Economic Axioms

Economic Axioms
by Mark Anderson, Columnist

April 22, 2003

"Dollars and Sense"

(1) Money's exchange value is derived from its utility value. Consequently, money is created through the market process, not by government or a social contract.

If you were to ask the typical Ph.D. in economics why people demand money, the essence of the response that you would hear can be captured with this: people demand money for the goods and services that money can be exchanged for. That, sadly, is the prevailing orthodox answer to the question. Now, let me ask you, what is wrong with that answer? Do you see the circularity in the reasoning?

Why would somebody exchange goods and services for money? Because the person selling the goods or services demands money. So, saying that people demand money for the goods and services that money can be exchanged for is akin to saying that people demand money because people demand money.

The above explanation should help you to understand this basic economic axiom: money must originate from a commodity with intrinsic value - ideally, one that is durable and divisible. Money starts out as a commodity with utility value, then, through demands which it satisfies alone, becomes a common medium of exchange, i.e., money. Even the fiat dollar derives its purchasing power from when it was backed by gold. We went from gold, to a paper substitute for the gold, to the acceptance of the paper notes themselves, to paper that is now completely divorced from gold, but has a purchasing power that descends from when it was originally backed by gold. This is best explained by Ludwig von Mises' Regression Theorem.

If I were to make cute little paper certificates and call them, say, Anderson notes, nobody would just accept them. Money originates as a commodity with utility value, and the dollar had to descend from something with a pre-existing demand.

(2) Paper money should be a money substitute.

This one shouldn't need much explanation. Since money is a commodity, then paper money is supposed to be a substitute for, not an addendum to, the money supply, redeemable in a fixed amount of specie.

Contrary to popular thinking, money is not supposed to be an abstract unit of account, nor is it imputed with value through some other good, but is, itself, a valuable commodity. Paper money should function much like that of a check, which does not add to the supply of money, but is a stand-in for cash.

I will not belabor the reasons why gold, historically, has been the preferred medium of exchange in this summary. However, I would like to point out a few of the virtues of gold, to help you better understand the issue of money. Gold is both divisible and durable. Its divisibility is what allows for indirect barter - which is what the process of exchanging goods and services for money is - possible. Its durability makes it a safe store of value. Milk, for example, spoils after a few days and cannot be saved. A paper based monetary system, where paper functions independently as money, like our system, poses the very same problems that using milk for money would pose. A paper currency, which can be debased, i.e., devalued, at the arbitrary discretion of a few central planners is not a safe store of value.

(3) Inflation is not a general rise in prices, nor is it an inevitable consequence of free market processes.

Prevailing orthodoxy tells us that inflation is a general rise in prices, using the Consumer Price Index [CPI] and Producer Price Index [PPI] to measure and gauge inflation. This, however, contorts Irving Fisher's own quantity theory of money. That definition also, conveniently, leaves no term to describe the debasement of currency. The general rise in prices is the usual result of inflation, which is an expansion of the inconvertible money supply.

In order to understand inflation better, we ought to look at the embryonic stages of the dollar. Depositors would deposit gold into bank warehouses, where they would be issued a receipt, i.e., a paper money substitute, redeemable in a fixed amount of specie, i.e., gold. This money exists and cannot disappear, i.e., deflation. As the population grew accustomed to using the paper money substitute in lieu of the gold, without ever demanding payment in specie, banks would lend duplicate claims on the same supply of gold. That is exactly what inflation is.

There cannot be deflation, which isn't as horrendous as public policy practitioners pretend, without previous inflation. Since there was no rightful owner of the money, i.e., a depositor, who lent their money to the borrower, but, instead, the bank artificially increased the amount of circulating credit, there is no place for this pseudo-money to go when it is paid back, other than be removed from the liabilities column, i.e., disappear.

Using the accurate definition of inflation, one can see, with cursory examination, that we have had nothing except chronic inflation for almost a century. See: http://www.federalreserve.gov/releases/h6/

Even looking at prices, you can see that we have had inflation. The policy wonks have managed to conveniently exclude many important items from the CPI and PPI to make it appear as though prices are not rising. Just look at the prices of housing, education and health care.

(4) Inflation is a tax.

Inflation is no different than a tax. It makes no difference if the government takes the money you have in your possession, or if they duplicate the money you have, consequently devaluing it.

(5) Dollars are created through socialistic endeavors.

The way dollars are created is one of the most convoluted processes there is. I am sure this is by design, so as to obfuscate the truth of the operation which is fragmented between government and the Federal Open Market Committee.

If federal employees are paid out of revenue derived from the income tax, then why do federal employees have to pay the income tax? The answer can be found by understanding where the government gets its revenue, which also reveals to us how dollars are created.

Say a bank receives a $1,000 deposit, being the "reserve" requirement is at ten percent, ninety percent of the deposit is considered to be "excess reserves." This means the bank can turn around and lend out $900 to another customer, which expands the money supply by $900, and, in turn, gets re-deposited into the banking system, where ninety percent of that can be lent out again. Since the "reserve" requirement is ten percent, deposits can be multiplied by ten. The initial $1,000 can be turned into $10,000 through this process of pyramiding credit expansion.

I would also like to point out that the fact that dollars are even printed is a mere technicality. Whether the dollars are actually printed or not, the monetary aggregates have still shifted upwards since bank deposits are payable on demand.

Where did the initial deposit come from? The answer is from government expenditures, made out of revenue derived from bonds. Say the federal government sells a $1 billion bond, created out of thin air and backed by nothing other than the government's power to tax, to Bank A in New York. The federal government now has its $1 billion to spend, and now the FOMC can purchase $100 million of old government bonds. The FOMC does this by writing out a check for all new dollars - expanding the dollar supply - which get deposited into commercial banks.

When a government bond, which was used for bank "reserves," comes to maturity, the "reserves," plus whatever amount was pyramided on top of the "reserves," would be extinguished. Thus, the FOMC waits for new bonds that are good for ten times the amount of the old bond before purchasing it, in order to "protect" the ninety percent of the "reserves." The FOMC purchases bonds with all newly created dollars. Keep in mind that the federal government also got its $1 billion to spend. It is the newly created dollars which become the base bank "reserves." These new "reserves" make it possible to keep inflating the "money" supply even more.

Now we can see that the source of the dollar supply is government spending, and, consequently, socialism is inextricably linked to the monetary system. Now that you understand how "reserves" are injected into the loan market, you should be able to understand what the income tax is for. If the government derived its revenue for expenditures through, say, the income tax or a sales tax, the monetary aggregates would not change one iota. The government would be shifting around individual bank M1 and M2 accounts, but there would be no overall change in the dollar supply. Eventually bank credit expansion would reach its peak, the bond(s) that were the basis for creating the initial "reserves" would come to maturity, and then the entire supply of dollars would disappear.

This means that the government cannot, in abstract, be deriving its revenue for expenditures through the income tax or a sales tax. The implication of this is that the methodology by which the government spends money is a tax itself. It is a one-two punch at the taxpayer. First, they tax us the moment they spend, as it is all newly created "money" out of thin air. That is taxation by inflation. Remember, as I have discussed previously, inflation is a tax like any other. Second, they tax the "money" back in order to extinguish those bonds - i.e., centrally planned deflation, to prevent us from realizing how watered down the milk really is. Saying that government increased spending "only at the rate of inflation" is akin to saying that it's raining, but only at the rate it's flooding.
In closing with point number five, since what constitutes "reserves" is nothing but deposits of fiat dollars, this isn't even fractional reserve banking. This is fictional reserve banking.

(6) Nominal interest rates, real interest rates, and the natural interest rate.

The interest rate - i.e., natural - is nothing other than profit for the entrepreneur. There are two groups of goods, i.e., capital and consumer. Capital goods, or higher order goods, are goods which are used to make other goods which satisfy more immediate demands, e.g., a printing press. Consumer goods, or short order goods, are goods which satisfy our most immediate demands, e.g., a newspaper.

The price of the final, short order goods which satisfy our most immediate demands must bear the costs of all previous factors of production, which means shorter order goods should have a higher price than higher order goods. The difference in price between the final consumer goods and the capital goods is the profit for the entrepreneur, and is the natural rate of interest. No government is needed, no central bank is needed, to set and manipulate this price. That is nothing short of a price control, and why do these same hierophants who see falling prices as the most dangerous enemy, see government suppression of interest rates as a virtue?

The nominal rate of interest is the ostensible rate of interest charged to the borrower by the lender. The nominal rates that the Federal Reserve can set are the Discount Rate, which is the rate of interest charged to commercial banks for borrowing from the Fed, and the Federal Funds Rate, which is the rate of interest commercial banks charge to other commercial banks for borrowing each other's "excess reserves."

Then there is the prime rate, which the commercial loan market charges to its customers, and then there is the long-term rate on mortgages. The Federal Reserve cannot set those two rates. Although an altitudinal descent of the Discount Rate or the Federal Funds Rate can certainly influence the direction of the prime rate, the long-term rate may actually move inversely with short-term rates in order to account for a depreciating dollar, i.e., inflation.

The real interest rate is the actual amount of interest the borrower pays the lender. The real rate of interest is the difference between the inflation rate and nominal rates. For sake of illustration, say somebody is paying a nominal rate of interest of five percent, while the dollar is being inflated at a rate of, say, fifteen percent. Although you would actually pay $105 back on a $100 loan, you are paying the loan off with a depreciated dollar, and - all things remaining equal and static - paying a real interest rate of minus ten percent. The interest actually paid is the real rate of interest.

The Federal Reserve and the government can artificially suppress interest rates through inflation in another way. By increasing the amount of available "reserves," the Federal Reserve is increasing the amount of available credit, which results in a lower price, i.e., interest rate, for credit. As mentioned previously, inflation also lowers the real interest rate by letting borrowers pay back lenders, i.e., savers, with a depreciated dollar.

(7) Money should be bought.

When you purchase goods or services, you are actually selling dollars. Money, like everything else, is something that should be bought, not created out of thin air. This ensures that real savings from output are being used to acquire money.

Purchasing power consists of other goods. If you exchange a $10 bill for, say, a compact disc, and then the owner of the compact disc gives you the $10 bill back in exchange for, say, a book, the real means of purchase for the compact disc was your book, while the real means of purchase for the book was the compact disc. No matter how hard the government tries to repeal this economic law, the real pool of funding will always consist of other goods and services.

(8) Inflation causes recessions.

One of the worst ideas on the cause of recession is that it is due to a "lack of consumer confidence." That is a dogma that is almost universally accepted as some sort of self-evident absolute. But, rather than that being the cause of recession, it is a symptom. Understanding this is important to trace the pathology of the problem back to the source. Too often, economic practitioners fail to trace the pathology of the problem. By consuming themselves with the "markers" of a recession - i.e., the revelations from statistics, graphs, charts and equations - they look for ways to adjust these markers, as though the present is hermetically sealed off from all previous human action. If we think this through logically, we should have no problem concluding that something must have caused these conditions.

Consumption is not limited by confidence, but by productivity. We cannot consume what isn't produced, nor should we be advocating schemes that enable people to consume without producing, which is exactly what inflation does.

In a free market exchange economy, purchasing power consists of other goods. In other words, if you want your neighbor's couch, you must give them something in return, e.g., a coffee table. With inflation, purchasing power is now created out of thin air for the beneficiary, and always at the expense of every other person with a cash balance. This allows people to satisfy their demands without having to satisfy a single demand of another. Consequently, mal-investments are inherently encouraged.

Inflation and low nominal rates create misleading signals to entrepreneurs. As the new dollars are infused into the economy, people and firms mistake the increase in the supply of dollars as an expansion of real savings. This makes projects that are really unprofitable appear to be profitable. It is, conversely, not an expansion of real savings; it is, rather, a redistribution of savings. Consequently, without the necessary capital to sustain a project, people end up over investing and mal-investing in truly unprofitable projects. This is something that can be eliminated with a genuine gold standard.

Inflation causes firms to over estimate profits. As firms sell their goods and services for all newly created "money," unbeknownst to them, they are receiving a devalued dollar. When it comes time to re-stock their inventories they find that they are actually having to re-invest original, and in some cases more than original, capital. Again, this would not be the case with a real gold standard.

Having a real gold standard would not allow this credit expansion, since, in order for somebody to borrow money, the real lender, i.e., depositor, would be required to surrender the money for the duration of the outstanding loan. Bank credit expansion cannot increase capital investment at all. Investment can only come out of savings. Bank credit expansion can, however, fool entrepreneurs into investing in an unprofitable project that now looks profitable due to the bank credit expansion itself.

(9) The way out.

Contrary to a lack of consumption being the problem, the problem is a lack of savings. Encouraging consumption and penalizing saving, which is what inflation does, is the antithesis of what we should be doing. Producers need to consume in order to sustain production. Encouraging everybody to run off and spend their cash balances only lengthens the process of production. Our problem is more like over consumption, which leads to capital decumulation and erodes savings. It was once widely understood that people cannot borrow in excess of available capital, since credit is the trading of future wealth for current wealth.

Within the circles of us gold standard advocates, there has been much discussion over how to make the dollar "convertible" into gold. I believe that is a false solution. That is not the way to return to a gold standard, as that would be a price control and would be no different than the government setting a price for anything else.

There are three alternatives that we can choose from: work, i.e., produce, liquidate our assets, or inflate more, i.e., borrow and spend more. Since loans must be called in at some time, there is nothing in between inflation and deflation, until we have deflated our way back to where the inflation began. Either we are going to have more inflation, or we will deflate our way back to sound money. The cure for our economic woes is a very simple one. The government needs to stop inflating, i.e., debasing, our currency. Without making the dollar convertible, just putting the brakes on inflation would compel debtors to meet their obligations, as a market driven deflation reverses previous inflation. I believe this would be the most equitable way to get us back onto a gold standard. Only then will a market correction take place.

As Professor Murray Rothbard saliently articulated in America's Great Depression, putting the brakes on inflation, subsequently leading to deflation, would just cause everything to work in reverse. Firms would under estimate profits, etc. It is impossible, in my estimation, to simply make fiat money convertible. Additionally, this would simply reward the beneficiaries of inflation, i.e., a dishonest source of "revenue." Of course, new problems would emerge, as it is a certainty that the ratio would either overvalue or undervalue gold.

If somebody takes out a loan and spends $X with firm A, they now have a debt. Should there be more bank credit expansion in order to allow debtors to escape their obligations? By ceasing to inflate, the debtor would either need to liquidate his assets, or go to work and produce something in order to earn the dollars back. By inflating, you make it more difficult for firm A to redeem those dollars for other goods and services.

(10) Concluding remarks.

Every policy must make dollar revaluation paramount for it to succeed. Until we see a revaluation of the dollar - i.e., offsetting reductions in government outlays - we will not have had a real tax cut. The loan market cannot keep underbidding the natural rate of interest and sustain itself for long. Eventually, nominal rates must rise to accommodate the loose monetary policy of the Fed. Perhaps then Americans will begin to wonder what is hitting them.

In conclusion, I would just like to say that I haven't even covered an atom of truth in the ocean of lies. I strongly recommend readers to read the works of Henry Hazlitt, Ludwig von Mises, and Murray Rothbard.

www.mises.org
www.lewrockwell.com
libertybooks.freeurl.com

I would like to leave you with an excerpt from an essay called, Gold and Economic Freedom, written by Alan Greenspan in 1967, before he "evolved."

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard. ***

Recommended Reading

1) What has Government Done to Our Money? by Murray Rothbard
2) The Theory of Money and Credit by Ludwig von Mises
3) Human Action by Ludwig von Mises
4) Man, Economy, and State by Murray Rothbard
5) The Case for a 100% Gold Dollar by Murray Rothbard
6) The Inflation Crisis, and How to Resolve It by Henry Hazlitt
7) Basic Economics by Clarence Carson
8) The Economic Pinch by Congressman Charles Lindbergh, Sr.
9) Banking and Currency and the Money Trust by Congressman Charles Lindbergh, Sr.
10) Economics in One Lesson by Henry Hazlitt
11) The Failure of the "New Economics" by Henry Hazlitt
12) America's Great Depression by Murray Rothbard

Click Here for Mark's Archives

Photo of the author courtesy of staff files