(Austrian School) How is Fiat Money Possible - Or, The Devolution of Money and Credit

8/8/2019 (Austrian School) How is Fiat Money Possible - Or, The Devolution of Money and Credit

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How is Fiat Money Possible?-or,The DevsPntiom off Moneyand CreditHans-Hermann Hoppe

F iat money is the term for a medium of exchange which isneither a commercial commodity, a consumer, or a producergood, nor title to any such commodity: i.e., irredeemablepaper money. In contrast, commodity money refers to a medium ofexchange which is either a commercial commodity or a title thereto.

There is no doubt tha t fiat money is possible. I ts theoreticalpossibility was recognized long ago, and since 1971, when the lastremnants of a former international gold (commodity) standard wereabolished, all monies, everywhere, have in fact been nothing butirredeemable pieces of paper.

The question to be addressed in this paper is rather how is a fiatmoney possible? More specifically, can f ia t money arise as the naturaloutcome of the interactions between self-interested individuals; or, isit possible to introduce it without violating either principles ofjusticeor economic efficiency?

It will be argued that the answer to the latter question must benegative, and that no fiat money can ever arise "innocently" or"immaculately." The arguments advancing this thesis will be largelyconstructive and systematic. However, given the fact th at the thesishas frequently been disputed, along the way various prominentcounterarguments will be criticized. Specifically, the arguments ofth e monetarists, especially Irving Fisher and Milton Friedman, andof some Austrian "free bankers," especially Lawrence White andGeorge Selgin, in ethical andlor economic support of either a total ora fractional fiat money will be refuted.

*Hans-Hermann Hoppe is professor of economics at th e University of Nevada, LasVegas.The Review o fAus t r i an Economics Vo1.7, No. 2 (1994): 49-74ISSN 0889-3047


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50 The Review of Austrian Economics Vol. 7, No. 2The Origin of MoneyMan participates in an exchange economy (instead of remaining inself-sufficient isolation) insofar as he prefers more goods over less andis capable of recognizing the higher productivity of a system ofdivision of labor. The same narrow intelligence and self-interest issufficient to explain the emergence of a-and ultimately only one-commodity money and a-and ultimately only one, world-wide-monetary economy.' Finding their markets as buyers and sellers ofgoods restricted to instances of double coincidence of wants (A wantswhat B has and B wants what A has), each person may still expandhis own market and thus profit more fully from the advantages ofextended division of labor if he is willing to accept not only directlyuseful goods in exchange, but also goods with a higher degree ofmarketability than those surrendered. For even if they have no directuse-value to an actor, the ownership of relatively more marketablegoods implies by definition that such goods may in turn be more easilyresold for other, directly useful goods in later exchanges, and hencethat their owner has come closer to reaching an ultimate goal unat-tainable through direct exchange.Motivated only by self-interest and based on the observation thatdirectly traded goods possess different degrees of marketability, someindividuals begin to demand specific goods not for their own sake butfor the sake of employing them as a medium of exchange. By addinga new component to the pre-existing (barter) demand for these goods,their marketability is still further enhanced. Based on their percep-tion of this fact, other market participants increasingly choose thesame goods for their inventory of exchange media, as i t is in their owninterest to select such commodities as media of exchange that arealready employed by others for the same purpose. Initially, a varietyof goods may be in demand as common media of exchange. However,since a good is demanded as a medium of exchange-rather than forconsumption or production purposes-in order to facilitate futurepurchases of directly serviceable goods (i.e., to help one buy morecheaply) and simultaneously widen one's market a s a seller of directlyuseful goods and services (i.e., help one sell more dearly), the morewidely a commodity is used as a medium of exchange, the better itwill perform its function. Because each market participant naturally

' s e e on the following, in particular Carl M enger, Principles of Economics (NewYork:New York Univers i ty Press, 1981);idem , Geld, in Carl Menger, Gesammelte Werke,vol. 4 ,F. A. Ha yek, ed . (Tiibingen: Mohr, 1970);Lu dw igv on M ises, Theory of Money andCredit (Inrington-on-Hudson,N.Y.: Foundation for Economic Education, 1971);i d e m ,Hu man Action: A Dea tise on Economics (Chicago:Regnery, 1966).


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Hoppe: How is Fiat Money Possible? 5 1prefers the acquisition of a more marketable and, in the end, univer-sally marketable medium of exchange to that of a less or non-univer-sally marketable one, "there would be an inevitable tendency for theless marketable of the series of goods used as media of exchange tobe one by one rejected until a t last only a single commodity remained,which was universally employed as a medium of exchange; in a word,money."2

With this, and historically with the establishment of the interna-tional gold standard in the course of the nineteenth century (until19141, the end desired through any one market participant's demandfor media of exchange is fully accomplished. With the prices of allconsumer and capital goods expressed in terms of a single commodity,demand and supply can take effect on a world-wide scale, unre-stricted by absences of double coincidence of wants. Because of itsuniversal acceptability, accounting in terms of such money containsthe most complete and accurate expression of any producer's oppor-tunity costs. At the same time, with only one universal money inuse-rather than several ones of limited acceptability-the marketparticipants' expenditures (of directly serviceable goods) on holdingsof only indirectly useful media of exchange are optimally economized;and with expenditures on indirectly useful goods so economized, realwealth, i.e., wealth in the form of stocks of producer and consumergoods, is optimized as well.

According to a long-Spanish-French-Austrian-American-tradi-tion of monetary t h e ~ r y , ~oney's originary function -arising out ofthe existence of uncertainty-is that of a medium of exchange. Moneymust emerge as a commodity money because something can be de-manded a s a medium of exchange only if it has a pre-existing barterdemand (indeed, it must have been a highly marketable bartercommodity), and the competition between monies qua media of ex-change inevitably leads to a tendency of converging toward a singlemoney-as the most easily resold and readily accepted commodity.

In light of this, several popular notions of monetary theory areimmediately revealed as misguided or fallacious.

What about the idea of a commodity reserve currency? Canbundles (baskets) of goods or titles thereto be money?4 No, because

' ~ i s e s ,heory of Money and Cred i t , pp. 32-33.3 ~ e eMurray N . Rothbard, "Ne w Light on the Prehistory o f the Austrian School,"in The Foundations of Modern Austrian Economics, E. G. Dolan, ed . (Kansas Ci ty:Sheed and W ar d, 1976); Joseph T. Salerno, "Two Tra dit ions in Modern Mon etaryTheory," Journal des Econom istes et des E tudes H um aines 2 , no. 213 (1 99 1 ).40n com mo dity reserve proposals see B . Graha m, Storage and Stabi l i ty (Ne w York:McGraw Hill, 1937);F. D. Gra ham , Social G oals and Economic Institutions (Princeton:


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52 The Review o fAustrian Economics Vol. 7 , No. 2bundles of different goods a re by definition less easily saleable thanthe most easily saleable of its various components, and hence com-modity baskets are uniquely unsuited to perform the function of amedium of exchange (and i t thus is no mere accident th at no historicalexamples for such money exist).What about the-Friedmanite-idea of freely fluctuating "na-tional monies" or of "optimal currency a r e a P 5I t must be regardedas absurd, except as an intermediate step in the development of aninter-national money. Strictly speaking, a monetary system withrival monies of freely fluctuating exchange rates is still a system ofpartial barter, riddled with the problem of requiring double coinci-dence of wants in order for exchanges to take place. The lastingexistence of such a system is dysfunctional of the very purpose ofmoney: of facili tating exchange (instead of making it more difficult)and of expanding one's market (r ather th an restricting it). There areno more "optimal"-local, regional, national or multi-national-mo-nies or currency areas than there are "optimal trading areas." In-stead, as long as more wealth is preferred to less and under conditionsof uncertainty, just a s the only "optimal" trading area is the wholeworld market , so the only "optimal" money is one money and the only"optimal" currency area t he ent ire globe.What about the idea, central to monetarist thought since IrvingFisher, that money is a "measure of value" and of the notion ofmonetary "~tabilization?"~t represents a tangle of confusion andfalsehood. First and foremost, while there exists a motive, a purposefor actors wanting to own media of exchange, no motive, purpose orneed can be discovered for wanting to possess a measure of value.Action and exchange are expressive ofpreferences: each person valueswhat he acquires more highly than what he surrenders-not ofidentity or equivalency. No one ever needs to measure value. It iseasily explained why actors would want to use cardinal numbers-tocount-and construct measurement instruments-to measure space,Princeton Univ ers i ty Press , 1942);a lso F. A. H aye k , "A Co m m od i ty Reserve Currency ,"Economic Jou rna l 210 (1 94 3) ;Mi l ton Friedm an, "C omm odi ty-Reserve Currency ," Jour-nal of Polit ical Economy (1 95 1) .5 ~ e eMil ton Friedm an, "T he Case for Flex ib le Exchan ge Ra tesn i n Friedman,Essays in Posit ive Economics (Chicago: Un iver s i ty o f Chicago Press , 1953); id em , AProgram for Monetary S tab i l i ty ( N e w York: Fordham Un iver s i ty Press, 19 59); a lsoPolicy Impl ica t ions of P a d e an d C urrency Zones:A S y m p o s i u m ( K a n s a s C i ty : F ed er alReserve Ba nk o f Kansas C i t y , 1991) .

' s e e I rving F i sher, Th e Purchas ing Power o f Money (N e w York : Augu s tus Ke ll ey ,1963) ; dem , S tab i li z ing the Do l lar (N e w York : Macmi l lan , 1920) ; i de m, T he MoneyI ll us io n ( N e w Y o r k : Ade lph i , 1929) ;M i l to n F r i e dma n , " A Monetary and Fiscal Frame-work for Economic Stabi l i ty ," American Economic Review (1948).


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53oppe: How is Fiat Money Possible?weight, mass and time: In a world of quantitative determinateness,i.e., in a world of scarcity, where things can render strictly limitedeffects only, counting and measuring are the prerequisite for success-ful action. But what imaginable technical or economic need couldthere possibly be for a measure of value?Second, set ting these difficulties aside for a moment and assum-ing that money indeed measures value (such that the money pricepaid for a good represents a cardinal measure of this good's value) inthe same way as a ruler measures space, another insurmountableproblem results. Then the question arises "what is the value of thismeasure of value?" Surely it must have value just as a ruler musthave value, otherwise no one would want to own either one. Yet itwould obviously be absurd to answer that the value of a unit ofmoney--one dollar-is one. One what? Such a reply would be asnonsensical a s answering a question concerning the value of a yard-stick by saying "one yard." The value of a cardinal measure cannotbe expressed in terms of this measure itself. Rather, its value mustbe expressed in ordinal terms: I t is better to have cardinal numbersand measures of length or weight than merely to have ordinal meas-ures a t one's disposal. Likewise i t is bet ter if, because of the existenceof a medium of exchange, one is able to resort to cardinal numbers inone's cost-accounting, rather than having to rely solely on ordinalaccounting procedures, a s would be the case in a barter economy. Butit is impossible to express in cardinal terms how much more valuablethe former techniques a re as compared with the latter. Only ordinaljudgments are possible. I t is precisely in this sense, then, that ordinalnumbers-ranking, preferring-must be regarded a s more funda-mental than cardinal ones and value be considered an irreduciblysubjective, non-quantifiable magnitude.Moreover, if it were indeed the function of money to serve as ameasure of value, one must wonder why the demand for such a thingshould ever systematically exceed one per person. The demand forrulers, scales, and clocks, for instance, exceeds one per person onlybecause of differences in location (handiness) or the possibility oftheir breaking or failing. Apart from this, a t any given point in timeand space, no one would want to hold more than one measurementinstrument of homogeneous quality, because a single measurementinstrument can render a ll possible measurement services. A secondinstrument of its kind would be useless.Third, in any case, whatever the characteristicum specificum ofmoney may be, money is a good. Yet if i t is a good, then i t falls underthe law of marginal utility, and this law contradicts any notion of astable- or constant-valued good. The law follows from the proposition


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54 The Review of Austrian Economics Vol. 7, No. 2that every actor, a t any given point in time, acts in accordance withhis subjective preference scale and chooses to do what he expects-rightly or wrongly-to satisfy him more rather than less, and that inso doing he must invariably employ quantitatively definite-lim-ited-units of qualitatively distinct goods as means and thus, byimplication, must be capable of recognizing unit-additions and -sub-tractions to and from his supply of means. From this incontestablytrue proposition i t follows (I) ,t ha t an actor always prefers a largersupply of a good over a smaller one, i.e., he ranks the marginalutility of a larger sized unit of a good higher than that of a smallersized unit of the same good; and (2), that any increment to thesupply of a good by an additional unit-of any unit-size tha t anactor considers and distinguishes as relevant-will be rankedlower (valued less) than any same-sized unit of this good alreadyin one's possession, as it can only be employed as a means for theremoval of an uneasiness deemed less urgent th an the least urgentone up-to-now satisfied by the same sized unit of this good, i.e., themarginal utility of a given-sized unit of a good decreases (in-creases) as the supply of such units increases (decreases). Eachchange in the supply of a good, then, leads to a change in this good'smarginal utility. Any change in the supply of a good A, a s perceivedby an actor X, leads to X's re-evaluation of A. X attaches a differentvalue-rank to A now. Hence, the search for a stable or constant-val-ued good is obviously illusory from the outset, on a par withwanting to square the circle, for every action involves exchange, andevery exchange alters the supply of some good. I t either results in adiminution of the supply of a good (as in pure consumption), or i t leadsto a diminution of one and an incrementation of another (as inproduction or interpersonal exchange). In either case, as supplies arechanged in the course of any action, so are the values of the goodsinvolved. To act is to purposefully alter the value of goods. Hence, astable-valued good-money or anything else-must be considered aconstructive or praxeological impossibility.

Finally, as regards the idea of a money-a dollar--of constantpurchasing power, there is first the fundamental problem that thepurchasing power of money cannot be measured and that the con-struction of price indices-any index-is scientifically arbitrary, i.e.,as good or bad as any other. (What goods are to be included? Whatrelative weight should be attached to each of them? What about theproblem that individual actors value the same things differently andare concerned about different commodity baskets, or tha t the sameindividual evaluates the same basket differently at different times?What is one to do with changes in the quality of goods or with entirely


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55oppe: How is Fia t Money P ossible?

new produ ~ts ?) .~oreover, what is so great about "stable" purchasingpower anyway (however that term may be arbitrarily defined)? To besure, it is obviously preferable to have a "stable" money rather thanan "inflationary" one. Yet surely a money whose purchasing powerper unit increased-"deflationary" money-would be preferable to a"stable" one.

What about the thesis that in the absence of any legal restrictionsmoney-non-interest bearing cash-would be completely replaced byinterest bearing securities?' Such displacement is conceivable only inequilibrium, where there is no uncertainty and hence no one couldgain any satisfaction from being prepared for future contingencies asthese are per assumption ruled out of existence. Under the omnipres-ent human condition of uncertainty, however, even if all legal restric-tions on free entry were removed, a demand for non-interest bearingcash-as distinct from a demand for equity or debt claims (stocks,bonds or mutual fund shares)-would necessarily remain in effect.For whatever the specific nature of these claims may be, they repre-sent titles to producer goods, otherwise they cannot yield interest. Yeteven the most easily convertible production factor must be lesssaleable than the most saleable one of its final products, and hence,even the most liquid security can never perform the same service ofpreparing i ts owner for future contingencies as can be provided bythe most marketable final non-interest bearing product: money. Allof this could be different only if i t were assumed-as Wallace inaccordance with the Chicago school's egalitarian predispositions tac-itly does-that all goods are equally marketable. Then, by definitionthere is no difference between the salability of cash and securities.However, then all goods must be assumed to be identical to each other,and if this were the case neither division of labor nor markets wouldexist.From Commodity Money to Fiat Money:The Devolution of MoneyIf money must arise as a commodity money, how can it become fiatmoney? Via the development of money substitutes (paper titles tocommodity money)-but only fraudulently and only a t the price ofeconomic inefficiencies.

7 ~ i s e s ,h eory o fM o n ey a n d C r ed i t , pp . 187-94;idem , Hu man Act ion, pp. 219-23.' s e e N . W a l la ce ,"ALegal R estrictions Theo ry of th e Dem and for 'Money',"FederalReserve Bank o f Minneapolis Q uarterly Review (1983);E . Fa m a, "Financial Interm e-diatio n and Price Level Control," Jou rna l of Mo netary Econom ics (1983);for a critiqu esee Lawrence W h it e, "Accounting for Non-Interest-Bea ring Currency," Journal ofMoney, Cre dit, and Banking (1987).


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56 The Review of Au str ian Economics Vol. 7,No. 2Under a commodity money standard such as the gold standarduntil 1914, money "circulated" on the one hand in t he form of stand-

ardized bars of bullion and gold coins of various denominationstrading against each other at essentially fixed ratios according totheir weight and fineness. On the other hand, to economize on thecost of storing (safekeeping) and transacting (clearing) money, in adevelopment similar to that of transferable property titles-includ-ing stock and bond certificates-as means of facilitating the spatialand temporal exchange of non-money goods, side by side with moneyproper also gold certificates-property ti tles (claims) to specifiedamounts of gold deposited at specified institutions (banks)-servedas a medium of exchange. This coexistence of money proper (gold) andmoney substi tutes (claims to money) affects neither the total supplyof money-for any certificate put into circulation an equivalentamount of gold is taken out of circulation (deposited)-nor the inter-personal income and wealth distribution. Yet without a doubt thecoexistence of money and money substitutes and the possibility ofholding money in either form and in variable combinations of suchforms constitutes an added convenience to individual market partici-pants. This i s how intrinsically worthless pieces of paper can acquirepurchasing power. If and insofar as they represent a n unconditionalclaim to money and if and insofar a s no doubt exists tha t they arevalid and may indeed be redeemed at any time, paper tickets arebought and sold a s if they were genuine money-they are tradedagainst money at par. Once they have thus acquired purchasingpower and are then deprived of their character a s claims to money (bysomehow suspending redeemability), they may continue functioningas money. As Mises writes: "Before an economic good begins tofunction as money it must already possess exchange-value based onsome other cause than its monetary function. But money that alreadyfunctions a s such may remain valuable even when the original sourceof its exchange-value has ceased to exist."gHowever, would self-interested individuals want to deprive papertickets of their character as titles to money? Would they want tosuspend redeemability and adopt intrinsically worthless pieces ofpaper as money? Paper money champions like Milton Friedman claimthis to be the case, and they typically cite a savings-motive as thereason for the substitution of fiat for commodity money: A goldstandard involves social waste in requiring the mining and mintingof gold. Considerable resources have to be devoted to the production

' ~ i s e s ,Theory of Money and Credit, p. 111


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Hoppe: How i s Fiat Money Possible?of money.1 With essentially costless paper money instead of gold,such waste would disappear, and resources would be freed up for theproduction of directly useful producer or consumer goods. I t is thus afiat money's higher economic efficiency which explains the presentworld's universal abandonment of commodity money! But is it so? Isthe triumph of fiat money indeed the outcome of some innocuoussaving? Is it even conceivable that it could be? Can self-interestedindividuals really want to save as fiat money champions assume th atthey do?

Somewhat closer scrutiny reveals tha t this is impossible, and th atthe institution of fiat money requires the assumption of a verydifferent-not innocuous but sinister-motive: Assume a monetaryeconomy with (at least) one bank and money proper ("outside money"in modern jargon) as well a s money substitutes ("inside money") incirculation. If market participants indeed wanted to save on theresource costs of a commodity money (with the ultimate goal ofdemonetizing gold and monetizing paper), one would expect thatfirst-as an approximation to this goal-they would want to give upusing any outside money (gold). All transactions would have to becarried out with inside money (paper), and all outside money wouldhave to be deposited in a bank and thus taken out of circulationentirely. (Otherwise, as long as genuine money was still in circula-tion, those individuals making use of gold coins would demonstrateunmistakably-through their very actions-that they did not want tosave on the associated resource costs.)

But is i t possible t hat money substitutes can thus outcompete-and displace-genuine money as a medium of exchange? No; evenmany hard money theoreticians have been too quick to admit such apossibility. The reason i s th a t money substitutes are substi tutes andhave one permanent and decisive disadvantage as compared to moneyproper. Paper notes (claims to money) are redeemable a t par only tothe extent tha t a deposit fee has been paid to the depositing institu-tion. Providing safeguarding and clearing services i s a costly busi-ness, and a deposit fee is the price paid for guarded money. If papernotes are presented for redemption after the date up to whichsafeguarding fees were paid by the original or previous depositor, thedepositing institution would have to impose a redemption chargeand such notes would then trade at a discount against genuinemoney. The disadvantage of money substitutes is th at they must be

los ee F riedman, "E ssays in Positive Economics, p. 2 1 0 ; i d e m , A Program forMonetary Stability, pp. 4-8; idem , Capitalism and Freedom (Chicago: Un iver sity ofChicago Pre ss, 1962), p . 40.


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58 The Review of Austria n Economics Vol. 7 , No. 2continuously re-deposited and re-issued in order to maintain theircharacter as money-their salability a t par-and thus tha t theyfunction a s money only temporarily and discontinuously. Only moneyproper (gold coins) is permanently suited to perform the function asa medium of exchange. Accordingly, far from inside money everdisplacing outside money, the use of money substitutes should beexpected to be forever severely limited-restricted essentially to thetransaction of very large sums of money and the dealings betweenregular commercial traders-while the overwhelming bulk of thepopulation would employ money proper for most of their purchasesor sales, thus demonstrating their preference for not wanting to savein the way fancied by F'riedman."Moreover, even if one assumed for the sake of argument that onlyinside money is in circulation while all genuine money is stored in abank, the difficulties for fiat money proponents do not end here. Tobe sure, in their view mat ters appear simple enough: All commoditymoney si ts idle i n the bank. Wouldn't i t be more efficient if all of thisidle gold were used instead for purposes of consumption or produc-tion-for dentistry or jewelry-while the function of a medium ofexchange were assumed by a less expensive-indeed, practicallycostless-fiat money? Not a t all.First, the envisioned demonetization of gold certainly cannotmean that a bank thereby assumes ownership of the entire moneystock, while the public gets to keep the notes. No one except thebankowner would agree to that ! No one would want such savings. Infact, th is would not be savings a t all but an expropriation of the publicby and to the sole advantage of the bank. No one could possibly wantto be expropriated by somebody else. (Yet the expropriation of pri-vately owned commodity money through governments and their cen-tral banks is the only method by which commodity money has ever

l1 Indeed, historically th is h as been the case: Traditionally, notes have always beenwidely dis trusted, an d thei r acceptability-as compared to th at of genuine money suchas gold or silver coins-was severely limited.

In order to increase the popularity of money substitutes two complementarymeasures were actually required: First, the note-issuing depositing institution had toovervalue deposit notes against genuine money by ei ther charging no depositing fee orby even paying inte rest on deposits. Secondly, because th e guarding of money is actuallynot costless and deposited money cannot possibly generate an interest return , the bank,in order to cover it s otherwise unavoidable losses, had to engage in fractional reservebanking, i.e., it had to issue and bring into circulation new, additional deposit ticketsthat , while physically indistinguishable from any other notes, were actually not coveredby genuine money.

On th e ethical and economic st at us of the practice of fractional-reserve banking seethe section, "From Deposit and Loan Banking to Fractional-Reserve Banking: TheDevolution of Credit," below.


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59oppe: How is Fiat Money Possible?been replaced by fiat money.) Instead, each depositor would want toretain ownership of his deposits and get his gold back.

Then, however, a n insurmountable problem arises: Regardlesswho-the bank or the public-now owns the notes, they representnothing but irredeemable paper. Formerly, the cost associated withthe production of such paper was by no means only that of printingpaper tickets, but more importantly tha t of attracting gold depositorsthrough the provision of safeguarding and clearing services. Now,with irredeemable paper, there i s nothing worth guarding anymore.The cost of money production falls close to zero, to mere printingcosts. Previously, with paper representing claims to gold, the noteshad acquired purchasing power. But how can the bank or the publicsell them, i.e., get anyone to accept them, now? Would they be boughtand sold for non-money goods at the formerly established exchangeratios? Obviously not. At least not as long as no legal barr iers to entryinto the note-production business existed; for under competitiveconditions, of free entry, if the (non-money) price paid for paper notesexceeded their production costs, the production of notes would imme-diately be expanded to the point a t which the price of money ap-proached its cost of production. The result would be hyperinflation.No one would accept paper money anymore, and a flight into realvalues would set in. The monetary economy would break down com-pletely and society would revert back to a primitive, highly inefficientbarter economy. Out of barter then, once again a new (most likely agold) commodity money would emerge (and the note producers onceagain, so as to gain acceptability for their notes, would begin backingthem by this money). What a way of achieving savings!

If one is to succeed in replacing commodity money by fiat money,then, a n additional requirement must be fulfilled: Free entry into thenote-production business must be restricted, and a money monopolymust be established. A single paper money producer is also capableof causing hyperinflation and a monetary breakdown. However, inso-far as he is legally shielded from competition, a monopolist can safelyand knowingly restrict the production of his notes and thus assurethat they retain their purchasing power. He then presumably wouldassume the task of redeeming old notes a t pa r for new ones, as wellas that of again providing safeguarding and clearing services inaccepting note deposits in exchange for his issuance of substitutes ofnotes-demand deposit accounts and checkbook money-against adepositing fee.

Regarding this scenario, several related questions arise. For-merly, with commodity money every person was permitted to enterthe gold mining and coining business freely-in accordance with the


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60 The Review of Austr ian Econom ics Vol. 7 , No. 2assumption of self-interested, wealth-maximizing actors. In contrast,in order for Friedman's "fiat money dividend" to come into existence,competition in the field of money production would have to be out-lawed and a monopoly erected. Yet how can the existence of a legalmonopoly be reconciled with the assumption of self-interest? Is itconceivable that self-interested actors could agree on establishing afiat money monopoly in the same way as they can naturally agree onparticipating in the division of labor and on using one and the samecommodity as a medium of exchange? If not, does this not demon-strate that the cost associated with such a monopoly must be consid-ered higher than all attending resource cost savings?

To raise these questions is to answer them. Monopoly and thepursuit of self-interest are incompatible. To be sure, a motive whysomeone might want to become the money monopolist exists. Afterall, by not having to store, guard and redeem a precious commodity,the production costs are dramatically reduced and the monopolistcould thus reap an extra profit; by being legally protected from allfuture competition, this monopoly profit would immediately become"capitalized," i.e., reflected permanently in an upward valuation ofhis assets, and on top of his inflated asset values he then would beguaranteed a normal rate of (interest) return. Yet to say that such anarrangement would be advantageous to the monopolist is not to saythat it would be advantageous to anybody else, and hence that it couldarise naturally. In fact, there is no motive for anyone wanting anyonebut himself to be this monopolist, and accordingly no agreement onthe selection of any particular monopolist would be possible. Theposition of a monopolist can only be arrogated-enforced against thewill of all excluded non-monopolists. By definition, a monopoly cre-ates a distinction between two classes of individuals of different legalquality: between those-privileged-individuals who are permittedto produce money, and those--subordinate-ones who, to the exclu-sive advantage of the former, are prohibited from doing the same.Such an institution cannot be supported in the same voluntary wayas the institutions of the division of labor and a commodity money. Itis not, as they are, the "natura1"result of mutually advantageousinteractions, but that of an unilaterally advantageous act of expro-priation (abrogation).Accordingly, instead of relying for it s continuedexistence on voluntary support and cooperation, a monopoly requiresthe threat of physical violence.12

121t might be argued that a monopoly agreement would be possible (conceivable),if the monopolistic bank of issue were owned by-and its profits distributed to-every-one. Wouldn't everyone, then, not just the monopolist, profit from the savings ofsubstituting paper for gold?


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Hoppe: How is Fiat M oney Possible? 61Moreover, th e incomp atibility of self-intere st a n d monopoly doesnot end once th e monopoly h as b een estab l ished bu t cont inues a s long

a s the monopoly remains in opera t ion . I t canno t bu t o pera te ineffi-ciently an d a t th e expense of th e excluded non-monopo lists. First ,under a regime of free com petition (free entr y) , every sing le produce ri s under cons tant pressure to produce whatever he produces a tm inimu m costs, for if h e does not do so, h e inv ites th e risk of beingoutcompeted by new en tra nt s who produce th e product i n quest ion a tlower costs. In co ntra st , a monopolist, shielded from co mpeti tion, isun de r no such p ressure. In fact , since th e cost of money productionincludes the monopol is t's own s ala ry a s well as all of his non-mone-ta ry rewards, a monopolist's "natural" inte res t i s to raise hi s costs.Hence, i t should be expected that the cost of a monopolist icallyprovided pape r m oney would v ery soon, if not from th e very ou tset ,exceed those associated with a competi t ively provided commoditymoney.Fu r t he r m or e , it can be predicted that the pr ice of monopo-list ically provided pa pe r m oney will ste ad ily increase, i.e., t h e pur-ch asin g power p er un it m oney, an d hence i t s quali ty will continuouslyfa ll . P ro tec t ed f rom n ew e n t r an t s , eve ry monopoli st i s a lwaystem pte d to raise price a n d lower quality. Yet th is is part icularly tr u eof a money m onopolist . While o th er mon opolists m u st consider thepossibil ity th a t pr ice increa ses (or qua l i ty decreases) due t o a n elast icdem and for the ir product may actual ly lead to reduced revenu es, a

In fact, such an agreement is illusionary. Joint ownership of the monopoly bankwould imply that tradeable stock certificates must be issued and distributed. But whoshould get how much stock? Bank clients, according to their deposit size? Yet al l privateholders of notes help save on gold and would want to be included among th e bank ownersaccording to the size of their note holdings. And what about the owners and sellers ofnon-money goods? In showing themselves willing to accept paper ins tead of gold, they,too, play their part in th e resource cost savings. But how in t he world is one to determinehow many shares to award them, when their contribution consists, as i t does, of variousquantities of heterogeneous consumer and producer goods? Here, a t the very latest, i twould become impossible to reach agreement.

Moreover, why would any new market participant-any later deposit, note andlornon-money good owner not initially endowed with bank stock-want to consent to andsupport this arrangement? Why should he pay for banking stock, while i t was distrib-uted to the initial wealth owners free of charge, even though he is now involved inresource cost savings just as much a s they were then? Such an arrangement wouldinvolve a systematic redistribution of income and wealth in favor of all initial wealthowners and a t the expense of al l later ones. Yet if new, additional bank stock were issuedfor each new deposit, note or non-money good owner, such stock would be worthlessfrom the outset and any bank offering it would be a non-star ter.

In addition, as will be explained below, regardless of how the ownership problemis resolved, th e very operation of the bank will-indeed must-have effects on-is notneutral t-the interpersonal income and wealth distribution.


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62 The Review of Au stria n Ecbnomics Vo2. 7 , N o. 2money monopolist can rest assured that the demand for his particularproduct-the common medium of exchange-will be highly inelastic.Indeed, short of a hyperinflation, when the demand for money disap-pears entirely, a money monopolist is practically always in a positionin which he may assume t hat h is revenue from the sale of money willincrease even as he raises the price of money (reduces it s purchasingpower). Equipped with the exclusive right to produce money andunder the assumption of self-interest, the monopoly bank should beexpected to engage in a steady increase of the money supply, for whilean increased supply of paper money does not add anything to socialwealth-the amount of directly useful consumer and producer goodsin existence-but merely causes inflation (lowers the purchasingpower of money), with each additional note brought into circulationthe monopolist can increase his real income (at the expense of lower-ing tha t of the non-monopolistic public). He can print notes a t prac-tically zero cost and then turn around and purchase real assets(consumer or producer goods) or use them for the repayment of realdebts. The real wealth of the non-bank public will be reduced-theyown less goods and more money of lower purchasing power. However,the monopolist's real wealth will increase-he owns more non-moneygoods (and he always has a s much money as he wants). Who, in thissituation, except angels, would not engage in a steady expansion ofthe money supply and hence in a continuous depreciation of thecurrency?

It may be instructive to contrast the theory of fiat money asoutlined above to the views of Milton Friedman, as the outstandingmodern champion of fiat money.

While the younger Friedman paid no systematic attention to thequestion of the origin of money, the older Friedman recognizes that,as a matter of historical fact, all monies originated as commoditymonies (and all money substitutes a s warehouse claims to commoditymoney), and he is-justly-skeptical of the older Friedrich A. Hayek'sproposal of competitively issued fiat currencies.13 However, misled byhis positivist methodology, Friedman fails to grasp that money (andmoney substitutes) cannot originate in any other way, and accord-ingly, that Hayek's proposal must fail.In contrast to the views developed here, throughout his entirework Friedman maintains t ha t a commodity money in turn would be"naturally" replaced by a-more efficient, resource cost saving-fiat

13see Milton Friedman and Anna Schw artz, "Has Government Any Role in Money?"Jou rna l of Monetary Econom ics (19 86); for Hayek's proposal see his Denationalizationof Money (London: Institu te of Economic Affairs, 19 76 ).


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63oppe: How is Fiat Money Possible?money regime. Amazingly, however, he offers no argumentative sup-port for this thesis, evades all theoretical problems, and whateverargument or empirical observation he does offer contradicts his veryclaim. There is, first off, no indication that Friedman i s aware of thefundamental limitations of replacing outside money by inside money.Yet if outside money cannot disappear from circulation, how, exceptthrough an act of expropriation, can the link between paper and amoney commodity be severed? The continued use of outside money incirculation demonstrates tha t i t is not regarded as an inferior money;and the fact that expropriation is needed for th e decommoditizationof money would demonstrate that fiat money is not a natural phe-nomenon!Interestingly, after evading the problem of explaining how thesuspension of redeemability can possibly be considered natural orefficient, Friedman explicitly recognizes--quite correctly-that fiatmoney cannot, for the reasons given above, be provided competitivelybut requires a monopoly. From there he proceeds to assert t hat "theproduction of fiat currency is, as it were, a natural m~nopoly."'~However, from the fact t hat fiat money requires a monopoly, i t doesnot follow that there is anything "natural" about such a monopoly,and Friedman provides no argument whatsoever as to how anymonopoly can possibly be considered the natural outcome of theinteractions of self-interested individuals. Moreover, the youngerFriedman in particular appears to be almost completely ignorant ofclassical political economy and i ts anti-monopolistic arguments: theaxiom that if you give someone a privilege he will make use of it , andhence the conclusion t hat every monopolistic producer will be ineffi-cient ( in terms of costs a s well as of price and quality). In light of thesearguments it has to be regarded as breathtakingly naive on Fried-man's part first to advocate the establishment of a governmentalmoney monopoly, and then to expect this monopolist not to use itspower, but to operate a t the lowest possible costs and to inflate themoney supply only gently (at a rate of 3-5% per year). This wouldassume that, along with becoming a monopolist, a fundamentaltransformation in the self-interested natu re of mankind would takeplace.It i s not surprising that the older Friedman, having had extensiveexperience with his own ideal of a world of pure fiat currencies as i tcame into existence after 1971,and looking back on his own central-resource cost savings-argument for a monopolistically provided fiat

14seeFriedman, Essays in Positive Economics, p. 2 1 6 ; also Friedman and Schwartz,"Has Government Any Role in Money?"


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64 The Review of Aus tria n Econom ics Vo2. 7 , No. 2money of nearly four decades earlier, cannot but acknowledge thathis predictions turned out patently false.15 Since abolishing the lastremnants of the gold commodity money standard, he realizes, infla-tionary tendencies have dramatically increased on a world-widescale; the predictability of future price movements has sharply de-creased; the market for long-term bonds (such as consols) has beenlargely wiped out; the number of investment and "hard money"advisors and the resources bound up in such businesses have drasti-cally increased; money market funds and currency futures marketshave developed and absorbed significant amounts of real resourceswhich otherwise-without the increased inflation and unpre-dictability-would not have come into existence at all or a t leastwould never have assumed the same importance that they now have;and finally, it appears that even the direct resource costs devoted tothe production of gold accumulated in private hoards as a hedgeagainst inflation have increased.16 But what conclusion does Fried-man draw from this empirical evidence? In accordance with his ownpositivist methodology according to which science is prediction andfalse predictions falsify one's theory, one should expect that Friedmanwould finally discard his theory as hopelessly wrong and advocate areturn to commodity money. Not so. Rather, in a remarkable displayof continued ignorance (or arrogance), he emphatically concludes thatnone of this evidence should be interpreted as "a plea for a return toa gold standard. . . . On the contrary, I regard a return to a goldstandard as neither desirable nor feasible."" Now as then he holdsonto the view tha t the appeal of the gold standard is merely "nonra-tional, emotional," and that only a fiat money is "technically effi-cient."" According to Friedman, what needs to be done to overcomethe obvious shortcomings of the current fiat money regime is find"some anchor to provide long-term price predictability, some substi-tute for convertibility into a commodity, or, alternatively, some devicethat would make predictability unnecessary. Many possible anchorsand devices have been suggested, from monetary growth rules totabular standards to the separation of the medium of exchange from

' 'see Milton Friedman, "TheResource C ost of Irredeema ble P aper Money,"Journalof Political Economy (1986).1 6 ~ o n e ta ri st shad predicted th at , as th e result o f the dem onetization o f gold andth e transit ion to a pure fiat mon ey sys tem , the price o f gold would fall-from the thenoff ic ia l a te of $35 per ounce to an estim ated non -mon etary value of gold o f around $6.In fact, the price o f gold rose . At one point it reached $850 per ounce, and for m ost o fthe t im e i t has l ingered be tween $300 and $400.As of hi s writ ing the price i s $375."F riedm an, "The Resource Cost o f Irredeemable Paper Money," p. 646.laF .n ed m an , Essays in Positive Economics, p. 250.


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65oppe: How is Fiat Money Possible?the unit of account. As yet, no consensus has been reached amongthem."lgFrom Deposit and Loan Banking to Fractional-ReserveBanking: The Devolution of CreditBanks perform two strictly separate tasks, only one of which has beenconsidered so far.20On the one hand, they serve as depositing insti-tutions, offering safekeeping and clearing services. They accept de-posits of (commodity) money and issue claims to money (warehousereceipts; money substitutes) to their depositors, redeemable a t parand on demand. For every claim to money issued by them they holdan equivalent amount of genuine money on hand, ready for redemp-tion (100 percent reserve banking). No interest is paid on deposits.Rather, depositors pay a fee to the bank for providing safekeeping and

lg~ r iedm an ,The Resource Cost of Irredeemable Paper Money," p. 646; also idem,Money Mischief: Episodes in Monetary History (New York: Harcourt Brace Jovanovich,1992), chap. 10.

Among the suggestions for an alternative f iat money "anchor" recently consideredby Friedman, the "frozen monetary base rulen deserves a brief comment (see Friedman,"Monetary Policy for the 1980s," in To Promote Prosperity , J . H. Moore, ed. [Stanford:Hoover Institution, 19841). In one respect this rule represents an advance over hisearlier 3 to 5 percent monetary growth rule. His advocacy of the la tter rule was basedessentially on th e erroneous-proto-Keynesian-notion that money constitutes par t ofsocial capital, such that an economy cannot grow by 3 to 5 percent unless i t is accommo-dated to do so by a proportional increase in th e money supply. In contrast, th e frozenmonetary base rule indicates a recognition of the old-Humean-insight th at anysupply of money is equally optimal or, in Friedman's own words, th at money's 'useful-ness to the community as a whole does not depend on how much money there is"[Friedman, Money Mischief, p. 28). Yet otherwise the proposal represents no advancea t all. For how in the world can a monopolist be expected to follow a frozen monetarybase rule any more than a less stringent 3 to 5 percent growth rule?

Moreover, even if th is problem were solved miraculously, th is would stil l not al te rth e monopoly's character as an inst rument of unilateral expropriation and income andwealth redistribution. For the monopolist, apa rt from offering depositing and clearingservices (for which his customers would pay him a fee), would also have to perform thefunction, to customers and non-customers alike, of replacing old, worn-out notes-one-to-one and free of charge-with new, identical ones (otherwise, who would want toreplace a permanent commodity money by a perishable fiat money?). Yet while the costsassociated with th is task may be low, they ar e definitely not zero. Accordingly, in orderto avoid losses and recoup his expenses, the monopolist cannot but increase themonetary base-and hence one would essentially be back a t the older monetary growthrule.

the following see in particular Murray N. Rothbard, The Mystery ofBanking(New York: Richardson and Synder, 1983); dem, The Case forA 100Percent Gold Dollar(Auburn, Ma.: Ludwig von Mises Insti tute , 1991);Mises, Theory of Money and Credit;idem, Human Action; also Walter Block, "Fractional Reserve Banking: An Interdisci-plinary Perspective," in Man, Economy, and Liberty: Essays in Honor of Murray N.Rothbard, Walter Block and Llewellyn H. Rockwell, Jr., eds. (Auburn, Ala.: Ludwig vonMises Institute, 1988); J. Koch, Fractional Reserve Banking: A Practical Critque(Master's thesis, University of Nevada, Las Vegas, 1992).


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66 The Review of Austrian Economics Vol. 7,No. 2

clearing services. Under conditions of free competition-free entryinto the banking industry-the deposit fee, which constitutes a bank'srevenue and possible source of profit, tends to be a minimum fee; andthe prof its-or rather. The interest returns-earned in banking tendto be the same as in any other, non-banking industry.

On the other hand, originally entirely separate institutionallyfrom deposit institutions, banks also serve as intermediaries betweensavers and investors-as loan banks. In this function they first offerand enter into time-contracts with savers. Savers loan money to thebank for a specified-shorter or longer-period of time in exchangefor the banks' contractual obligation of future repayment plus someadditional interest return. From the point of view of savers, theyexchange present money for a promise of future money: the interestreturn constituting their reward for performing the function ofwaiting. Having thus acquired temporary ownership of savingsfrom savers, the bank then reloans the same money to investors(including itself) in exchange for the lat ters' obligation of futurerepayment and interest. The interest differential-the differencebetween the interest paid to savers and that charged to borrow-ers-represents the price for intermediating between savers andinvestors and constitutes the loan bank's income. As for depositbanking and deposit fees, under competitive conditions the costs ofintermediation also tend to be minimum costs, and the profits fromloan banking likewise tend to be the same as those that can be earnedelsewhere.

Neither deposit banking nor loan banking as characterized hereinvolve an increase in the money supply or a unilateral income orwealth redistribution. For every newly issued deposit note a n equiva-lent amount of money is taken out of circulation (only the form ofmoney changes, not i ts quantity), and in the course of loan bankingthe same sum of money simply changes hands repeatedly. All ex-changes-between depositors and depositing institution as well asbetween savers, the intermediating bank and investors-are mutu-ally advantageous.

In contrast, fractional reserve banking involves a deliberate con-fusion between the deposit and the loan function. It implies anincrease in the money supply, and it leads to a unilateral incomeredistribution in the bank's favor as well a s to economic inefficienciesin the form of boom-bust business cycles.

The confusion of both banking functions comes to light in the factthat under fractional reserve banking, either depositors are beingpaid interest (rather than having to pay a fee), andlor savers aregranted the right of instant withdrawal (rather than having to wait


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Hoppe: How is Fiat Money Possible? 67with their request for redemption until a specified future date).Technically, the possibility of a bank's engaging in such practicesarises out of th e fact that the holders of demand deposits (claims tomoney redeemable on demand, instantly, at par) typically do notexercise their right simultaneously, such th at all of them approachthe bank with the request for redemption a t the same time. Accord-ingly, a deposit bank will typically hold a n amount of reserves (ofmoney proper) in excess of actual daily withdrawals. I t becomes thusfeasible for the bank to loan these "excess" reserves to borrowers, thusearning the bank an interest return (which the bank then maypartially pass on to its depositors in the form of interest payingdeposit accounts).

Proponents of fractional reserve banking usually claim that th ispractice of holding less than 100 percent reserves represents merelya n innocuous money "economizing," and they are fond of pointing outth at not only the bank, but depositors (receiving interest) and savers(receiving instant withdrawal rights) profit from the practice as well.In fact, fractional reserve banking suffers from two interrelated fatalflaws and is anything but innocuous and all-around beneficial. Firstoff, it should be noted th at anything less th an 100 percent reservedeposit banking involves what one might call a legal impossibility.For in employing its excess reserves for the granting of credit, thebank actually transfers temporary ownership of them to some bor-rower, while the depositors, entitled a s they are to instant redemp-tion, retain their ownership over the same funds. But i t is impossiblethat for some time depositor and borrower are entitled to exclusivecontrol over the same resources. Two individuals cannot be theexclusive owner of one and t he same thing a t the same time. Accord-ingly, any bank pretending otherwise-in assuming demand liabili-ties in excess of actual reserves-must be considered a s actingfraudulently. Its contractual obligations cannot be fulfilled. From theoutset, the bank must be regarded as inherently bankrupt-as re-vealed by the fact th at it could not, contrary to i ts own presumption,withstand a possible bank run.

Second, in lending its excess reserves to borrowers, the bankincreases the money supply, regardless whether the borrowers re-ceive these reserves in the form of money proper or in that of demanddeposits (checking accounts). If the loan takes the form of genuinemoney, then the amount of money proper in circulation is increasedwithout withdrawing a n equivalent amount of money substitutesfrom circulation; an d if i t takes th e form of a checking account, thenthe amount of money substitutes is increased without taking acorresponding amount of genuine money out of circulation. In either


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68 Th e Rev iew of Au stria n Economics Vol. 7, No. 2case, there will be more money in existence now than before, leadingto a reduction in the purchasing power of money (inflation) and, init s course, to a systematic redistribution of real income in favor of thebank and its borrower clients and at the expense of the non-bankpublic and all other bank clients. The bank receives additional inter-est income while it makes no additional contribution whatsoever tothe real wealth of the non-bank public (as would be the case if theinterest return were the result of reduced bank spending, i.e., sav-ings); and the borrowers acquire real, non-monetary assets with theirfunds, thereby reducing the real wealth of the rest of the public bythe same amount.Moreover, insofar as the bank does not simply spend the excessreserves on its own consumption but instead loans them out againstinterest charges, invariably a business cycle is set in motion.21Thequantity of credit offered is larger than before. As a consequence, theprice of credit-the interest charged for loans-will fall below whatit otherwise would have been. At a lower price, more credit is taken.Since money cannot breed more money, the borrowers, in order to beable to earn an interest return-and a pure profit on top of it-willhave to convert their borrowed funds into investments, i.e., they willhave to purchase or rent factors of production-land, labor, andpossibly capital goods (produced factors of production)-capable ofproducing a future output of goods whose value (price) exceeds thatof the input. Accordingly, with an expanded volume of credit, morepresently available resources will be bound up in the production offuture goods (instead of being used for present consumption) thanotherwise would have been; and in order to complete all investmentprojects now under way, more time will be needed than that requiredto complete only those that would have been begun without the creditexpansion. All the future goods which would have been createdwithout the expansion plus those that a re newly added on account ofthe credit expansion must be produced.

However, in distinct contrast to the situation where the interestrate falls due to a fall in the rate of time preference, i.e., the degreeto which present goods are preferred over future goods, and hencewhere the public has in fact saved more so as to make a larger fundof present goods available to investors in exchange for their promiseof a return of future goods, no such change in time preference and

2 1 ~ nhe theory o f he busin ess cycle see in particular Ludwig von Mises, Geldwert-stabilis ierung und Konjunkturpolit ik (Je na : Gu sta v Fischer, 1928); dem, HumanAction, chap . 20;F.A. Ha yek , Prices an d Production (L ondo n:Routledge & Kegan Paul,1931);Murray N . Rothb ard, America's Great Depression ( K an sa s C it y: Sheed & War d ,1975).


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69oppe: How is Fiat M oney Possible?savings has taken place in the case under consideration. The publichas not saved more, and accordingly, the additional amount of creditgranted by the bank does not represent commodity credit (creditcovered by non-money goods which the public has abstained fromconsuming), but it is fiduciary or circulation credit (credit that hasbeen literally created out of thin air-without any correspondingsacrifice, in the form of non-consumed non-money goods, on the part ofthe creditor).22Had the additional credit been commodity credit, anexpanded volume of investment activities would have been warranted.There would have been a sufficiently large supply of present goods thatcould be devoted to the production of future goods such that all-theold as well as the newly begun-investment projects could be success-fully completed and a higher level of future consumption attained. Ifthe credit expansion is due to the granting of circulation credit,however, the ensuing volume of investment must actually proveover-ambitious. Misled by a lower interest rate, investors act a s ifsavings had increased. They withdraw more of the presently availableresources for investment projects, to be converted into future capitalgoods, than is warranted in light of actual savings. Consequently, capitalgoods prices will increase initially relative to consumer goods prices, butonce the public's underlying time preference rate begins to reassertitself, a systematic shortage of consumer goods will arise. Accordingly,the interest rate will adjust upward, and i t is now consumer goodsprices which rise relative to capital goods prices, requiring the liqui-dation of part of the investment as unsustainable malinvestment.The earlier boom will turn bust, reducing the future standard of livingbelow the level that otherwise could have been reached.

Among recent proponents of fractional reserve banking the cases .of Lawrence White and George SelginZ3 eserve a few critical com-ments, if for no other reason than that both are critics of Friedrnanitemonetarism and they hark back, instead, to the tradition of Austrianand in particular Misesian monetary theory.24Their monetary idealis a universal commodity money such as an international gold

220nthe fundamen tal distinction betw een commodity credit and circulation cred it,see Mises, Theory of Money an d C re di t, pp. 263 ff.'%ee Law rence W hite , Com peti tion and Currency (N ew York: New York U nive rsityPress, 1989); George Selgin, The Theory of Free Banking (Totowa, N .J. : Rowman &Littlefield, 1988).

2 4 ~ o rcritique of White and Se lgin as m isinterpreting the fundam ental thru st ofMises's theory of money a nd ban king se e Joseph Salerno, 'The Concept of Coordinationin Austrian Macroeconomics," in Austrian Economics: Perspectives on the Past andPro spe cts for the Futu re , Richard Ebeling, ed. (Hil lsdale, Mich.: Hil lsdale CollegePress , 1991); dem, "M isesan d Hayek Dehomogenized,"R eview o f ~ u s t r i a n c o n o m i c s6, no. 2 (1993): 113-46.


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70 The Review of Austrian Economics Vol. 7, N o. 2s tan dar d an d, based on this , a system of compet i tive ba nk ing which,the y claim, would-and should be permitted to do so for reaso ns ofeconomic effic iency a s well a s jus t ic e-e ng ag e in f ract ional reservebank ing a n d th e gra nt in g of fiduciary credi t.As to the quest ion of jus t ice , White and Selgin offer but onearg um ent dest ined to show th e a l legedly non-fraud ulent chara cter offract ional reserves: that outlawing such a practice would involve aviolation of th e principle of freedom of co ntra ct by pre ve ntin g "banksand the i r cus tomers f rom making whatever sor t s of cont rac tua larran ge m en ts a re mu tual ly agreeable ."25 Yet th is i s surely a sillyargum ent . Fi rs t off, a s a m at te r of his tor ical fact f ract ional reservebanks never informed thei r deposi tors that some or a l l of thei rdeposits would actua lly be loaned out an d hence could not possiblybe ready for redempt ion a t an y time. (Even if the bank were to payintere s t on deposit accounts , an d hence i t should h ave been c lear th atth e ban k m us t loan ou t depos it s, th i s does not imply th a t an y of thedeposi tors ac tua lly un ders tand th i s fact . Indeed , i t i s sa fe to s ay th a tfew if an y do, even am ong tho se who ar e not economic il l i terates.) Nordid f ract ional reserve b an ks inform thei r borrowers th a t some or allof the c redi t g ranted to them ha d been crea ted out of th in a i r a n d wassubject to being recal led a t a ny t ime. How, th en , can the i r pract ice becalled an yth ing bu t f rau d an d embezzlement!Second, and more decisive, to believe that fract ional reservebanking should be regarded a s fa l ling und er a nd pro tec ted by theprinciple of freedom of co ntra ct involves a complete mis un de rsta nd -ing of th e very m ea nin g of thi s principle. Freedom of contra ct doesnot imply t h a t every m utual ly advan tageous con tract should be per-mitted. Clearly, if A a n d B contractually ag ree to rob C, this wouldnot be in accordance w ith th e principle. Freedom of contrac t meansi n st ea d t h a t A a n d B should be a llowed to mak e a ny con tract what-soever regard ing thei r own proper ties , yet f ract ional reserve bank inginvolves the making of contracts regarding the proper ty of thi rdpar t ies . W henever th e ban k loans i t s "excess" reserves to a borrower,such a bi la teral contract af fects the proper ty of thi rd par t ies in athreefold way. F irs t , by there by increa sing th e money supply, thepu rcha sing pow er of al l oth er money ow ners is reduced; second, alldepositors are harmed because the l ikel ihood of their successfullyrecover ing thei r own possess ions is lowered; and thi rd, a l l o therborrowers-borrowers of com mo dity credit-are h ar m e d be cau se th e

2 5 ~ h i t e ,ompeti t ion and Currency, p. 156, also pp. 55-56; George Selgin, "Short-Changed i n Chi le: The Truth about t h e F ree-Banking Episode," Au stria n EconomicsNewsletter (W interlSpring, 1990):5.


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Hoppe: How is Fiat Money Possible?injection of fiduciary credit impairs the safety of the entire creditstructure and increases the risk of a business failure for everyinvestor of commodity credit.In order to overcome these objections to t he claim that fractionalreserve banking accords with the principle of freedom of contract,White and Selgin then, a s their last line of defense, withdraw to theposition that banks may attach an "option clause" to their notes,informing depositors tha t the bank may a t any time suspend or deferredemption, and letting borrowers know that their loans may beinstantly recalled.'= While such a practice would indeed dispose of thecharge of fraud, i t i s subject to another fundamental criticism, forsuch notes would no longer be money but a peculiar form of lotteryticket^.'^ It is the function of money to serve as the most easilyresalable and most widely acceptable good, so as to prepare i ts ownerfor instant purchases of directly or indirectly serviceable consumeror producer goods a t not yet known future dates; hence, whatever mayserve a s money, so as to be instantly resalable a t any future point intime, it must be something that bestows an absolute and uncondi-tional property right on its owner. In sharp contrast, the owner of anote to which an option clause is attached does not possess anunconditional property title. Rather, similar to the holder of a "frac-tional reserve parking ticket" (where more tickets are sold than thereare parking places on hand, and lots are allocated according to a"first-come-first-served" rule), he is merely entitled to participate inthe drawing of certain prizes, consisting of ownership- or time-rentalservices to specified goods according to specified rules. But as draw-ing rights-instead of unconditional ownership titles-they only pos-sess temporally conditional value, i.e., until the drawings, and be-come worthless as soon as the prizes have been allocated to the ticketholders; thus, they would be uniquely unsuited to serve as a mediumof exchange.As regards the second contention: that fractional reserve bankingis economically efficient, it is noteworthy to point out that White,although he is undoubtably familiar with the Austrian-Misesianclaim that any injection of fiduciary credit must result in a boom-bustcycle, nowhere even mentions the problem of business cycles. OnlySelgin addresses the problem. In his at tempt to show that fractionalreserve banking does not cause business cycles, however, Selgin thenfalls headlong into the fundamental Keynesian error of confusing the

" ~ h i t e ,Currency and Compet i t ion , p. 157; Selgin, Th e Theory of Free Bankin g ,p. 137.

2 7 ~ e elock, "Fractional Reserve Banking: An Interdisciplinary Perspective,"p. 30.


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72 The Review of Austrian Economics Vol. 7, No. 2demand for money (determined by the utility of money) and savings(determined by time preference).28

According to Selgin, "to hold inside money is to engage in volun-tary saving"; and accordingly, "an increase in the demand for moneywarrants an increase in bank loans and investments." For, "whenevera bank expands its liabilities in the process of making new loans andinvestments, it is the holders of the liabilities who are the ultimatelenders of credit, and what they lend are the real resources they couldacquire if, instead of holding money, they spent it."" And based onthis view of the holding of money as representing saving and anincreased demand for money as being the same thing as increasedsaving, then, Selgin goes on to criticize Mises's claim that any issu-ance of fiduciary media, in lowering the interest rate below its"natural" level, must cause a business cycle as "confused." "No illconsequences result from the issue of fiduciary media in response toa greater demand for balances of inside money."30Yet the confusion is all Selgin's. First off, it is plainly false to saythat the holding of money, i.e., the act of not spending it, is equivalentto saving. One might as well say-and this would be equally wrong-that the not-spending of money is equivalent to not saving. In fact,saving is not-consuming, and the demand for money has nothing todo with saving or not-saving. The demand for money is the unwilling-ness to buy or rent non-money goods-and these include consumergoods (present goods)and capital goods (future goods). Not-spendingmoney is to purchase neither consumer goods nor investment goods.Contrary to Selgin, then, matters are as follows: Individuals mayemploy their monetary assets in one of three ways. They can spendthem on consumer goods; they can spend them on investment; or theycan keep them in the form of cash. There are no other alternatives.While a person must at all times make decisions regarding threemargins a t once, invariably the outcome is determined by two distinctand praxeologically unrelated factors. The consumption/investmentproportion, i.e., the decision of how much of one's money to spend onconsumption and how much on investment, is determined by a per-son's time preference, i.e., the degree to which he prefers presentconsumption over future consumption. On the other hand, the sourceof his demand for cash is the utility attached to money, i.e., the

or a critique of th is error see Rothba rd,Arnericals Great Depression, pp. 39-43;Hans-Hermann Hoppe, "Theory o f Em ploym ent, Money, Interest , and the Cap italistProcess: T h e Misesian Ca se Against Keyn es," in The Economics and Ethics o f PrivateProperty, Hoppe, ed. (Bo ston :Kluwer, 1993),pp . 119-20, 137-38.29~elgin,he Theory of Free Ba nk in g, p. 54-55.30~b i d . ,p. 61-62.


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73oppe: How is Fiat Money Possible?personal satisfaction derived from money in allowing him immediatepurchases of directly or indirectly serviceable consumer or producergoods a t uncertain future dates.Accordingly, if the demand for money increases while the socialstock of money is given, this additional demand can only be satisfiedby bidding down the money prices of non-money goods. The purchas-ing power of money will increase, t he real value of individual cashbalances will be raised, an d a t a higher purchasing power per unitmoney, th e demand for and th e supply of money will once again beequilibrated. The relative price of money versus non-money willhave changed. But unless time preference is assumed to havechanged a t th e same time, real consumption and real investmentwill remain the same as before: the additional money demand issatisf ied by reducing nominal consumption a n d investment spend-ing in accordance with th e same pre-existing consumption/invest-ment proportion, driving the money prices of both consumer as wella s producer goods down an d leaving real consumption and invest-ment a t precisely their old levels. If time preference is assumed tochange concomitantly with an increased demand for money, how-ever, then everything i s possible. Indeed, if spending were reducedexclusively on investment goods, an increased demand for moneycould even go hand i n hand with a n increase in th e ra te of interestan d reduced sav ing an d inves tment. Yet this, or the equally possi-ble opposite outcome, would not be due to a change in t he demandfor money but exclusively to a change (a rise, or a fall) in th e timepreference schedule. In any case, if the banking system were tofollow Selgin's advice and accommodate a n increased demand forcash by issuing fiduciary credit, th e social ra te of time preferencewould be falsified, excessive inves tment would resu lt, and a boom-bust cycle would be set in motion, rendering the practice of frac-tional reserve banking fraudulent a s well a s economically ineffi-cient.White's and Selgin's proposal of a commodity money based systemof competitive fractional reserve banking-of part ial fiat money-isneither just (and hence the term "free banking" i s inappropriate),nor does it produce economic stability. I t i s no fundamental im-provement as compared to t he monetar ist reality of monopolisticallyissued pure fiat currencies. Indeed, in one respect Friedman's purefiat money proposal contains a more realistic and correct analysisthan White's and Selgin's because Friedman recognizes "what used tobe called 'the inherent instability' of fractional reserve banking," and heunderstands that this inherent instability of competitive fractionalreserve banking will sooner or la ter collapse in a "liquidity cfisis'' and


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74 The Review of Austrian Economics Vol. 7,No. 2

then lead to his favored regime-a governmentally provided pure fiatc u r r e n ~ ~ - a n ~ w a ~ . ~ ~

Only a system of universal commodity money (gold), competitivebanks, and 100 percent reserve deposit banking with a strict func-tional separation of loan and deposit banking is in accordance withjustice, can assure economic stability and represents a genuine an-swer to the current monetarist fiasco.

Documents

(Austrian School) How is Fiat Money Possible - Or, The Devolution of Money and Credit