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Leave Money Production to the Market

May 14, 2012

Tags The FedFree MarketsBusiness CyclesInterventionism

[Written Testimony before the Subcommittee on Domestic Monetary Policy and Technology Committee on Financial Services, US House of Representatives, May 8, 2012]

In a seminal article published in 1920, Ludwig von Mises demonstrated that there is only one test of whether or not production of something conveys a benefit on society at large.[1] It must be shown that resources have greater value when used to produce a good to satisfy the preferences of some people than when they are used to produce a different good to satisfy the preferences of other people. Production left to the market satisfies the profit-and-loss test of socially beneficial production.



Like the production of all other goods, production of money left to the market is regulated by profit and loss. Additional money is produced when demand for money increases or demand for other goods produced by the same resources decreases. If the demand for money increased, the value of gold coins would rise. Minting companies would increase production to capture the profit. As they increased the supply of the certification service, its price would decline; and as they increased their demands for resources to certify gold, resource prices would rise and the profit would dissipate. If demand for other goods declined, input prices would fall. Minting companies would increase production to capture the profit and, by doing so, eliminate profit from further production. In this way production of money in the market is socially optimal.[2]

The profit-and-loss test also applies to the production of money certificates in the market.[3] Money certificates are titles of ownership to money issued by banks that serve as money substitutes. People may find convenience and safety in using checking-account balances instead of commodity money when making trades. Banks will produce and maintain checking accounts for customers if they are willing to pay fees to banks that generate revenues sufficient to cover the costs of managing the accounts. If the demand for checking accounts increased, then banks would expand them to capture the profit. As they increased their supply of checking account services, the fees would decline. And as they increased their demand for the resources to manage checking accounts, their prices would rise. As a consequence, profit would dissipate and additional production would cease at the socially optimal point.



Monetary Inflation and Credit Expansion

An elastic currency breaks the integration of production on the market by being an element foreign to the test of profit and loss. An elastic currency has two characteristics: a central bank empowered to issue fiat paper money and commercial banks empowered to issue fiduciary media.[4] The production of fiat paper money cannot be regulated by profit and loss. It is always profitable to produce more. In 2011, the average cost of the 5.8 billion Federal Reserve Notes produced was $0.091.[5] So a profit of around $4.90 is made by printing and spending a $5 bill. If the Fed continued order the printing of fractional reserve notes (FRNs) as long as it was profitable, then eventually prices of inputs would rise so that it cost more than $5 to print a $5 bill. Then the Fed could order the printing of $50 bills instead and so on indefinitely as we have witnessed in hyperinflations like Zimbabwe's. To avoid destruction in hyperinflation, production of fiat paper money must be regulated by policy, by a rule that is arbitrary with respect to economizing production for society at large.

The production of fiduciary media cannot be regulated by profit and loss.[6] Fiduciary media are redemption claims for money that are fractionally backed by a reserve of money. Banks issue fiduciary media by creating loans. For example, a customer applies at his local bank for an auto loan of $25,000. If the bank agrees to extend the loan, it just writes a $25,000 balance into the customer's checking account. The loan generates interest revenue for the bank while the cost of issuing fiduciary media is nominal. It is always profitable for the bank to create another loan by issuing fiduciary media. If a bank issues more fiduciary media by creating credit as long as it is profitable, it will become illiquid and insolvent and end in collapse. To avoid such destruction, a bank must regulate its issue of fiduciary media via credit creation by policy, by a rule that is arbitrary with respect to economizing production for society at large.

Advocates of an elastic currency realize that its production cannot even be subjected to, let alone pass, the profit-and-loss test. As F.A. Hayek wrote,



Maintaining Price Stability

There is no social benefit from keeping the price level stable. The alleged benefit is that price stability prevents wealth transfers between creditors and debtors and between workers and capitalists. But such transfers assume that entrepreneurs fail to anticipate changes in money's purchasing power. Entrepreneurs can earn profits and avoid losses by anticipating these changes just as well as changes in prices of other goods. If they anticipate rising prices for goods overall, then they will increase their demands for resources today bidding up wages today. Likewise, lenders will insist on higher interest rates today. An elastic currency adds another dimension of uncertainty to changes in money's purchasing power. It makes the task of entrepreneurs more, not less, difficult.

In extreme cases, an elastic currency can result in wildly unstable prices that paralyze entrepreneurial decision-making and destroy production on the market. Being regulated by profit, production of commodity money responds only to changes in people's demands. If money demand rises, the resulting increase in money's purchasing power would bring forth more production of money and moderate falling prices. The modest price deflation over time in a market economy is an integral part of its economizing production.

Moreover, in practice the advocates of price stability aim at price inflation of around 2 percent per year. But, if entrepreneurs can adjust their expectation to cope with a 2 percent per year price inflation in an elastic currency system, then certainly they can properly anticipate and deal with a 2 percent per year price deflation under a commodity money system.[8]

Finally, two of the periods of most rapid economic growth in US history were from 1820–1850 and 1865–1900. In each of these periods, the purchasing power of the dollar roughly doubled.[9]

Preventing Price Deflation

There is no social benefit from preventing price deflation. There are two claims to the contrary. The first alleged benefit is that if prices begin to fall then people form expectations that they will fall further and they put off spending today, which pushes prices down even further, which reinforces deflationary expectations. The collapse of spending discourages production and employment. But, the downward spiral of prices is merely the logical implication of assumptions about expectations within formal economic models. If you assume that the agents operating in an economic model suffer from expectations that are self-reinforcing, then the model will produce a downward spiral. But, people in the real world can only obtain the services of goods by buying them. They choose at some point to buy a good even if they expect its price to fall further. This happens every day in markets for consumer electronics as people buy tablet computers, cell phones, and so on, knowing that prices will be lower and quality higher in the future.





UCLA economist Andrew Atkinson and Minneapolis Federal Reserve Bank economist Patrick Kehoe, in a 2004 American Economic Review article, have shown that there is no correlation between deflation and depression.[10] Looking at the evidence across 17 countries over more than 100 years, they concluded,



When all periods are put together, they found that "a 1-percentage-point drop in inflation is associated with a drop in the average real growth rate of just 0.08 of a percentage point, say, from 3.08 to 3.00."[13]

Finally, when they break the data into pre–World War II and post–World War II, they find a stronger correlation between deflation and depression for the early period, but a correlation between inflation and depression in the later period.

Stimulating Economic Growth


The capital structure of the economy is the stages of production from extraction of raw materials to the production of intermediate capital goods to the production of consumer goods. Iron is mined out of the ground, then steel is made, then fenders for an automobile, then the automobile is assembled. In a market economy, not only is each production process justified by passing the profit-and-loss test, but the entire capital structure satisfies people's intertemporal, or time, preferences. The degree to which they desire to postpone their current consumption by saving and investing to build up capital capacity across the capital structure in order to enjoy more and better consumer goods in the future is satisfied in the market.


Credit expansion suppresses interest rates below the levels determined by people's time preferences and increases funds for investment beyond the amount determined by people's preferences for saving. When the borrowers spend the additional money, they bid up the prices of the goods they are buying. Prices of houses and cars, for example, are pushed up by the addition demand of consumers made possible by credit creation. Prices of producer goods are also bid up by the additional demand of entrepreneurs made possible by credit creation. Prices for auto factories, lumber mills, are pushed up and the capital goods across the capital structure used to produce goods in the expanding areas, iron mines, timber lands, and so on.

Monetary inflation through credit expansion makes it possible for borrowers to demand more assets without lenders reducing demands for other goods. Therefore, rising asset prices increase the profitability of their production while the profitability of other goods need not decline. Not enough resources are released from the production of other goods to complete all of the projects made profitable by the credit expansion. With a market monetary system, the proper amount of resources is made available because an increase in the supply of credit can only be brought about by people saving more and consuming less. The additional investment projects made profitable by the increase in saving are balanced by the projects no longer profitable because of the reduced consumption. But with an elastic currency system, the buildup of capital capacity and other investment projects financed with created credit do not wind up satisfying people's time preferences. The buildup of the capital structure during the boom is unsustainable. It ends in the liquidation of the buildup in the bust.

What brings the boom to an end is the reestablishment of people's time preferences and preferences for saving. People do this through the disbursement of their incomes. The credit created during the boom is spent by the borrowers to buy goods, houses, factories, etc. The entrepreneurs who produce these goods then receive the new money as revenues for selling the goods. They pay producers to buy the resources used to produce the goods. The new money is then income for the producers. People disburse their income to satisfy their preferences, including their time preferences. They prefer to save only a fraction of their incomes. Although the entire amount of the new money issued starts out increasing the supply of credit, only a fraction of it winds up as a supply of credit. Monetary inflation and credit expansion run counter to people's time preferences, and market economies operate to satisfy people's preferences.

Another factor working against the sustainability of the boom is that, the further credit expansion extends, the riskier the projects and the less creditworthy the borrowers become. As financial intermediaries, banks economize credit lending to the highest-return, most-secure projects and the highest-interest-rate, most-creditworthy borrowers. Additional credit must be extended to lower-return, less-secure projects and lower-interest-rate, less-creditworthy borrowers. If monetary inflation and credit expansion go on far enough, investors refuse to accept the additional risk and sell out of the lines of production expanded during the boom. Since the prices of assets in the more-sound projects have been bid up along with the prices of projects in the less-sound projects, investors in the more-sound projects will also lose wealth if they continue to hold their investments.

Once people restore interest rates and asset prices to the levels that reflect their preferences, the particular lines of production in which malinvestments have been made in building up the capital structure during the boom are revealed. The bust consists of reconfiguring the malformed capital structure to best satisfy people's preferences. Malinvested assets must be sold to entrepreneurs in lines of production that will prove to be profitable. Labor must be reallocated away from boom lines into production supported by people's preferences. As with all production decisions, these can be made in the most economizing fashion by entrepreneurs earning profits from their superior foresight in satisfying preferences and suffering losses for their inferior foresight.






Monetary Reform

The goal of monetary reform is to make money production subject to the profit-and-loss test of socially beneficial production. Money production must become an integral part of the market economy. There may be several viable paths of transition to a system of market production of money, but any such path must take account of Carl Menger's famous demonstration that an item can only arise as money consistently with what people are actually using as the most widely traded good.[16] After the transition, a monetary system integrated into the market economy could begin.[17]

Federal Reserve Notes are money in the American economy. Thus, the most direct way to establish a market monetary system is to reestablish FRNs as redemption claims for commodity money. The most widely recognized commodity money today is gold coins. The primary step in monetary reform, then, is to turn FRNs into 100-percent-reserve redemption claims for gold coins.





Banks, too, should be put under the general laws of commerce including those relating to warehousing money by holding a 100 percent reserve of money against their money substitutes. Banks would earn profit by producing the amounts and types of money substitutes that satisfied people's demands. To earn profit, they would keep their costs down and invest and innovate when people's demands made it profitable. The operation of 100 percent reserve banking is described in Jesús Huerta de Soto's book, Money, Banking, and Economic Cycles. As he documents, money-warehouse banks thrived in Amsterdam for over 100 years in the 17th and 18th centuries.[20]


No one can describe today the configuration of commodity money and money certificates that entrepreneurs would bring about if permitted to operate private enterprises in their production any more than one could have predicted in 1900 the development of the 21st-century automobile industry or predicted in 1950 the 21st-century consumer-electronics industry. What we do know is that their production would be regulated by profit and loss and therefore would result in the satisfaction of people's preferences. The monetary inflation and credit expansion of our elastic currency system would be eliminated and with it the booms and busts that have plagued our history.


[1] This is an implication of Mises's famous argument that central planners cannot economize the use of resources in society. See Ludwig von Mises, Economic Calculation in the Socialist Commonwealth (Auburn, Ala.: Mises Institute, 1990 [1920]) and Mises, Human Action, scholar's edition (Auburn, Ala.: Mises Institute, 1998 [1949]), pp. 685–711.

[2] Mises wrote that making money production conform to profitability and not politics, "is not a defect of the gold standard; it is its main excellence," Human Action, p. 471.



[5] Bureau of Engraving and Printing. (moneyfactory.gov/uscurrency/annualproductionfigures.html). April 27, 2012.



[8] The annualize rate of increase in the purchasing power of the dollar from 1815–1850 was 2.24 percent and from 1865–1900 was 1.75 percent.

[9] Murray Rothbard, A History of Money and Banking in the United States (Auburn, Ala.: Mises Institute, 2002), pp. 42–179.

[10] Andrew Atkinson and Patrick Kehoe, "Deflation and Depression: Is There an Empirical Link," American Economic Review Papers and Proceedings 94 (May 2004): 99–103. They define deflation "as a negative average inflation rate" and depression "as a negative average real output growth rate." Ibid., p. 99.

[11] Ibid., p. 102.

[12] Ibid., p. 101.

[13] Ibid., p. 102.

[14] On the boom-bust cycle, see Mises, Human Action, pp. 535–583;de Soto, Money, Bank Credit, and Economic Cycles, pp. 265–395; F.A. Hayek, Prices and Production and Other Works (Auburn, Ala.: Mises Institute, 2008 [1931]); and Murray Rothbard, America's Great Depression (Auburn, Ala.: Mises Institute, 2000 [1963]).

[15] George Selgin, William Lastrapes, Lawrence White, "Has the Fed Been a Failure?," Cato Working Paper Dec. 2010, p. 1.

[16] Carl Menger, "On the Origin of Money," Economic Journal 2 (1892): 239–55; Peter G. Klein and George A. Selgin, "Menger's Theory of Money: Some Experimental Evidence," in John Smithin, ed., What Is Money? (London: Routledge, 2000), pp. 217–34.

[17] On such monetary reform, see Rothbard, Mystery of Banking, pp. 247–268; Salerno, Money, Sound and Unsound, pp. 333–363; and de Soto, Money, Bank Credit, and Economic Cycles, pp. 736–745.


[19] George Selgin, Good Money: Birmingham Button Makers, the Royal Mint, and the Beginnings of Modern Coinage, 1775–1821 (Ann Arbor: University of Michigan Press, 2008).

[20] De Soto, Money, Bank Credit, and Economic Cycles, pp. 37–114.


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