By Frank Shostak*
Demand for goods stems from perceived benefits. For example, individuals ask for food because it feeds them. This is not the case, however, with the pieces of paper we call money, so why do we accept them?
According to Plato and Aristotle, the acceptance of money is a historical fact approved by government decree. It is a government decree, it is claimed, that causes a particular thing to be accepted as a general medium of exchange. Carl Menger, however, doubted the merits of this view, writing:
“An event of so lofty and universal importance, and of such inevitable notoriety, as the establishment by law or convention of a universal medium of exchange, would certainly have been retained in the memory of man, of all the more certainly as it should have been performed in a large number of places. However, no historical monument provides us with worthy information on transactions either conferring a distinct recognition on means of exchange already in use, or referring to their adoption by peoples of relatively recent culture, even less testifying to an initiation of the first ages from economic civilization to the use of money.“
Why classic demand and supply analysis fails to explain the price of silver
How does something that the government proclaims become the medium of exchange, acquire value? We know that the price of a good is the result of the interaction between supply and demand. From this we could conclude that the price of silver is also set by the laws of supply and demand.
While demand for goods emerges due to perceived benefits, people demand money because of its purchasing power relative to various goods. The demand for money depends on the purchasing power of money while the purchasing power of money depends on the demand for money.
We are caught in a circular trap. (The demand for money depends on its purchasing power while the purchasing power depends for a given supply on the demand for money). The circularity seems to justify the idea that the acceptance of money is the result of a government decree.
Mises Supports Menger’s InsigHT
Ludwig von Mises’ regression theorem supports Menger’s ideas. Mises not only solved the problem of the circularity of money, but he also confirmed Carl Menger’s view that the money did not come from a government decree.
Mises began his analysis by noting that the demand for money today is determined by the purchasing power of money yesterday. Therefore, for a given money supply, the current purchasing power of money is established. Yesterday’s demand for money was in turn set by the purchasing power of yesterday’s money. For a given money supply, yesterday’s money price has been fixed. The same procedure applies to past periods.
However, this does not solve the circularity problem, rather seeming to push it back to infinity. That’s not the case, argues Mises. Going back in time, we will eventually come to a time when money was just an ordinary commodity whose price was set by supply and demand. The commodity had an exchange value in terms of other commodities, so barter establishes its exchange value.
When a commodity becomes money, it already has purchasing power or an established price in terms of other commodities. This purchasing power allows us to establish the demand for this commodity as money. This in turn, for a given supply, fixes its purchasing power on the day that this commodity begins to function as money.
Once the price of silver has been established, it serves as input for the establishment of the price of silver tomorrow. It follows that without yesterday’s information about the price of money, the purchasing power of money today cannot be established. With respect to other goods and services, history is not needed to set current prices, as demand for these goods arises due to the perceived benefits of their consumption. The advantage of money is that it can be exchanged for goods and services. Therefore, one must know the past purchasing power of the currency to establish the current demand.
Using the regression theorem, we deduce that it is not possible that money has emerged because of a government decree, because the decree cannot confer purchasing power on a thing whose government proclaims that it will become the medium of exchange. According Hans Hoppe:
Money must emerge as a commodity because something can only be demanded as a medium of exchange if it has a pre-existing demand for barter.
Once a commodity is accepted as a medium of exchange, it will continue to be accepted even if its non-monetary utility disappears. The reason for this acceptance is the fact that people now possess information about the purchasing power of yesterday, which allows the formation of the demand for money today.
From commodity money to paper monHey
Originally, paper money was not considered money but simply a representative of money, which was gold. Various paper certificates were claims on gold stored with banks. Holders of paper certificates could convert them into gold whenever deemed necessary. As individuals found it more convenient to use paper certificates to exchange goods and services, these certificates came to be seen as money.
The introduction of paper certificates accepted as a medium of exchange has opened the door to fraudulent practices. Banks might be tempted to increase their profits by lending certificates not backed by gold.
In a free market economy, a bank that over-issues its paper certificate will quickly find that the exchange value of its certificate in terms of other banks’ certificates will drop. This decline in exchange value will induce individuals to convert excess issued paper bank certificates into gold to protect their purchasing power.
The excessive issuing bank, however, would not have enough gold to honor all the paper certificates issued and would be declared insolvent. The threat of bankruptcy would therefore deter banks from issuing paper certificates not backed by gold. Thus, in a free market economy, paper money cannot take on a “life” of its own and become independent of commodity money.
The Central Bank applies the paper standard
In response to the excessive issuance of currency by banks, the government could, by decree, abolish the convertibility of paper certificates into gold, thus preventing these banks from failing. However, once banks are not forced to redeem paper certificates in gold, it opens up the possibility of profits, as this action would generate incentives for the expansion of paper certificates, which in turn could produce hyperinflation and an economic collapse.
To avoid collapse, the paper money standard must be managed in such a way as to prevent various competing banks from over-issuing paper certificates. This can be achieved by creating a monopoly central bank, which manages the expansion of paper money. To assert its authority, the central bank introduces its own paper certificates to replace commercial bank certificates. The purchasing power of central bank certificates is established because commercial bank paper certificates are exchanged for the central bank certificate at a fixed exchange rate.
The central bank’s paper certificate, which is declared to be legal tender – i.e. money – also serves as a reserve asset for banks, which then sets a limit on expansion. bank credit. It would seem that through monetary policies, the central bank can now manage and stabilize the monetary system. However, this is not the case – the paper standard must be constantly reinforced to prevent its collapse.
This means continuous and ever-increasing monetary pumping by the central bank to keep the system “stable”. However, this leads both to declines in the purchasing power of money and to boom-bust cycles, which, in turn, destabilize the entire monetary system.
Mises’ regression theorem shows that the money did not emerge because of a government decree. The acceptance of money is dictated by its previous purchasing power. The regression theorem shows that purchasing power is acquired because money is originally a commodity. The regression theorem also shows that paper money has purchasing power because it was initially fully backed by a commodity like gold.
*About the Author: Frank ShostakApplied Austrian School Economics’ consulting firm provides in-depth assessments of financial markets and global economies. Contact email.
Source: This article was published by the MISES Institute