Posted by Notevenwordshere on 07/22/10

Note: This is the fifth and final part of my essay The Origin and Abuse of Money: Lessons From Austrian Business Cycle Theory Toward a Policy of Sound Money.  You may read the first four parts -- titled "The Origin of Money", "The Abuse of Money", "A Summary of a Austrian Business Cycle Theory", and "Economic Value" -- by clicking the links.

Please feel free to disseminate, for educational purposes, the ideas discussed in this essay.

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Part 5: What Are the Qualities of Sound Money?

Truly, money is a good. It is not an objective bystander arbitrating contracts. It is a subjective player in the market, too, and the degree of its stability depends largely on those two great hallmarks of economics: supply and demand. Futz with either, and the value of money will change; consequently, prices will change.

(There is, of course, one other thing which affects the value of money - that is, goods and services in supply - but that topic is for another time.)

So what are the qualities of sound money? We've discussed the origins and evolution of money. We've spent the time emphasizing the need for a sound currency. Clearly, our current system falls far short of this standard. Then, finally, how do we get it? And how can we know we have it?

A truly libertarian policy toward sound money would include a competitive process. It would necessitate the overthrow of our current monetary scheme and supplant it with - well, with nothing, really. Supplanting is for usurpers. In the eyes of a libertarian who stuck with the principle of nonaggression, no system would be forced to be adopted; instead, much like how it did in the past, money would rise spontaneously again. People would be free to contract in whatever form of payment they wished, and, indeed, certain transactions would be made in unusual ways. But, based on certain characteristics, a commodity or series of commodities would dominate as the preferred choice of money.

Here is a non-exhaustive list of those characteristics:

1. Money must be durable and not easily destroyed
2. It must be light and easy to transport
3. It must be in perpetual demand
4. It cannot be easily replicated
5. It must be in scarce supply
6. It must be frangible and divisible

Each of these criteria satisfies practical concerns. For instance, wood is easily destroyed, so it is not a good choice. Sand is useful for many things, but its abundant supply makes it useless. Food might be useful for bartering, but its non-durability keeps it from being a store of value. Diamonds would seem to meet all the criteria until one reaches number 6: diamonds are hard to divide into usable units. Also, though infeasible now due to costs, diamonds are able to be manufactured.

Paper money, on the other hand, meets very few of the criteria. Yes, it is light and easy to transport, but it is not durable. And it can be destroyed easily. Also, paper money is very easily replicated, and as a result is not in scarce supply. It can be divided into usable units, but the only reason it is in demand is because legal tender laws require its use.

What does satisfy all or most of these criteria? Precious metals, like gold, silver, or copper. Metals are relatively easy to divide, they're in demand, they can be light and portable, etc. Their supply is stable, too. Because of the long-term process of mining, increases in the supply of gold are almost always predictable and non-disruptive to an economy.

Objections to Commodity Money

While I doubt too many mainstream economists would dispute my argument that commodities would take up a central role as a monetary instrument in the absence of a fiat paper currency, they might have a couple pragmatic objections. I will attempt to anticipate them here.

1. Metals are not stable in value.

This objection is based on the observation that the prices of metals have fluctuated wildly over the years. For instance, gold has experienced an increase in price of nearly $1000 an ounce over the last decade. An economist who thus embraces paper money would say that clearly gold is too wild to be trusted as money.

To be frank, this argument is ridiculous. First of all, the root of the objection is that stability is valuable. However, we must note that paper currencies are not at all stable! Do I need to call to mind the German Weimar Republic of post-World War I? To this day, it remains one of the worst cases of hyperinflation in recorded history. Or how about Zimbabwe, which is giving the Weimar Republic a run for its money? (Did I just make a pun?) Oh, but I needn't only point out those two disasters, as I could just as easily point to the United States, where, as aforementioned, the value of the dollar has dropped over 95% since the Federal Reserve was established. If stability is truly a concern, paper money is no refuge.

My second rebuttal is even more damning. While it is true that metals fluctuate in value, we must ask the question: how exactly are we measuring this fluctuation? Why, we measure it in paper money! It should become obvious, then, that it is not usually the metal whose price changes, it is the value of the money in which the metal is measured that changes!

2. People trust paper currencies.

This objection is framed around the belief that to get rid of paper money would cause great upheaval, and therefore it should be kept, because it maintains order.

First, if it is true that there is so much trust in fiat money, then why are there legal tender laws that require people to use it? And yet still more, why is it often illegal to transact in other forms of money?

I am more than a little skeptical of anything which is defended on the basis of "maintaining order", or something similar. I could easily refute the objection by pointing out that central banks, through inflationary practices, have created their own brand of disorder.

As for the supposed upheaval that would result if paper money was overthrown - well, it is just that: a supposed upheaval. The great comedian Emo Philips has a joke that goes something like this: "I remember when I was younger I used to think that the human mind was the most amazing thing there is. And then I realized, 'Well, look what's telling me that.'" Similarly, whenever those in and supporting central banking drone about how necessary they are to human civilization and how an unshackled money system would never work, I am forced to ponder just who is telling me this.

Metals Have Value; Paper Money Does Not

Like other things, metals like gold also have value. They must be prospected and dug out of the ground. This requires labor and investment, acts which state that the metals themselves are more worthwhile than the costs of mining. Once removed from deposits, the metals are made useful: if not as money, then for other purposes. Along the way, the production and manufacturing processes add unique values to the final, usable commodity.

Contrast this process with one for fiat money, which has no usefulness beyond its legally-required one. The process for fiat money used to consist of printing, which includes the investments of ink, paper, and machinery. Old paper money, which was all physical, possessed at least a small amount of value for its process. The digital age, however, has made obvious what before was just a poorly-kept secret: that fiat money is all but worthless. For now it can be conjured with a few strokes of the keyboard, a few buttons pushed.

Put simply, in the creation of central banks, we have given an imaginative kid a toy that redraws the borders of what can be imagined. But there are borders. Finite worlds all have them. Economics is no different. The question, then, is how much we are willing to endure. As I said, the monetary story in America is filled with injustices and fraud. But the greatest of these is still ongoing, and can be laid at the steps of the Federal Reserve. Its greatest mischief can be placed at the feet of men like Alan Greenspan. Eventually, if America's current path holds, Ben Bernanke will outstrip Greenspan and raise a new standard of monetary destruction.

It is time that the people of America - and those around the world, to their equivalents in their own lands - stood up to these tyrants of money.

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Thank you for reading this essay, and for contributing to the causes promoted herein.  I hope you have enjoyed my presentation of history and theory, and have found it enlightening.

Tu ne cede malis!

Posted by Notevenwordshere on 07/21/10
Last updated 07/22/10

Note: This is Part 4 of a 5 part essay.  The preceding titles are "The Origin of Money", "The Abuse of Money", and "A Summary of Austrian Business Cycle Theory", and you may read each by clicking their respective link.

If you're curious, the essay has been broken up into parts because its entire length of 6,000 words is prohibitive in the forum of a blog.  Thus, the parts are carved into posts about 1,200 words each.

As always, please feel free to distribute this essay as educational material.

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Part 4: Economic Value

When one begins a discussion of economic value, it is important to note the rapid changes in accepted theory of the past few hundred years. For hundreds of years, the accepted theory of value was the labor theory, which states simply that things produced are worth only what it costs to produce them. This theory informed economic thought as old as Thomas Aquinas - and older, too. It also prevailed with men such as Adam Smith and John Locke, both of whom greatly advanced free market theory, and theories of human action as well, notably Smith's sublime Theory of Moral Sentiments.

Another person who was heavily influenced by the labor theory of value was Karl Marx. Marx correctly extrapolated that, if true, the labor theory of value implied an evil in profit: for if things are worth only what it costs to make them, then workers are of course being exploited by their employers when the latter sell goods for prices higher than costs. It is an interesting caveat in the story of economic thought that communism partly originates as a correct conclusion drawn from an incorrect fragment of the free market theory of the time. Marx would've been right about the exploitation, but it depended on the correctness of the labor theory of value.

Ultimately, the labor theory was wrong, though it still stands elite among the theories of intrinsic value, which believe that all goods have a value which can be objectively measured. This stands in contrast to the subjective theory of value, which became popular in the late 19th century and is now the dominant theory. Carl Menger, a forerunner of Mises and the true founder of the Austrian School, was one of the first to develop the subjective theory of value in any systematic way, in his treatise Principles of Economics.

Therefore, properly understood, value is subjective. This value is measured according to its usefulness, which is its marginal utility. My favorite illustration of this proof is food. To one person, a vegetarian, a hamburger has no value; to another, a meat-lover, a hamburger might be worth quite a bit; and to yet another, who eats meat but is not a fan of beef, a hamburger is worth very little.

In other words, marginal utility is the satisfaction - or profit, if you will - gained from making a trade. When I buy a bottle of plum juice, for example, what I am doing is stating, by my purchase, that the juice is more valuable to me than the money I must part with in order to acquire the bottle.

Price (In)Flexibility

True as this subjective theory may be, we must reconcile this fact with ordinary transactions, for which prices do not often vary. If you want to buy a certain t-shirt from a chain store, it is presumably futile to argue with the cashier about how much it is worth to you. The multitude of transactions affects the flexibility of prices in certain goods. Thus we may observe that prices for goods that are mass produced are rigid with regard to individuals. However, prices for goods that are in short supply are more easily negotiated.

It is seen, then, that the answer to price flexibility on a market is determined by supply and demand. For instance, there is a difference (not just an aesthetic one, if you ask me) between a painting by El Greco and a painting by Thomas Kincade. Supply, far outweighing demand, not only sets prices for the latter's work very low, but also it creates price rigidity. In the former's case, while demand, far outweighing supply, drives the price of an El Greco painting sharply upward, it leaves great room for price maneuvering.

We see, then, that price inflexibility is not a valid objection to the subjective theory of value. Now, finally, we may examine the case for sound money.

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Part 5, "The Qualities of Sound Money", can now be read at your leisure.  Thank you for reading.

Posted by Notevenwordshere on 07/14/10
Last updated 07/21/10

Note: This is Part 3 of a 5 part essay.   I've broken it up into parts to make it easier to read.  You may read Part 1, "The Origin of Money", and Part 2, "The Abuse of Money", by clicking the respective links.

Please feel free to use the material herein for educational purposes.

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Part 3: A Summary of Austrian Business Cycle Theory

Patient and attentive reading of Parts 1 and 2 should've yielded these conclusions: 1) inflation is the practice of printing money; and 2) the business cycle - that is, economic booms and busts - is caused by inflation. And skeptical reading should yield this question: "Can you prove it?" Yes, I can.

First, we must understand how money is created. There is a process, which, fortunately, is not that complicated: it is the adjustment of interest rates. The Federal Reserve, having made a decision either to raise or lower interest rates, goes about creating money. Anymore this is mostly done by entering extra zeros into the computer.

Second, we must understand the interest rate. It is the price of renting money. Properly understood, money is a good. The price of a good can depend largely on how much of that good there is available to consumers. For instance, the more chairs there are, the lower the average price of chairs. The same is true with the interest rate. The more money there is, the lower the interest rate. The reverse also holds true.

If the Fed lowers rates, they do so by increasing the amount of money banks can lend. The Fed pumps the new money into banks, which then turn around and loan it out. On the other hand, if the Fed wants to raise rates, they either create less or remove money from circulation: thus the banks have fewer funds to loan out and they will increase their interest rates.

This may all sound well and good, or it may sound like trickery. But what you should have gleaned without making any judgments on the merits of the process is that interest rates are determined based on how much money is available to lend. The amount of funds and interest rates share an inverse relationship. Fed defenders and their Austrian critics alike agree on this. So what's the problem? Why is it bad if banks can lend to people who might otherwise not get any loans? Here's why:

In a free market, interest rates are determined by the amount of savings that banks have on deposit. If there is an abundance of savings, interest rates will reflect this fact by being low. If there is a dearth of savings, then banks, having few funds to lend, will jack up interest rates. This, then, is how the free market sets interest rates.

Time Preference and Stages of Production

Many of the flaws in other economic paradigms originate in their failure to distinguish types of production, focusing instead on a monolith known only as "demand". The Keynesians are the greatest of the guilty, but also the Friedmanites share some fault for their reliance on aggregates as measures of wealth. To Keynesians, the solution to depressions is to spur on demand. The citizenry, being broke and scared in the wake of the bust, is unable to take up the mantle. So the Keynesians advocate for profligacy in the fiscal and monetary devices of government. Friedmanites, the wiser, recognize the distortions of deficits in the market economy but implicitly sanction it through their endorsement of monetary inflation.

Ultimately, these two lines of reasoning fail, among other reasons, for not distilling the structure of production beyond the basic aggregates. Total, or aggregate, demand reveals nothing about consumer preferences or about the dynamic of interest rates. The Austrians, then, remedy these errors by their insights into the structure of production.

In the Austrian view, there are three basic projects undertaken by entrepreneurs, and they are measured in stages. The stages are defined by their place in the production process in relation to the end consumer. The lower-order stages are characterized by services and goods which are nearly or immediately to be consumed: food at the grocery store; retail clothing; a car wash; etc. As we move toward the higher-order stages, we also move further away from the consumer. Processes in these higher-order stages include mining, land development, and other things which are far removed from the end-user. Between these two stages is the middle-order stage.

To undertake new projects requires new funds, which means one needs a loan from a bank. If the interest rate is low, that is a benefit to those projects in the higher-order stages, as they are years from being profitable. If the interest rate is high, such projects will prove too costly to begin. The evidence is clear that the interest rate determines what types of production processes will be undertaken.

As mentioned above, in a free market, interest rates are a function of savings. Putting it simply, the decision to save money is another way of saying that one is choosing to delay consumption for the future. If this happens en masse, and the interest rate falls, then this will arouse the activity of businesses toward those long-term, higher-order projects, which are more sensitive to changes in interest rates than are short-term ones. In effect, the increased savings send a signal, in the form of a lowered interest rate, to producers to adjust the structure of production to reflect consumers' desires for the future. The market thus coordinates time preference (whether to consume now or later) with interest rates.

If a central bank like the Federal Reserve enters this fray, it disrupts the coordination of time preference and interest rates. When the Fed lowers rates, it is not the result of an increase in savings. It is the result of newly-created money in the form of credit.

The problem should be apparent already, but let's spell this out. Yes, the entrepreneurs and speculators have money to begin their long-term projects, spurring economic activity. But there is not a pool of savings available for future consumption. Consumers have not set aside the money that will be necessary to sustain these long-term projects when the time comes. What's more, because interest rates are pushed lower, any consumer who is saving has less incentive to save, and thus more incentive to consume in the present, further widening the gap of funds necessary to sustain the higher-order stages.

Ludwig von Mises, often acknowledged as the founder of the Austrian School, used an example of a master builder who is building a house. The builder is keeping an eye on the supply of bricks to ensure he can complete the project. However, because the supply of bricks is reported wrongly, he takes on a scheme for which there are not enough bricks. Obviously, the sooner he discovers the error, the better off the builder is. But, in the world of central banking, the solution is, to extend the analogy, to get the builder drunk so that he does not realize the mistake at all, and continues with his plan. Eventually, however, the truth is revealed, and the master builder is forced to scrap his plans and fire any employees he has. Worse, he has squandered his time and resources: even if he can liquidate, he will still have lost a lot of wealth.

The real punch of this illustration is to imagine that scenario on an economy-wide scale, as occurs during an economic boom and bust.

Unlike in a market system, where the actions of consumers and producers are coordinated with an accurate interest rate, a central bank pits consumer against producer. Both the lower-order and higher-order stages are competing for the same resources, with the long-term projects receiving a boost from artificial credit. But this credit cannot be sustained without massive inflation, which itself would wreck the economy. So central banks like the Fed will usually only keep interest rates low for a short period of time in order to fend off the threat of high price inflation. However, the moment the monetary spigot of cheap credit is cut off, the un-sustainability of the boom, especially in the higher-order stages of production, becomes obvious. Speculators and entrepreneurs rush to liquidate the malinvestments and integrate what can be salvaged into other, sustainable projects. This causes a crash, or bust. There is absolutely nothing that can be done to stop the bust from coming.

Applications of the Theory

The theory sounds like a fantastic explanation, and it certainly, from a superficial glance, appears true. Clearly the U.S. has experienced periods of artificially-low interest rates at the hands of the Federal Reserve. In the 2000s alone, Americans have seen rates reach 1% for a full year under Alan Greenspan; and, under Ben Bernanke, rates are effectively at the ridiculous rate of 0%, and have been so for over a year. Further, we can look up the statistics and see that savings rates reached all-time lows during this past decade, trough-ing below 1% more than once (and this tally does not include new debt incurred through credit). Also, we have witnessed huge booms in long-term projects like housing and real estate, and the eventual bust of those same industries. Finally, we can point to the Austrian School's predictions prior to the bust, which were spot-on in their assertions of a coming collapse.

Some, like Milton Friedman, generally a free-marketer, say the theory doesn't hold up under scrutiny. So let's scrutinize. For example, look at Japan (and another, older look) where the central bank has kept rates at or near 0% for the better part of the past two decades. And yet, one notes, the currency has not collapsed or experienced massive price inflation. But, of course, we do see the predicted results in Japan: speculation and high prices in real estate, persistent and repetitive malinvestments, and unending recession. Japan has been stuck in a mire for almost two decades, but it benefits from a few things: 1) its government is not a profligate militaristic state; 2) the country has kept up a trade surplus; and 3) the people of Japan had maintained a good savings rate (though this is rapidly declining in recent years). Many of the arguments presented by those (like Paul Krugman) who criticize the Austrian theory of the business cycle are merely to attack something they think is the theory, instead of an empirical analysis. Among the better is Gordon Tullock, who has a few worthy criticisms, but makes a few mistakes and comes far short of a full critique.

In Part 2, I also attributed the various Panics of the 1800s to fractional reserve banking, which is the practice of creating money. So, with or without a central bank, booms and busts can occur, because the practice of creating money need not have a central bank. But, if one exists, like the Fed, it merely institutionalizes the problem, and perpetuates the wake of destruction. And, long after the bust has run - if it is even allowed to take its natural course - and the market corrected itself, consumers are still left with the burden of inflation, and its resulting increase in prices.

Central banking is theft. It punishes people's life-savings by inflating its value away; it robs the poor by raising the cost of living; and it enriches the few, favored rich by giving them access to the new money before the effects of inflation are felt. And it does all of this under the guise of stabilizing the economy and protecting the consumer. If ever the phrase "bad joke" was more applicable....

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Part 4, "Economic Value", is now available to peruse.  Thank you for reading.

Posted 07/15/10 LizLiz Brooklyn, NY

I am sure you know... but they don't even teach the Austrian school of thought in many colleges.. We have an army of Keynesian graduates - how frightening.

Posted 07/21/10 Notevenwordshere Lakeland, FL

Frightening indeed. And to your point that Austrianism is not taught in many universities, you are correct. I myself was not exposed to it until after I graduated, even though I had a business degree and took many economics courses. Keynesianism, fortunately, seemed fishy to me even then. Also, I have always been more deductive than inductive in my approach to human beings. So once I discovered Austrianism, it was easy to jump headfirst into its depths.

Posted by Notevenwordshere on 07/12/10
Last updated 07/14/10

Note: This is Part 2 out of a 5 part essay.  I've broken it up into parts to make it more palatable to the reader.  You may read Part 1, "The Origin of Money", by clicking the link.  The other parts will be posted in the coming days.

As with my last post, please feel free to disseminate the material in this post for educational purposes.

Part 2: The Abuse of Money

The life cycle of societies and their money goes something like this: Primitive societies will evolve from barter to commodity money; a civilized society evolves from commodity money to commodity-backed money; and government will attempt to monopolize money production to advance its own power. Eventually, this dilution of a standard on which to base money leads to a devaluation of the currency, if not a total collapse.

One needs to look no further than the United States dollar. The monetary history of the United States is tricky to navigate, filled as it is with numerous injustices and inflations: beginning with the Continental dollar in use during the American Revolution, we can see the abuse of the currency. Many of the Founding Fathers (though by no means all) became distrustful of paper (or fiat) money following the rapid debasement of the Continental to fund the war. Thomas Jefferson in particular despised un-backed money, calling it immoral. Alexander Hamilton, a veritable statist by comparison, lobbied relentlessly for a central bank. Hamilton won the battle, and George Washington signed into law a charter for the first Bank of the United States. Jefferson - on this point, at least - never shied from his principles, and his friend James Madison (also from Virginia, and an ally ideologically) subsequently let the charter expire in 1811, during the latter's first term in office.

(It is, of course, incumbent upon me to point out that Madison, who opposed the 1791 charter signed by Washington, signed into law a charter in 1816 for the Second Bank of the United States; his justification being that the War of 1812 had caused severe inflation - duh! - and the credit of the young Union had been heavily damaged. A more irascible man, Andrew Jackson, let the Second Bank of the United States expire in 1836.)

The 1800s, too, are rife with examples of monetary abuse. A handful of major panics - which are the modern equivalent of recessions - hit as a result of the fraud associated with money. While this fraud was not a result of a government-managed currency, it was often practiced under the protections thereof, particularly during wartime conditions. Through the credit expansion allowed by fractional reserve banking (a fancy name for "printing the money"), paper money was pushed into circulation, leading to booms not unlike the one which precipitated the 2008 stock market crash. The bust, inevitably the outcome of such credit expansion, came about. Because of the lack of a monopolized money system, however, bailouts were not easily orchestrated, and fraudulent banks were not as easily propped up: thus the malinvestments which were given life through credit expansion were liquidated; and the crises ended relatively quickly - the policies of the Whigs and Hamiltonians (who were the Republicans, basically) notwithstanding.

Overall, the monetary story of the 1800s is a positive one. While not as robust as it might have been had the interventions and wars of government not taken place, the fact remains that between 1789 and 1913 - a space of time which includes all the major panics in American history; a sum total of 4 major (and likely unjustified) wars, including the disastrous Civil War; and the tenure and demise of 3 central banks (if one counts the Lincoln-era, Greenback-originating "National Banks" as a central bank) - the purchasing power of money increased by approximately 30 percent. By contrast, since 1913, the year the Federal Reserve was founded and the monopolization of money in America was achieved, the purchasing power of money has fallen by more than 95 percent.

The U.S. dollar has long been buoyed by its status as the most widely-used reserve currency in the world. This affords it the luxury of being in constant demand. As G. Edward Griffin points out in his book The Creature From Jekyll Island, the dollar's reserve status opened the door for the Fed to create massive amounts of money, in effect to "finance its trade deficit with fiat money - counterfeit, if you will - a feat which no other nation in the world could hope to accomplish." However, troubles with the dollar, a fault of central bank (the Federal Reserve's) policies, will eventually lead to its displacement on the international stage.

It is the contention of those in the Austrian School that, great as the growth and development in America has been, it would have been far greater were it not for the Federal Reserve and other government interventions. The period of Federal Reserve dollar management is a litany of credit expansions, political maneuvering and backdealing, and inflationary bouts. Recessions and depressions have been their fruits.

Criticisms of Austrian Thought

Some have claimed that the Federal Reserve has stabilized the monetary system, resulting in fewer crises. However, this is demonstrably erroneous. The regime of the Federal Reserve shows a great number of recessions - on average, once every handful of years. And then there are multiple depressions: 1920, the Great Depression (1929-1946), 1973-75, 1981, 1990, and our current economic quandary. And, of course, then there was inflation: notwithstanding the nearly-continuous inflation, there were especially bad inflations in the 1970s and 2000s. Again, how is this record better than the pre-Fed days?

Advocates of the Federal Reserve System will point out, correctly, that many downturns occurred during the 1800s as well. The Austrians do not dispute this. However, they do dispute the claim made by Fed defenders that the 1800s were a period of "free banking". A lack of a central bank does not translate to a free banking system.

We can trace the origins of the Panic of 1819 to the debts incurred by the War of 1812. Banks lent money to the federal government to fight the war. Because of the massive costs of the war, these loans were made over and above reserve levels. Inflation resulted, and the credit of the United States was damaged. James Madison, who was president at the time of the War of 1812, subsequently chartered the Second Bank of the United States in 1816, to aid the United States in inflating its way out of debt. Similarly, the Panic of 1873 has its origins in a post-war environment, particularly the post-Civil War havoc, and also subsidies for railroad expansion. As it concerns the railroads, the mercantilist policies of the time were similar to recent government policies which helped to create the housing bubble that burst in 2007-8, and also the tech bubble in the late 1990's. The work of H.A. Scott Trask on the Panic of 1837 shows that the crisis can be partially attributed to Mexican bimetallism, which led to an influx of silver holdings in banks. The banks, practicing fractional reserve banking (the same practice on which Austrians blame the business cycle), lent out specie at five times the amount held in reserves, thus setting in motion the boom and - eventually - bust.

These tales present a complicated web of history. Obviously, there is more than meets the eye, and it is too tempting to dismiss the probing necessary to reach proper conclusions; rather, we should wish for the easy task of improbity and merely aggrandize our own views. Instead, under scrutiny, we find much to be critical of, and less to laud than we would have hoped. All of this, however, serves to reinforce the crux of the Austrian argument for sound money: the lack of it, even in situations otherwise symptomatic of healthy policies, can spell disaster for an economy.

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Part 3, "A Summary of Austrian Business Cycle Theory", is now available to read.

Posted 07/20/10 imanoutkast Hatfield, PA

Once again, excellent. Some great links that really help things make sense. This seems to be a very unbiased and straightforward approach to the topic at hand. Refreshingly good to read. Thank you.

Posted 07/21/10 Notevenwordshere Lakeland, FL

You're very welcome. I appreciate that someone has taken the time to read my essay. Please share it with others. I am no originator of these theories and histories, so I am not bothered by this essay's free distribution. Continue commenting, too. If you have any questions, I am glad to clarify: the best of my knowledge is at your disposal.

Posted by Notevenwordshere on 07/11/10
Last updated 07/14/10

Note: This is Part 1 of a 5 part essay.  I've broken it up into more easily-digestible lengths for the benefit of the reader.

Parts 2 through 5 are, respectively, titled "The Abuse of Money", "A Summary of Austrian Business Cycle Theory", "Economic Value", and "The Qualities of Sound Money".  Each part will be published on Campaign for Liberty in the coming days.  I encourage you to read them all, and to aid toward that end I will be including links in each post to the previously-posted sections.

Please feel free to distribute this material for use as tools for education.

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Where Does Money Come From?

If you were to ask the above question to any passersby, the answer you would likely receive - if you got an answer instead of a leering, suspicious look - would be something to the effect that a governing body, through a system of laws, provides money.

But is this true? The answer is clearly no, for it presupposes a government which can enforce its money laws. In some cases, a society has existed without government, or effectively so: how then did the citizens trade? A more astute answer, then, might be to argue that good money - that is, money which has endured - has come through government fiat. But this, too, is incorrect. The testimony of history is awash in examples of government mismanagement (to say the least) of the money it commands.

Often, an ambitious political body will purposely maltreat its money in order to achieve desired ends, to benefit favored friends, or both. Disturbingly, most empires have sprung up and been maintained on meretricious monetary policies which enabled the profligacy of the military state. For instance, Rome, in order to continue its military expansion, devalued its coins by diluting its metals. America, too, uses inflation as a tool to finance its wars. A circumspect examination of fiat money would therefore take into account the direct correlation of inflation and war, both being policies of government, and the latter being nearly impossible without the possibility of the former, and the former being wholly impossible without fiat money.

But then, where does good money come from? If money does not arise by fiat, then how does it arise?

Money Arises Spontaneously

In Austrian economics, this is a very important point: money arises spontaneously. People, needing a medium of exchange, will, by process of trial and error, find a good whose qualities support its use as money.

This is not hard to prove. Even in today's world, if a government collapsed or was wiped out in a coup, would trade suddenly cease? Of course not. In the case of hyperinflation or an unreliable fiat currency, does trade become nonexistent? Of course not. Black markets give us the proof that money arises spontaneously. In the absence of a government-mandated currency, markets do not fail; they simply turn to new currencies, ones which they trust to maintain value while the fiat money flounders.

Money exists with or without government mandate. It exists because it is economically efficient, as opposed to barter, which is used only in the most primitive of direct exchange (i.e., one man trades Good A directly for another man's Good B, with no intermediary which we could call money). Further, money requires no law to operate as such. Any government emerging from social unrest would be remiss to attempt to impose a new currency on its subjects. Clever and foolish governments alike know this. Therefore, to the extent that a neophyte government experiments with the market's chosen money, it is usually only to the extent of monopolization of its production, or some smaller intervention. It can be concluded, then, that money cannot be "discovered" by government fiat - that is, created as a newly accepted money; rather, the spontaneously-chosen money of the market is usurped by fiat.

An Explanation of What is Meant by "Spontaneous"

If money does arise spontaneously on the market, and, as Austrians contend, never can it be created through fiat, then what are the processes that bring about the acceptance of money?

For, properly understood, when Austrians say money arises "spontaneously", they do not mean it literally, in the same sense that one might describe an individual, suddenly having free time, spontaneously deciding how to use up that time. The usage here is perfectly in line with the equally non-literal usage of the word "chaos" in the dynamical systems study called Chaos Theory.

Most people's conception of Chaos Theory is synonymous with the term "butterfly effect", which, in short, is the hypothesis that if a butterfly flaps its wings over Peking then the weather in New York changes. The principle behind this is air displacement, which would grow so large over time as to affect weather systems. It is a popularization, however, and not a full picture.

At its core, Chaos Theory is predicated on the idea of sensitivity to initial conditions. In other words, tiny changes in initial conditions yield wildly diverging predictions. (This is demonstrated by the Lorenz Attractor.) This is due to the interplay of the things comprising the "initial conditions" leading up to the time for which predictions are made. This interplay, though deterministic, is what gives Chaos Theory its name.

Regressing back to the spontaneous rise of money, we see its similarity to Chaos Theory. How money is chosen is not so deterministic as to fit a chaotic paradigm, but, similarly, its "spontaneity" consists in the indeterminacy of the exact timing and circumstances of money arising on a market.

Human action results in a monetary phenomenon we call money. Praxeological drivers - which is to say, motivation for human action - are not perfectly predictable. Hence, from the initial conditions of "no money"; with the natural incentive toward a money system; plus the uncertainty of the timing of human action all conspire to a spontaneous commencement of money.

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Part 2, "The Abuse of Money", is now posted.  Thanks for your readership.

Posted 07/20/10 imanoutkast Hatfield, PA

Awesome! This is the kind of stuff we need. "Educating and inform the whole mass of the people...They are the only sure reliance for the preservation of our liberty." I'll be the first to admit, I don't understand all this stuff fully, but that of course comes with time. I know in my gut Austrian Economics does a far better job explaining inflation and market dynamics, but I want to know why and how...and of course this series is a great place to start. Thank you for posting.