True freedom

"Freedom means that in some measure we entrust our fate to forces we do not control; and this seems intolerable to those positivist / rationalist who believe that men can master his fate; as if civilization and reason itself were the fate of his making"
F.A. Hayek

Tuesday, July 3, 2012

Money, part 2.

Natural money, centralized creation, sub-optimality and self-organizing processes
Author: Pablo Paniagua
Editor: Victoria Finn

The centralized creation of money, Fiat money, the price system and sub-optimality:

Money is nothing more than a medium of exchange and it completely fulfills its function when the exchange of goods and services is carried on more easily with its help than would be possible by means of barter. Attempts to carry out economic reforms from the monetary side can never amount to anything but an artificial stimulation of economic activity by an expansion of its circulation.”
Ludwig von Mises

It is extremely important to understand money’s origin and evolution as a spontaneous order of an evolutionary self-coordinating system in which individuals spontaneously come up with the best available solution in a free and noncoercive interaction. Real Money will always be like this under a completely free-market economy, meaning that if we let people spontaneously and freely decide their own money to facilitate their transactions, every single society in the world would end up adopting some sort of the most marketable commodity generally linked with a type of metal; in most cases, it would end up being gold.

As we saw in last week’s article related to languages, any attempt to apply reason and knowledge to create an institution as complex and important as money, language and others is just a futile attempt and falls in the rational-positivist trap. The fact that believing we can establish some sort of “artificial” money through reason and planned coordination, we will always fall short on the real scope of what money should do. Since it is planned by some centralized authority, it will always be an unnatural outcome of what society would have spontaneously and naturally chosen.    

The majority of optimal results in complex societies come from free individual coordination. As we have seen in languages, and in this case money, the optimal solution fitting for a complex system in a decentralized society will always lie in the hands of unprompted determination. It is therefore out of the individual’s capacity, understanding and design. Like Mises stated in his quote above, any attempt to apply human knowledge towards reforming the monetary system can bring unintended consequences and will eventually undermine and impede the coordination of individuals and therefore damage the source of economic growth. This problem of unintended consequences arises every time politicians, technocrats and statesman intervene and corrupt the money system, imposing other forms of state money such as Fiat money or a paper money system. 

The Fiat money system, also understood as a paper money system, is not similar to commodity money in the sense that the Fiat system is not freely adopted by the collaboration and interaction of individuals. Fiat money’s structure is generally imposed by an oppressive state, which systematically constrains and forces people to use it. As we have seen through money’s evolution, humans freely adopted some sort of inelastic commodity money as a way to subconsciously and spontaneously keep it neutral and away from the centralized authorities. The inelastic supply of a commodity keeps the amount of money in the economy stable and allows for better entrepreneurial economic calculations. It also keeps it out of politicians’ and technocrats’ reach and temptation to expand the monetary base in order to promote their own interests. Unfortunately nowadays we live in a global money system which is artificially created and imposed by the state. Our current money system is just a scheme of paper money backed by thin air and therefore is not redeemable for anything: metal or any other good. Fiat money is just paper with faces of deceased presidents on it which can be printed at will and can meet the central authority’s arbitrary goals. Fiat money completely bypasses the natural spontaneous decision of real individuals’ interactions. For more than 40 years we have sadly been living in this extremely unrestricted, global, arbitrary paper money scheme in which states can freely print as much money as they want. When President Nixon in 1971 ended the last relationship between the dollar and gold, it ended the last relationship between paper money and the most marketable good. Now this is the very first time in history that we have an international abuse and misuse of political paper money.

When a central authority artificially creates a monetary system, it is suboptimal and against the free interaction of individuals; even worse, it opposes individuals’ natural needs since it has been created by a central authority, so it primarily answers the needs of certain groups and their politic agendas. On the contrary a system spontaneously created does not respond to anyone’s interests; it is almost inelastic and therefore cannot be increased at will or capriciously intervened. Real money only answers to individuals’ interests and indirectly to the whole good of society. Artificial systems created by human reason and political authority will always improve the positions of those who impose it on others in the first place. Hence the artificially created money will always be biased and will be used as leverage to meet specific political goals. The optimal system for a complex society is not another unnatural, politicized, planned  Fiat money like the ones  hundreds of cultures have tried, imposed and failed, but rather a natural money system in which there is neither master nor any intended political or nationalist end.

Since Fiat money systems have been created by states, they have the tendency to experience secular inflations since there is practically no cost of printing paper. States have the tendency to just keep printing it, especially if it statistically creates some increases in growth measures. Unfortunately this monetary base inflation and expansion will eventually benefit some people at the expense of others since is uses the monetary expropriation of wealth (see article on the Cantillon Effect and the redistribution of wealth). Not only will it do that but as Mises stated, “this expansion of the monetary base is the constant source of ineffective and shortsighted stimulation of the economy, which eventually end in boom and bust cycles.” The people who benefit the most from these artificial systems are of course those who created and imposed it on the rest of society; it also benefits those who are at the beginning of the monetary expansion, those who first receive the money. It is no surprise then why people in the government and financial banking institutions are obviously willing to promote and back money printed by the state and use laws and enforcement to impose this system on others. 

Politicians love this monetary scheme since they can create and command money’s expansion through fractional reserve banking and artificially low interest rates in order to artificially encourage investment and credit. The system falsely promotes short term growth that might help them get reelected. This injection of artificial money in the economy is neither wanted nor necessary for the better exchanging of goods, creation of wealth or growth in an economy. 

The true source of sustainable long term growth is real savings. New money printed by the state and poured into the economy will only disrupt and damage the price system’s coordination, change relative prices and impede a correct form of economic calculation for entrepreneurs. This can lead to massive misallocations of capital and investments. These huge distortions will consequently end in recessions and liquidation of the previous artificially-created growth. Fortunately for the politician who started the expansion, he can enjoy the short term stimulus while neglecting the long term misallocation crises and economic damage that will only become self-evident when he is no longer in office. At that point during a massive paper money crisis, he would be either be reelected or else it would be someone else’s recession problem. In the long run we are all dead, right? Unfortunately those who make long term capital structure misallocations haven’t read Keynes.

The price system and the symbiotic relationship with money:

“Fundamentally in a system in which the knowledge of the relevant fact is dispersed among many people, prices can act to co-ordinate the separate actions of different people in the same way as subjective values help the individuals to co-ordinate the parts of his plan.”
Friedrich A. von Hayek

“Prices in short are seen as a continuous information collecting and disseminating process, but it is the institutional monetary framework that determines, both the extent and the degree of success in which prices will be able to perform their potential signaling and
allocative function.”
Friedrich A. von Hayek

Money is totally indispensable in a complex, decentralized society. It has a fundamental and symbiotic relationship with the price system’s coordination. In a society in which knowledge is so heterogeneous and rich, the only way that fundamental information about competitiveness, efficiencies and cost-opportunities can be transmitted is through a common pricing language. Hence money steps in as the universal common language and prices can be seen as pure words facilitating this communication among individuals and economic actors. Money enhances the extension of human cooperation and allows a more reliable and stable source of market value calculation, increasing reciprocal cooperation beyond our awareness.

Hayek’s second quote helps us to understand that the adoption or creation of any form of monetary framework will determine the degree of the price system’s success as an information disseminator. Similar to any spontaneously created language determining the level of success of the words adopted (remember Esperanto?), the chosen money system (whether it is a natural commodity or an artificial and imposed paper monetary system) will in the long run determine the success and extension of the price mechanism’s real role and coordination in society. Hayek clearly understood the symbiotic relationship between the price system and money: he saw that paper money systems are so far away from the natural spontaneous outcome of commodity money that they can only generate false signals, huge distortions and misinformation in the price system, covertly dampening a potentially superior resource allocation.

In this case, a paper money system and in particular their centralized and controlled monetary supply is arbitrary and politically directed. The system’s most relevant characteristic is not only its political bias but also the fact that it interferes with the symbiotic relationship between natural money and prices, creating great disturbances. It alters entrepreneurial expectations because it intervenes and creates changes in relative prices, leading to distortions in the capital accumulation which will eventually result in a form of malinvestment. Arbitrarily supplied paper money creates deep unforeseen structural changes in the economy, especially in the global capital structure of goods’ production processes. This is the sort of sub-optimality that I wish to address in this essay; paper money is never really fully exposed to market forces and is severely dependent on centralized decisions and political aims. It is these capricious forces which will always prevail and push the paper money supply even further into the long run, creating secular inflation of the monetary base and making money ever more elastic, unstable and politicized. This in turn makes the entrepreneurial calculation ever more difficult. It creates so many price distortions in the long run which undermine the whole degree of the price system’s success and makes it impossible to fully differentiate between prices that are corrupted by paper money and those that are not.  A political and unnatural selected money system erodes the free market system, its society and the true entrepreneurial function. It dampens the correct resource allocation system through the price mechanism of coordination and corrodes a nation’s long term production capacity. 

Finally it is necessary to again stress the relevance of a natural social institution like money; when money is organically created, it achieves its basic objective to facilitate exchanges and indirectly creates a healthy and stable framework for entrepreneurial economic calculation. When money is organically created, it means that its origin lies outside any particular interest or economic ambition, therefore it does not answer to any authority. Prices under this system fully reflect the market system coordination since these prices are the most “natural” and “unadulterated” as possible, reflecting only the true market economy interactions. These unadulterated prices are the most relevant and unadulterated source of information for entrepreneurs in order to make their capital investments and allocations.

Unfortunately when paper money is introduced and created by a central authority, it clashes with the natural money institution’s real objective. This form of money answers to political control and is created with economic purposes, therefore its market economy implementation is disturbing. It constantly alters the price mechanism that disseminates the relevant information for an efficient resource allocation. The elastic money supply by the central banks makes the money supply deeply intertwined with the economy’s capital structure, changing the potential capital accumulation. Hence when paper money is being constantly and discriminately introduced, it interferes with the real information of the natural prices and creates huge unintended misallocations.  This is the most fundamental flaw and sub-optimal source which generates constant danger to potential organic growth in the economy.

In a nutshell, a paper money scheme is unnatural, monopolized, centralized and fundamentally in opposition to any form of free human interaction. Paper money undermines the free market society’s real values and individuals’ free collaboration; it brings potentially enormous and unintended consequences, crises, instability, misallocations and sub-optimality.  We have seen the damage of adopting an artificial and politically created paper money system but we have also understood that a commodity money system is far from totally perfect. A commodity system is also keen to unbalances and distortions but at least these distortions are free from politics and centralized planners. There will always be distortions based on natural interactions and based on man’s freely adopted money which are not imposed by a coercive authoritarian state.

“It is never too late to become wise, but if change comes late, there is always more difficulty in starting a reform.”
Immanuel Kant

“It would, indeed, be harsh to ask what has become of this respect for money in our time…. To restore this respect and the corresponding discipline in money and credit policy is one of the most important conditions for the durable success of all our efforts to restore and maintain a free economy and, therewith, a free society.”
Wilhelm Röpke

Sources:

-          Michael Polanyi, The Logic of Liberty, the Liberty Fund, Inc 1998.
-          F.A. Hayek, The Fatal Conceit, Chicago Press 1988.
-          F.A. Hayek, Individualism & Economic Order, Ludwig Von Mises Institute, 2009.
-          Carl Menger, Problems of Economics and Sociology, University of Illinois press 1963.
-          Carl Menger, Principles of Economics, Ludwig Von Mises Institute, 2007.
-          David Boaz, Libertarianism, The Free Press, 1997.
-          Detlev Schlichter, Paper Money Collapse , John Wiley & Sons, 2011.  
-          Ludwig von Mises, The Theory of Money and Credit, Signalman Publishing, 2009.
-          Ludwig von Mises, Human Action: the Scholar’s Edition, Ludwig Von Mises Institute, 2008.

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