Timothy Chase
Timothy Chase

Global Crisis and Debased Currency

Proponents of the gold standard are correct in pointing out that US currency is fiat money. We do have gold reserves, but they are not sufficient to back US currency, and thus, at least in principle, US currency is no different from the Russian rouble. What is a mystery is how US currency (or for that matter, any currency which is not backed by the presence of some commodity, such as gold or silver) is able to maintain any purchasing power at all, or for that matter, able to acquire purchasing power in the first place, or have a purchasing power which is greater than the commodity which it is backed by.

The answer to this paradox lies in what is called (at least by Ludwig von Mises) "monetary demand." Originally, gold had demand merely as a commodity. It was good for jewellery, and even now has plenty of industrial uses. However, due to the fact that it is uniform, non-perishable, does not lose its value, exists in a relatively stable quantity, etc., another form of demand for gold came into existence: its demand as a medium for exchange. This increased its market value, making the same amount of gold more valuable (measured in terms of its "price" relative to other goods, which is its "purchasing power") because it had an additional use which it could be employed in: as a medium of exchange. The more people were willing to accept it for exchange (even in the absence of any immediate use for themselves, but because other people would accept it as a medium of exchange), the more its demand as a medium of exchange grew, and its pre-eminence as a medium of exchange was established.

Originally, the existence of such a medium of exchange was a market phenomenon. In time, the government took over the function of assuring a standard degree of purity by minting coins. However, being a central authority, the government had a tendency to abuse this function. For example, in the last days of the Roman empire, the purity of the coins was greatly "debased" by the addition of higher levels of less valuable metals so that the government could pay for various welfare programs and entertainment back in Rome and the rest of Italy. (Slave labour in the colonies was leading to unemployment at home.) This was inflation, the deliberate attempt of a government to increase the quantity of money, in this case, to finance programs which it could not otherwise afford. To "correct" the "problems" which resulted from such a policy (rising prices), the emperor instituted price controls. But of course, this did not correct the underlying problem, but merely transformed it, from rising prices to shortages. This was the cause of the break-up of the Roman Empire.

In time, it became obvious that it was easier to have some sort of paper stand-in for a given amount of gold, and which could be exchanged for that gold at any given time. After all, paper is more easily transported than gold. At first, the amount of gold (or silver) which that paper money stood for was equal to the money itself. At that point, the paper money was 100% backed by gold. But in the effort to finance various programs, fractional reserves were introduced on the theory that not everyone would want to cash in their paper money for gold at the same time. The gold, it seemed, could be put to other uses (actually, this sort of reasoning is still quite common — the International Monetary Fund has recently borrowed gold from western nations to try to stabilise the rouble by lending Russia gold). At this point, the quantity of paper money has not increased; thus, there is no actual inflation in its quantity, and there is likely to be little if any price inflation.

Once governments no longer back their paper money 100% by real assets, they are likely to start financing programs through the creation of artificial money. They print more, or, through more complicated processes, artificially generate money in the broader sense of the term (e.g., by inflating the credit supply, by, for example, printing government bonds, which are repaid through future taxes, and selling them to the banks in exchange for real money, which banks treat as real assets to be loaned to other organisations, or even the government itself).

For example, in the early twenties, Germany found it necessary to borrow money from other countries in order to make overly harsh reparations for WWI. In time, it had to borrow money simply in order to make the interest payments on the money it had already borrowed. Germany went further into debt, and as a consequence, had to borrow more money. This became a vicious circle. Then, in order to finance its programs and make payments, it began to print money.

At first, prices were relatively stable. But then some prices began to rise. When these prices rose, they increased the prices of related products (products which competed for similar markets, or which depended upon the same factors of production as the products first influenced by the introduction of artificial demand through the printing of additional money). Then people started to anticipate further increases in prices. This marks the onset of hyper-inflation, since the anticipation of further increases in prices is built into current prices. The government must print even more money to off-set the anticipated increase in prices, but this only increases the anticipation of further increases in prices. It becomes a vicious circle. In the end, Germans were rushing out to buy things when they got paid at lunchtime, because at dinnertime, their money would be worth only half as much. Germans were carrying around baskets of money just to buy a loaf of bread. And the German government was printing money so quickly that they could not wait for it to dry on one side before printing the other, so they left one side blank. There is the flight into real goods, where people abandon the use of money for goods which will hold their value, such as vodka in Russia today, or whatever they can get their hands on. They return to barter just in order to survive.

For Germany, that was the period from 1921-1922. In 1922, Austria was considering a similar policy. Ludwig von Mises almost single-handedly convinced the government officials not to follow Germany, and saved Austria's economy.

High interest rates are almost universally repugnant. During the 1920s, they were especially repugnant in Great Britain. Consequently, Britain pursued a "loose credit" policy of artificially low interest rates. Investors knew precisely what to do: they proceeded to move their savings to the United States. In an unbridled act of diplomacy and altruism, the United States government decided to help Britain out by artificially lowering its own interest rates by inflating the credit supply from 1926-28. But this created an imbalance of long-term investments relative to short-term investments. This resulted in the bubble of the late twenties. Eventually, the imbalance was uncovered, first through a rise in the prices of the most durable goods, then in the labour market. By this time, the crash of 1929 was inevitable.

Similarly, much of Southeast Asia has pursued a "loose credit" policy to finance the building of its industrial infrastructure. The government had banks artificially reduce the interest rates, which redirected the factors of production to long-term investments, which resulted in an imbalance of long-term investments over short-term ones. This resulted in the creation of now-empty skyscrapers which were built to hold businesses that were never created, because they would have depended upon some of the same factors of production that went into the building of these skyscrapers, the broadest of these factors of production being human labour. The skyscrapers were then uncovered too late as malinvestments. The stock market responded to the banking crisis as the loans on the long-term investments could not be repaid, and consumers began saving their money rather than buying either domestic goods or imports in response to economic uncertainty. Japan's government is now trying to bail out the banking system, but even if this succeeds, it will probably be no more than a temporary solution. The principles have remained the same. Economic crises are caused by government intervention, not the free market — and then the crises are usually made worse by more government intervention, which blocks long range business planning by making the future more uncertain.

Prior to the Great Depression, there was an earlier, deeper depression in 1920-1 which the United States recovered from very quickly. In fact, by late 1921, we were already in a period of recovery, which reached new highs in industrial production by the spring of 1923. Like the Great Depression, this earlier depression was caused by government intervention in the credit supply. But unlike the Great Depression, the United States government allowed the earlier depression to take its course, liquidating the malinvestments, and redirecting the factors of production to those lines of production for which they were most needed, and restoring the price co-ordination which exists naturally in a free market economy.

The US dollar is not like the rouble at present — we are not presently pursuing a loose credit supply, thanks in no small part to the integrity of Alan Greenspan (who would like to see the Federal Reserve eventually abolished in favour of some free market alternative). But the people who hold an office change over time. Either they are influenced by the incentives of their office, or they retire and are replaced. Eventually we will not be so lucky to have someone of Greenspan's calibre in office, and then the difference between the dollar and the rouble may decrease, or vanish altogether.

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