The Fiasco of Fiat Money [Mises Daily]
June 8, 2012 Leave a comment
Today’s worldwide paper-, or “fiat-,” money regime is an economically and socially destructive scheme — with far-reaching and seriously harmful economic and societal consequences, effects that extend beyond what most people would imagine.
Fiat money is inflationary; it benefits a few at the expense of many others; it causes boom-and-bust cycles; it leads to overindebtedness; it corrupts society’s morals; and it will ultimately end in a depression on a grand scale.
All these insights, however, which have been put forward by the scholars of the Austrian School of economics years ago, hardly play any role among the efforts of mainstream economists, central banks, politicians, or bureaucrats in identifying the root cause of the current financial and economic crisis and, against this backdrop, formulating proper remedies.
This should not come as a surprise, though. For the (intentional or unintentional) purpose of policy makers and their influential “experts” — who serve as opinion molders — is to keep the fiat-money regime going, whatever it takes.
The fiat-money regime essentially rests on central banking — meaning that a government-sponsored central bank holds the money-production monopoly — and fractional-reserve banking, denoting banks issuing money created out of thin air, or ex nihilo.
In The Mystery of Banking, Murray N. Rothbard uncovers the fiat-money regime — with central banking and fractional-reserve banking — as a form of embezzlement, a scheme of thievery.
Rothbard’s conclusion might need some explanation, given that mainstream economists consider the concept of fiat money as an economically and politically desirable, acceptable, and state-of-the-art institution.
An understanding of the nature and consequences of a fiat-money regime must start with an appreciation of what money actually is and what it does in a monetary exchange economy.
Money is the universally accepted means of exchange. Ludwig von Mises emphasized that money has just one function: the means-of-exchange function; all other functions typically ascribed to money are simply subfunctions of money’s exchange function.
With money being the medium of exchange, a rise in the money stock does not, and cannot, confer a social benefit. All it does is reduce, and necessarily so, the purchasing power of a money unit — compared to a situation in which the money stock had remained unchanged.
What is more, an increase in the money stock can never be “neutral.” It will necessarily benefit early receivers of the new money at the expense of the late receivers, or those who do not receive anything of the new money stock — an insight known as the “Cantillon effect.”
Because a rise in the money stock benefits the money producer most — as he obtains the newly created money first — any rational individual would like to be the among the money producers; or even better: to be the sole money producer.
Those who are willing to disrespect the principles of the free market (that is, the unconditional respect of private property) will want to obtain full control over money production (that is, holding the money production monopoly).
Once people have been made to think that the state (the territorial monopolist of ultimate decision making with the right to tax) is a well-meaning and indispensible agent, money production will sooner or later be monopolized by the state.
The (admittedly rather lengthy) process through which government obtains the monopoly of money production has been theoretically laid out by Rothbard in What Has Government Done to Our Money?.
Having obtained the monopoly of money production, government will replace commodity money (in the form of, say, gold and silver) with fiat money, and the regime of legalized counterfeiting gets started.
Commercial banks will press for fractional-reserve banking, meaning that they should be legally allowed to issue new money (fiduciary media) through credit extension in excess of the reserves they obtain from their clients. Fractional-reserve banking is a rather attractive profit-making scheme for lenders; and it provides government with cheap credit for financing its handouts (well) in excess of regular tax receipts.
Fiat money will be injected through bank-circulation credit: banks extend credit and issue new money balances which are not backed by real savings. Economically speaking, this is worse than counterfeiting money.
Fiat money is not only inflationary, thereby causing all the economic and societal evils of eroding the purchasing power of money and leading to a non-free-market related redistribution of income and wealth among the people; banks’ circulation credit expansion also artificially lowers the market interest rate to below the rate that would prevail had the credit and fiat-money supply not been artificially lowered, thereby making debt financing unduly attractive, especially for government.
It is the artificial lowering of the market interest rate that also induces an artificial boom, which leads to overconsumption and malinvestment, and which must ultimately end in a bust. Mises put it succinctly:
The boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a “crack-up boom” and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis. The depression follows in both instances.
A fiat-money regime depends essentially on the demand for money. As long as people are willingly holding fiat money (and fiat-money-denominated government, bank, and corporate bonds, for that matter), the fiat-money regime can be run quite smoothly, for then people raise their demand for fiat money as its supply increases.