by Fred E. Foldvary, Senior Editor
Money is one of the most difficult concepts to understand in economics. We all use money and understand it is a medium of exchange, and most folks know that if too much money is issued, we will get inflation. But few people understand the link between money and interest rates, and why it is important that the rate of interest be set by the market rather than central bankers. Thanks to The Progress Report, the Henry George schools, the Robert Schalkenbach Foundation, and other educational efforts, there is a growing number of people enlightened about geoism, the social philosophy and economic policy of using land rent for public revenues and sharing the benefits of natural resources, also referred to as "Georgism." Geoism includes the elimination of barriers on trade and production. Geoists understand why economic freedom is just and beneficial in the production of goods, but some geoists favor state socialism and central planning for money, thinking that only the government can or should provide the money.
Henry George, the father of today's geoist movement, properly distinguished between real wealth in goods, and financial wealth, which is a claim or draft on real wealth. But that does not imply that money cannot also be real wealth. Historically, money evolved as commodities that were widely traded and therefore could be used in indirect exchange. Commodities that served as money included sea shells, cocoa beans, salt, cattle, beads, copper, silver, and gold.
Over time, gold became the most widely used commodity for money because of its superior qualities, being uniform, permanent, limited in supply, and easily cut into small pieces. But most of the circulating currency was not gold itself, but money substitutes, namely paper money and bank deposits. A $20 paper bank note could be redeemed for a $20 gold coin. While paper money and checks drawn on bank accounts served well for transactions, the ability to redeem them in gold kept the money sound, avoiding price inflation.
In most countries, governments took over the money. They made gold coins a government monopoly (often showing a portrait of the king), and they also controlled the banks and the issue of paper money. There were a few exceptions, such as Scotland, where they money was provided by private banks which issued their own private notes, redeemable into gold. But the Bank of England, the UK's central bank, took over the Scottish banking system in 1844.
The main problem with the royalist central control of money is that the monetary chiefs lack the knowledge of how much money to provide. It is not a matter of getting and processing the data. The right amount of money is unknowable. Money issued today will impact the economy months into the future, and nobody knows the demand for money in the future. A second problem is that central banks are not totally independent of political pressures and influences.
When too much money is issued, we get price inflation. What is not so well recognized is that when there is too much or too little money growth, interest rates get goofy. The rate of interest plays an important role in adjusting the amount of investment so that the amount of savings equals the net amounts that people want to borrow for investment. If more people save money, the banks have more money to loan out, and the interest rate falls to equalize savings and borrowings. The interest rate equilibrates spending for consumption and spending for investment, since when folks save more, they consume less, and there is more investment.
When a central bank such as the US Federal Reserve expands the money supply too much, the banks have more money to lend, and this lowers the interest rate. This increases investment, especially in long-term projects such as real estate construction, but folks did not change the amounts they wanted to consume, so now consumption competes with investment for goods and speculation in land, and we get price inflation. Because the Fed does not want inflation, they reduce the expansion of money, and interest rates go back up. The investments and land speculation that were being made when the interest rate was low become unprofitable at the higher rate, so as costs rise, investment falls, and some workers get laid off. That reduces the demand for goods, and the whole economy goes into a recession and then a depression.
In the US, the Federal Reserve has lowered interest rates by expanding the money supply. But nobody knows whether interest rates are ever too low or too high. Since the interest rates are manipulated by the central bank, it cannot play its economic role properly. A fixed rule such as expanding the money by a fixed percent per year has not worked, because inflation also depends on the demand for money, which the central bank cannot control. A central banking wizard can never know how to equilibrate savings and investment, and spending for consumption versus investment. Only the market can do that. So it is little wonder that the economy is out of whack. The interest rate is not allowed to do its job!
In a truly free market, supply and demand would determine the money supply and interest rates. With free banking, the monetary base, the real money, would be some commodity, and the banks would issue notes and have demand deposits (bank accounts) redeemable into the base money. The competitive issue of private money substitutes would be limited to the public's demand for money, avoiding inflation. The interest rate would be determined by the preference of folks for savings versus consumption, rather than by the wizards of some central bank.
Gold still serves as money. Some people have accounts in gold and use gold for exchanges. Central banks and governments still hold a lot of gold. Many people hold some gold because they know that government money today is all fiat, used because of law and custom, and its value can disappear. The use of gold does not confuse money with real wealth, but rather recognizes that sound money is based on its being independent of the whims of governments.
The United States has never had free banking, pure free-market banking. Between the Civil War and the establishment of the Federal Reserve system in 1913, the US Treasury Department acted as a central bank. Before the Civil War, the States tightly regulated the banks, forcing them to hold State bonds, and restricting branch banking. The wild-cat banks and crazy expansions of credit were the result of State intervention. Geoists should realize that economy-choking land speculation has been fueled by government-caused over-expansions of money and credit.
Some monetary gurus have proposed 100% reserve banking, where banks do not expand the money supply by lending out more money than they have in deposit. But in a true free market, it is up to private owners and customers to made such decisions. So long as the policy is disclosed to the depositors, they should be able to choose between the greater safety of a warehouse bank that holds all money deposited, and the higher interest paid by a bank that can lend out some of the money deposited, possibly insured privately for more safety. Fractional reserve banking worked very well in Scotland during the free-banking era.
Geoists need to better understand the monetary side of the economy. If freedom is good for goods, why not also for money? A restriction on the private use of money is a trade barrier and a tax. A free market is especially needed for money and interest, since these are too important to be left to the guesswork of central planners who have to drive a money-supply road with no map.
-- Fred Foldvary
Copyright 2002 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.
Email this article Sign up for free Progress Report updates via email
What are your views? Share your opinion with The Progress Report:
Page One Page Two Archive Discussion Room Letters What's Geoism?