Fortunately, inflation cannot go on forever. For eventually people wake up to this form of taxation; they wake up to the continual shrinkage in the purchasing power of their dollar.
At first, when prices rise, people say: “Well, this is abnormal, the product of some emergency. I will postpone my purchases and wait until prices go back down.” This is the common attitude during the first phase of an inflation. This notion moderates the price rise itself, and conceals the inflation further, since the demand for money is thereby increased. But, as inflation proceeds, people begin to realize that prices are going up perpetually as a result of perpetual inflation. Now people will say: “I will buy now, though prices are ‘high,’ because if I wait, prices will go up still further.” As a result, the demand for money now falls and prices go up more, proportionately, than the increase in the money supply. At this point, the government is often called upon to “relieve the money shortage” caused by the accelerated price rise, and it inflates even faster. Soon, the country reaches the stage of the “crack-up boom,” when people say: “I must buy anything now—anything to get rid of money which depreciates on my hands.” The supply of money skyrockets, the demand plummets, and prices rise astronomically. Production falls sharply, as people spend more and more of their time finding ways to get rid of their money. The monetary system has, in effect, broken down completely, and the economy reverts to other moneys, if they are attainable—other metal, foreign currencies if this is a one-country inflation, or even a return to barter conditions. The monetary system has broken down under the impact of inflation.
This condition of hyper-inflation is familiar historically in the assignats of the French Revolution, the Continentals of the American Revolution, and especially the German crisis of 1923, and the Chinese and other currencies after World War II.5
A final indictment of inflation is that whenever the newly issued money is first used as loans to business, inflation causes the dread “business cycle.” This silent but deadly process, undetected for generations, works as follows: new money is issued by the banking system, under the aegis of government, and loaned to business. To businessmen, the new funds seem to be genuine investments, but these funds do not, like free-market investments, arise from voluntary savings. The new money is invested by businessmen in various projects, and paid out to workers and other factors as higher wages and prices. As the new money filters down to the whole economy, the people tend to re-establish their old voluntary consumption/saving proportions. In short, if people wish to save and invest about 20 percent of their incomes and consume the rest, new bank money loaned to business at first makes the saving proportion look higher. When the new money seeps down to the public, it re-establishes its old 20–80 proportion, and many investments are now revealed to be wasteful. Liquidation of the wasteful investments of the inflationary boom constitutes the depression phase of the business cycle.6
3.
Compulsory Monopoly of the Mint
For government to use counterfeiting to add to its revenue, many lengthy steps must be travelled down the road away from the free market. Government could not simply invade a functioning free market and print its own paper tickets. Done so abruptly, few people would accept the government's money. Even in modern times, many people in “backward countries” have simply refused to accept paper money, and insist on trading only in gold. Governmental incursion, therefore, must be far more subtle and gradual.
Until a few centuries ago, there were no banks, and therefore the government could not use the banking engine for massive inflation as it can today. What could it do when only gold and silver circulated?
The first step, taken firmly by every sizeable government, was to seize an absolute monopoly of the minting business. That was the indispensable means of getting control of the coinage supply. The king's or the lord's picture was stamped upon coins, and the myth was propagated that coinage is an essential prerogative of royal or baronial “sovereignty.” The mintage monopoly allowed government to supply whatever denominations of coin it, and not the public, wanted. As a result, the variety of coins on the market was forcibly reduced. Furthermore, the mint could now charge a high price, greater than costs (“seigniorage”), a price just covering costs (“brassage”), or supply coins free of charge. Seigniorage was a monopoly price, and it imposed a special burden on the conversion of bullion to coin; gratuitous coinage, on the other hand, overstimulated the manufacture of coins from bullion, and forced the general taxpayer to pay for minting services utilized by others.
Having acquired the mintage monopoly, governments fostered the use of the name of the monetary unit, doing their best to separate the name from its true base in the underlying weight of the coin. This, too, was a highly important step, for it liberated each government from the necessity of abiding by the common money of the world market. Instead of using grains or grams of gold or silver, each State fostered its own national name in the supposed interests of monetary patriotism: dollars, marks, francs, and the like. The shift made possible the preeminent means of governmental counterfeiting of coin: debasement.
4.
Debasement
Debasement was the State's method of counterfeiting the very coins it had banned private firms from making in the name of vigorous protection of the monetary standard. Sometimes, the government committed simple fraud, secretly diluting gold with a base alloy, making shortweight coins. More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of “pounds” or “marks,” but of a lighter weight. The leftover ounces of gold or silver were pocketed by the King and used to pay his expenses. In that way, government continually juggled and redefined the very standard it was pledged to protect. The profits of debasement were haughtily claimed as “seigniorage” by the rulers.
Rapid and severe debasement was a hallmark of the Middle Ages, in almost every country in Europe. Thus, in 1200 A.D., the French livre tournois was defined at ninety-eight grams of fine silver; by 1600 A.D. it signified only eleven grams. A striking case is the dinar, a coin of the Saracens in Spain. The dinar originally consisted of sixty-five gold grains, when first coined at the end of the seventh century. The Saracens were notably sound in monetary matters, and by the middle of the twelfth century, the dinar was still sixty grains. At that point, the Christian kings conquered Spain, and by the early thirteenth century, the dinar (now called maravedi) was reduced to fourteen grains. Soon the gold coin was too light to circulate, and it was converted into a silver coin weighing twenty-six grains of silver. This, too, was debased, and by the mid-fifteenth century, the maravedi was only 1.5 silver grains, and again too small to circulate.7
5.
Gresham's Law and Coinage
A. Bimetallism
Government imposes price controls largely in order to divert public attention from governmental inflation to the alleged evils of the free market. As we have seen, “Gresham's Law”—that an artificially overvalued money tends to drive an artificially undervalued money out of circulation—is an example of the general consequences of price control. Government places, in effect, a maximum price on one type of money in terms of the other. Maximum price causes a shortage—disappearance into hoards or exports—of the currency suffering the maximum price (artificially undervalued), and leads it to be replaced in circulation by the overpriced money.
We have seen how this works in the case of new versus worn coins, one of the earliest examples of Gresham's Law. Changing the meaning of money from weight to mere tale, and standardizing denominations for their own rather than for the public's convenience, the governments called new and worn coins by the same name, even though they were of different weight. As a result, people hoarded or exported the full weight new coins, and passed the worn coins in circulation, with governments hurling maledictions at “speculators,” foreigners, or the free market in general, for a condition brought about by the government itself.
A particularly important case
of Gresham's Law was the perennial problem of the “standard.” We saw that the free market established “parallel standards” of gold and silver, each freely fluctuating in relation to the other in accordance with market supplies and demands. But governments decided they would help out the market by stepping in to “simplify” matters. How much clearer things would be, they felt, if gold and silver were fixed at a definite ratio, say, twenty ounces of silver to one ounce of gold! Then, both moneys could always circulate at a fixed ratio—and, far more importantly, the government could finally rid itself of the burden of treating money by weight instead of by tale. Let us imagine a unit, the “rur,” defined by Ruritanians as 1/20 of an ounce of gold. We have seen how vital it is for the government to induce the public to regard the “rur” as an abstract unit of its own right, only loosely connected to gold. What better way of doing this than to fix the gold/silver ratio? Then, “rur” becomes not only 1/20 ounce of gold, but also one ounce of silver. The precise meaning of the word “rur”—a name for gold weight—is now lost, and people begin to think of the “rur” as something tangible in its own right, somehow set by the government, for good and efficient purposes, as equal to certain weights of both gold and silver.
Now we see the importance of abstaining from patriotic or national names for gold ounces or grains. Once such a label replaces the recognized world units of weight, it becomes much easier for governments to manipulate the money unit and give it an apparent life of its own. The fixed gold-silver ration, known as bimetallism, accomplished this task very neatly. It did not, however, fulfill its other job of simplifying the nation's currency. For, once again, Gresham's Law came into prominence. The government usually set the bimetallic ration originally (say, 20/1) at the going rate on the free market. But the market ratio, like all market prices, inevitably changes over time, as supply and demand conditions change. As changes occur, the fixed bimetallic ratio inevitably becomes obsolete. Change makes either gold or silver overvalued. Gold then disappears into cash balance, black market, or exports, when silver flows in from abroad and comes out of cash balances to become the only circulating currency in Ruritania. For centuries, all countries struggled with calamitous effects of suddenly alternating metallic currencies. First silver would flow in and gold disappear; then, as the relative market ratios changed, gold would pour in and silver disappear.8
Finally, after weary centuries of bimetallic disruption, governments picked one metal as the standard, generally gold. Silver was relegated to “token coin” status, for small denominations, but not at full weight. (The minting of token coins was also monopolized by government, and, since not backed 100 percent by gold, was a means of expanding the money supply.) The eradication of silver as money certainly injured many people who preferred to use silver for various transactions. There was truth in the warcry of the bimetallists that a “crime against silver” had been committed; but the crime was really the original imposition of bimetallism in lieu of parallel standards. Bimetallism created an impossibly difficult situation, which the government could either meet by going back to full monetary freedom (parallel standards) or by picking one of the two metals as money (gold or silver standard). Full monetary freedom, after all this time, was considered absurd and quixotic; and so the gold standard was generally adopted.
B. Legal Tender
How was the government able to enforce its price controls on monetary exchange rates? By a device known as legal tender laws. Money is used for payment of past debts, as well as for present “cash” transactions. With the name of the country's currency now prominent in accounting instead its actual weight, contracts began to pledge payment in certain amounts of “money.” Legal tender laws dictated what that “money” could be. When only the original gold or silver was designated “legal tender,” people considered it harmless, but they should have realized that a dangerous precedent had been set for government control of money. If the government sticks to the original money, its legal tender law is superfluous and unnecessary.9 On the other hand, the government may declare as legal tender a lower-quality currency side-by-side with the original. Thus, the government may decree worn coins as good as new ones in paying off debt, or silver and gold equivalent to each other in the fixed ratio. The legal tender laws then bring Gresham's Law into being.
When legal tender laws enshrine an overvalued money, they have another effect; they favor debtors at the expense of creditors. For then debtors are permitted to pay back their debts in a much poorer money than they had borrowed, and creditors are swindled out of the money rightfully theirs. This confiscation of creditors property, however, only benefits outstanding debtors; future debtors will be burdened by the scarcity of credit generated by the memory of government spoliation of creditors.
6.
Summary: Government and Coinage
The compulsory minting monopoly and legal tender legislation were the capstones in governments' drive to gain control of their nations' money. Bolstering these measures, each government moved to abolish the circulation of all coins minted by rival governments.10 Within each country, only the coin of its own sovereign could now be used; between countries, unstamped gold and silver bullion was used in exchange. This further severed the ties between the various parts of the world market, further sundering one country from another, and disrupting the international division of labor. Yet, purely hard money did not leave too much scope for governmental inflation. There were limits to the debasing that governments could engineer, and the fact that all countries used gold and silver placed definite checks on the control of each government over its own territory. The rulers were still held in check by the discipline of an international metallic money.
Governmental control of money could only become absolute, and its counterfeiting unchallenged, as money-substitutes came into prominence in recent centuries. The advent of paper money and bank deposits, an economic boon when backed fully by gold or silver, provided the open sesame for government's road to power over money, and thereby over the entire economic system.
7.
Permitting Banks to Refuse Payment
The modern economy, with its widespread use of banks and money-substitutes, provides the golden opportunity for government to fasten its control over the money supply and permit inflation at its discretion. We have seen in section 12, page 38, that there are three great checks on the power of any bank to inflate under a “free-banking” system: (1) the extent of the clientele of each bank; (2) the extent of the clientele of the whole banking system, i.e., the extent to which people use money-substitutes; and (3) the confidence of the clients in their banks. The narrower the clientele of each bank, of the banking system as a whole, or the shakier the state of confidence, the stricter will be the limits on inflation in the economy. Government's privileging and controlling of the banking system has operated to suspend these limits.
All these limits, of course, rest on one fundamental obligation: the duty of the banks to redeem their sworn liabilities on demand. We have seen that no fractional-reserve bank can redeem all of its liabilities; and we have also seen that this is the gamble that every bank takes. But it is, of course, essential to any system of private property that contract obligations be fulfilled. The bluntest way for government to foster inflation, then, is to grant the banks the special privilege of refusing to pay their obligations, while yet continuing in their operation. While everyone else must pay their debts or go bankrupt, the banks are permitted to refuse redemption of their receipts, at the same time forcing their own debtors to pay when their loans fall due. The usual name for this is a “suspension of specie payments.” A more accurate name would be “license for theft;” for what else can we call a governmental permission to continue in business without fulfilling one's contract?
In the United States, mass suspension of specie payment in times of bank troubles became almost a tradition. It started in the War of 1812. Most of the country's banks were located in New England, a section unsympathetic to America'
s entry into the war. These banks refused to lend for war purposes, and so the government borrowed from new banks in the other states. These banks issued new paper money to make the loans. The inflation was so great that calls for redemption flooded into the new banks, especially from the conservative nonexpanding banks of New England, where the government spent most of its money on war goods. As a result, there was a mass “suspension” in 1814, lasting for over two years (well beyond the end of the war); during that time, banks sprouted up, issuing notes with no need to redeem in gold or silver.
This suspension set a precedent for succeeding economic crises; 1819, 1837, 1857, and so forth. As a result of this tradition, the banks realized that they need have no fear of bankruptcy after an inflation, and this, of course, stimulated inflation and “wildcat banking.” Those writers who point to nineteenth century America as a horrid example of “free banking,” fail to realize the importance of this clear dereliction of duty by the states in every financial crisis.
The governments and the banks, persuaded the public of the justice of their acts. In fact, anyone trying to get his money back during a crisis was considered “unpatriotic” and a despoiler of his fellowmen, while banks were often commended for patriotically bailing out the community in a time of trouble. Many people, however, were bitter at the entire proceeding and from this sentiment grew the famous “hard money” Jacksonian movement that flourished before the Civil War.11
Despite its use in the United States, such periodic privilege to banks did not catch hold as a general policy in the modern world. It was a crude instrument, too sporadic (it could not be permanent since few people would patronize banks that never paid their obligations)—and, what's more, it provided no means of government control over the banking system. What governments want, after all, is not simply inflation, but inflation completely controlled and directed by themselves. There must be no danger of the banks running the show. And so, a far subtler, smoother, more permanent method was devised, and sold to the public as a hallmark of civilization itself—Central Banking.
What Has Government Done to Our Money? Page 5
