in existence. It is not wiped out by the failure of any debtor. Under such a system, financial failures do not become cumulative self-reinforcing waves. Such a system would offer the maximum of monetary stability.

The 100-percent-reserve system is logically urged only for checking deposits and banknotes (currency), not for savings deposits or time deposits. There is a crucial difference in that savings and time deposits do not represent spendable money as such. When an individual makes a savings deposit or a time deposit, he temporarily gives up the use of his money. He cannot spend the savings or time deposit as such. If he wants his money, he must go and withdraw his deposit or wait until it matures. He must obtain actual money. When a bank lends the proceeds of a savings or time deposit, therefore, it is not engaged in the creation of money, but merely in the transfer of a given amount of money from a lender— that is, the savings or time depositor—to a borrower. Under the 100-percent-reserve system, therefore, banks would continue to lend out savings and time deposits, just as now. For the rest, they would earn money by charging fees for the storage of precious metal, its transfer from checking account to checking account, the issue of banknotes, and whatever other services they might perform. 17

The supporters of the 100-percent-reserve principle divide into two groups. There are those who advocate its imposition by law. Those among this group who are committed to the principle of individual rights and laissez-faire capitalism justify this by claiming that the creation of fiduciary media is tantamount to counterfeiting and is fraudulent. They claim that it is the same in principle as accepting goods in a warehouse, issuing receipts for the goods, and then selling the goods; or selling more tickets to a theater performance than there are seats. 18

The second group holds that if the issuance of fiduciary media is conducted openly, without deception— that is, if it is no secret to the owners of banknotes and checking deposits that the backing for them is debt—one cannot outlaw the practice. These supporters of the 100-percent-reserve principle advocate its achievement by

means of a policy of free banking—that is, merely the total absence of all government intervention in banking. This view is well expressed in a passage quoted in von Mises’s Human Action from the nineteenth-century French economist Cernuschi. It was made in reference to fiduciary media in the form of banknotes, but it applies equally to fiduciary media in the form of checking deposits as well. Cernuschi said: “I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.” 19

In what follows, I content myself with providing an elaboration of the position of the second group of the supporters of the 100-percent-reserve principle—namely, the view that in an economy that was free of government interference in money and banking, the creation of fiduciary media would be legal, but for all practical purposes would not take place. This view is supported by such facts as that any granting of fiduciary media would place the customers of the banks that granted them in a position to expand their purchases from the customers of banks that did not grant them or granted them less rapidly, because such customers would have relatively more money to spend. The effect would be an adverse clearing balance against the expanding, or more rapidly expanding banks, which would thus lose reserves to the sounder banks.

The problems of the expanding banks would be further compounded by the existence of a growing demand for gold and silver coin on the part of the public. In conditions in which gold and silver coins are extensively used as money, this would occur as the by-product of any increase in the overall quantity of money. It would occur for much the same reasons as an increase in the demand for twenty dollar bills, say, when there is an increase in the quantity of money in the form of hundred dollar bills or ten dollar bills. Indeed, just as some of the hundreds or tens would be brought to banks for exchange into twenties, so, in an economic system in which gold or silver coin was extensively used, any increase in the supply of paper currency or checkbook money would necessarily be accompanied by the exchange of part of it for additional gold and silver coins, simply in order for people to maintain proper proportions among the different kinds of money they used. Such redemptions of currency and checkbook money, would, of course, represent an additional pressure on the banks’ reserves if they pursued a policy of increasing the supply of paper or checkbook money.

Moreover, in a banking system totally unprotected and unsupported by the government—a banking system without any form of government controls, government inspections, examinations, assurances, guarantees, or endorsements—people would realize that when they made deposits in banks that did not hold a 100 percent reserve, they were in fact taking some risk of loss. They would realize that what they were doing was granting credit, not holding money, and that if they wanted to grant credit, they had better learn how to read a bank’s balance sheet, how to evaluate it, and how to distinguish between good and bad banks. Those not prepared to do this, and whose real intention was to hold money, would realize that if that is what they wanted to do, they should hold deposits at 100-percent-reserve banks. The transferable deposits of fractional-reserve banks would cease to be regarded as money. They would be regarded as credit instruments, to be held only by those prepared to grant credit, not by people desiring to hold money.

All along, however, the government has sought to encourage the existence and growth of fiduciary media. The government has acted in the belief that the mere expansion of bank credit—i.e., the creation and lending out of fiduciary media—could create real capital goods and thus generate prosperity. From the beginning, the government was urged on and applauded by businessmen seeking lower rates of interest—seeking what they call “easy money.” What actually happened, of course, was not prosperity, but the trade cycle. 20

In the eighteenth and nineteenth centuries, fiduciary media were encouraged by the existence of government-supported central banks, such as the Bank of England and, in this country, the First and Second Banks of the United States. So long as the central banks were and are able to go on creating reserves, banks are rescued from the loss of reserves they would otherwise experience as the result of an adverse clearing balance with other banks. They are able to obtain fresh reserves, and in an even larger quantity. To the extent that the government or its central bank is able to substitute the use of its paper currency for gold and silver coin, it also reduces the pressure on reserves of a greater need for currency to keep pace with the overall growth in the quantity of money taking place. For the government can manufacture whatever additional paper currency it may wish, to replace lost reserves, while it cannot manufacture additional gold and silver coin as it may wish.

Again and again, when banks did fail, the government stepped in and allowed them to suspend payment in specie, in flagrant violation of their agreement to pay their depositors specie on demand. This prevented the wiping out of fractional-reserve banks and enabled such banks to return to issue still more fiduciary media. Restrictions on the formation of new banks and on the expansion of more conservatively managed existing banks—the latter in the form of restrictions on branch banking—also served to promote the existence of fiduciary media. This was the result insofar as the effect of the free competition

of such banks, if it had been allowed, would have been a greater problem of adverse clearing balances for banks expanding their issue of fiduciary media. In addition, all government measures that built confidence in the banking system, such as imposing minimum capital requirements, double liability for bank stockholders, and bank examinations, also importantly aided in the promotion of fiduciary media in the eighteenth and nineteenth centuries.

In this century, the government has encouraged the expansion of fiduciary media principally through the Federal Reserve System. The Federal Reserve System has supplied the banking system with vastly larger reserves of standard money in the form of Federal Reserve notes and deposit credits than it could possibly have acquired if its reserves had had to be in a standard money of gold, as was the case before World War I. This more rapid growth in bank reserves of standard money has been a necessary foundation for the more rapid growth in checking deposits, because the deposits banks can create are always tied to the amount of standard-money reserves at their disposal. With more reserves, they can support more deposits, and so they create more deposits.

In addition, the government, again operating largely through the Federal Reserve System, has made it possible for any given volume of reserves to support a larger volume of deposits. It has done this by virtue of following one of the avowed objectives of the Federal Reserve’s foundation, which was to act as a “lender of last resort” to the commercial banks. The Federal Reserve System stands ready to lend standard money to the banks or buy assets from them whenever they require. This permits the banks to hold such assets as the Federal Reserve will lend money on or buy, in place of holding actual standard-money reserves. The result is an expansion of deposits relative to reserves, because when the banks acquire these assets, the sellers usually take the proceeds of their sale and bring them back to the banking system in the form of fresh deposits. For example, if a bank buys a Treasury bill, say, or commercial paper, in the knowledge that it can obtain standard money from the “Fed” by means of these assets, the seller of the asset now has standard money. He will almost certainly deposit this standard money in some bank. The effect is that the banking system now ends up with more deposits and with just as much standard money as it had initially. Thus, the same reserves of standard money now support a larger volume of deposits.

Finally, the government has further promoted the existence of fiduciary media in this century through such measures as deposit insurance, increased governmental supervision of banks, and increased control over the nature of the loans and investments banks can make. All of these measures promote confidence in fiduciary media by virtue of the government’s word rather than by virtue of the fact of financial soundness. If not for these and other such measures that I have described, some of them going back even before the nineteenth century, banks would have to hold far larger reserves in relation to checking deposits to instill the same degree of confidence.

In all of these ways, therefore, the government has been responsible for the creation of fiduciary media. It is against this background that the imposition of legal minimum reserve requirements by the Federal Reserve System must be viewed. For example, currently the Federal Reserve requires that on checking deposit liabilities in excess of $51.9-million, banks hold an amount equal to a minimum of 10 percent of such deposits as a reserve, in the form of currency on hand or checking account balance with the Federal Reserve. 21 This requirement exists in a situation in which current market conditions would enable the banks to get by with a smaller percentage of reserves. The preceding discussion makes it clear, however, that it would be a profound mistake to conclude from these facts that government intervention operates to impose higher reserve requirements than would a free market. For the imposition of the reserve requirements takes place in a context in which generations of government intervention, including the intervention directly carried out by the Federal Reserve System, has radically reduced the reserves that are required in current market conditions, which market conditions fully reflect the government’s intervention. The Federal Reserve’s minimum reserve requirements merely serve to prevent the banks’ reserve ratios from declining quite as far as all the other government intervention has made it possible for them to do.

On the basis of its responsibility for the creation of fiduciary media, the government must bear the responsibility for the boom-bust pattern of our economic history. In addition, of course, its promotion and support of fiduciary media have played a major role in the rapid increase in the quantity of money that has taken place in recent decades. Today, by virtue of the government’s unlimited ability to create standard money and to supply it to banks in need of it, and by virtue of its commitment to do so, fiduciary media can be considered as practically the equivalent of standard money created by the government itself, that is, as part of the overall supply of fiat money.

In the light of recent developments, this last statement must be qualified with respect to checking deposits held in smaller banks. As the result of substantial losses, and spurred on by recent legislation, the Federal Deposit Insurance Corporation has increasingly refused to make

good depositors’ losses on bank accounts in excess of $100,000, which is the current legal limit of its obligation. However, in the case of large banks, where a substantial number of depositors would be involved, the policy of the FDIC still appears to be that of making good all losses of depositors, irrespective of the amount. 22 Moreover, the Federal Reserve System is still in a position to rescue any bank it wishes, simply by providing the necessary funds either as a loan or as a purchase of assets.

Today, money is created in the first instance primarily by means of the socalled open market operation of the Federal Reserve System. That is, the Federal Reserve System enters the government securities market and buys outstanding government securities with standard money that is newly created, virtually out of thin air. When the sellers of the securities deposit the proceeds in their banks, the banks obtain additional deposits and equivalent additional reserves of standard money. On the basis of their additional reserves, they in turn create additional fiduciary media, whose redeemability in standard money is, of course, virtually guaranteed by the government, with the limited exception just mentioned. Government deficits are a constant source of new government securities, and for all practical purposes can be viewed as being financed directly by the Federal Reserve System, just as in the example of the social security checks earlier in this chapter.

Apart from ceasing all of its intervention in favor of fiduciary media, including its issuance of paper currency, there is one further important and totally legitimate step the government could take, short of prohibiting fiduciary media outright on the grounds of fraud. This is to follow the example of President Andrew Jackson’s specie circular and refuse to accept checks or private banknotes that are not 100 percent backed by gold or silver. To accept such checks or banknotes places the government in a position in which it can be construed as granting credit to the banks in question—in which, according to the supporters of fiduciary media, it is granting credit to those banks, inasmuch as it knowingly accepts claims that do not represent actual money, but largely debt. The government has no business granting credit to anyone. By all the ordinary principles of laissez faire, it should not be in business of any kind; it should not be a lending agency of any kind. The only way it can unequivocally avoid granting credit is if, insofar as any money is due it, it requires payment in specie or in notes or deposits that are 100 percent backed by specie. When it receives such money, it is fully and finally paid; in that case, no question can arise of its granting credit. Such a policy by the government would all by itself do a great deal to restrain the issuance of fiduciary media. Added to consistent abstention from all other acts favoring fiduciary media, it could well make their issuance virtually impossible.

3. The Quantity of Money and the Demand for Money

The volume of spending in the economic system is determined not only by the supply of money—the quantity of money—but also by the demand for money. The demand for money refers to the extent to which people desire to hold balances of money relative to the receipts they take in and the sums they pay out. People need to hold money in order to make purchases and pay bills in the future. Under varying circumstances, they choose to make a larger or a smaller demand for money. The greater is the demand for money, the greater are the balances of money that people wish to hold relative to their receipts and expenditures. The smaller is the demand for money, the smaller are the balances of money that people wish to hold relative to their receipts and expenditures.

It should be obvious from these statements that the socalled velocity of circulation of money is determined by the demand for money. The greater is the demand for money, the lower is the velocity of circulation of money. The smaller is the demand for money, the higher is the velocity of circulation of money.

The reason for this relationship between velocity and the desire to hold money can be understood by considering the case of any given individual who owns money. Imagine an individual who owns $1,000 in the form of currency or a checking-account balance. If this individual feels that he needs to hold, say, $700 out of his thousand in order to make purchases or pay bills in the period starting one week from the present, then the most he can afford to spend out of his thousand dollars this week is $300. If, however, he should decide that he only needs to hold, say, $600 for the period starting a week later, then, this week, he could afford to spend $400 out of the thousand he owns. Clearly, the individual’s ability to spend the money he owns is the greater, the less of it he needs or desires to hold for the future; and is the smaller, the more of it he needs or desires to hold for the future.

It follows that anything that occurs which makes individuals decide to reduce the cash they hold for the future will increase spending and therefore velocity. By the same token, anything that occurs that makes individuals decide that they need to increase the cash they hold for the future will reduce spending and therefore velocity.

To quantify the relationship between the demand for money and the velocity of money more precisely, a socalled income velocity of 4 reflects the fact that people want to hold balances of money equal to 1 ⁄ 4 of

their annual incomes and consumption expenditures. The higher income velocity of 6 reflects a lower demand for money balances, equal to only 1 ⁄ 6 of people’s annual incomes and consumption expenditures. The lower income velocity of 3 reflects a higher demand for money balances, equal to 1 ⁄ 3 of people’s annual incomes and consumption expenditures. Whenever the demand for money falls, people step up their expenditures out of their existing cash holdings, and thus velocity rises. Whenever the demand for money rises, people cut back on their expenditures, in an effort to increase their cash holdings, and thus velocity falls.

The demand for money is determined by a variety of factors. One of the most important, and, indeed, the most fundamental, is the security, or lack of security, of property. Where property is insecure—where it is subject to arbitrary confiscation by the government or to plunder by private gangs—saving and provision for the future will be low, because people will not be in a position to count on benefitting from it. But such saving and provision for the future as does occur will largely take the form of holding precious metals and gems—items easily concealable and easily transportable. A gold money in such circumstances has a very low velocity of circulation. 23

By the same token, under conditions in which property is secure from confiscation and plunder, the demand for gold for holding will be less, and thus the velocity of circulation of a gold money will be greater. The same result is aided by the development of financial markets and financial institutions, which make it easier and more profitable for people to invest their savings rather than hold them in the form of precious metals or precious stones.

Interestingly, the effect of lack of security of property is very different on a paper money than on a gold money. In conditions in which a government loses the power to stop private plunder or itself becomes a looter, people switch their savings from assets denominated in the government’s paper to precious metals and precious stones. They lose the desire to hold such paper, because it becomes more and more likely that the government will sharply reduce its value by rapidly increasing its supply. Thus, the velocity of a paper money tends to rise in such circumstances.

The velocity of money can also be increased by such developments as improvements in transportation, which reduce the time money is in transit and correspondingly increase the speed with which it is available for respending. The development of clearing houses reduces the amount of money that is required to perform a given volume of transactions: instead of all of the transactions needing to be effected by means of the transfer of money, only the settlement of the net amounts owed or owing, after the canceling of offsetting debts by the clearing process, needs to be effected by means of the actual transfer of money. The money set free by the clearing process is thereby made available for spending for other things. Thus, the total spending that the same quantity of money can effect is increased.

What is especially worthy of note is the fact that in the context of an economic system with developed financial institutions and financial markets, saving operates to raise the velocity of circulation of money. (This may be the cause of some surprise, in view of the popular fallacy that confuses saving with hoarding.) There are two reasons for this. First, under such conditions funds that are saved are likely to be made available for spending sooner than funds that are held for consumption. For example, the part of his paycheck that an individual deposits in his savings account is available for lending by the bank almost immediately. However, the part of his paycheck that he retains in his possession in the form of cash that he plans to spend on consumers’ goods in the coming days or weeks prior to his receipt of his next paycheck will enter into the hands of others only over the length of this considerably longer period. Second, to the extent that the availability of additional savings contributes to credit being readily available, it becomes possible for individuals and business firms to substitute to some extent the prospect of obtaining such credit for the holding of money as the means of providing for their future need for funds. To this extent, they reduce their cash holdings and thus bring about a rise in the velocity of circulation of money. 24

It should be realized that in the conditions in which the velocity of circulation of a gold money rises, there is unlikely to be any fall in the purchasing power of gold as a result. This is the case because the rise in velocity here is the accompaniment of a process that sharply increases the physical ability to produce—above all, the growth of saving and the channelling of those savings into productive investment. In addition, a further factor that must be mentioned, which is especially relevant in appraising the effects of the development of clearing procedures, is that the productive process also tends to become more complex at the same time that the demand for gold holdings falls. Because of the intensification of the division of labor, which is inextricably bound up both with the growth of saving and investment and the increase in production, a tendency exists toward an increase in the number of payments needed in the production and distribution of ultimate consumers’ goods. For example, instead of a farmer selling his food to a consumer, he sells it to a food processor, who sells to a wholesaler, who in turn sells to a retailer. Possibly several processors and wholesalers are involved. The intensification of such

specialization and its requirement for additional acts of exchange more or less keeps pace with the decline in the desire to own balances of gold. Consequently, while the total of spending of all types combined rises relative to the quantity of gold, it does not follow that spending specifically for consumers’ goods rises relative to the quantity of gold. In other words, the velocity that actually rises is the socalled transactions velocity, but not necessarily income velocity, or certainly not to the same degree. (Furthermore, it should not be assumed that either the fall in demand for gold holdings or the growth in complexity of the productive process necessarily goes on indefinitely.)

Changes in the Quantity of Money as the Cause of

Changes in the Demand for Money

There is a further source of changes in the demand for money—a source that would probably not be present at all under a 100-percent-reserve gold standard, but which exerts an extremely powerful influence under a fractional-reserve gold standard and under a system of fiat paper money. This is rapid changes in the supply of money itself.

Under a 100-percent-reserve gold standard, the supply of money increases no more rapidly than the supply of gold, which increase is almost always quite modest. 25 Equally important, for all practical purposes, the supply of money can never decrease under a 100-percent-reserve gold standard. The gold that people take to the grave with them in such things as dental fillings is dwarfed by the current production of gold. The occasional ship or plane that goes down carrying gold, which gold cannot then be found or salvaged, is also not enough to make a difference. Thus, as stated before, once a gold money comes into existence, it stays in existence. It is not wiped out by the failure of any debtor.

Under a fractional-reserve gold standard, on the other hand, there are periods in which the money supply can be increased relatively rapidly, by means of the issuance of fiduciary media. In these periods, the increase in the supply of money corresponds not only to the increase in the supply of gold, but also to the decrease in the ratio of gold reserves. And then, of course, when banks fail and their fiduciary media lose the character of money, the money supply can sharply decline.

Under a system of fiat paper money, the money supply can be increased at any rate the government desires. For reasons to be explained later in this book, a powerful tendency exists under this kind of monetary system for the increase in the quantity of money to accelerate. 26 The only intrinsic limit to such acceleration is the total destruction of the demand for the money, at which point the money ceases to be accepted in payment and loses its character as money. Examples of the process of an accelerating increase in the quantity of money carried to the point of the destruction of the fiat money concerned are the continental currency of the United States in the American Revolution, the French assignats during the French Revolution, the German mark following World War I, and the currency of nationalist China following World War II.

The connection between changes in the quantity of money and the demand for money is simply this: the more rapidly the quantity of money increases, the lower tends to be the demand for it; the less rapidly the quantity of money increases, the higher tends to be the demand for it. 27 In conditions in which the quantity of money actually decreases, the demand for money becomes all the greater. To state the relationship in terms of the velocity of circulation of money, the more rapidly the quantity of money increases, the higher tends to be the velocity of circulation of money; the less rapidly the quantity of money increases, the lower tends to be the velocity of circulation of money. In the face of a decrease in the quantity of money, velocity tends to be lower still.

We can find some immediate confirmation of this principle if we ask which currencies people prefer to own and why—for example, Argentine pesos, English pounds, or U.S. dollars? Obviously, the peso is the least desirable of the three currencies to own, and the dollar the most desirable. The reason the peso is the least desirable of the three to own is that it is the one whose quantity is most rapidly expanded and which therefore loses purchasing power the fastest. As a result, no one wants to own more than the barest minimum of pesos necessary to transact business in Argentina. The dollar, on the other hand, is the most desirable of the three to own, because its quantity is expanded the least rapidly and it therefore retains its purchasing power better than the others. Accordingly, among these three countries, the velocity of circulation of money is highest in Argentina and lowest in the United States. It is also higher in the United States today than it was in the United States in previous decades, when the increase in the supply of dollars was less rapid.

There are four avenues by which changes in the quantity of money affect the demand for money. Perhaps the most widely recognized is its effect on prices and the prospects for changes in prices. As was implicit in the previous paragraph, once an expanding quantity of money creates the expectation of rapidly rising prices in the future, people conclude that it pays to buy goods right away, before their prices rise further. They come to the conclusion that the continued holding of cash balances must cause them a substantial loss of purchasing power, and so they attempt to reduce their holdings of money. Conversely, the anticipation of a fall in prices in the

future, resulting from a contraction in the quantity of money and volume of spending, increases the desirability of owning money. In such circumstances, it pays people to postpone purchases in order to take advantage of lower prices in the future. 28

A second, closely related connection between changes in the quantity of money and the velocity of money concerns the ability to substitute holdings of other assets for holdings of money. If the quantity of money is rapidly increasing, it pays to hold other assets, such as inventories of various commodities, rather than money itself. In such circumstances, these other assets are a better source of meeting future needs for cash than the holding of money, because they can easily be sold for more money than they cost. This principle applies not only to businessmen holding inventories of commodities that they produce, but also to consumers. As inflation accelerates, it pays even the ordinary consumer to hold commodities as a source of future cash rather than cash itself—above all, gold and silver or less rapidly inflating foreign moneys.

Conversely, if the quantity of money decreases rather than increases, not only does the holding of commodities represent a financial loss while the purchasing power of money in contrast rises, but people also want to hold money even in place of such things as shortterm securities and savings and time deposits. This is because in such circumstances—namely, a deflation and depression—people cannot be sure of converting these near moneys into actual money, since the issuer of the securities or the bank where one has the deposit may go bankrupt first. These are major reasons why periods of deflation—i.e., of a decrease in the quantity of money/volume of spending—are periods of an intensified desire to hold money, and, therefore, of a drop in the velocity of money.

The two remaining reasons why increases in the quantity of money tend to increase velocity, and why decreases in the quantity of money tend to reduce it, pertain to the effects of changes in the quantity of money on the availability of credit and on interest rates.

The desire to hold money—especially on the part of business firms—is largely determined by the prospective availability of credit. If credit is expected to be available easily and profitably when funds are required, the perceived need and thus the desire to hold money will be correspondingly less. If credit is expected to be unavailable or available only with great difficulty and at a loss when funds are required, the perceived need and thus the desire to hold money will be correspondingly greater. In effect, as we have seen, prospective credit that is readily and profitably available serves as a substitute for the holding of money.

Now the increase or decrease in the money supply is a major factor determining the availability of credit at any given time. When the money supply is increasing, a very large portion of the increase usually enters the economic system in the form of new loans, with the result that credit is made easier. This is particularly true when the increase in the quantity of money takes the form of additional fiduciary media. It is what people have in mind when they talk of “easy money.” Conversely, when the money supply decreases, as in a depression accompanied by bank failures and the wiping out of fiduciary media, the decrease results in a sharp reduction in the availability of credit.

Thus, an expansion of the money supply reduces the perceived need to hold money through its effect on the current and prospective availability of credit. In an economy which has become accustomed to “easy money,” or which offers the prospect of “easy money,” businessmen will consider it safe to operate with lower money balances than they would otherwise. They will expect to be able to obtain a larger portion of the money they will later require, through credit at the time. Consequently, they will invest more fully, either in the purchase of physical assets or in the purchase of securities. And since those who receive this money will tend to behave in the same way, what occurs is an increase in the total volume of spending, lending, and trading of all kinds in relation to the quantity of money; that is, there is an increase in the velocity of money.

On the other hand, in a deflationary period, when the quantity of money is falling and credit is virtually unobtainable, businessmen find it necessary to hold relatively large money balances in order to be sure of being able to meet their obligations when they come due. In these conditions, there is a corresponding reduction in the velocity of circulation of money. 29

The final avenue that connects changes in the quantity of money and the velocity of circulation of money is by way of the rate of interest. As we know from Chapter 6, the basic determinant of the rate of interest is the rate of profit. 30 And as Chapter 16 will show, to this must be added the fact that an expanding quantity of money, in raising total spending and total sales revenues from year to year, raises the nominal rate of profit. 31 This rise in the nominal rate of profit brings about a rise in the nominal rate of interest. The rate of interest rises because the higher rate of profit permits business borrowers to offer a higher rate of interest, and their mutual competition for loans forces them to do so. Also, insofar as loanable funds are supplied by those who have the alternative of directly investing in business and earning profits, a rise in the rate of profit makes such lenders require a higher rate of interest as the condition of their finding it worthwhile to continue lending.

Here I must briefly digress, because the connection I have just described between the increase in the quantity of money and the rate of interest is the opposite of that which is usually believed to exist. The usual belief is that an increase in the quantity of money entering the loan market reduces the rate of interest. In view of the prevalence of this belief, some further comments on my part are in order.

An increase in the quantity of money can reduce the rate of interest only temporarily. As soon as the new and additional money is borrowed and spent, it begins to raise sales revenues and profit margins, and thus the rate of profit. The rise in the rate of profit then raises the rate of interest. To prevent the rate of interest from rising in the face of the higher rate of profit, an acceleration in the rate of credit expansion would be necessary. The effect of such an acceleration would be a still more rapid rate of increase in the volume of spending and thus in business sales revenues, with the result that profit margins and the rate of profit would rise still higher, which, of course, would operate all the more powerfully to raise the rate of interest. To prevent the rate of interest from rising at this point, an even more rapid rate of credit expansion would be required, which would cause yet a still higher rate of profit, and so on. Thus, the use of credit expansion to prevent the rise in the rate of interest that results from an increase in the quantity of money would quickly entail such enormous rates of increase in the quantity of money as to destroy the monetary system.

For example, starting with a rate of profit of 4 percent and a rate of interest of 3 percent, credit expansion might temporarily reduce the rate of interest to, say, 2.75 percent. But once the new and additional money succeeds in raising sales revenues and profit margins, the rate of profit rises to, say, 4.25 percent. To keep the rate of interest at 2.75 percent in the face of this higher rate of profit, requires more credit expansion than before. If it is forthcoming, then the rate of profit rises perhaps to 4.5 percent, which means that still more credit expansion will be required if the rate of interest is to be held at 2.75 percent. Since the difference between the rate of profit and the rate of interest steadily widens, making borrowing more and more profitable, exponentially increasing amounts of credit expansion would be required to prevent the rate of interest from rising. To avoid rapid destruction of the monetary system, there is no practical alternative but to allow the rate of interest to follow the rate of profit on up as the quantity of money increases. In pattern, the rise in interest rates in the United States over the thirtyfive years following World War II is explainable on the basis of a progressively more rapid rate of increase in the quantity of money, taking place in large measure in the form of credit expansion.

The mistaken notion that increases in the quantity of money reduce the rate of interest is largely the result of thinking of the rate of interest as “the price of money” and then applying the principle that increases in supply reduce prices. A more accurate description of the rate of interest than the price of money is the difference between the money that is borrowed and the money that is repaid. Thus, for example, one should think of the payment of a 10 percent rate of interest on a one-year loan of a thousand dollars not as a price for the borrowing of the thousand dollars, but as the difference between the eleven hundred dollars that will have to be repaid and the thousand dollars that is borrowed. If one thinks of interest this way, then it is not surprising that interest rates turn out to be higher rather than lower as the consequence of an increasing supply of money. Because to the extent that more money exists and is spent and earned at the time of repayment than at the time of borrowing—which is the necessary consequence of an increasing quantity of money—correspondingly more money is available to be repaid and is thus likely to have to be repaid than would otherwise be the case.

Thus, the effect of a more rapidly increasing quantity of money and volume of spending has been shown to be to raise the rate of interest after temporarily reducing it. As a result, it is possible to return to considering the connection between the increase in the quantity of money and the velocity of circulation of money that exists by way of the rate of interest.

The rise in the nominal rate of interest that results from a more rapid rate of increase in the quantity of money and volume of spending is significant in drawing out of cash holdings sums that it would not pay to invest at lower rates of interest. It does this by decreasing both the size of the principal and the period of time for which it must be invested in order to make lending worthwhile.

For example, at a 2 percent annual rate of interest, it would probably not pay in present conditions to lend $100,000 for a period as short as a week, because the interest that could be earned would amount only to about $40. (Two percent of $100,000 is $2,000, which, when divided by 50 weeks, equals $40.) If we assume that the minimum amount of interest that must be earned by a significant-sized business firm merely to cover the bookkeeping and related costs of a financial transaction, and thus make it worthwhile entering into, is $100, then the smallest-sized sum that it pays such a firm to lend out for a period as short as a week is $250,000, if the annual interest rate is 2 percent. (Two percent of $250,000 is $5,000, which, when divided by 50 weeks, equals $100.) At a 2 percent annual rate of interest, it would not pay to lend a sum as small as $100,000 for a period of less than two and a half weeks. However, at a 4 percent annual rate

of interest, it pays to lend a sum as small as $125,000 for a week, and it pays to lend $100,000 for a period as short as a week and a quarter. At still higher rates of interest, the minimum-sized sum that it pays to lend out for a given short period, such as a week, becomes still smaller, and the minimum period of time for which it pays to lend any given-sized sum, such as $100,000, shortens further.

Thus, as the rate of interest rises, it becomes profitable to lend out progressively smaller and shorter-term sums. Consequently, these sums are drawn out of cash holdings and into the stream of spending. Since there are always such sums in the possession of various firms, the effect of a rise in interest rates—itself caused by a more rapid increase in the quantity of money—is to elevate the velocity of money throughout the year. By the same token, of course, a fall in the rate of interest brought about by a reduction in the rate of increase in the quantity of money operates to decrease the velocity of money.

(In order to avoid a possible erroneous inference, I must point out that a reduction in the rate of profit and interest that might result from a higher rate of saving should not be presumed to increase the demand for money and thus reduce the velocity of money. This is because, as we saw earlier in this section, the greater availability of savings and thus credit, operates itself to reduce the demand for money. The same observation, of course, applies mutatis mutandis to increases in the rate of profit and interest caused by decreases in the rate of saving. In other words, the relationship between the rate of interest and the demand for money applies only insofar as the rate of interest is determined by changes in the quantity of money and volume of spending, not insofar as it is determined by the rate of saving.

I must also point out that it is of no relevance that the effect of increases in the quantity of money is not only to add to the rate of interest, but also progressively to increase the size of the minimum sum for which it is worthwhile to lend, at least in comparison with what it otherwise would have been. This is because the increase in the minimum-sized sum does not affect the proportion of the money supply that it pays to lend for given short periods of time at any given rate of interest. Other things being equal, an economic system with a doubled quantity of money and a doubled minimum-sized sum for which lending is worthwhile will tend to have the same proportion of its money supply available for shortterm lending at any given interest rate as an economic system with the original quantity of money. If, however, its interest rate is higher, because of a more rapid rate of increase in the quantity of money, it will tend to lend out a larger proportion of its money supply. Therefore, its velocity of circulation will be higher.)

Thus, in the four ways I have explained, increases in the quantity of money raise the velocity of money, and decreases in the quantity of money decrease it.

Let us turn to the historical statistics of the money supply and its velocity of circulation for verification of this relationship. These statistics are shown in Table 12–1.

In viewing the statistics, of course, we should not expect the relationship to hold with immediacy. Very importantly, the influence of earlier changes in the quantity of money can continue to be felt for a time after the direction of change in the quantity of money has been reversed. Thus, a period of inflation which begins after a sustained period of deflation, and in which people’s expectations continue to be influenced by their experience of deflation, will not be accompanied by an immediate rise in the velocity of circulation of money. On the contrary, it will be accompanied initially by a fall in the velocity of circulation of money. This will be the case in such an environment because people will want to take the opportunity of an increased availability of money to build up their cash reserves, as a precaution against renewed deflation. Only after a period of time has gone by, and the memory of the deflation has given way to the continuing experience of inflation, will the demand for money start to fall and velocity to rise.

By the same token, after a period of sustained inflation, the immediate effect of a slowdown in the rate of increase in the quantity of money may well be a further rise in the velocity of circulation of money. This will be the case if people believe that the inflation will soon resume on as great or greater a scale than before and hence become willing temporarily to operate with even lower cash holdings than before.

It is also possible that velocity may drop in the face of an undiminished rate of increase in the supply of money, indeed, even in the face of an accelerated rate of increase in the supply of money. This result can occur if the realization of people’s expectations concerning inflation presupposes a more rapid rate of increase in the quantity of money than actually takes place. In such circumstances, they will have reduced their demand for money unduly in the light of the facts. Thus, they will need to increase their demand for money.

The data in Table 12–1 can be broken down into four main periods: 1914–29, 1929–45, 1945–82, and 1982 to the present. The first of these periods runs from just prior to the outbreak of World War I in Europe to the start of the Great Depression. The second runs from the start of the Great Depression to the end of World War II; the third, from the end of World War II to the most severe postwar recession; the fourth spans the subsequent recent years.

Since reliable GDP/GNP statistics are unavailable prior to 1929, it is not possible to compute values for

Table 12–1

Money Supply, Consumer Demand (GNP/GDP), and Velocity of Circulation in the United States, Selected Years, 1914–1993

Money Supply Consumer Demand

Year Velocity

(in billions) (GNP/GDP in billions)

1914 Je. $11.5 N. A.

1920 Je. 23.7 N. A.

1921 Je. 20.8 N. A.

1925 Je. 24.9 N. A.

1929 Dec. 26.4 $103.1 3.9 1933 Je. 19.2 55.6 2.9 1939 36.2 90.5 2.5 1945 102.3 211.9 2.1 1950 116.2 284.8 2.5 1955 135.2 398.0 2.9 1960 144.2 503.7 3.5 1965 171.3 681.2 4.0 1970 219.6 976.4 4.4 1975 294.8 1506.0 5.1 1980 414.9 2633.1 6.3 1981 441.9 2957.8 6.7 1982 479.9 3069.3 6.4 1983 527.1 3405.7 6.5 1984 558.5 3765.0 6.7 1985 620.1 4014.9 6.5 1986 725.4 4240.3 5.8 1987 750.8 4526.7 6.0 1988 787.8 4861.8 6.2 1989 794.1 * 5250.8 6.6 1990 826.1 5522.2 6.7 1991 899.3 5677.5 6.3 1992 1026.6 5945.7 5.8 1993 1128.4 6343.3 5.6 * Data are for GDP starting with 1989.

Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics 1914–1941 (Washington, D. C.: Board of Governors of the Federal Reserve System, 1943), p. 34; idem, Banking and Monetary Statistics 1941–1970 (1976), pp. 5, 17–19; idem, Annual Statistical Digest 1971–1975 (1976), p. 49; idem, Federal Reserve Bulletin , December 1981, pp. A13, A52; February and November 1985, pp. A13, A51; October 1986, pp. A13, A51; March 1989, pp. A13, A53; April 1992, pp. A14, A51; October 1994 pp. A14, A51. National Income and Product Accounts of the United States 1929-1965 (Washington, D.C.: U.S. Department of Commerce, 1966), pp. 2–3.; Survey of Current Business, July 1972, p. 7. From 1939 on, money supply data are for December of each year.

velocity in the first period, as we are able to do for all the years from 1929 on simply by dividing the money supply into the GDP or GNP. Nevertheless, we can infer a rise in velocity over the course of the 1920s from all the reports depicting the era as a period of great financial boom. To qualify for such a description, it seems certain that the increase in spending over the period had to exceed the 27 percent cumulative increase in the money supply between June of 1921 (the reporting date following the reduction in the money supply in the depression of that year) and December of 1929. For that increase works out to be only slightly more than 2.8 percent per year on a compound annual basis.

Velocity rose in the twenties on the foundation of a combination of the sharply increased money supply of World War I and an aggressively easy money policy on the part of the Federal Reserve System from June of 1921 to the end of 1925. From June of 1921 to June of 1925, the money supply increased at a compound annual rate of slightly more than 4.6 percent. Also very important in explaining the rise in velocity in the 1920s was the widely held conviction that the Federal Reserve System, by virtue of its ability to increase the supply of currency and member-bank reserves, had the power to prevent depressions and achieve permanent prosperity. In this environment, the demand for money fell and business firms became relatively illiquid.

The far more modest rate of increase in the quantity of money in the late 1920s presaged a fall in velocity. From June of 1925 to June of 1929, the money supply increased at a compound annual rate of approximately only 1.1 percent. 32 The fall in velocity began by the end of 1929, and intensified thereafter. The disastrous monetary contraction of the period 1929–1933 can be explained on the basis, first, of an undue increase in the quantity of money, coupled with the conviction that the Federal Reserve System would prevent any future depression. These factors reduced the demand for money and raised the velocity of money to levels that could not be sustained in the absence of a continued rapid increase in the quantity of money. This continued rapid increase in the money supply did not occur. When, as a result, the demand for money finally increased and velocity correspondingly fell, the effect was reduced spending, hence reduced revenues and incomes, and thus a decreased ability to repay debts.

This last, in turn, resulted in bank failures and an actual decrease in the quantity of money, as fiduciary media were wiped out under the fractional-reserve monetary system of the time. The decrease in the quantity of money caused a further decrease in spending and, concomitantly, a further decrease in revenues and incomes, and thus an even greater reduction in the ability to repay debt, with the result of still more bank failures and a still greater reduction in the quantity of money. The cumulative fall in the money supply between 1929 and 1933 was approximately 27 percent! (This put the money supply in 1933 below where it had been in 1921.)

In the face of a declining quantity of money, velocity fell still further, as it became urgently necessary for business firms to raise cash to be sure of being able to pay their debts and as the expectation grew that investments made in the present could not only be made cheaper in the future, once wage rates and other costs fell, but, if made in the present, would incur an actual financial loss. The prospect of falling prices accompanied by the prospect of being unemployed in the future led consumers, too, to retrench on current spending. In the face of lack of profitable investment opportunities caused by declining sales revenues, their retrenchment in consumption spending largely meant a reduction in spending as such. Because of these factors, velocity fell from 1929 to 1933—from 3.9 to 2.9.

Our table shows, of course, that the velocity of circulation continued to fall from 1933 to 1945, despite very major increases in the money supply from 1933 on. But this is not difficult to explain. The disastrous deflation of the early thirties, in which, as just noted, the money supply fell by more than 25 percent, in which credit was unobtainable by virtually all but the strongest enterprises, in which thousands upon thousands of firms went bankrupt, was an experience that guaranteed a very high degree of financial conservatism for many years to come. As a result, even though the money supply began to increase again after 1933, funds were used to an uncommon degree to build liquidity; that is, firms chose to operate with unusually large money balances. They acted out of fear of the recurrence of deflation. This explains the continuing fall in velocity during the remainder of the thirties.

In World War II, velocity fell because of wartime government controls that limited demand. During the war, the government imposed all-round price and wage controls and instituted a system of consumer rationing. This necessarily limited the amount of spending in the economic system, because no one could spend a sum larger than the controlled prices times the limited quantities of goods available to him. At the same time, of course, the money supply was sharply increased. The combination of a governmentally limited demand and a sharply rising money supply mathematically necessitated a falling velocity of circulation.

By the early postwar years, the memory of the Great Depression and the fear of its recurrence had substantially receded, and from this period on the velocity of circulation began to rise. As in the late twenties, the years

1955 to 1960 experienced only a modest rate of increase in the quantity of money—approximately only 1.3 percent per annum. Indeed, in the early sixties, there was even a stock market crash—the most severe since 1929. But this time, the government saw to it that the quantity of money did not decrease but increased more rapidly. And thus by 1965 we see velocity reaching levels in excess of the 1929 peak.

From 1960 on, the rate of increase in the quantity of money accelerated in every five year period until 1985. From 1960 to 1965, the five-year rate of increase was 18.8 percent; from 1965 to 1970, 28.3 percent; from 1970 to 1975, 34.2 percent; from 1975 to 1980, 40.7 percent; and from 1980 to 1985, 51 percent. Not surprisingly, the velocity of circulation of money went on increasing over most of this period. It reached a peak of 6.7 in 1981.

The increase in the velocity of circulation from the end of World War II until 1981 is exactly what we would expect on the basis of our theoretical knowledge. It was an effect of the increase in the quantity of money that had been going on since 1933 and which tended to accelerate over time, with no sign of major interruption. By the end of the 1970s the demand for money in the United States had fallen to a point where it reflected a growing expectation that the country might soon experience a Latin-American style inflation.

This expectation did not materialize, however. And since 1982, velocity has receded from its 1981 peak. This result, too, is what we should expect on the basis of our theoretical knowledge. For in 1980 and 1981, what occurred for the first time in the post–World War II era was precisely a major interruption in the accelerating rate of increase in the quantity of money. In those two years, the Federal Reserve System made a sharply reduced rate of growth in the money supply its highest priority. It supplied additional reserves to banks only at a ruinously high discount rate of 16 percent. People who had been counting on a rapidly accelerating increase in the money supply—who had further overextended themselves when such an increase failed to materialize, in the belief that it very soon would, in conformity with the pattern established in all the previous recessions experienced since the end of World War II—were caught short and had to scramble for funds.

In response to their desperate demand for funds, the government brought about an increase in the money supply of 8.5 percent in 1982 and 9.8 percent in 1983 (following an increase of 6 percent in 1980 and 6.5 percent in 1981), but only at interest rates so high as to make most borrowing unprofitable and only in order to prevent what otherwise would certainly have been the start of a major depression. Even so, the consequence of the change in government policy was the most serious recession—the first actual depression, according to some observers—since the 1930s. A further consequence was that since that time the U.S. government has been viewed as being unwilling to allow a continuous acceleration in the rate of increase in the quantity of money. The effect of this has been an increase in the demand for dollars and a consequent tendency toward a decline in the velocity of circulation of dollars. (In the early 1980s, a major factor cushioning the effects of the increase in the demand for money for holding was the rapid increase in socalled money-market-mutual-fund accounts. These are interest-bearing savings accounts that closely resemble checking accounts in that their holders have the right to write up to three checks per month against them. Between December of 1978 and December of 1982, these accounts grew from a little over $10 billion to $230 billion. 33 )

Ironically, the effect of the increase in the demand for money inaugurated by the government’s policy of restricting the growth in the supply of money earlier in the decade was to enable the government to resort to a renewed acceleration of the increase in the supply of money in 1985 and 1986, with rates of increase of in those years of 11.1 percent and 16.9 percent, respectively.

Given the prevailing still relatively low state of demand for money that has resulted from decades of inflation, such rapid rates of increase in the money supply are necessary to prevent the greater demand for money corresponding to moderate increases in the money supply from resulting in a decline in total spending in the economic system and thus launching a depression. This conclusion is confirmed by subsequent events. In the remainder of the decade the rate of increase in the money supply was sharply reduced: in 1987 it was 3.4 percent; in 1988, 5 percent; in 1989, 1 percent; in 1990, 4 percent. The five-year rate of increase in the money supply between 1985 and 1990 ended up as 33 percent—the first five-year increase since 1960 that was less than the previous five-year increase. Not surprisingly, in late 1990, and in 1991 and 1992, the economic system seemed poised for a major depression.

In an effort to overcome the slide toward depression, in 1991 the increase in the quantity of money was stepped up to almost 9 percent. In 1992, it was in excess of 14 percent, and in 1993, more than 10 percent. Because these increases in the quantity of money took place in an environment of largely deflationary psychology, the result was a substantial fall in the velocity of circulation of money over the years 1991–93, namely, from 6.7 in 1990 to 5.6 in 1993, as shown in Table 12–1. Finally, in late 1993, because of the sharply increased quantity of money and the consequent ability of sales revenues and profits

to increase from year to year, along with the rise in liquidity constituted by the lower velocity of circulation, the widespread fears of impending depression gave way. In the current year, 1994, there are growing fears of a resumption of more rapidly rising prices. The Federal Reserve System shares these fears, and in the present year has once again sharply reduced the rate of increase in the quantity of money—to a little over 2 percent on an annual basis (i.e., from $1,128.4 billion at the end of December 1993, to $1,149.4 billion in mid-October of 1994). 34

What is certain is that if the rapid rates of increase in the money supply that prevailed from 1991 through 1993 were to be continued, the demand for money would once again sharply decline, in which case rapid increases in the quantity of money would be joined by a substantial rise in the velocity of circulation of money, with the result that very rapid increases in spending would ensue. On the other hand, it is no less certain that if the present, modest rate of increase in the money supply were to remain in force, a major increase in the demand for money would take place, such as began in 1990. This would result in a largescale monetary contraction—that is, a major deflation/depression. To put it mildly, the present monetary situation is highly unstable, possessing as it does the potential both for major inflation and for major deflation. Under present monetary conditions, the economic system is poised between both dangers, with the government undertaking to prevent the one only by means of unleashing the other and then hoping to be able to change course quickly enough to overcome the momentarily greater danger by enlarging and setting against it the momentarily smaller danger.

It should never be forgotten that this deadly alternative would not exist if the policy of inflation had not been resorted to in the first place. Even now, I do not think that the alternative is inescapable, and in Chapter 19 I will present a solution for stopping inflation without precipitating a depression—a solution that is fully consistent both with a sharp increase in the demand for money and consequent major decline in the velocity of circulation, and yet, at the same time, with no decrease, indeed, an increase, in the volume spending in the economic system expressed in dollars. 35 As I will also show in Chapter 19, in the absence of once and for all ending the policy of inflation, the problem must remain substantial, as a minimum. More likely, it will grow worse. 36

4. The Demand for Money: A Critique of the “Balance of Payments” Doctrine

Knowledge of the demand for money sheds light on the questions of the “balance of trade” and the “balance of payments.” These are matters in connection with which arguments have been advanced, and generally accepted, to the effect that the vital self-interest of countries requires restrictions on the freedom of international trade. Worse, on the foundation of the belief that countries benefit from an excess of exports over imports, or of receipts from abroad over outlays to abroad, and are harmed by the opposite type of excess, the implication arises, in the clearest possible terms, that the self-interests of countries are necessarily opposed to one another. For, in the nature of the case, it is impossible for a country to have an excess of exports over imports, or receipts from abroad over outlays to abroad, without other countries having an equivalent excess of the opposite kind. Thus, each country, in pursuing what is believed to be its economic self-interest is perceived as bent at the same time on a policy that causes harm to other countries. In this way, the doctrine of the balance of trade or balance of payments serves as a leading cause of international conflict and, ultimately, of war. Few things, therefore, can contribute more to world peace than its overthrow. In accordance with this objective, I will first present the substance of the doctrine and then turn to a critique of it.

The balance of trade is the difference between the money received by the citizens of a country in exchange for exports of goods to foreign countries and the money expended by the citizens of that country in exchange for imports of goods from foreign countries. The balance of payments is an essentially similar, but more comprehensive concept. It is the difference between the total of a country’s receipts from abroad and the total of its outlays to abroad. Under the heading of receipts are included not only receipts from the export of goods, but also receipts from the sale of services to foreigners, such as shipping, insurance, and the hosting of tourists. Dividends and interest received from abroad, the proceeds from the sale of securities, such as stocks and bonds, to abroad, and the proceeds of borrowings and the repayment of debts from abroad are also included. By the same token, outlays to abroad include, along with outlays for imports, the purchase of services from foreigners, dividends and interest paid to them, remissions of gifts by individuals to abroad, government foreign aid, the purchase of securities from abroad, and the granting of loans and repayment of debts to abroad.

For historical reasons that will be made clear shortly, an excess of exports over imports is mistakenly called a favorable balance of trade, while an excess of imports over exports is mistakenly called an unfavorable balance of trade. Similarly, an excess of the total of all categories of receipts from abroad over the total of all categories of outlays to abroad is mistakenly called a favorable balance of payments, while an excess of the total of all

categories of outlays to abroad over the total of all categories of receipts from abroad is mistakenly called an unfavorable balance of payments.

From the perspective of the history of economic thought, the concepts of the balance of trade and the balance of payments can be taken as interchangeable. This is because when the concept of the balance of trade became prominent, with the writings of the Mercantilists in the seventeenth and eighteenth centuries, commercial dealings with foreign countries were essentially limited to imports and exports. There was as yet no significant international capital market, and the international exchange of services was also not significant.

In order to understand the importance attached to these concepts historically, it is necessary to consider the context in which the Mercantilists wrote and the ideas they advanced in connection with these concepts. The Mercantilists lived in a time when gold and silver constituted the money of all countries. Countries which did not possess gold and silver mines, which was the situation of most of the European nations of the period, could obtain an additional supply of money only from abroad. Insofar as the money was to be obtained by trade, an excess of exports over imports was the only possible means.

Obtaining an additional supply of money in a country was originally thought to be important as a means of financing future foreign wars. It was thought that the additional money would be available for taxation when it became necessary for the king to finance foreign military ventures, which would require the spending of precious metals abroad, and that it was possible and necessary to heap up sufficient “treasure” in a country to cover all or at least a substantial part of the cost of such ventures. Increasingly, however, a wider economic perspective entered in. It came to be held that a growing quantity of money obtained from an excess of exports over imports would provide an economic stimulus to production and employment in the country by virtue of increasing the volume of spending, and could lower interest rates by providing a larger quantity of money for lending. For all of these reasons, an excess of exports over imports was held to represent a “favorable” balance of trade.

In exactly the same way, an excess of imports over exports was perceived as reducing the quantity of money in a country. This, it was thought, not only impaired the ability of the country to finance future foreign wars, but reduced spending, production, and employment in the country, and raised its interest rates as well, which further contributed to its economic woes. For all of these reasons, an excess of imports over exports was called unfavorable.

On the Mercantilist view of things, in the absence of government intervention to secure a favorable balance, the balance of trade (payments) was determined on an essentially accidental basis. It was the fortuitous outcome of the unrelated actions of everyone who happened to sell to abroad or buy from abroad. Any individual action which increased exports was thought to improve the balance of trade correspondingly. Any individual action which increased imports was thought to harm the balance of trade correspondingly. On the mercantilist view of things, imports had the potential of completely draining a country of its money supply—if, for a period of years purchases from abroad happened to exceed receipts from abroad by a wide enough margin. Indeed, the only justification of imports was thought to be either their absolute necessity in meeting important needs that otherwise could not be supplied or in bringing about subsequent exports that would constitute an improvement in the overall balance of trade. (The latter was thought to be the case insofar as imports were in the form of raw materials or equipment advantageous to the production of subsequent exports.)

The element of “heaping up treasure” to finance future foreign wars is no longer prominent. Among other things, it was shown to be incapable of making any significant contribution to the end sought, since the size of money holdings is always quite modest relative to the volume of expenditures which must be made. The actual source of wartime military expenditures abroad is always, overwhelmingly, the proceeds of current exports and borrowings from abroad. The plans of kings and emperors for accumulating precious metals within the borders of their countries turned out, on calculation, to be sufficient for supporting the war expenses of no more than a few weeks or months.

But apart from this element, Mercantilism has a very contemporary ring to it. It bears a close similarity to the ideas of Keynes and his followers in its concern with finding a source of economic “stimulus,” and in its fear that in the absence of such stimulus, the economic system must languish in unemployment and poverty. Its views on the ability of a larger quantity of money to reduce interest rates are also practically indistinguishable from those of Keynes.

Mercantilism’s treatment of the balance of trade (payments) as being the fortuitous outcome of the unrelated actions of individuals is also shared by most contemporary writers and commentators on the subject. It is manifested in such attitudes as that the American balance of payments is unfavorable because Americans are buying too much specifically from the Japanese, or, even more specifically, too many automobiles and electronics products from the Japanese. At other times, the specific sources of the trade or payments imbalance of the United

States has been held to be such things as the purchase of imported wines from France, tourism by Americans in foreign countries, American lending abroad, the stationing of American soldiers abroad, and the giving of foreign aid.

The presumption is that if each or any of these outlays was not present, total outlays would be equivalently reduced and thus the difference between outlays and receipts correspondingly improved. On the basis of the view that the problem of an unfavorable balance originates in this way, the remedy that appears to follow is the imposition of restrictions or prohibitions on the particular dealings in question. Thus, depending on what is being singled out at the moment, Americans have variously been urged to buy less French wine, take their vacations at home, reduce their lending abroad, and, most recently, not to buy Japanese products. Needless to say, corresponding laws and regulations have been proposed and enacted.

Of course, by the same token, any particular source of receipts from abroad is capable of being singled out for praise, on the grounds of its corresponding contribution to the country’s balance of trade or payments. For example, in the 1960s, the members of a prominent rock ’n roll group were made Members of the Order of the British Empire on the basis of their alleged contribution to Britain’s balance of payments through their receipt of large concert fees and recording royalties earned in the United States and Continental Europe. Of course, an obvious implication of the view that any given receipt from abroad represents a corresponding improvement in a country’s trade or payments balance is the subsidization of exports. Export subsidies—the taxpayers’ loss—are thought to be the basis of a gain to the nation.

The Balance of Payments Doctrine and Fiat Money

Now the first thing which should be realized about the concepts of the balance of trade and the balance of payments is that whatever plausibility they may have had in the days when a country’s money supply depended on gold obtained from abroad, they no longer possess even that plausibility. Indeed, it is highly ironic, but nowadays expenditures for the importation of gold itself are believed to add to a country’s balance of payments deficit. (For example, an important motivation in the decision of the U.S. Congress to order the minting of a new American gold coin a few years ago was the belief that it would help the United States’ balance of payments to some extent by giving American citizens an alternative to buying imported gold coins, such as the Canadian Maple Leaf and the South African Krugerrand.)

Over two centuries ago, Adam Smith wrote, for reasons that will soon become apparent, “Upon every account, therefore, the attention of government never was so unnecessarily employed, as when directed to watch over the preservation or increase of the quantity of money in any country.” 37 When one realizes that today, the whole concern over the balance of trade and the balance of payments is over an alleged outflow of irredeemable paper money, this concern must be judged utterly absurd.

Even if it were the case that an unfavorable balance of payments meant a corresponding reduction in the quantity of money in a country, absolutely nothing could be more easily replaced than a loss of fiat money. All that is required is additional paper and ink, and not even that—just some additional credit entries on the ledgers of the banks. Indeed, to some extent every year there is an outflow of currency from the United States. For there are people living in many foreign countries whose currencies depreciate far more rapidly than the dollar, and who therefore prefer to have holdings of dollars rather than holdings of their own currencies—who want to have dollars in safety deposit boxes or even hidden under their mattresses. Indeed, there is an important demand almost everywhere for dollars to be used as an international currency, that is, in financing trade among most foreign countries. To that extent, there is a demand for dollars in the form of checking deposits as well. But these phenomena do not cause any actual reduction in the supply of money in the United States. They merely cause a somewhat lesser rate of increase. That is, the quantity of money in circulation in the United States does not increase by the full magnitude of the increase in the supply of dollars, but by an amount which is less to the extent that part of the increase is taken by foreigners, in exchange for goods and services they supply us. It is difficult to see how there is anything at all that is “unfavorable about this.” It achieves the equivalent of a lesser degree of inflation in the United States and provides the American economy with real goods and services in exchange for intrinsically worthless pieces of paper.

But what is truly ironic is that the far greater part of what is recorded as an unfavorable balance of payments does not even represent any actual outflow of money— not even fiat money! On the contrary, it is constituted by an increase in shortterm foreign lending to the citizens of the country, or to its government. For example, when foreigners take the dollars they have earned in selling goods or services in the United States, or simply go out and exchange their own money for dollars, and then deposit the proceeds in American banks or their overseas branches, which then remit them to the United States, or when foreigners buy U.S. treasury bills or commercial paper—that increase in shortterm liabilities to foreigners is said to constitute an unfavorable balance of payments to the United States!

It is no less difficult to understand what is unfavorable about this than about an outflow of fiat currency. The dollars that the foreigners deposit in banks here or abroad are lent out and spent in the United States, and the same is certainly true of the funds they use to purchase U.S. treasury bills or commercial paper. 38 Indeed, such shortterm foreign lending should be regarded as an indication of the strength of a country’s economic system, in that it shows that foreigners consider the country to be a worthwhile place to invest their money. The same point, of course, applies even more strongly to intermediate and longterm foreign investment.

Foreign lending and investment contribute to domestic capital formation and thus, as later chapters of this book will show, to the rise in the productivity of labor and real wages—developments that are as favorable to a country as can be imagined. And, in passing, it should be realized that, at least until recently, foreign lending and investment in this country have helped greatly to alleviate the drain of capital funds that would otherwise have resulted from our massive government budget deficits. They have also prevented the pressure that would then exist to finance those deficits through the more rapid creation of money. There is nothing “unfavorable” about this.

Obviously, the receipt of funds in connection with foreign shortterm lending and investing should very definitely be counted among a country’s international receipts. Its omission creates the appearance of an imbalance in a country’s international accounts when in fact there is none. And it makes what in reality is a perfectly favorable development appear unfavorable. To this extent, the doctrine of the balance of payments represents a fiction as well as an absurdity.

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This leads to a wider problem in the concept of the balance of trade and payments—namely, that it is not seen that the various items in the accounts are not independent, but rather are mutually interconnected. For example, the socalled unfavorable balance of trade (the excess of imports over exports) that the United States has experienced in recent years is precisely the result of the excess of receipts by the United States over outlays in the vital area of lending and investing.

This latter excess has been largely due to the fact that in the early and mid-1980s the United States came to be considered the outstanding country in which to invest. This was the result of an apparent determination on the part of its government to restrain the growth in the money supply, to provide a more favorable tax treatment of profits, and to reduce the extent of its own interference in the economic system. All this was coupled with the existence of historically very high rates of interest.

As the result of a massive inflow of foreign funds seeking dollars for investment purposes, the exchange value of the dollar rose sharply in terms of other currencies. This rise in the foreign-exchange value of the dollar, in turn, made American goods correspondingly more expensive for foreigners to buy, inasmuch as foreigners first had to buy more expensive dollars in order to buy American goods, and, by the same token, made foreign goods correspondingly cheaper for Americans to buy, inasmuch as a dollar now bought more of foreign currencies and thus more of foreign goods. Thus, the foreign investment resulted in an excess of imports over exports. It provided both the financial means of purchasing imports without making corresponding exports and, at the same time, a financial incentive, in the form of a high foreign-exchange value of the dollar, leading the economic system to do precisely that.

Indeed, it is in the very nature of foreign investment that it be accompanied by a socalled unfavorable balance of trade in the country receiving the investment. What the foreign investment contributes is physical wealth from abroad. In the country receiving the wealth, this means an importation of goods without a corresponding exportation of goods. Only in this way can there be a net inflow of wealth.

Perhaps the clearest illustration of how foreign investment means an “unfavorable” balance of trade can be found in the economic development of a wilderness area. Thus, imagine, for example, that there is a stretch of coastline somewhere that contains oil deposits. To exploit the oil deposits, wells must be drilled, a refinery and storage tanks constructed, piers and warehouses built, and so forth. All of this must come from outside the area—from abroad. Its coming represents a great investment. But it is simply impossible that there can be corresponding exports while the area is in process of development. Its development is possible only so long as it is able to obtain funds with which to pay for imports of all kinds without as yet having to make corresponding exports. Yet, incredibly, while the area’s development is going on, its balance of trade is called “unfavorable,” because it imports more than it exports. What would allegedly not be unfavorable is if the area did not receive the imports that make its development possible.

The same principles, of course—the same actual favorableness of the “unfavorable” balance of trade— apply to a great nation that already is very highly developed, but is undergoing still further development. They also apply to a case in which the influx of wealth from abroad serves to offset the consumption of capital at home by a voracious government.

Such an excess of imports over exports does not in the least cause unemployment. And the truth of this state—

ment is confirmed by the fact that precisely in the period of its massive trade deficits, the unemployment rate in the United States has been among the lowest of any major nation. As should already be clear, the purchase of the imports does not represent any significant carrying out of money from the United States or any reduction in total, overall spending for goods and services in the United States. On the contrary, the imports represent new and additional wealth brought into the United States, where they are added to the supply of domestically produced goods and made available for purchase by the same total expenditure of money that would otherwise take place. In other words, the American public obtains more for its money. The real wealth in the economic system is increased and the rise in prices is correspondingly retarded. (The reduction in exports that foreign investment in the country achieves by means of raising the foreign-exchange value of the country’s money contributes to the same result. For a portion of the country’s output which otherwise would have been exported is made available for purchase domestically instead.)

The following example shows the actual nature of what takes place. Thus, imagine that there is a German business firm that exchanges two million marks for one million dollars. The German firm places these million dollars in a bank, in a time deposit. The bank lends them out to an American business firm, which now expends them in the United States in the purchase of such things as plant and equipment, materials, and labor services. The firm’s employees, in turn, spend their wages in buying various consumers’ goods from other American businesses. Observe. There is no reduction in the number of dollars in the American economy, nor any reduction in spending for goods and services in the American economy. All that is different in the American economy is that the seller of the million dollars to the German firm now has two million marks and thus the means of importing two million marks’ worth of goods into the American economy. In other words, there is the same money and spending as before, but more goods in the American economic system for the same volume of aggregate spending to buy.

Let us take another example. A Japanese automobile company sends a shipload of cars to the United States, for which it is paid a sum of dollars. It must use most of these dollars to buy yen, in order to have the funds to maintain its operations in Japan. Some of the dollars, however, it saves and deposits in American banks or uses to buy American securities. These dollars are spent in the United States, just as in the previous example. Most of the dollars that are exchanged for yen will be used by Japanese to import from the United States. The rest of the dollars are used to invest in the United States and, of course, are expended here in the process. Again, the full supply of dollars turned over to the foreigners comes back as purchases within the United States. But what occurs is that the supply of goods in the United States is correspondingly larger: it is larger to the extent that the United States’ import of automobiles exceeds its export of goods purchased with the dollars coming into the hands of foreigners. This last is the result insofar as the foreigners invest their dollars in the United States rather than import from it.

The rise in the foreign exchange value of a country’s money that foreign investment in the country causes not only does not cause unemployment in that country, but actually tends to be accompanied by less unemployment. This is because the demand for labor is made overwhelmingly out of capital, which foreign investment increases. Foreign investment enlarges the capital funds in the possession of the average business firm in the country and thus puts it in a better position to employ labor. True enough, the rise in the foreign-exchange value of the country’s money encourages imports and reduces exports, but it does not reduce the quantity of money or volume of spending in the country and actually tends to increase the volume of spending for labor and capital goods. What it does, to say it yet again, is increase the overall supply of goods in the country.

It is perfectly true that there are individual industries, such as automobiles and steel in the United States today, which are presently suffering largescale unemployment because of their inability to meet foreign competition. If foreign competition were prohibited, these industries would suffer less unemployment. But unemployment in the rest of the economic system would grow more than correspondingly, or else wage rates in the rest of the economic system would have to fall. This is because the purchase even of the same quantity of domestically produced automobiles and steel as are presently purchased, under foreign competition, would require the expenditure of substantially larger sums of money at the higher prices that would then prevail. This would imply a reduction in expenditure for the output of the rest of the economic system, given the supply of money and the volume of aggregate spending in the economy. The reduction in expenditures elsewhere in the economic system would be all the greater, to the extent that the quantity of domestically produced automobiles and steel purchased at the higher prices was increased. In addition, the loss of foreign investment would operate to reduce the aggregate demand for labor in the United States. Thus, the additional employment offered by the auto and steel industries would be more than offset by the reduction in employment that the rest of the economic system could offer.

Thus, in sum, an end to the socalled unfavorable

balance of trade would come about as the result of the end of net foreign investment in the United States. It would be accompanied by a spurt in the level of prices, reflecting a reduced supply of goods available for sale. It would also mean that the full burden of the federal budget deficits would fall on the American economy. And it would tend to be accompanied by a higher overall rate of unemployment, not a lower one. Unfortunately, government policies in the United States may well have the effect of ending net foreign investment and thus of producing these highly undesirable consequences.

It is worth pointing out, as a final irony in the misconceptions surrounding the balance of payments and the balance of trade, that by any rational standard what is called a favorable balance of trade can in fact be fully as much unfavorable as an allegedly unfavorable one is favorable. A country that desires to achieve an excess of exports over imports has only to give money to its prospective customers, and they will import more and it will export more. This is exactly the kind of “favorable” balance of trade achieved by foreign aid. It can be duplicated on a small scale by any businessman who is willing to employ a doorman to give money to passersby on the condition that they spend the money in his shop.

The Balance of Payments Doctrine Under an International Precious Metal Standard

It is necessary to give some consideration to the balance-of-trade and balance-of-payments doctrines under an international gold standard. For in one form or another, this was the monetary system of the world until fairly recently, and could well become so once again. It will be seen that here, too, one of the most important things to keep in mind is that the individual items in the balance are not independent and fortuitous, but mutually interconnected.

Under a system in which the money supply of the various countries consisted of the precious metals, all of the beneficial effects of foreign investment explained above would be equally present. Instead of resulting in a higher foreign exchange value of a country’s money, however, foreign investment would operate to enlarge the recipient country’s money supply somewhat and, in so doing, make its prices higher than they would otherwise have been and thereby encourage imports and discourage exports. The resulting excess of imports over exports would once again be the physical mechanism by which foreign capital was transmitted to the country. And once again, the effect on overall employment would be positive, not negative, because of the greater availability of capital funds in the country.

In addition, further important principles would apply. A tendency would exist for the money supply of each individual country to follow the country’s proportion of the world’s production and trade. A country whose economy represented 10 percent of the world’s economy would tend to possess 10 percent of the world’s money supply within its borders. A country whose economy represented 20 percent of the world’s economy would tend to possess 20 percent of the world’s money supply within its borders, and so on. This is because money is demanded for making purchases and paying bills. The larger the relative size of a country’s economy, the larger would tend to be its relative sales revenues and purchases to the same extent, and thus the larger its relative need for and ability to obtain holdings of money.

In such conditions, if the world supply of precious metals grew at a rate of, say, 2 percent per year, a country whose economy grew at the same rate as the world’s economy and which, therefore, continued to constitute the same proportion of the world’s economy, would tend to experience a 2 percent annual rate of increase in its money supply. The principle is that the money supply of an individual country would grow at the same rate as the world’s money supply if its economy grew at the same rate as world’s economy. By the same token, countries whose economies grew at a faster rate than the world’s economy and whose relative share of the world’s economy, therefore, tended to increase, would experience a rate of growth in their money supplies more rapid than the rate growth in the world’s money supply. At the same time, those countries whose economies grew at a rate slower than that of the world’s economy would experience below-average rates of increase in their money supplies, or even decreases in their money supplies.

These facts have an obvious bearing on the balance of payments positions of the various countries. Other things being equal, the more rapidly growing is the economy of a country relative to that of the rest of the world, the greater will tend to be its importation or the less will tend to be its exportation of the precious metals. This is because it will require within its borders a correspondingly larger proportion of the world’s supply of precious metals. Thus, the more “favorable” or the less “unfavorable” will tend to be its balance of payments. Conversely, the less rapidly growing is the economy of a country relative to that of the rest of the world, the less will tend to be its importation or the greater will tend to be its exportation of the precious metals—that is, the less “favorable” or the more “unfavorable” will tend to be its balance of payments.

To take a major historical illustration, the rapid growth of the British economy relative to that of the rest of the world in the eighteenth and nineteenth centuries operated to produce a rising demand for money in Great Britain and a “favorable” balance of trade for Great Britain. At

the same time, the stagnation and thus the relative decline of the economies of countries like India and China operated to produce a decline in the demand for money in those countries and an outflow of the precious metals.

The relative rates of growth in the economies of the different countries is not the only principle governing their balance-of-payments positions under a world precious metals standard. An equally important factor is the extent to which a country possesses or lacks precious-metal mines. Those countries in which the precious metals are mined in substantial quantities would regularly experience an “unfavorable” balance of payments. They would regularly export precious metals in exchange for the importation of ordinary commodities. By the same token, the countries in which there was little or no mining of the precious metals would regularly experience a “favorable” balance of payments: they would import precious metals in exchange for ordinary commodities.

These results would take place because of differences in the buying power of the precious metals between the two types of countries. In the countries in which the precious metals were mined, the supply of money would tend to be unduly high, and thus prices would tend to be higher than elsewhere in the world. This would make the importation of goods more attractive, since imports would be relatively cheap, and, at the same time, the exportation of goods other than the precious metals, less attractive, since such exports would be relatively more expensive than the goods people could buy elsewhere. An outstanding historical illustration is provided by the discovery of the California gold fields in 1848. The great local abundance of gold relative to ordinary commodities resulted in such phenomena as the price of a single egg being as high as a dollar for a time (a gold dollar of one-twentieth of an ounce of gold, which today represents the value of a substantial number of paper dollars). Thus, it was cheaper to buy almost everything outside of California. In this way, the gold originating in California found its way to the rest of the country and the rest of the world.

The same principle always applies, though when effective means of transportation exist, the disparity in prices need not be very great: the newly mined gold will be carried off rapidly and sufficient quantities of ordinary goods will be brought in rapidly, so that prices in the gold-mining areas will tend to exceed prices elsewhere by little more than the costs of transportation.

Alongside these two principles, and always limiting their operation, is a third principle, which is that, other things being equal, the balance of trade and payments of all countries always tends toward balance. That is, given the relative size of a country’s economy in the world economy, and given the total quantity of money in the world’s economy, there is a tendency for the receipts and outlays of money of all countries respectively to equalize.

This principle exists by virtue of the effects of changes in the quantity of money in the different countries. Countries whose money supply increases through an excess of receipts over outlays experience a tendency toward rising prices, while countries whose money supply decreases through an excess of outlays over receipts experience a tendency toward falling prices. The resulting changes in prices makes the countries which have experienced an inflow of money relatively less favorable markets and those which have experienced an outflow of money relatively more favorable markets. Thus, the inflow and outflow of money is ultimately stopped. In other words, the balance of trade and payments comes into balance.

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Whether the balance of trade and payments of a country were in balance or not in balance, there would always be a sufficient quantity of precious metals in every country to buy all that it is capable of producing and to employ all of its inhabitants who are able and willing to work. As later chapters will show, this is strictly a question of the prices and wage rates in that country. At the appropriate level of prices and wages, any given quantity of money and volume of spending is capable of purchasing the entire supply of goods that a country can produce and of employing its entire supply of labor. 39 Indeed, as the present discussion makes clear, the problem a country experiences of an outflow of precious-metal money accompanying a decline in its relative economic position in the world is the result of its not having increased its production sufficiently. What is required to stop such an outflow of precious metals is precisely an increase in its ability to produce.

In this connection, the potentially extremely destructive role of monopoly labor unions must be mentioned. Such unions play a major role in retarding the rise in the productivity of labor in a country and thus in bringing about a decline in its relative position in the world economy. This decline means, as a minimum, a slower rate of increase in the supply of precious metals in the country. This, in turn, means that full employment can be achieved only at a lower level of money wage rates than would otherwise be necessary—possibly at a level of money wage rates which represents an absolute fall. But the unions are unlikely to be willing to accept the relatively lower wage rates, and almost certainly not an absolute fall in wage rates. Thus, unemployment develops. And so long as the unions retard the rise in the domestic productivity of labor, while it goes on rising more rapidly abroad, the problem of unemployment worsens.

This point, of course, has application to current con—

ditions in the United States, even though the country is not on a gold standard of any kind. In a world of multiple fiat moneys, changes in the relative size of the economies of the various countries are still reflected in corresponding changes in the proportion of the world’s money supply circulating within their borders. Only now, the change is effected partly by changes in the foreign exchange value of the various currencies and partly by changes in their respective quantities. The more rapidly production increases in one country relative to the others, the higher, other things being equal, becomes the value of its currency relative to the value of foreign currencies. By the same token, the more rapidly production increases in a country relative to other countries, the more rapidly can that country increase its quantity of money without depreciating the value of its currency relative to the value of foreign currencies. Thus, the fraction of the world’s quantity of money that exists within the territory of a country is still determined by the size of its economy relative to the economy of the rest of the world.

It follows, even under the present system of multiple fiat moneys, that to the extent that labor unions in the United States have retarded the rise in the productivity of labor in the United States relative to that in foreign countries, they have caused a fall in the fraction of the world’s money supply that circulates in the United States. It further follows that to the extent that they insist on continuing to receive wage rates conforming to a previous, higher relative productivity of labor in the United States, the effect must be unemployment.

These results exist in dramatic form in such major American industries as automaking and steel, where labor unions have greatly retarded the rise in the productivity of labor, at the same time that the productivity of labor in these industries in important foreign countries has sharply increased. The rise in the relative productivity of labor abroad has enabled foreign competitors to undersell American producers even while paying rapidly rising wage rates. The only thing that has prevented the unions from causing mass unemployment in the United States is the fact that many branches of industry in the United States are nonunion and have thus been in a position to absorb additional workers. 40

Inflation as the Cause of a Gold Outflow

I have already explained how the gold standard of the eighteenth and nineteenth centuries and the earlier part of this century was a fractional-reserve gold standard. Under such a gold standard, the world supply of money can be increased by the creation of fiduciary media in any given country. (This includes, of course, fiduciary media created by governments in issuing claims to gold in excess of their actual gold holdings.) So long as the fiduciary media are accepted in commerce as the equivalent of gold, an increase in their supply appears on the market as though it were an increase in the supply of gold.

From this point on, the effects are largely analogous to those resulting from the discovery of additional gold mines in a country. The increase in the world’s supply of money is initially concentrated in the country in which the additional fiduciary media are created. The effect is a disproportionate enlargement of that country’s money supply relative to the money supply of other countries. On the foundation of this larger money supply, the inhabitants of the country step up their expenditures, including, of course, their expenditures to abroad. At the same time, prices in the country rise relative to prices in other countries. In addition, the appearance of the additional fiduciary media on the loan market operates to reduce interest rates in the country relative to interest rates abroad. For all of these reasons, an unfavorable balance of payments develops, as a substantial portion of the additional money supply begins to move abroad. Indeed, in the absence of the simultaneous creation of fiduciary media abroad, the only portion of the additional money supply which the country in question could retain would be the proportion corresponding to its proportion of the world’s economy. That means, for example, that if it represented 5 percent of the world’s economy, it could retain only 5 percent of the additional supply of money it created.

Here the analogy to the discovery of additional gold mines ends. For a country’s additional fiduciary media are not in fact additional gold. And the additional money supply that foreigners will usually wish to hold is not the expanding country’s additional fiduciary media, but a corresponding quantity of gold. Thus, the effect is that a loss of gold reserves ensues in the expanding country.

Of course, the loss of gold reserves resulting from the creation of fiduciary media is the less severe to the degree that the policy is pursued at the same time by other countries. To the extent that all countries expand fiduciary media at the same time, each will tend to have mutually offsetting claims against the gold reserves of the others. The policy can also be carried further to the extent that a country’s fiduciary media are sought for holding in other countries, as was the case with the U.S. dollar in the decades following World War II, and, to a lesser extent, in the years following World War I.

Despite its actual cause, the gold outflow that occurs in such circumstances is typically blamed on the actions of the citizens, who, it is alleged, are spending too much for this or that category of import, travelling outside the country excessively, or lending abroad on too great a scale—as previously described.

534 CAPITALISM

Blaming the unfavorable balance of payments on the citizens and attempting to restrict their outlays to abroad (or stimulate their receipts from abroad) overlooks entirely the fact that the problem is the result of a lack of demand for the additional money in the country in which it originates. There is simply no basis for the citizens of the country wanting to retain the additional quantity of money all within its borders. And so long as this is the case, efforts to restrict their outlays to abroad for this or that specific purpose, such as French wines, tourism, or securities purchases, are absolutely futile. Their futility can be illustrated by imagining the case of someone who receives a $500 check on his birthday and who wants to spend the money on a new suit, say. If this person is prohibited from buying the suit, the result will certainly not be that he then simply adds the $500 to his cash holding. On the contrary, he will buy something else. If his second-choice expenditure, too, is prohibited, he will buy his third choice, and so on. If he is totally blocked from spending the additional $500 for any purpose, he will reduce his other receipts of money by $500, for there is no purpose in earning money he cannot spend. In no case can he be made to add the $500 to his cash holding until he perceives a need to do so.

It is the same in international trade. If Americans are blocked from spending money for French wines, foreign vacations, or foreign securities, they will spend it for other things from abroad. This result is guaranteed, because so long as the additional money remains in the United States, it operates to make American prices higher than prices elsewhere, and does so to the degree that the additional money is retained in the United States, with the result that the more powerful is the encouragement of imports and, at the same time, the greater is the discouragement of exports. Thus, no sooner is one avenue of outlay to abroad blocked, than another is opened up, or receipts from abroad decline.

It should be realized that a corollary of the present discussion is that when the citizens of a country do have a demand for its existing quantity of money, no amount of outlays to abroad will for very long deprive them of any part of that quantity of money. Thus, for example, if, under an international gold standard, Americans want to hold their present quantity of money and American tourists happen to spend an additional billion or five or ten billion dollars touring Europe, that additional outlay will not reduce the quantity of money in the United States. Instead, it will automatically result in the generation of additional receipts from abroad, or in a reduction in other expenditures to abroad. It will do so in the same way and for the same reason that an individual who decides to buy some item that he likes does not finance the purchase of that item by reducing his normal cash holding.

For example, if someone normally needs to carry fifty dollars in his wallet and comes upon something he likes that costs forty dollars, which he decides to buy, that individual will not then decide to walk around with only ten dollars. He will quickly move to restore his cash holding, by withdrawing money from his savings account, say, or he will reduce his purchases of other items so that he can replenish his cash holding out of his next pay check. Indeed, to the extent that individuals know in advance that they will step up their expenditure for something, they first take steps to increase their receipts or to reduce their other expenditures. In any case, only in the most immediate and temporary sense are purchases made at the expense of running down cash holdings, unless the cash holdings were initially excessive.

To demonstrate, in as dramatic a way as possible, that outlays abroad are not made at the expense of running down cash holdings, when the cash holdings are not initially excessive, let us take the highly unpopular case of government outlays for foreign aid (which the present writer, of course, totally opposes). Let us imagine that a new foreign aid bill is passed and, as part of it, an army of tax collectors is dispatched into the streets to seize money from every passerby and from every shopkeeper and businessman. The money, we can imagine, is then loaded into armored cars, rushed to nearby airports, and then flown to various foreign capitals. Will this foreign aid be at the expense of the cash holdings of the American people? Will the American people now walk around and conduct their businesses with cash holdings diminished by the amounts the tax collectors have taken from them?

If one looks at matters subsequent to a span as short as a few days, the answer to these questions is no. The American people would immediately have to take steps to replenish their cash holdings. This is because at the prevailing level of wages and prices, their former cash holdings are necessary if they are to buy the things which they want to buy and to conduct their businesses on the scale on which they want to conduct them. Precisely their efforts to replenish their cash holdings would result in a rapid return of the funds that had been taken from them.

There would be substantial withdrawals of cash from banks, reductions in the expenditure for many items, and the widespread holding of sales by businessmen, as methods of raising cash. The effect of these actions would be a rise in interest rates and fall in the prices of various commodities in the United States. Meanwhile, in the foreign capitals, opposite results would be taking place. There, the presence of the additional cash would operate to reduce interest rates and raise commodity prices. The effect would be that the cash would probably be loaded back onto the very same planes on which it had arrived and be returned to the United States on practically

the very same day it had left.

The loss to the American people would take the form not of a reduction in their cash holdings, but of a diminution in the quantity of goods they were able to buy: the recipients of the foreign aid would have the funds to buy more goods, while Americans had to buy less goods. Also, the indebtedness of the American people would be increased, which they would have to repay by further restricting their consumption in favor of the recipients of the foreign aid. Of course, to some extent, instead of buying less, the American people would also have to sell more, in order to replenish their cash holdings. In other words, the foreign aid measure and the initial loss of currency it entailed would automatically be financed by a combination of a decrease in imports and increase in exports. It would not be financed by any significant loss of currency.

Considerations such as these fully confirm the observation of Adam Smith, quoted earlier in this section, that “the attention of government never was so unnecessarily employed, as when directed to watch over the preservation or increase of the quantity of money in any country.”

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A final analogy will help to bring into focus what is wrong with the whole balance of payments approach.

Thus, if we had nothing better to do with our time, we might construct a “balance of food account.” This would show all sources of food entering a family’s refrigerator and all uses of the food taken from that refrigerator. The food entering the refrigerator, of course, would be the counterpart of receipts; the food taken from the refrigerator, of outlays. The change in the quantity of food in the refrigerator, of course, is always equal to the difference between the receipts of food entering the refrigerator and the withdrawals (outlays) of food leaving the refrigerator.

We might then appoint a government official to stand guard over the refrigerator and spend his time worrying about the food balance. We can imagine him watching the food in the refrigerator diminishing, and blaming it on excessive outlays for snacks or parties, or perhaps insufficient receipts from the nearby supermarket. We can imagine him rejoicing at the increase in the amount of food in the refrigerator when a bag of groceries is unpacked and put away. We can imagine him projecting plans and issuing regulations concerning what alleged excesses on the food-outlays side must be controlled and what alleged deficiencies on the food-receipts side must be overcome, in order to secure a stable or growing stock of food.

And, finally, we might imagine trying to explain to this good civil servant that the amount of food in the family’s refrigerator is not in fact the result of the hap— penstance difference between receipts and outlays of food, but of deliberate decisions by the family to build up or run down its stock of food, which decisions determine the food receipts and outlays in such a way as to achieve the desired change in the stock of food. Thus, for example, if we observe the stock of food increasing, the explanation is not that food receipts exceed food outlays, but that the family has decided to give a party, say, and has gone out and done the necessary extra shopping. Similarly, if we observe the stock of food decreasing, the explanation is not that the amount of food being withdrawn from the refrigerator exceeds the amount being put into it, but that the family has decided to go away for a vacation and thus to use up the food it has without replacing it.

In sum, what needs to be explained is that the change in the stock of money in people’s pockets, like the change in the stock of food in their refrigerators, is fully within their control and that their decisions about changes in the stock determine the relationship between the receipts and outlays, not that the relationship between the receipts and outlays determines the change in the stock.

Unilateral Free Trade and the Balance of Trade

The analysis of the balance of trade/payments that has been given above sheds light on the effects of adopting a policy of unilateral free trade or unilateral tariff reduction.

Under an international gold standard, the adoption of such a policy would temporarily be accompanied by an “unfavorable” balance of trade/payments in the country concerned. This is because the immediate effect of the country’s elimination or reduction of trade barriers would be that foreign goods suddenly became cheaper, while domestically produced goods remained at their initial prices. Thus, the demand for imports would increase and there would be no immediate change in the quantity demanded of exports. Accordingly, under an international gold standard there would be an outflow of gold.

However, this very loss of gold and thus the reduction in the quantity of money in the country would operate to reduce wages and prices in the country, and to increase them in the countries to which the gold was sent. These changes, in turn, would make the country’s producers more competitive both in the domestic market of their country and in the international export market. The effect would be that some part of the domestic market initially lost to imports would be regained and at the same time an expansion of exports would take place.

Thus the country would end up both importing more and exporting more. Its citizens would be as fully employed as they were before. The only difference would be that more of them would be employed in export

536 CAPITALISM industries and fewer of them in industries producing for the domestic market. The net gain of the citizens would be that the additional imports they obtained represented more and better goods than they could produce with the same labor devoted to producing for the domestic market. By the same token, the citizens of foreign countries would gain more from the additional exports of the country in question than they lost by devoting part of their labor to producing the additional imports for that country. In other words, both the citizens of the country in question and the citizens of the countries it dealt with would enjoy greater benefits from the operation of the law of comparative advantage. 41

An essential requirement of being able to adapt to the consequences of a temporary outflow of money is the absence of labor legislation. This is because it is vital that the wage and price level of the country be free to fall to the extent necessary for the country to become sufficiently competitive to have full employment. Precisely this is what such legislation prevents.

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The present discussion provides the opportunity to deal with the question of what would happen if one country pursued a policy of free trade, while all other countries absolutely prohibited the importation of its goods.

In such a case, under an international gold standard, the country would experience an outflow of gold until its wages and prices fell so low, and those in other countries rose so high, that its citizens simply wished to purchase nothing whatever from abroad.

The existence of such a case is virtually impossible, however. As wages and prices in the country concerned fall, its goods become an ever more powerful attraction to foreign buyers. Thus, it is almost unthinkable that it would not at some point increase its exports. To whatever extent it is able to do so, then its citizens—and the citizens of foreign countries—gain the benefit of greater operation of the law of comparative advantage.

It should be obvious that if unilateral free trade is viable under the conditions of an international gold standard, and, indeed, even under conditions in which, in addition, other countries follow policies of the most extreme protectionism, then it should certainly pose no great difficulties under the conditions of a fiat money, in which there cannot even be any significant outflow of money.

5. Invariable Money

Under the head of money, it is essential to deal with the concept of invariable money, whose meaning and vital role in economic analysis I will at once proceed to explain.

When prices change, people usually take for granted that the change is the result of something taking place on the side of goods. When prices rise, they say that goods are becoming more expensive; when prices fall, they say that goods are becoming cheaper.

This presumption was overthrown when economists realized that money itself is subject to the same forces of supply and demand as are goods. This realization meant that changes in prices can reflect changes taking place on the side of money as well as changes taking place on the side of goods. Indeed, precisely this is the case whenever there is inflation or deflation. During an inflation, it is not actually goods which are becoming more expensive, but money which is becoming cheaper. During a deflation, it is not actually goods which are becoming cheaper, but money which is becoming dearer. The rise in prices during an inflation is the result of expressing them in a medium that is itself of declining value; the fall in prices during a deflation is the result of expressing them in a medium that is itself of rising value. This point has already been made clear in the example of expressing the lower price of video tape recorders in terms of pocket calculators, whose price has fallen even more, which produces the result of the price of video tape recorders appearing to rise rather than fall. 42

That example, and its underlying theoretical insight, should not be thought of as esoteric in any way. They help to shed a great deal of light on, among other things, the respective roles of a system of fiat paper money and the businessman’s profit motive in the causation of the rising prices we see almost all around us. It is a fact that prices are rising. But it is no less a fact that the profit motive of the businessman tends constantly to reduce prices. The two facts are reconciled by the third fact that we currently express prices in terms of a monetary unit whose own value falls more rapidly than businessmen are able to cut costs and reduce prices. Our present monetary unit is, of course, a mere piece of paper, whose cost of production is virtually zero to begin with, whose quantity can be expanded without limit, and which is in fact rapidly expanded. Thus, prices rise even though, if expressed in a monetary unit whose own value did not decline, they would show a pronounced fall. 43

The variability of the value of money coming from the side of money does not apply only to a fiat paper money, however. It applies even to a pure gold or silver standard—that is, to a 100-percent-reserve gold or silver standard. The supply of gold and silver tends to increase, which, other things being equal, operates to reduce their value, i.e., to raise the prices of all other goods. Of course, the increase in the supply of precious metals tends to take place in conjunction with an increase in the supply of goods and services in general and thus tends not to result

in an actual rise in prices. Moreover, because the increase in the supply of precious metals is relatively slow and steady and the supply virtually incapable of any significant sudden decrease, the demand for the precious metals would tend to be highly stable under a 100-percent-reserve, precious-metal standard. But even so, the increase in the supply of precious metals would still operate to make the fall in commodity prices less than it would otherwise be, i.e., to raise commodity prices in comparison with what they would have been in the absence of any change in the supply of the precious metals.

When economists realized that even a gold money is regularly subject to forces that tend to change its value from the side of money, they launched a search for a money of invariable value—that is, for a money under which changes in prices would reflect exclusively changes operating on the side of goods, not money. These efforts, and the recognition of their importance, were carried furthest by Ricardo, who declared:

If then, I may suppose myself to be possessed of a standard so nearly approaching to an invariable one, the advantage is that I shall be enabled to speak of the variations of other things without embarrassing myself on every occasion with the consideration of the possible alteration in the value of the medium in which price and value are estimated.

To facilitate, then, the object of this inquiry, although I fully allow that money made of gold is subject to most of the variations of other things, I shall suppose it to be invariable, and therefore all alterations in price to be occasioned by some alteration in the value of the commodity of

which I may be speaking. 44

Ricardo believed that in order for gold to be an invariable standard of value, the principle requirement that it would have to fulfill is always to require the same quantity of labor in its production. Even then, he held, it would not be perfect as an invariable standard of value, because changes in the rate of profit and in the period of time elapsing between the performance of labor in the production of gold and the exchange of that gold in the market could alter its value from its own side. 45

In my judgment, Ricardo’s discussions of an invariable standard of value and his applications of the concept, while essentially brilliant, are badly flawed and needlessly obscured by his constant intermingling of the labor theory of value. Thus, in place of Ricardo’s criteria for an invariable monetary standard, I offer my own, whose nature has been indicated in previous pages of this book. Namely, what would be required for gold to be an invariable standard of value would be a fixed, constant aggregate expenditure of gold for products—e.g., a fixed aggregate expenditure for products of one billion ounces of gold per year. 46 This would be consistent with a fixed quantity of gold money and a fixed velocity of circulation of that money in relation to products. The latter requirement, of course, would be consistent with an essentially fixed demand for gold for holding.

Under these conditions, price changes on the aggregate level—that is, changes in the weighted average or general level of prices—would reflect changes taking place on the side of the production and supply of products exclusively. Indeed, the implication of a fixed aggregate expenditure is that the aggregate demand curve for products would be such that all changes in the aggregate supply of products produced and sold would result in inversely proportionate changes in the weighted average of product prices. That is, if production and supply doubled, prices would halve. If they tripled, prices would be cut to one-third, and so on. This follows because an unchanged aggregate expenditure means that it is represented by the number “one.” Whatever the increase in production and supply, it is always divided into one. Hence, the price level is always the reciprocal of production and supply. In the technical language of economists, the aggregate demand curve would have unit elasticity, which is to say that quantities of products demanded would change in inverse proportion to prices.

Changes in demand, of course, would, still take place in the economic system, but only at the level of individual industries and companies. At the aggregate level, they would always be mutually offsetting. If expenditure for product X increased, then expenditure for product Y, or for a group of products denoted as Y, would have to decrease equivalently. Thus changes in demand would be a factor determining relative prices only, not the general level of prices. All changes in the prices of individual goods would reflect changes specific to those goods, including the evaluation of those goods, not changes operating on the side of money. 47

Invariable Money and the Velocity of Circulation

The concept of an invariable money should not be confused with the assumption of an invariable velocity of circulation of money other than that of an invariable velocity of circulation confined to the demand for products only. It is consistent with substantial variations in overall total expenditures relative to the same total quantity of money and thus with substantial variations in broader measures of velocity, such as transactions velocity and “total revenue velocity,” which last would relate the combined sum of expenditures either for products or for labor to the quantity of money. 48 This is because changes in the demand for securities and in lending and borrowing operations need have no effect on changes in the aggregate demand for products inasmuch as the sellers of securities and the recipients of loans can simply take the place of the buyers of securities and the grantors

of loans in making purchases of products. 49 In the same way, a rise in the demand for labor that is made possible by a fall in the consumption expenditure of employers enables wage earners to make a demand for products in place of their employers and thus also does not reduce the demand for products. The same is true even of taxation insofar as it transfers the ability to buy products from the taxpayers to the government or to other individuals to whom the government gives the tax proceeds.

Thus the aggregate demand for products can remain the same on the foundation of a fixed quantity of money in the economic system, while other forms of expenditure increase or decrease.

The Contribution of the Concept of Invariable

Money to Economic Theory

The concept of an invariable money is an invaluable tool of economic analysis. (It should go without saying that as an analytical tool, it should not be confused with any kind of objective to be established by government intervention in the economic system. It is a method to be used in thinking about the economic system, not a political goal to be imposed upon it.) A few paragraphs ago, I recalled its value in reconciling the benevolent nature of the profit motive with the existence of rising prices. It should also be recalled how an analysis based on the assumption of an invariable money served to reconcile the benevolent nature of economic competition with reductions in money income on the part of less capable competitors. For it showed how competition operates to reduce prices to the same extent as it operates to reduce the incomes of the less capable competitors and, indeed, to a greater extent. 50

Applying the concept of an invariable money permits the separate analysis of the effects of changes operating on the side of the production and supply of goods and services, and changes operating on the side of money and the monetary demand for goods and services. Its application thus makes possible the adoption of a procedure analogous to that of mechanics, which takes as its analytical starting point the existence of a vacuum and then proceeds to develop its basic laws in a context in which there is no friction and in which, therefore, it can conceptually isolate the effects of the forces operating on objects. Indeed, the assumption of an invariable money is and must be made at least implicitly by everyone who thinks about economic phenomena insofar as his theorizing is based on the assumption of all other things being equal, which, of course, is the necessary starting point of all economic analysis. Among the most important of the other things that must be held equal in economic analysis is the quantity of money and the aggregate spending for the goods and services of business that it supports. Instead of leaving the assumption to mere implication, however, it should be made explicitly and adhered to unless and until it is necessary to relax it.

Accordingly, my typical procedure in the chapters that follow will be to begin with the assumption that the quantity of money and aggregate volume of spending in the economic system for the goods and services of business are fixed. With the aid of this analytical context, we will be in a position to trace out in isolation the effects of all phenomena acting on the production and supply of goods—for example, such phenomena as an increase in the productivity of labor resulting from the adoption of improved machinery or any other cause, or an increase in the supply of labor, whether an increase in the number of workers employed or an increase in the number of hours or days worked by the average employed worker. We will be able to examine the effects of all such changes on prices, wage rates, average money incomes, and the average standard of living. Then, in a separate analytical procedure, we will trace out the effects of an increase in the quantity of money and volume of spending in the economic system. Finally, in a manner similar to the addition of separate vectors in mechanics, we will add the results of the two separate analytical procedures in order to arrive at a complete description of what occurs in the world around us.

I will name now some of the leading findings that this method will reach. It will validate the proposition known as Say’s Law of Markets, that aggregate real demand— that is, what any given aggregate monetary demand can actually buy—is determined by aggregate supply. It will confirm the corollary proposition of the classical economists that a general or absolute overproduction is impossible—that the only kind of overproduction that can exist is a partial, relative overproduction in some portions of the economic system, which is always counterbalanced by a precisely equivalent partial, relative underproduction elsewhere in the economic system. In close connection with these points, our method will show that the falling prices caused by increased production do not constitute deflation, in that they are not accompanied by the other leading symptoms of deflation, namely, a greater difficulty of repaying debts and a decline in the general profitability of business. It will show that deflation properly so called is always a phenomenon operating on the side of money, in the form of a reduced supply and/or increased demand for money and thus in a reduction in aggregate expenditure.

Economic analysis based on the context of an invariable money will show not only that unemployment can be eliminated by means of a fall in wage rates and prices but, at the same time, that the restoration of full employment achieved in this way tends to be accompanied by a

MONEY AND SPENDING 539 rise in the real wages of the average worker—that is, by a rise in the goods and services he is actually able to buy with his money wages. Here, such analysis shows, is a major case in which money wages fall and nevertheless real wages rise—in which, indeed, the fall in money wages is the precondition of the rise in real wages. Economic analysis based on the context of an invariable money will show that real wages are determined primarily and overwhelmingly by the productivity of labor, while the average level of money wages is determined primarily by the quantity of money.

This method of economic analysis will lead to the further conclusion that the rate of increase in the quantity of money and volume of spending in the economic system adds a roughly equivalent increase to the average nominal rate of profit and interest, while the rate of increase in the volume of production and supply of goods adds a roughly equivalent increase to the average real rate of profit—that, for example, a 2 percent annual increase in the quantity of money and volume of spending in the economic system add approximately 2 percent to the nominal rate of profit, while a 2 percent annual increase in the volume of production and supply add approximately 2 percent to the real rate of profit. Analysis on the basis of an invariable money will also make it possible to grasp the determinants of the nominal rate of profit other than the rate of increase in the quantity of money.

In addition, economic analysis based on the context of an invariable money will make it possible for the first time to grasp the actual relationships between saving, on the one side, and capital accumulation, real wages, and the rate of profit, on the other, and to discern causes of capital accumulation which otherwise must remain concealed—notably, technological progress and anything else which operates to increase production. It will show, among other things, that the value of technological progress in connection with capital accumulation is as a source of capital accumulation, not as a use of capital goods accumulated by saving. It will show that nominal net saving, i.e., saving out of money income, is possible as a permanent phenomenon only on the basis of an increasing quantity of money and would disappear if the increase in the quantity of money were to come to an end. It will show that the real significance of saving is to be found at a level beyond that of money income, namely, in the proportion of gross revenue saved and productively expended versus the proportion consumed, and in the ratio of accumulated nominal capital to consumption. It will show that capital accumulation does not in any way necessitate or imply a falling rate of profit, and that even nominal net saving also does not imply a falling rate of profit in the context in which it continues indefinitely, namely, that of an expanding quantity of money.

A major theme which develops on the basis of the analytical framework of an invariable money is that of the distinction between monetary value and real wealth, or, as Ricardo put it, the distinction between “value and riches.” 51 It will become apparent how mistaken it is to assume that wealth and the monetary value of wealth necessarily move together. For again and again, it will become clear how production and real wealth can increase at the same time that alleged monetary measures of that production and wealth, such as national income or gross domestic product (gross national product), show no increase or actually decrease, and, by the same token, how alleged monetary measures of production and wealth can increase while the production and wealth involved actually tend to decrease.

Thus, we have already seen how competition among workers can reduce the money incomes of broad categories of workers and yet still be the basis of a rise in the general standard of living, including the standard of living of the workers whose money incomes are reduced. Going even further, we will see how capital accumulation and improvements in machinery are capable of being accompanied by reductions in the money income of all wage earners taken together, and yet at the same time still be the basis of a rise in the standard of living of the average wage earner. 52 Indeed, we will see that the whole mentality, which is so typical of the labor unions, that the way to raise the standard of living is to raise money wages is completely mistaken when applied to the economic system as a whole. It will become clear that the rise in the general standard of living always takes place from the side of forces tending merely to reduce prices, and not to increase money incomes, indeed, tending sometimes to reduce money incomes. We will see also that forces operating to increase average money incomes can, at the same time, be the source of a fall in real incomes, and that this is true not only of the undue increase in the quantity of money, viz., inflation, but also of taxes paid for with funds that otherwise would have been expended to buy capital goods, and of government budget deficits similarly paid for. Such taxes and deficits, we will see, operate to raise pretax nominal profits and, at the same time, to undermine capital formation and reduce the ability to produce and thus the general standard of living. 53

Perhaps among the greatest instances of the distinction between value and riches is the one we have seen in the preceding chapter. I refer, of course, to the fact that in Adam Smith’s “early and rude state of society,” all income would be profit and the rate of profit would be infinite, while at the same time the level of production and general standard of living would be barbarously low.

Under the assumption of an invariable money, advance from such a state of affairs would be accompanied not only by a fall in the nominal rate of profit, but also by a fall in the size of nominal national income (national income being taken as the sum of profits plus wages). For as productive expenditure grew, not only would wages rise at the expense of a fall in profits, but so too would the expenditure for capital goods and thus costs on account of the expenditure for capital goods. In other words, the fall in profits would exceed the rise in wages, as what had been profits became both wages and a demand for capital goods. Yet real wealth and prosperity would be the greater and all the more rapidly progressing, the further this process was carried.

While the distinction between value and riches—between the effect of things on money income and their effect on the actual standard of living—is at its sharpest in the context of an invariable money, it also appears again and again in the world around us. The explicit assumption of an invariable money is essential to understanding the nature of economic phenomena by thinking through the full consequences of their operation and not stopping at the point merely of recognizing their positive or negative effect on money income. When this is done, the benevolent nature of the pursuit of material self-interest under economic freedom, and the destructive nature of government violations of economic freedom, stand forth in unparalleled clarity and completeness.

Notes

1. The time of writing is the fall of 1994. The figure for the money supply comes from The New York Times, October 28, 1994, p. C13, while the estimate for the GDP is based on the data reported for the second quarter of 1994 in The Federal Reserve Bulletin, October 1994, p. A51.

2. See ibid., p. A14. This measure of the money supply is reported as M 1 . Other, larger measures add to M 1 such totals as time and savings deposits, certificates of deposit, Treasury Bills, and so forth. These further items are easily convertible into money and represent highly liquid assets. But they are not directly spendable as such. One cannot, for example, walk into a store and spend directly out of one’s savings-account passbook, as one can spend out of one’s checkbook. Such assets can be thought of as near moneys, but they are not in fact money themselves. Concerning a recent important development pertaining to this subject, see below, p. 965 n. 100.

3. See ibid., p. A51. Both government expenditures—virtually in their totality—and private expenditures for owner-occupied housing must be categorized as consumption because, as previously explained, they are not made for the purpose of bringing in subsequent sales revenues. Hence, they lack the ability to replace the funds expended in carrying on the activity. Those funds are used up and gone—consumed. If they are to be replaced, it must be from an outside source of revenue: taxes or money creation in the case of the government, a job or business in the case of private individuals. See above, pp. 442–456.

4. The reasons for this equivalency with national income are explained below, on pp. 700–702 and on p. 712.

5. The concept of Gross National Revenue is elaborated below, on p. 712.

6. See below, pp. 519–526, for a whole series of further connections between more money and more demand.

7. These definitions, of course, accord with the usage of the British classical economists, which was explained in Chapter 5. The demand/supply formula was also present implicitly in Chapter 6, in my exposition of the theory of price formation for goods and services in limited supply, and more or less explicitly in Chapter 7, in my discussion of price controls and inflation.

See above, pp. 152, 202, and 220.

8. See above, p. 220.

9. See above, pp. 141–142.

10. In most of its essential features, this discussion of the origins and evolution of money follows the writings of Menger. Cf. Carl Menger, Principles of Economics, trans. and ed. by James Dingwall and Bert F. Hoselitz (Glencoe, Ill.: The Free Press, 1950), pp. 257–271, 280–285.

11. See above, p. 142.

12. Menger did not emphasize this advantage of the precious metals. As a result, his account of why the precious metals in particular became money is highly deficient. See Menger, Principles, pp. 265–268.

13. Gold and silver rarely circulated at the same time, because of government interference in the form of bimetallism, that is, the imposition of a price control on one or the other of the two moneys. Prior to 1834, the government compelled merchants to accept gold coin as the equivalent of only 15 ounces of silver to one ounce of gold, while in the bullion market gold was worth about 15.5 ounces of silver. The result was that gold did not circulate in this period. From 1834 on, the government required that silver coin be accepted at the rate one ounce of silver equals one-sixteenth of an ounce of gold, while in the bullion markets it was more valuable. The result was that silver coins disappeared from circulation.

14. Cf. Ludwig von Mises, The Theory of Money and Credit, new ed. (1953; reprint ed., Irvington-on-Hudson, N. Y.: Foundation for Economic Education, 1971), p. 133; idem, Human Action, 3d ed. rev. (Chicago: Henry Regnery Co., 1966), pp. 432–434.

15. Federal Reserve Bulletin, October 1994), p. A13.

16. Charles Holt Carroll, a nineteenth-century monetary theorist, aptly described the phenomenon as “the organization of debt into currency.” See his Organization of Debt Into Currency, and Other Papers, ed. with an Introduction by Edward C. Simmons (1964; reprint, New York: Arno Press and The New York Times, 1972).

17. Until the mid-1970s, only commercial banks could offer checking accounts. Now more than half of total checking

MONEY AND SPENDING 541 accounts are held at other types of financial institutions, such as savings banks and savings and loan associations.

18. See Murray Rothbard, What Has Government Done to Our Money? (Novato, Calif.: Libertarian Publishers, 1979), pp. 22–24. In support of this view, see also below, pp. 957–958. 19. Cf. von Mises, Human Action, p. 446.

20. The best explanations of the trade cycle are to be found in von Mises, Human Action, pp. 398–586, 780–803, and Charles Holt Carroll, The Organization of Debt Into Currency.

21. Federal Reserve Bulletin, October 1994, p. A10.

22. On this subject, see New York Times, March 26, 1992, pp. C1–C2.

23. For the sake of brevity, in what follows I generally refer to gold and gold money, but, of course, my discussion applies equally to silver and silver money.

24. The destructive effects of fiduciary media become apparent in the light of this principle. See the discussion of the effects of credit expansion on the demand for money, below, p. 256. See also below, pp. 938–940.

25. Compared with rates of increase in the supply of paper money, even the gold added by the Spanish conquest of the new world and later by the California gold fields was relatively modest. See below, p. 920.

26. See below, pp. 942–950.

27. Cf. von Mises, Theory of Money and Credit, pp. 227–229; Human Action, pp. 426–428.

28. For reasons that I will explain in the next chapter, in connection with the discussion of Say’s Law, falling prices caused by increases in production, rather than by decreases in the quantity of money and volume of spending, do not operate to increase the demand for money or, therefore, to reduce the velocity of circulation of money. Only those price reductions emanating from decreases in the quantity of money and/or volume of spending cause a rise in the demand for money. See below, pp. 574–576.

29. Chapter 19 explains why credit expansion is followed by periods of credit contraction and thus of deflation and depression. See below, pp. 938–941. See also von Mises, Human Action, pp. 538–586.

30. See above, pp. 186–187.

31. See below, pp. 762–774.

32. This calculation is based on data supplied in Banking and Monetary Statistics 1914–1941, p. 34.

33. Cf. Federal Reserve Bulletin, December 1982, p. A14; December 1983, p. A13. See below, p. 965 n. 100, concerning the more recent role of money-market mutual funds.

34. The calculation of the most recent rate of increase in the money supply is based on year-end data appearing in Federal Reserve Bulletin, July 1994, p. A14, and weekly money supply figures as reported in New York Times, October 17, 1994. 35. See below, pp. 959–962.

36. See below, pp. 942–950, especially pp. 946–949.

37. Adam Smith, The Wealth of Nations (London, 1776), bk. 4, chap. 1; reprint of Cannan ed., (Chicago: University of Chicago

Press, 2 vols. in 1, 1976), 1:458.

38. For the most part, the foreigners’ bank deposits are saving or time deposits, or take the form of the purchase of certificates of deposit.

39. See, for example, below, pp. 542–594 passim.

40. For further discussion of the destructive effects of labor unions, see below, pp. 655–659.

41. For a discussion of the law of comparative advantage and its relationship to international competition and to competition in general under capitalism, see above, pp. 350–356.

42. See above, pp. 179–180.

43. Cf. above, ibid.

44. David Ricardo, Principles of Political Economy and Taxation, 3d ed. (London, 1821), chap. 1; reprinted as vol. 1 of The Works and Correspondence of David Ricardo, ed. Piero Sraffa (Cambridge: Cambridge University Press, 1962), p. 46. Subsequent page references to the Sraffa edition will appear in brackets. 45. Ibid. [pp. 43–46].

46. In most contexts, but not all, the fixed aggregate demand for products can be taken as pertaining simply to newly produced products. For a leading exception, however, see below, pp. 578–579. Those pages contain an analysis in which the demand for products must be extended to include the demand for previously produced products.

47. The assumption of an invariable money in my sense, that is, of a fixed aggregate expenditure for products, appears implicitly throughout much of Henry Hazlitt’s Economics in One Lesson and Bastiat’s “What Is Seen and What Is Not Seen,” and is a major source of the great analytical strength of those works. See Henry Hazlitt, Economics in One Lesson, new ed. (New Rochelle, N. Y.: Arlington House, 1979) and Frederic Bastiat, Selected Essays on Political Economy, trans. Seymour Cain (New York: D. Van Nostrand, 1964), pp. 1–50.

48. For discussion relevant to the concept of total revenue velocity, see below, pp. 706–707.

49. Indeed, if anything, such transactions are part of a process that actually serves to increase the demand for products. See above, the discussion of the effect of saving on the velocity of money, on p. 518.

50. See above, pp. 367–371.

51. Cf. Ricardo, Principles of Political Economy and Taxation, especially chap. 20.

52. Ironically, Ricardo himself was led astray from his principle when he came to cases entailing a change in the aggregate demand for labor. Thus, he came to the mistaken conclusion that the adoption of machinery is against the interests of wage earners if it reduces the aggregate demand for labor and that war is in the interests of wage earners insofar as taxation diverts funds from expenditure for luxury goods to an additional demand for labor. Cf. ibid., chap. 31. See the analysis of Ricardo’s errors on these points, below, on pp. 639–641 and 647–650.

53. See below, pp. 826–830. This point applies to the socalled balanced budget multiplier doctrine of the Keynesians, concerning which, see below, pp. 712–715.