The Mystery Of Banking

by Murray N. Rothbard

  Or, put another way, at the lower money supply people scramble to increase cash balances. But since the money supply is set and outside their control, they cannot increase the supply of cash balances in the aggregate.1 But by spending less and driving down the price level, they increase the value or purchasing power of each dollar, so that real cash balances (total money supply corrected for changes in purchasing power) have gone up to offset the drop in the total supply of money. M might have fallen by $30 billion, but the $70 billion is now as good as the previous total because each dollar is worth more in real, or purchasing power, terms.

  An increase in the supply of money, then, will lower the price or purchasing power of the dollar, and thereby increase the level of prices. A fall in the money supply will do the opposite, lowering prices and thereby increasing the purchasing power of each dollar.

  The other factor of change in the price level is the demand for money. Figures 3.6 and 3.7 depict what happens when the demand for money changes.

  FIGURE 3.6 — AN INCREASE IN THE DEMAND FOR MONEY

  The demand for money, for whatever reason, increases from D to D’. This means that, whatever the price level, the amount of money that people in the aggregate wish to keep in their cash balances will increase. At the old equilibrium price level, 0A, a PPM that previously kept the demand and supply of money equal and cleared the market, the demand for money has now increased and become greater than the supply. There is now an excess demand for money, or shortage of cash balances, at the old price level. Since the supply of money is given, the scramble for greater cash balances begins. People will spend less and save more to add to their cash holdings. In the aggregate, M, or the total supply of cash balances, is fixed and cannot increase. But the fall in prices resulting from the decreased spending will alleviate the shortage. Finally, prices fall (or PPM rises) to 0B. At this new equilibrium price, 0B, there is no longer a shortage of cash balances. Because of the increased PPM, the old money supply, M, is now enough to satisfy the increased demand for cash balances. Total cash balances have remained the same in nominal terms, but in real terms, in terms of purchasing power, the $100 billion is now worth more and will perform more of the cash balance function. The market is again cleared, and the money supply and demand brought once more into equilibrium.

  Figure 3.7 shows what happens when the demand for money falls.

  FIGURE 3.7 — A FALL IN THE DEMAND FOR MONEY

  The demand for money falls from D to D’. In other words, whatever the price level, people are now, for whatever reason, willing to hold lower cash balances than they did before. At the old equilibrium price level, 0A, people now find that they have a surplus of cash balances burning a hole in their pockets. As they spend the surplus, demand curves for goods rise, driving up prices. But as prices rise, the total supply of cash balances, M, becomes no longer surplus, for it now must do cash balance work at a higher price level. Finally, when prices rise (PPM falls) to 0B, the surplus of cash balance has disappeared and the demand and supply of money has been equilibrated. The same money supply, M, is once again satisfactory despite the fall in the demand for money, because the same M must do more cash balance work at the new, higher price level.

  So prices, overall, can change for only two reasons: If the supply of money increases, prices will rise; if the supply falls, prices will fall. If the demand for money increases, prices will fall (PPM rises); if the demand for money declines, prices will rise (PPM falls). The purchasing power of the dollar varies inversely with the supply of dollars, and directly with the demand. Overall prices are determined by the same supply-and-demand forces we are all familiar with in individual prices. Micro and macro are not mysteriously separate worlds; they are both plain economics and governed by the same laws.

  IV.

  THE SUPPLY OF MONEY

  To understand chronic inflation and, in general, to learn what determines prices and why they change, we must now focus on the behavior of the two basic causal factors: the supply of and the demand for money.

  The supply of money is the total number of currency units in the economy. Originally, when each currency unit was defined strictly as a certain weight of gold or silver, the name and the weight were simply interchangeable. Thus, if there are $100 billion in the economy, and the dollar is defined as 1/20 of a gold ounce, then M can be equally considered to be $100 billion or 5 billion gold ounces. As monetary standards became lightened and debased by governments, however, the money supply increased as the same number of gold ounces were represented by an increased supply of francs, marks, or dollars.

  Debasement was a relatively slow process. Kings could not easily have explained continuous changes in their solemnly defined standards. Traditionally, a new king ordered a recoinage with his own likeness stamped on the coins and, in the process, often redefined the unit so as to divert some much needed revenue into his own coffers. But this variety of increased money supply did not usually occur more than once in a generation. Since paper currency did not yet exist, kings had to be content with debasement and its hidden taxation of their subjects.

  1. WHAT SHOULD THE SUPPLY OF MONEY BE?

  What should the supply of money be? What is the “optimal” supply of money? Should M increase, decrease, or remain constant, and why?

  This may strike you as a curious question, even though economists discuss it all the time. After all, economists would never ask the question: What should the supply of biscuits, or shoes, or titanium, be? On the free market, businessmen invest in and produce supplies in whatever ways they can best satisfy the demands of the consumers. All products and resources are scarce, and no outsider, including economists, can know a priori what products should be worked on by the scarce labor, savings, and energy in society. All this is best left to the profit-and-loss motive of earning money and avoiding losses in the service of consumers. So if economists are willing to leave the “problem” of the “optimal supply of shoes” to the free market, why not do the same for the optimal supply of money?

  In a sense, this might answer the question and dispose of the entire argument. But it is true that money is different. For while money, as we have seen, was an indispensable discovery of civilization, it does not in the least follow that the more money the better.

  Consider the following: Apart from questions of distribution, an increase of consumer goods, or of productive resources, clearly confers a net social benefit. For consumer goods are consumed, used up, in the process of consumption, while capital and natural resources are used up in the process of production. Overall, then, the more consumer goods or capital goods or natural resources the better.

  But money is uniquely different. For money is never used up, in consumption or production, despite the fact that it is indispensable to the production and exchange of goods. Money is simply transferred from one person’s assets to another.1 Unlike consumer or capital goods, we cannot say that the more money in circulation the better. In fact, since money only performs an exchange function, we can assert with the Ricardians and with Ludwig von Mises that any supply of money will be equally optimal with any other.2 In short, it doesn’t matter what the money supply may be; every M will be just as good as any other for performing its cash balance exchange function.

  Let us hark back to Figure 3.4. We saw that, with an M equal to $100 billion, the price level adjusted itself to the height 0A. What happens when $50 billion of new money is injected into the economy? After all the adjustments are made, we find that prices have risen (or PPM fallen) to 0B. In short, although more consumer goods or capital goods will increase the general standard of living, all that an increase in M accomplishes is to dilute the purchasing power of each dollar. One hundred fifty billion dollars is no better at performing monetary functions than $100 billion. No overall social benefit has been accomplished by increasing the money supply by $50 billion; all that has happened is the dilution of the purchasing power of each of the $100 billion. The increase of the money supply was socially usel
ess; any M is as good at performing monetary functions as any other.3

  To show why an increase in the money supply confers no social benefits, let us picture to ourselves what I call the “Angel Gabriel” model.4 The Angel Gabriel is a benevolent spirit who wishes only the best for mankind, but unfortunately knows nothing about economics. He hears mankind constantly complaining about a lack of money, so he decides to intervene and do something about it. And so overnight, while all of us are sleeping, the Angel Gabriel descends and magically doubles everyone’s stock of money. In the morning, when we all wake up, we find that the amount of money we had in our wallets, purses, safes, and bank accounts has doubled.

  What will be the reaction? Everyone knows it will be instant hoopla and joyous bewilderment. Every person will consider that he is now twice as well off, since his money stock has doubled. In terms of our Figure 3.4, everyone’s cash balance, and therefore total M, has doubled to $200 billion. Everyone rushes out to spend their new surplus cash balances. But, as they rush to spend the money, all that happens is that demand curves for all goods and services rise. Society is no better off than before, since real resources, labor, capital, goods, natural resources, productivity, have not changed at all. And so prices will, overall, approximately double, and people will find that they are not really any better off than they were before. Their cash balances have doubled, but so have prices, and so their purchasing power remains the same. Because he knew no economics, the Angel Gabriel’s gift to mankind has turned to ashes.

  But let us note something important for our later analysis of the real world processes of inflation and monetary expansion. It is not true that no one is better off from the Angel Gabriel’s doubling of the supply of money. Those lucky folks who rushed out the next morning, just as the stores were opening, managed to spend their increased cash before prices had a chance to rise; they certainly benefited. Those people, on the other hand, who decided to wait a few days or weeks before they spent their money, lost by the deal, for they found that their buying prices rose before they had the chance to spend the increased amounts of money. In short, society did not gain overall, but the early spenders benefited at the expense of the late spenders. The profligate gained at the expense of the cautious and thrifty: another joke at the expense of the good Angel.5

  The fact that every supply of M is equally optimal has some startling implications. First, it means that no one—whether government official or economist—need concern himself with the money supply or worry about its optimal amount. Like shoes, butter, or hi-fi sets, the supply of money can readily be left to the marketplace. There is no need to have the government as an allegedly benevolent uncle, standing ready to pump in more money for allegedly beneficial economic purposes. The market is perfectly able to decide on its own money supply.

  But isn’t it necessary, one might ask, to make sure that more money is supplied in order to “keep up” with population growth? Bluntly, the answer is No. There is no need to provide every citizen with some per capita quota of money, at birth or at any other time. If M remains the same, and population increases, then presumably this would increase the demand for cash balances, and the increased D would, as we have seen in Figure 3.6, simply lead to a new equilibrium of lower prices, where the existing M could satisfy the increased demand because real cash balances would be higher. Falling prices would respond to increased demand and thereby keep the monetary functions of the cash balance-exchange at its optimum. There is no need for government to intervene in money and prices because of changing population or for any other reason. The “problem” of the proper supply of money is not a problem at all.

  2. THE SUPPLY OF GOLD AND THE COUNTERFEITING PROCESS

  Under a gold standard, where the supply of money is the total weight of available gold coin or bullion, there is only one way to increase the supply of money: digging gold out of the ground. An individual, of course, who is not a gold miner can only acquire more gold by buying it on the market in exchange for a good or service; but that would simply shift existing gold from seller to buyer.

  How much gold will be mined at any time will be a market choice determined as in the case of any other product: by estimating the expected profit. That profit will depend on the monetary value of the product compared to its cost. Since gold is money, how much will be mined will depend on its cost of production, which in turn will be partly determined by the general level of prices. If overall prices rise, costs of gold mining will rise as well, and the production of gold will decline or perhaps disappear altogether. If, on the other hand, the price level falls, the consequent drop in costs will make gold mining more profitable and increase supply.

  It might be objected that even a small annual increase in gold production is an example of free market failure. For if any M is as good as any other, isn’t it wasteful and even inflationary for the market to produce gold, however small the quantity?

  But this charge ignores a crucial point about gold (or any other money-commodity). While any increase in gold is indeed useless from a monetary point of view, it will confer a nonmonetary social benefit. For an increase in the supply of gold or silver will raise its supply, and lower its price, for consumption or industrial uses, and in that sense will confer a net benefit to society.

  There is, however, another way to obtain money than by buying or mining it: counterfeiting. The counterfeiter mints or produces an inferior object, say brass or plastic, which he tries to palm off as gold.6 That is a cheap, though fraudulent and illegal way of producing “gold” without having to mine it out of the earth.

  Counterfeiting is of course fraud. When the counterfeiter mints brass coins and passes them off as gold, he cheats the seller of whatever goods he purchases with the brass. And every subsequent buyer and holder of the brass is cheated in turn. But it will be instructive to examine the precise process of the fraud, and see how not only the purchasers of the brass but everyone else is defrauded and loses by the counterfeit.

  Let us compare and contrast the motives and actions of our counterfeiter with those of our good Angel Gabriel. For the Angel was also a counterfeiter, creating money out of thin air, but since his motives were the purest, he showered his misconceived largess equally (or equi-proportionately) on one and all. But our real-world counterfeiter is all too different. His motives are the reverse of altruistic, and he is not worried about overall social benefits.

  The counterfeiter produces his new coins, and spends them on various goods and services. A New Yorker cartoon of many years ago highlighted the process very well. A group of counterfeiters are eagerly surrounding a printing press in their basement when the first $10 bill comes off the press. One counterfeiter says to his colleagues: “Boy, retail spending in the neighborhood is sure in for a shot in the arm.” As indeed it was.

  Let us assume that the counterfeiting process is so good that it goes undetected, and the cheaper coins pass easily as gold. What happens? The money supply in terms of dollars has gone up, and therefore the price level will rise. The value of each existing dollar has been diluted by the new dollars, thereby diminishing the purchasing power of each old dollar. So we see right away that the inflation process—which is what counterfeiting is— injures all the legitimate, existing dollar-holders by having their purchasing power diluted. In short, counterfeiting defrauds and injures not only the specific holders of the new coins but all holders of old dollars—meaning, everyone else in society.

  But this is not all: for the fall in PPM does not take place overall and all at once, as it tends to do in the Angel Gabriel model. The money supply is not benevolently but foolishly showered on all alike. On the contrary, the new money is injected at a specific point in the economy and then ripples through the economy in a step-by-step process.

  Let us see how the process works. Roscoe, a counterfeiter, produces $10,000 of fake gold coins, worth only a fraction of that amount, but impossible to detect. He spends the $10,000 on a Chevrolet. The new money was first added to Roscoe’s
money stock, and then was transferred to the Chevy dealer. The dealer then takes the money and hires an assistant, the new money stock now being transferred from the dealer to the assistant. The assistant buys household appliances and furniture, thereby transferring the new money to those sellers, and so forth. In this way, new money ripples through the economy, raising demand curves as it goes, and thereby raising individual prices. If there is a vast counterfeiting operation in Brooklyn, then the money supply in Brooklyn will rise first, raising demand curves and prices for the products there. Then, as the money ripples outward, other money stocks, demand curves, and prices will rise.

  Thus, in contrast to the Angel Gabriel, there is no single overall expansion of money, and hence no uniform monetary and price inflation. Instead, as we saw in the case of the early spenders, those who get the money early in this ripple process benefit at the expense of those who get it late or not at all. The first producers or holders of the new money will find their stock increasing before very many of their buying prices have risen. But, as we go down the list, and more and more prices rise, the people who get the money at the end of the process find that they lose from the inflation. Their buying prices have all risen before their own incomes have had a chance to benefit from the new money. And some people will never get the new money at all: either because the ripple stopped, or because they have fixed incomes—from salaries or bond yields, or as pensioners or holders of annuities.