by Patrick Barron
Understanding today’s convoluted domestic and international fiat monetary
system frankly requires a great deal of time and study. One must understand
fractional reserve banking, and the way this system affects the money supply.
One must understand the multi-step process by which banks create money out of
thin air.
One must understand central bank open market operations. Internationally,
one must try to understand floating exchange rates, how they are manipulated by
central banks, and the resulting impact on national economies. For example, is
it best for a country to drive down its exchange rate in relation to other
currencies or do the opposite?
These issues are never understood by policymakers, who appear to be among
the most illiterate in economic matters, so monetary policy swings to-and-fro
according to which economic group has temporary control over the levers of the
government, and particularly of central banks.
So Simple Even a
Child Can Understand It
In a sound money environment, on the other hand, there is little confusion
or controversy. Under sound money—in which money is a commodity (for discussion
purposes let us assume it to be gold)—everyone, to some extent, understands
monetary theory. Whether it be an individual, a family, a corporation, or a
nation, either one has money or one does not. It really is as simple as that.
Even children learn the nature of money. A child quickly learns that the things
he wants cost money and either he has it or he does not. If he does not, he
quickly grasps that there are ways to get it. He can ask his parents for an
increase in his allowance. Or, he can earn the money he needs by doing chores
around the house or for friends and neighbors. He might be able to borrow the
money for large purchases, promising to pay back his parents either from his
future allowance or from anticipated future earnings from doing extra chores.
His parents can evaluate this loan request simply by considering the likelihood
that his allowance and chore income are sufficient.
How is this any different when applied to adults, companies, or
governments? In a sound money environment, they are the same. Individuals earn
what they spend on the family and may borrow from the bank to buy a home or a
new car. The lender will examine whether the person’s income is sufficient to
pay back the loan. If the family hits hard times, they may ask for assistance
from relatives or a charity. Companies have more means with which to fund their
operations. Stockholders provide the company with its initial capital.
Thereafter, when normal earnings are insufficient to fund desired expansion,
the company can borrow against accounts receivables and inventories, both of
which provide varying degrees of security for the lender.
So Simple Even a
Politician Can Understand It
A national government’s finances, under a sound money system, are little
different from either a household’s or a company’s. It needs to collect in
taxes what it spends. If it suffers a budget deficit, it can cut back spending,
attempt to raise taxes, or borrow in the open market. In a sound money
environment, there is a limit to the amount of debt that even a government can
incur, due to the need to pay back the loan from future tax revenue. If the
market believes that this may not be forthcoming, the nation’s credit rating
may suffer and its borrowing costs will rise, perhaps to the point that the
nation is completely shut out of the credit market. But this is a good thing!
The market instills practical discipline that even a politician can understand!
Under sound money, one does not need a special education to understand the
monetary system.
Taking the process one step further, anyone can understand international
monetary theory in a sound money environment. The national currency is simply
shorthand for a quantity of gold. A US dollar may be defined as one
thirty-fifth of an ounce of gold, and a British pound defined as roughly one
seventh of an ounce of gold. Exchange rates become mathematical ratios that do
not vary. So an American purchasing English goods would exchange his dollars
for pounds at a ratio of five dollars per British pound; i.e., one seventh of
an ounce of gold (a pound) divided by one thirty-fifth of an ounce of gold (a
dollar) equals five dollars to a pound. Through the banking system, the English
exporter would demand gold from the issuer of dollars, whether it be from a
central bank or private bank, at thirty-five dollars per ounce. When a currency
is simply a substitute for gold, either the issuer has gold with which to
redeem its currency or it does not.
Money Issuers
Subject to Normal Commercial and Criminal Law
When a nation overspends internationally, its gold reserves start to
dwindle. Money, which is backed one hundred percent by gold, becomes scarce
domestically. Domestic prices fall, triggering a rise in foreign demand for the
nation’s goods. The process of gold depletion is halted and then reversed. This
is the classical “Currency School” of international monetary theory. Commercial
banks present checks drawn on one another every day and the same process would
exist for gold-backed currencies. If a bank issues more scrip than it can
redeem for gold at the promised price, it is guilty of fraud. Its officers and
directors can be sued in court for any loss incurred by those who accepted the
bank’s scrip. Furthermore, the officers and director could be prosecuted for
the crime of fraud. In other words, banking would be subject to normal
commercial laws and bank officers and directors would be subject to normal
criminal laws.
Good Money Drives
Out Bad
The free market
monetary system would drive bad money issuers out of the market. Plus, bad
money issuers would suffer the loss of both their personal finances and, in the
case of outright fraud, loss of their personal freedom. This would be a
sobering incentive to deter criminals and attract only legitimate money
issuers. Money would be a bailment; i.e., property held for the benefit of
another, which must be surrendered upon demand for redemption. All around us
exist analogous bailment examples of entrusting valuable goods to complete
strangers. We leave our cars with valets at parking garages, our clothing at
neighborhood cleaners, our overcoats at coat checks, our luggage to the
airlines, valuable merchandise with shippers. In these cases, we fully expect
that our property will be returned to us. And it almost always is! If it is
not, public trust in the fraudulent outfits evaporates, and they quickly go out
of business. Likewise, money issuers would thrive only when the public trusts
their integrity, which would be enhanced by regular outside audits by respected
firms of the existence of one-hundred-percent reserves to back the money
issuer’s scrip. How different this would be from our present system in which
the Fed will not allow an audit of its gold reserves even when held for
the benefit of other central banks! It is clear that in a free market
monetary system such a policy would drive Federal Reserve Notes out of the
market through lack of demand. Even were the Fed to back its notes with its
gold reserves, in a totally free market in which private banks could issue
their own gold-backed scrip, the Fed would suffer from its past history of
blatant money debasement and secrecy in its operations. The market would prefer
the money issued by a well-respected private bank whose operations are
transparent and subject to outside audit by respected accounting firms.
Conclusion
In a sound money environment everyone understands monetary theory. Money is
like any other desired commodity, except it is not consumed. It is a medium of
indirect exchange, which traders accept in order to exchange for something else
at a later time. This is easily understood, whether the trader is a child, a
parent, a company, or a nation. One either has money or one does not. The money
can be a money substitute, a bailment, with which one can demand the redemption
of the real money—gold. Money issuers must keep one-hundred-percent reserves
against their money substitutes in order to abide by normal commercial and
criminal law. No special agencies or monetary authorities are necessary to make
the system work. The system emerges naturally and is regulated via the normal
commercial and criminal legal system.
This is the system
that government does not want us to have, because it provides no special favors
for enhancing state power. Sound money shackles the government to the
will of the people and not vice versa. As Ludwig von Mises stated
in The Theory of Money and Credit:
It is impossible
to grasp the meaning of the idea of sound money if one does not realize that it
was devised as an instrument for the protection of civil liberties against
despotic inroads on the part of governments. Ideologically it belongs in the
same class with political constitutions and bills of rights.
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