Let's face it -- almost nobody is interested in monetary theory, the history of banking, gold, or even the broader topic of the economy itself. Forget about accounting and bookkeeping. Most people are more interested in their own pursuits and their friends and families, and really aren't concerned with a bunch of obscure facts and ideology on such topics. They are more practically minded, and don't much care about the way these things work so long as they actually do.
In a way, there is wisdom in this attitude. Life really isn't about money, and the value in our lives is in what we actually produce and achieve, not in the details of accounting practices. Too much interest in money for its own sake is probably unhealthy and a sign of bad priorities. Unfortunately, money and accounting systems play critical roles in the pursuit of pretty much everything else, and a misunderstanding of money opens the door to all sorts of bad ideas with disastrous consequences. Accepting for granted whatever the conventional 'experts' say and whatever money system is presently in use could turn out to be a grave mistake.
Last time, I attempted to describe the 'standard' view, a.k.a. 'The Premise,' of how a money supply functions in an economy, and how it leads one to the conclusion that an ever growing money supply is necessary in the event of economic and population growth. This is in contrast to the Austrian assertion that growing money supplies create economic distortions and that relatively fixed money supplies are more ideal. The Premise seems reasonable so long as it remains vague, but once any sort of specificity gets applied, it begins to break down fairly quickly. Looking at the way that it breaks down, one begins to see that The Premise was linked with several other ideas which proved equally unreasonable under scrutiny, such as the notion of objective pricing and an incorrect basis for how money 'represents' goods in a transaction.
Now it is time to take a look at the Austrian view.
The Austrian Premise
I want to sketch a different mental image of money that more closely describes the Austrian premise. This time, picture a single rail on an abacus. The two ends connect two economic actors, and the 'beads' slide back and forth acting as money between them.
But there's a difference with this abacus -- the beads are infinitely divisible into smaller 'slices' so that any arbitrary quantity greater than zero and less than the total present on the end of the rail in question may be slid across to the other side. Also, no additional bead-money may ever be added to the rail.
The two actors engage in production and trade with one another. The two sides accumulate piles of wealth, with the unchanging money supply whizzing back and forth between them with each transaction. It doesn't matter how much they produce over a given period of time, or how big or small their respective piles of wealth get. The money still performs its function as it whisks back and forth.
To think of an entire economy, just imagine each actor as a hub with abacus spokes radiating outwards to every other actor. Each actor becomes a locus of money and wealth, with the ability to send money down any rail as necessary, but unable to increase or decrease it's total supply. Wealth, meanwhile, accumulates (or doesn't) at each hub and zips from actor to actor according to their individual decisions and activities. You might even think of a wealth rail running alongside each money rail so that each transaction has a countertransaction on its paired rail, wealth flowing one way and money the other as one actor pays for goods from the other.
Taking this particular idea to its extreme (and it is always a good idea to at least inspect the extremes of a new idea) money ceases to be clearly distinct from goods in general. It is merely another good circulating in the economy, just as subject to supply and demand as anything else. Goods are priced in money and money priced in goods. This is the unique function of money just as turning screws is the unique function of a screwdriver. It is shuffled around to act as an accounting device as needed. It is nothing more than a crutch for the human brain to help guide the decision-making that really matters -- the effective application of resources for the generation of wealth in accordance with consumer demand. In reality, material wealth dominates the picture, with money itself of only secondary concern, which is as it should be. This is a free-market treatment of money, which will ultimately be important later on.
This description is more like the Austrian conception of money. As you can see, it doesn't matter how much wealth has accumulated or how much is 'in play' -- circulating in the system vs. sitting idle in some actor's 'hoard.' Money is used as an accounting device rather than a proxy, 'representing' goods solely for the transaction in question, each tradeoff standing on its own merit. Economic actors don't need more of it for more wealth and more transactions because the same money is used over and over for each transaction. Money in this system responds to supply and demand, even of itself, unlike in the previous example where some supposedly omniscient entity managed the overall quantity while ignorant of the intricate details of individual circumstance.
Most particularly in this regard are two twin dispositions. The first is that it responds to the desire of traders to be holding something for which they can be reasonably confident of retaining its trading value and for which it will be difficult for others to cheat precisely because the supply is rigidly fixed. He doesn't want to worry about more 'coming on the market' through either legitimate or illegitimate means while he is holding it. A money system with this property will always displace one without it in a free-market. It will always be 'supplied' to the market if it exists because it is 'in high demand.' Secondly, it acts as a better, more accurate economic accounting device because of its better 'value retention,' which is what I am concerned with here, and this property in no way interferes with the other. They are 'two sides of the same coin,' so to speak.
The important thing about money, at least as far as our normal, disinterested pragmatist is concerned, is that it allows rational economic calculation by performing its accounting function, e.g. that it 'works.' However, one must be careful when using words like 'accounting' and 'calculation' in this context. Here one confronts another premise which the Austrian school does not always share with other points of view.
According to the Austrian, and really, to common sense, all pricing is inherently subjective. Economics is not math, at least as we normally think of math as an 'objective science.' Pricing relies on the estimates of each actor involved in each transaction, and is therefore a matter of circumstance and human judgement or estimation. But in the end, this is not and never was a question of objective quantification.
The function of money is more about a tool performing its function reliably over time, and that function is to help humans navigate the complex transactions they are making in a subjective value environment. This is an extremely difficult task. The most important calculation in this capacity is the profit and loss calculation. In interacting with suppliers and customers to determine prices, a producer is able to get a handle on the value of his raw materials and his products to others in the marketplace, and to then determine the best way to generate value for others with his own actions. Money is a harmonizing and economizing instrument, working to maximize the production of subjective value as determined by actors in the market.
Money, Prices, Value and Slavery
This goal is best achieved if the supply of money is fairly well conserved. The less it is conserved, the greater the degree of functional breakdown. One way an increasing money supply warps its inherent function is that it inevitably attaches economic value to sources of money rather than value to people. In Austrian lingo, this would be called a violation of consumer sovereignty. Under a fixed money regimen with basic rule of law, money may only be acquired by generating value in the eyes of the marketplace. Thus, value is necessarily traded for value.
Once again, yes, they are only estimated and subjective values, but that is not the same as arbitrary values, and it is not the same as invalid or irrelevant or meaningless values. A price is an agreement between a buyer and a seller, two humans engaging in an act of economy. That is what economics is all about. Such 'subjective values' are precisely what the economy exists to serve, and therefore they must reflexively be the ultimate source of value and meaning for this system. Objections about 'objectivity' and 'instability' are useless. There is no higher authority to which to appeal.
It is systematically skewed valuations that result from fluctuating money supplies and coercive intrusion that are un-meaningful, even when the intent and supposed effect is pricing stability. Economies exist to serve people, not the other way around. It is only proper that individual human choice and desire determine the value of goods, however inconvenient that might be to the planners on the left and the growth-at-any-cost mongers on the right alike. Anyone who objects to that prioritization probably does not belong in any free-market camp.
A system with a fungible money supply inevitably usurps human needs and desires as the final arbiters of value and the whole system becomes subservient to the entities which are the source of the new money. The world is only too recently learning this lesson as the banking system, governments and their hangers-on have practically enslaved all other entities.
Likewise, transactions and activities which "generate" money, i.e. for which money is not conserved, as opposed to those which simply make a profit, will tend to proliferate disproportionately to transactions which are merely legitimately profitable. Again, economic calculation under such circumstances is incorrect and human derived values are not served. As fractional reserve accounting creates new money through the extension of loans against bank deposits, it is easy to see how the credit markets would tend to overheat and debts are encouraged to pile up inordinately. Generally speaking, overcapitalized and overindebted business structures are the result of this effect.
Every chemist and engineer knows that material balance is only possible when matter is conserved. Assuming that it has been conserved when in fact material has leaked into or out of a system can lead to a situation where the observed result does not reflect the properly calculated outcome and appears to defy the physical laws of the universe. Decisions made under such 'delusions' can be touchy and dangerous, and more than a few chemists and engineers can relate stories of thrills and tragedies which have ensued when mass was supposed to have balanced, but somehow didn't.
The same holds true for money. In a system with a changing money supply, accounts can look as if they balance in a formal sense, but may be horribly skewed in a real, value-denominated sense. The accounting will have been screwed up because money was not conserved over the course of many transactions.
An excellent example of this kind of miscalculation is the calculation of GDP. GDP is usually calculated, roughly, by determining the sum of all goods sold in a particular year. The critical leap of intuition here is not so much that all goods sold in that year represent all goods produced that year, which they probably do not, but that all money spent must have been earned through some productive economic activity. Activities which were unproductive because they did not gain their practitioners any purchasing power do not count towards national productivity. You know, activities like raising a family.
What this calculation ignores (among other obvious things) is that money is not conserved over time in our system, so that some fraction of money spent was not acquired through an act of production. It was created by a bank.
Every year, a certain amount of new money is created out of nothing by the banking system through central bank purchases and lending against deposits. Since not many people borrow money just to sit on it, virtually all of it is spent. This is in addition to legitimate earnings that were spent. The GDP calculation would be more or less valid if money were conserved, but this anomaly upsets it. The money system 'leaks.'
Here is a more concrete example. Suppose that, for whatever reason, the FED decided to buy a brand new 51st state, and payed for it by simply by printing the money, as it does when purchasing any asset. US GDP would register that 'sale' just as if somebody had actually worked hard enough to get the money to build the state himself (without foregoing any other purchases.) For that particular year, there would be a tremendous spike in GDP, even though there was no actual increase in production, because the 'production' of the state would have been with resources diverted from other processes by the printed money, not from the blood, sweat and tears required to earn pre-existing money. GDP would not reflect reality. Though the books would formally balance, this transaction would not be in any way descriptive of the real world.
Many other such situations are created or tolerated by this kind of thing, some of them absurd and bizarre. The FED currently lists the value of its gold holdings at $42 per oz. On the actual market it would fetch upwards of $1100 per oz. The FED bailed out the financial sector without a peep of consumer-price-anything.
Even mundane things like business and family finance fall victim, as the imbalance created on the banking balance sheet gets transferred to theirs. Income and profit are supposed to represent productivity, and a checkbook ledger or balance sheet the balance between income and expenditures. How is it that suddenly and without warning, an enormous fraction of households and businesses no longer have balancing checkbooks in a year like 2008 when their activities have not appreciably changed? Because stabilization of the money supply caused recession and revealed the pent up mispricing, and though they may have been balanced in formal sense, most of these entity's finances were probably not balanced in a value-denominated sense for some time. They only thought they were generating wealth when actually they were wasting it away.
Similarly, the housing market got far out of kilter due to expanding money supplies. Households thought they could borrow far more than was really possible, and lenders likewise had overwhelming amounts to lend and thought that they could do so without a great deal of risk. Gently rising house prices made the collateral look very safe, which made the issuance of derivatives against loans look like a smart deal. Everything looked like it all balanced out, right up to the point that it didn't. The culprit -- an expanding money supply -- had pushed prices, wages, and interest rates far out of anything remotely resembling reality. Real decisions, like agreeing to the long term effort to service the debt necessary to acquire an expensive house, were made under false 'formal' pretenses. The real, value denominated agreements weren't nearly so attractive, and when prices corrected, many walked away.
What do balance sheets and income statements mean if they don't mean anything? Why keep them? Formal solvency? Legal protection from bankruptcy proceedings? None of this nonsense would be possible in a world with a strictly conserved money supply. But even when the chicanery is not deliberate, it is no less real or consequential.
The beads of the abacus allow the calculator to keep track of reality. Fungible money supplies create illusions and pretend to escape it. That is how both were designed.
The Time Aspect
But what about 'keeping track' across time? As wealth accumulates, or possibly dissipates over time, doesn't that cause prices to systematically change? How can it be economically legitimate for prices to rise and fall in this way? Shouldn't a good have the same value over time under a legitimate money system?
Hopefully by now the reader understands that this question is illegitimate. Who is to say? Once again, economic value is subjective. It is what a human in a specific context decides it is, and future contexts will surely be different from today's. Why wouldn't it be legitimate for prices to drop over time as a reflection of increasing productivity? Maybe identical goods really are worth less in the future under such conditions, and money really is worth more.
How much less and how much more? Again, this is a quantitative question asked of a subjective system in expectation of an objective answer, and not something some human with divine pretenses should be toying with. But supposing someone should answer such a question -- who better than that buyer and seller on that future date who know their situations far better than the hypothetical observer today?
Such questions betray unreasonable expectations of the money system itself. It is like asking a screwdriver to function as a lawnmower. Actually, in some ways it is more like asking a screwdriver to develop omniscience and become a god-like arbiter of everything. Money is not a god; making it one will surely turn out badly.
Blame the Progressives
If you ask me, the development of this kind of attitude towards money and the subject of economics in general (and BTW, kudos to Akaky for pointing this out in a comment to a previous post), where it clearly isn't warranted, is an isolated example of a greater trend. It seems to me part of the greater Progressive philosophical movement that asks all subjects to become an objective science, or at least to be treated like objective sciences when they are not. It asks all issues to be reduced to mechanical issues. It asks government to become a technocratic ruling elite, omniscient, omnipotent and omnicompetent and the one and only avenue for societal problem solving. Everything is a petri dish to be managed under the government microscope and scalpel. Or something like that.
Prior to the twentieth century, at least some economic theorists recognized the limitations inherent in the application of numbers to their subject. It is modern economists, in particular in keeping with the approaches of mathematician/non-economist John Maynard Keynes, that treat their subject as if it were a branch of calculus or physics. I notice that sometimes I tend to do so as well. I suppose the bug is contagious. Maybe we all could use a thorough brain washing and waxing to purge us of our inherited Progressive tendencies towards quasi-scientific simplicism. Sometimes I wonder whether, if I were taken back in time, I would marvel as much at the 18th or 19th century standard of thought and articulation on these subjects just as much as those people would marvel at a modern computer.
At any rate, it is the crotchety, eccentric old Austrian school that still maintains that economics is limited to theory and qualitative approaches, and will never approach the certainty of Newtonian physics. Half the value of this school must lie in the fact that it has been largely abandoned and ignored in the last century, and so managed to escape most of the Progressive mindrot which seems to have infected everything else. And I need to get back to the subject at hand...
Look -- No Bubbles!
Interestingly, it is easy to see that the sort of price deflation caused by increasing productivity against a background of a fixed money supply cannot distort relative prices the way a credit inflation does precisely because it happens throughout all markets at the same time. It can't help but do so. Therefore, it is not possible for this sort of 'deflation' to cause a business cycle. There are no relative price distortions to instigate malinvestment. But the converse -- monetary inflation with no distortion of relative pricing -- isn't really conceivable, at least by me. The money has to enter the system somewhere and according to some set of rules, where it will distort prices and economic activities.
Where comes this irrational impetus for enforced price constancy? Supposing there was a possibility that it might be done as the non-Austrian imagines, is it worth the inherent risk to try? It is a risky thing to do for nothing more than attempt to satisfy simplistic notions of valuation that aren't in keeping with the real world. Real prices change over time. That's reality.
All may rest assured that the economy will get along just fine with a fixed money supply. Better a free-market in money with a hard and fast gold coin standard than half-baked experimentation with fiat money systems and bank accounting practices managed by people who only pretend to know what they are doing.
The worth of a thing is necessarily subjective. By maintaining a free market in money and treating it as any other good in the marketplace, if a special good with a few unique properties that no other good possesses, Austrian theory provides as best as can conceivably be provided for a stable money system that accurately reflects human valuation and causes minimal distortion of the economy. This is the best regimen for allowing money to reliably perform its most basic function -- acting as a unit of account.
Fiat money systems directed by governments and banking bureaucracies suffer from what I would call the C. S. Lewis Problem. In placing undue importance on notions like maintaining stable prices, ensuring ample availability of credit, and stimulating economic activity rather than preserving the most basic function of money, which is to act as the unit of account, fiat money systems invert the proper ordering of a money system's priorities. By placing 'second things first,' these systems engage in value-accounting fraud and inevitably find themselves 'losing both first and second things.' But if they had only placed 'first things first,' they would have found that second things tend to take care of themselves.
Inflation is not just some kind of fudge-factor. It is a pernicious destroyer of economies. Correcting for inflation is about as credible as correcting for napalm.
The only plausible, stable money that escapes this destruction is one that exists in fixed supply. Next time, I'll look at practical implementation.