Hegemonic Bonds vs. Contractual Bonds

Society is a system of men connected by bonds. Without bonds society wouldn't exist. Humans would just co-exist in an autarkic, self-sufficient manner. This is of course nothing but a theoretical construct. In reality humans need society, hence bonds, in order to satisfy there needs.

Bonds can either be coercive (hegemonic) or peacful (contractual).

Hegemonic Bonds

Hegemonic bonds are easy to conceive. One man beats another man into submission if he does no obey. No high level of intelligence is required in order to understand hegemonic bonds. Even animals understand and follow this system. The stronger ones prevail, the weaker ones obey.

Hence, the first systems of human society were based upon these coercive bonds. Up until the ages of feudalism, those men who managed to obtain arms or were stronger in terms of their physique, the aristocrats and their corollary, ruled over the poor. They had them toil and sweat for their own benefit.

Contractual Bonds

Over the course of human history men have come to realize that there are other types of bonds. One man bakes bread and another man builds furniture. If each of them values his product less than the other man's product they will enter into an exchange. This is a contractual bond. It is not based upon compulsion and coercion, it is based upon mutual agreement. Both benefit. Moreover, both benefit more than every single one would in a system of hegemonic bonds.

As the hegemonic bonds of feudalist society were broken apart, contractual bonds prevailed in the western societies. Men have ever since enjoyed unprecedented wealth and amenities that a Croesus would have envied them for. How uneasy would an American worker feel if he had to live in a medieval lord's castle without all the plumbig and sanitation facilities he has gotten used to!

In such a system the government, the social apparatus of compulsion and coercion, does nothing but protect the individual's freedom and contractually obtained property.

Contractual bonds are the requirement for a wealthy society. They are not a given. Societies frequently change the way they govern themselves. Interventionism is again on the rise. Hegemonic bonds are substituted for contractual ones. It is up to the people to decide what ends they want to attain: Do they want to live in medieval conditions or do they want to enjoy more and cheaper products and services of improving quality?

Imagine...

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...a world in which everybody were free to live and work as entrepreneur or as employee where he wanted and how he chose, and ask which of these conflicts could still exist.

Imagine a world in which the principle of private ownership of the means of production is fully realized, in which there are no institutions hindering the mobility of capital, labor, and commodities, in which the laws, the courts, and the administrative officers do not discriminate against any individual or groups of individuals, whether native or alien.

Imagine a state of affairs in which governments are devoted exclusively to the task of protecting the individual's life, health, and property against violent and fraudulent aggression. In such a world the frontiers are drawn on the maps, but they do not hinder anybody from the pursuit of what he thinks will make him more prosperous. No individual is interested in the expansion of the size of his nation's territory, as he cannot derive any gain from such an aggrandizement. Conquest does not pay and war becomes obsolete.

(Mises, Human Action, Chapter 14, Section 5)

Put The Stock Market In Perspective

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I want to explain how to put things into perspective as far as the stock market is concerned. In another article I will then explain how to try and predict the mid-run stock market movements.

The major booms and crashes on the stock market (just as those on the real estate market, on the oil market, on the gold market, on the foreign exchange and on other markets) are the repercussions of the cheap money policy of the Federal Reserve Bank.

It all boils down to one thing: the dollar losing value against other commodities/currencies during the boom and the dollar regaining value against them in the recession.

The federal reserve tries to foster business activity by injecting additional credit into the loan market. Interest rates drop in the short term. Credit becomes cheap. Entrepreneurs embark upon projects which they usually wouldn't touch. The factors of production they need to purchase are financed by cheap credit. They would have usually been employed for other projects which fulfill more urgent needs of consumers.

In the wake of these events, investors also obtain cheap credit and channel it into other markets, such as the stock market, the real estate market, the commodities and gold market, they invest in oil futures and oil prices rise.

It is important to understand that this is all one chain of interconneced events. Contrary to common media claims, it is utterly wrong to believe that a drop in oil prices id good for the stock market and vice versa. The oil prices themselves do not affect the stock market. It is the cheap credit that causes the rise on both these markets. History has shown us that oil prices, gold prices, real estate prices and the stock market movements are strongly correlated.

The rise in prices results in a premium that lenders apply after some period in order to account for the principal and interest payments' loss in value. Loans become more expensive again. The Federal Reserver now steps in in order to rectify its previous mistake of unnecessarily exuberant credit expansion. Government officials start realizing that commodity prices are rising at an uncomfortably high pace. The FED tries to curb credit expansion by selling bonds and hence withdrawing credit from the market. It increases the dicount rate.

But inflation still lingers on. Entrepreneurs keep investing time and toil into their projects. Investors on the stock market are still convinced that prices will keep rising. As it is with human nature, once a significant amount of money has been invested, men are always prone to stay the course as long as they see a slight chance of success.

The FED keeps trying to curb the excessive credit expansion. This goes on until investors start realizing that government bonds now provide a much higher and safer yield than their commodity and business investments. The inevitable happens, the stock market crashes, housing prices drop, gold prices drop. Malinvestments are cleared. Unprofitable projects are put on hold or completely discarded.

Prices drop. Necessarily wage rates would also have to drop in order to adjust to the new state of affairs and to ensure full employment. However, wage rates are rigid downwards. Governments have imposed minimum wage restrictions in order to appeal to the workers which are the majority of people. Some employers can't afford to pay the wages required by government decree. Hence, unemployment ensues.

The FED heroically steps in and again injects cheap credit. The cycle begins anew.

"It is what you do that defines you."

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I recently watched the movie "Batman Begins". In one scene Rachel sees Bruce enjoying his playboy life with two European mistresses. He is embarrassed and tells her "Rachel, this is not me...I am different inside." Responds Rachel: "It's not what you are inside, but what you do, that defines you".

I think this is a fascinating statement and pretty much sums up all problems and fallacies we often have to face in political and economic discussions.

Having established that economics ultimately depends on human action, it only makes perfect sense:

It's what you DO that defines you.

It is NOT

• what you call yourself.
• what other people call you.
  
• what you claim to be.
• what label is attached to you.
• how you got to doing what you do.

The only way to properly categorize individuals or organizations in economic analyses is to do it based on their actions, because economics is ultimately a science of human action.

That being said, I want to outline some of the implications:

• A Mafia makes money by extorting people and by forcing them to pay. There is no contractual bond that states that the Mafia victim has to pay money to the Mafia. It is generally agreed that this behavior is unjust and illegal. A government makes money by forcing people to pay taxes. If you don't they will make you. There is no contractual bond that you have entered that states that you have to pay money to the government. For some reason it is generally accepted that this is an ethical/correct/unavoidable/reasonable/just way of conduct.
• In the Soviet Union, the basic good food was produced by government. Private production of food was outlawed. We saw the implications of this procedure. Inefficient bureaucracy led to poor quality and misallocations. It is generally accepted that this system has failed and that food should be produced in a competitive market. In the United Stated, the good money is produced by government. Private production ("counterfeiting") of money is outlawed. We see the implications of this procedure. Inefficient bureaucracy leads to poor quality (inflation) and misallocations (stock market/real estate bubbles, budget deficits, wars, boom bust cycles, unemployment, corruption). Yet, for some reason we accept this way of conduct and call it a necessary/reasonable/proper/standard procedure.
• A government entity makes money based on budgets allocated to it which again depend on the amount of tax money received by the IRS. Government contractors, such as Halliburton, Boeing, Westinghouse, Bechtel, Lockheed Martin make money based on budgets allocated to them which again depend or the amount of tax money received by the IRS. Yet, people tend to mistake these for private entities and impute the ensuing corruption to fierce, chaotic free market capitalism. It is unnecessary but nonetheless interesting to point out that the more government a country has, the more corruption prevails.

These are just a few examples to think about. Again, if one wants to thoroughly understand economics, it is crucial to understand and accept the absolute principles and rules of human action.

There is not a single reason deprecate the fact that men always act because they want to attain an improvement of their perceived condition and remove perceived uneasiness.

All other deductions need to be based upon that logic. All acting entities, organizations, people hence need to be categorized based on their actions, not on their names or labels.

Marketing Paranoia

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I would like to use an excerpt of Mises' "Money, Method, and the Market Process" in order to address the paranoid theories about powerful corporations who supposedly exploit the general public by the means of a large and deceitful marketing machinery:

"It is generally admitted that the average man displays poor taste. Consequently business, entirely dependent on the patronage of the masses of such men, is forced to bring to the market inferior literature and art. (One of the great problems of capitalistic civilization is how to make high quality achievements possible in a social environment in which the "regular fellow" is supreme.)

It is furthermore well known that many people indulge in habits that result in undesired effects. As the instigators of the great anti-capitalistic campaign see it, the bad taste and the unsafe consumption habits of people and the other evils of our age are simply generated by the public relations or sales activities of the various branches of "capital",— wars are made by the munitions industries, the "merchants of death";dipsomania by alcohol capital, the fabulous "whiskey trust," and the breweries.

This philosophy is not only based on the doctrine depicting the common people as guileless suckers who can easily be taken in by the ruses of a race of crafty hucksters. It implies in addition the nonsensical theorem that the sale of articles which the consumer really needs and would buy if not hypnotized by the wiles of the sellers is unprofitable for business and that on the other hand only the sale of articles which are of little or no use for the buyer or are even downright detrimental to him yields large profits. For if one were not to assume this, there would be no reason to conclude that in the competition of the market the sellers of bad articles outstrip those of better articles.

The same sophisticated tricks by means of which slick traders are said to convince the buying public can also be used by those offering good and valuable merchandise on the market. But then good and poor articles compete under equal conditions and there is no reason to make a pessimistic judgment on the chances of the better merchandise. While both articles, the good and the bad, would be equally aided by the alleged trickery of the sellers, only the better one enjoys the advantage of being better."

(Mises, Money, Method, and the Market Process, Chapter 14)

History of Money

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The Origins of Money

When society started evolving, humans realized very quickly that they can't live in a self sufficient manner.

The crucial need for exchange of products and services and the division of labor arose because humans realized that the best way to improve their standard of living is letting everyone do what they do best and exchange products and services that one party deems less valuable for products and services it deems more valuable.

The reason why division of labor started evolving naturally is the fact that every human has different talents and abilities and that different geographical regions provide different conditions for production and exploitation of natural resources.

A human being who tries to live in a completely self sufficient manner would be doomed to die from starvation with a very high certainty. Humans need to interact in order to stay alive and improve their status.

At a very early stage humans realized that if party A provides services or products to party B , party B does not always provide services or products that party A has demand for, however party B might be providing services to party C the next day and receive products or services that party A has demand for. Or, vice versa, party A might produce a product that no party in his vicinity has a demand for right away, but at a later point in time. Products and services needed to be channeled to their ultimate consumers in the most efficient manner
The need for a medium of exchange, money, arose.

People started using products that would ultimately be used for consumption as media of exchange. For example, party A would produce a table, give it to party B, but instead of demanding a product that A would consume, A would rather ask for a product that he/she could give to someone else at a later point in time for exchange against a consumer product.

People started using different things as mediums of exchange, such as cattle, tobacco, tea, beans, or coffee. People started using products that made for good media of exchange as such.

What are the requirements for a good medium of exchange?

• It has to be easily divisible
• It has to be easily measurable in a certain unit
• It has to be relatively scarce, so there is just enough for everyone to use it
• It should be relatively durable
• It should be homogeneous (same units should not differ in quality, e.g. two different pieces of it, both 1 ounce should have equal quality)
• It should be as widely accepted as possible

For example most people needed to eat, so cattle was accepted as medium of exchange. However, there were certain limitations as to how cattle could be used as money. For example it was not very divisible. Also different bulls could have different quality. Tea was very divisible, however, there was still the problem that one ounce of tea might be of worse quality than a different ounce of it.

This makes it clear that money is nothing but a good. A good that enables exchange which society has a natural desire for. It is not very different from answering questions, such as:

What makes a good lunch dish? (non-poisonous, healthy, pleasant taste, etc.)
What makes a good vehicle? (an object with wheels, etc...)
What makes a good material to build houses?( firm and solid structure, yet easy to apply inbetween bricks)

Individuals in a free market figure out the answers to those questions pretty quickly.

Over the centuries, in a free market, people tried lots of different products as money. Different commodities with more or less moneyish attributes competed against each other. Finally, over time people found that there was one commodity that fulfilled the requirements for a good medium of exchange best.

• It was easily divisible because it could be easily smelted and made solid again
• It was measurable in units of weight
• It was available just sufficiently not to lose value but could be used by everyone
• It was infinitely durable
• It was more homogeneous than any other potential medium of exchange
• It was widely accepted as an ornament and people enjoyed its beauty

The commodity that I am talking about, the one that prevailed as the best money in a free, unhampered society was gold. In addition to gold there was another metal that was not quite as scarce but also fulfilled all the requirements for a good medium of exchange: silver. Silver was mainly used for smaller transactions.

People in a free, unhampered exchange market, tried lots of different moneys until the BEST moneys, gold and silver, prevailed. The value of products and services in gold units was determined based on the simple and efficient laws of supply and demand.

Gold Warehouses

People, over centuries, have always stored commodities in warehouses because they did not need them at that particular point in time but later. Also they did not always want to carry heavy things with them and needed them to be protected against theft.

They would receive a paper ticket from that particular warehouse which represented a claim for the item deposited.

The same was the case for gold.

People would deposit their gold in gold warehouses and receive a paper ticket that served as a claim for the amount of gold (in weight units).

Currency units, such as "Dollar", "Mark", "Pound Sterling" used to be nothing but another way of stating a particular amount of gold. The "Dollar" for example, was defined as 1/20 of a gold ounce, the pound sterling as slightly less than 1/4 of a gold ounce, and so on. This meant that the "exchange rates" between the various national currencies were fixed, not because they were arbitrarily controlled by government, but in the same way that one pound of weight is defined as being equal to sixteen ounces.

Because those paper tickets were claims to gold, people started using those instead of gold as a medium of exchange, always knowing that they could exchange them for the precious metal at any time and at a ratio stated on the paper ticket and stipulated contractually.

Gold warehouses started accepting paper tickets from other respected gold warehouses as a service to their customers. They would then approach the original issuers of those tickets and redeem the tickets for gold and by doing so take that burden away from their customers, of course demanding a price for that service.

Soon the gold warehouse owners would notice that they would always have a certain amount of gold available that would not leave their vaults. Hence they would create more paper claims to gold than they actually had gold lend them s to other people as loans and earn interest money on them.

By doing so they were violating their contractual obligation to their clients. At the same time they were causing inflation with its negative effects as outlined in "Negative Impacts of Inflation". Of course their clients were not stupid.

As it is in every type of business in the free market, customers will swiftly notice that something is wrong and switch to a better service provider. In the gold warehouse business, customers would notice that the value of the paper tickets was depreciating and quickly redeem them for gold at the ratio stipulated. Those gold warehouses that printed too many paper tickets would pretty soon be bankrupt and go out of business.

The free market puts severe limits on malpractice in any type of business, and so it did in the money storage business. There is a history of bankruptcies of gold warehouses, or "deposit banks" as they would soon be called. Bankruptcies, that were the well deserved result of malpractice and low quality service.

Soon it would become a major success determinant for banks to be widely trusted and to make sure their paper tickets don't lose value. It was in their own best interest not to perform malpractice.

As Rothbard puts it: "The international gold standard meant that the benefits of having one money medium were extended throughout the world. One of the reasons for the growth and prosperity of the United States has been the fact that we have enjoyed one money throughout the large area of the country. We have had a gold or at least a single dollar standard with the entire country, and did not have to suffer the chaos of each city and county issuing its own money which would then fluctuate with respect to the moneys of all the other cities and counties. The nineteenth century saw the benefits of one money throughout the civilized world. One money facilitated freedom of trade, investment, and travel throughout that trading and monetary area, with the consequent growth of specialization and the international division of labor." (http://www.mises.org/money/4s1.asp)

Government Meddling

Governments pursue the profession of exercising power over people in a forceful and coercive manner. Unlike in other professions and organizations, competition amongst governments leads to bloody and fierce battles. Over history governments have always tried to find convenient ways to finance their wars. Taxes were one option, however it is never easy to sell tax hikes.

Another option was to obtain loans from industrials and banks. This was a great opportunity for those banks who intended to print more paper tickets than they had gold in their vaults. A collaboration between private banks and governments begun.

Some banks would print paper tickets out of thin air and supply those as loans to governments. This ensued all the typical effects that inflation has on society. What happened to the blessing forces of the free market? Of course people who were using these banks to store their gold would recognize that their paper tickets were losing value and that they would probably not be able to redeem them for gold ("redeem them in specie"). This would lead to a so called "bank run".

What did the banks do? Usually, in a free, non-coercive market they would not stand a chance, they would go bankrupt and be out of business. However, since they now had the support of a powerful, coercive, and arms-bearing organization, namely government, they sought for help with it. Following the principle "You scratch my back and I'll scratch yours", governments would now permit their banks to refuse specie redemption to their customers. - Probably the most fateful violation of property rights in all of history. Resistances would be crushed violently and people had to accept the fact that they would not be able to redeem in specie. After a precedence was set, governments all over the world would occasionally, and with all their power of arms and police, grant banks that financed their wars the permission to suspend specie redemption.

Banks would always try to pursue inflationary practices if they could. They would be amongst the inflation beneficiaries and could maximize their income that way. As we have seen, the free, non-coercive market system put strict limits on these ambitions. However, as soon as governments started meddling with the money market, banks realized the opportunities that this entailed. Those "private" banks that were working in tandem with the government, were the strongest proponents for the establishment of a central bank. Why?

We have seen that some banks have tried to maximize their profit by printing more paper tickets than they had gold in their vaults. We have also seen that this malpractice was prevented in a free money system. Example: If a customer C were to own accepted paper tickets from bank A, but redeemed them with bank B because it is the only bank within its vicinity, ultimately bank B would approach bank A for specie redemption. Any exuberant issuance of paper tickets by bank A would immediately result in bankruptcy of bank A's business, as soon as bank B would approach them for redemption.

If not the customers themselves redeemed their paper tickets in specie with the original issuer, ultimately bank A would approach bank B to redeem tickets from bank B in specie.

Hence, in order to avoid these market pressures different banks occasionally tried to partner up and form cartels were they agreed to inflate the paper ticket supply but not approach each other for specie redemption. However, cartels or monopolies can't exist for a long time in a free , non-coercive market, no matter how large they are. Free market competition, entrepreneurs , and a dynamic venture capital market would always quickly put and end to their practices. In addition, as the paper ticket supply would ultimately lead to hyperinflation, the customers themselves would approach the original issuers and put them out of business.

The Central Bank

The only way for a monopoly to persist in the long run is by teaming up with an entity that specialized in the unethical profession of exercising force and coercion, namely government. This would enable the monopolists to ultimately use the forceful power of arms and police in order to make people accept the way it operates. In addition, government could always force people to accept a suspension of specie payment if needed.

A government supported central bank would give banks the opportunity to finally enjoy government's benign aegis and protect them from the bothersome forces of the free, unhampered money market.

This is how it would work:

• Government would inaugurate a law that would state that only paper tickets from one bank, the central bank, shall be accepted as claims to gold and as mediums of exchange
• The central bank would store gold and provide paper tickets as claims for gold evenly to all private banks
• Private banks would then inflate their paper ticket supply by providing more paper tickets or even just demand deposits (also called checking accounts) to its customers on top of the gold-backed paper tickets (fractional reserve banking)
  
• People who were not willing to accept the depreciating paper tickets in exchange for products or services were deemed criminals and violently forced by law to accept them
• Whenever an exuberant supply of paper tickets would lead to a bank run, government would grant the central bank permission to suspend specie payment

The establishment of this system would make life a lot easier for inflationary banks and debt-hungry governments. Banks were now virtually protected against free market forces and the threads of bankruptcy and competition; governments had found a convenient way of exploiting productive individuals in a more subtle and harder to unveil manner than taxation.

However, they still weren't satisfied. The biggest problem for them was now the bothersome dependency of paper currency on real money. In order to completely free themselves from any dependency they desired to change the system in a way that allows them to print paper currency without any ties to gold or silver. They desired to be able to print paper out of thin air and completely free themselves from any obligation to redeem in specie. This would finally free them from all remaining checks and balances.

All over the world, sooner or later governments would make their central banks go "off gold". Most of the time this happened with the argument of avoiding monetary "inelasticity". However, it was clear that the ultimate reason was the incentive for government and banks to establish a permanently inflationary system.

This system in essence means that government steps in and forces people to accept a lower quality money instead of a money that has prevailed in the free, unhampered market. Coincidentally, government itself happens the producer of this low quality money.

To make it easier to comprehend: The exact equivalent of this arrangement in a different market, such as the automotives market, would mean that the government produces one brand of cars and does not permit any competition within its borders. This is what the governments of the former Soviet Union experimented with. I think this makes it a little more obvious how devastiating the effects of a 100% government controlled paper money system will ultimately be.

The United States were the last country to go off gold in 1970 under president Nixon subsequent to the collapse of the Bretton Woods system.

This is how we got to the monetary system of today, as described in the article "Negative Impacts of Inflation".

Over centuries, the centralization and the monopolization of the money market went hand in hand with an ever growing and powerful government.

The government imposed central banking system has reshaped the money market from a decentralized, efficient, and fair system to a centralized, inefficient, and unethical one that allows for major violations of property rights.

Government Constraints

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In my article "Human Action and Economics" I outlined the importance of human action for economic outcomes. In particular, I outlined how people act under certain constraints. In this article I want to delve into human action as it applies to government officials.

We have established that government can only exist by applying force and coercion. If that wasn't the case then government could simply threaten us with the shut down of its services if we don't pay taxes. This is not the case. Even if we don't agree to this arrangement: If we don't pay taxes some federal agent will one day knock on our door and we stand a pretty good chance of going to jail. It's as simple as that.

As we established, humans are selfish and always want to improve their status until they are satisfied. Is there any reason to believe that this would not also apply to government officials? Are they exempt superhuman beings? Based on the simple natural laws of human nature and human action I have to say: No. (I have not yet heard a decent explanation on why government officials should be excluded from this rule. The most popular, but nonetheless primitive, arguments range from "they don't work for profit, so they will act in the public's best interest" to "they have been elected so they need to satisfy their voters").

It applies to government officials just as much as it does to anybody else. The real questions are:

• What means can they pursue in order to achieve an improvement of status.
• What constraints are they under?
• What ideas do they conceive and refine based on those constraints.
• What actions do they finally take in order to achieve the objective of status improvement?
• And most importantly: Do they violate any ethical principles along the way and to what extent does an improvement of their status entail an equivalent improvement for those who pay them?

Improvement of Status

A government official mainly improves his status by increasing his salary. It is paid for from taxes or from government debt. Taxes are income the state receives by forcing people to pay them. There is no other way. The choice for people from the private, non-coercive, productive sector is to either pay taxes or go to jail. (I would also not call it a choice if on election day you can choose between paying 40% taxes or paying 41% taxes by submitting your vote!) Government debt financing is mainly facilitated through the central bank and is a vital part of the exploitative inflation mechanism. Ultimately, inflation is nothing but a more subtle form of taxation. Based on this we can infer: Just as a private enterprise would like to drive prices for its products and services up to infinity (curbed by the constraints of competition), the government official will always try to maximize taxes and government debt and subsequently maximize his/her salary.

Government Constraints

This is the most important question: What constraints does the government official face? We have established that a private entrepreneur who exists without applying the means of force and coercion, in the unhampered free market mainly faces the constraints of qualitative customer demand, quantitative customer demand, resources available, own talents and skills, and competition from other entrepreneurs. All ideas conceived and refined and his subsequent actions taken will depend on these.

The government official, because his existence is contingent upon the application of force and coercion, naturally faces very different constraints.

He certainly does not face the constraint of qualitative consumer demand. He does not need to provide the consumer, the taxpayer, what he is looking for because he will have to pay his taxes either way. The amount of taxes we pay, in other words, the price for government, is not determined by an efficient free mechanism but is based on arbitrary decisions made by a few people in government.

He certainly does face the constraint of customer (taxpayer) quantity. Except for very few exceptions, a government can only collect taxes from people living within the borders of its territory.

He also does face the constraint of his own skills and abilities. The government officials core competency is to exercise power over people. The amount of money he can collect certainly depends on the extent of his skill set to do so.

Of course he is also constrained by the resources available within his government's territory.

Within his nation's borders he is hardly constrained by any type of competition over the products and services that he provides. Government alone provides the service of domestic and international security. Government alone provides the service of printing money. Government alone provides the services of building and managing interstate highways, streets, and high schools. Government alone provides the service of justice. This leads us to a very important point: Within its borders, a government does not face the competition of a free market entrepreneur. We all know that competition is vital for maximizing quality, minimizing prices at a certain quality level, and for keeping humans from exploiting others by, for example, jacking up prices (as I outlined in my example in the article "Human Action and Economics", where a furniture selling entrepreneur tries to deliberately double his prices but is then constrained by another entrepreneur who offers the same product at a lower price.) As it is with any type of free, non-coercive business, we as the consumers always feel very safe with the service providers or producers we pick, and even if we don't, we enjoy the freedoms of picking better ones. This does not apply to the services government provides. Competition in the fields that government controls is almost always outlawed by government itself which happens to have the authority to make the laws.

If the free market constraints fail for government officials, why don't they impose 100% taxes on us? Why don't we live in a completely authoritarian system? Well, if we think about it, governments have tried these kinds of arrangements throughout history. Over time, coercive people have figured out that in fact the authoritarian state is very instable and doomed to fail in the long run. Why is this? Because ultimately a government is constrained by an additional factor, that is rather secondary, if not tertiary for a free market entrepreneur: public opinion.

Government officials hire experts in order to mold public opinion in their favor. Even though some people know that a lot of assertions that government officials make are completely wrong, the ability to persistently tell the same lies again and again and finally mold public opinion accordingly, has throughout history only been in governments officials' favor. Propaganda is one of the most important tools that governments apply in order to attain their ends of convincing the public.

Implications

To sum it up:

• Government officials can only improve their status by earning tax money.
• Taxes only work by the means of force and coercion.
• This circumstance leads to a very different set of constraints: Governments are virtually excluded from the constraint of competition and mostly constrained by public opinion
• Governments mold public opinion by the means of propaganda.
• The outcome of this is that governments never reciprocate in transactions. They receive tax money, but what they do with it is a completely different story. While in the free market one man can only improve his condition by providing products and/or services that others demand, government can make money without providing something that is being demanded. It is only natural that most of the money will end up in the pockets of high level government officials or government contractors without them providing the according value.
  

What is the result of this? We all see it. Everyday. In the fields that government controls we have nothing but problems. However, we fail to comprehend that government itself is the reason for these problems.

• Our highways are full of traffic jams. But who is there to provide better traffic services?

• In almost every major city in the USA there are areas where killings and shootings are a regular occurrence. But who is there to compete in the field of domestic security?

• Public schools are struggling to provide a decent education, especially kinds from poor families suffer. But who is there to compete in the low price education market?
  

• Our money keeps depreciating and inflation raises its ugly head again and again. Business cycles of boom and recession confuse us and constantly undermine the stability of a free, unhampered market. But who is there to provide a money of better quality?

• soldiers are being sent abroad for reasons that no taxpayer understands anymore. We are paying for services that we don't know anything about. Who is to believe that the people who are pursuing these policies are truly doing it in the nations best interest. Discussions on this subject have been crippled to simple phrases such as "We fight for freedom!". The ones who gain from this are usually big government affiliates and "private" contractors that have managed to infiltrate the governmental structure and utilize its power for their own benefit. These so called contractors are essentially nothing but an extension of government and cannot exist without it. They do not face the constraints that a private entrepreneur faces.
  

• Lots of people who immigrate are forcefully deprived of their rights to live and work just like any other human being in this country. Yet they are entitled to generous government benefits. Frustration on both ends, the immigrants and the residents, ensues. Government is failing to integrate people from abroad.

• We hear again and again about scandals, such as ENRON, or no bid contracts for companies such as Halliburton. But do we ever ask the question: Why do these companies actually exist? What is the root of all evil? Could these scandals really have ensued if there had not been a big government to exploit the taxpayer and give the money to those companies. People need to realize that the more monopolized a society (and government is the ultimate monopoly), the more fertile the ground for corruption, lies, and exploitation.

• People who would act independently in a free unhampered market are made lazy benefits recipients by the means of a large governmental welfare and social security system.
  

• Government imposed minimum wage distorts the market and causes persistent unemployment and frustration.
  

Let's be realistic. Government officials don't have the incentives that are necessary to provide quality at the lowest cost possible. The argument that governments actually curb the greediness of the free, unhampered market and ensure social equality is nothing but a huge hypocrisy. If there was a bit of truth in that statement, then where is the alleged social equality in our society today?

Products would be much less expensive, quality would be much better, people would be much more independent, richer and more innovative in a truly free, non-coercive market society without aggressive government intervention.

Human Action and Economics

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Human Action

The science of economics deals with the production, distribution, and consumption of goods and services that can be quantified in money prices. It so happens that in our world today human beings play a vital role in all of these processes. Henceforth, human action is the foremost determinant for their outcome. Economics is nothing but a subset of the general science of all human action.

As Mises puts it:

"First we must realize that all actions are performed by individuals. A collective operates always through the intermediary of one or several individuals whose actions are related to the collective as the secondary source. It is the meaning which the acting individuals and all those who are touched by their action attribute to an action, that determines its character. It is the meaning that marks one action as the action of an individual and another action as the action of the state or of the municipality. The hangman, not the state, executes a criminal. It is the meaning of those concerned that discerns in the hangman's action an action of the state. A group of armed men occupies a place. It is the meaning of those concerned which imputes this occupation not to the officers and soldiers on the spot, but to their nation. If we scrutinize the meaning of the various actions performed by individuals we must necessarily learn everything about the actions of collective wholes. For a social collective has no existence and reality outside of the individual members' actions. The life of a collective is lived in the actions of the individuals constituting its body. There is no social collective conceivable which is not operative in the actions of some individuals. The reality of a social integer consists in its directing and releasing definite actions on the part of individuals. Thus the way to a cognition of collective wholes is through an analysis of the individuals' actions." (Mises, Human Action, Part 1, Chapter II)

What influences human action?

I will leave the exact analysis of human nature to people who understand it much better than I do. Remarkable work has already been conducted in this fascinating field of science.

For our purposes, the most important cornerstones of human nature are the following:

• Humans strive for an improvement of their current situation until they are satisfied
• Every human being decides for him/herself what he/she considers an improvement of his/her current situation
  
• A human being is first and foremost concerned about his/her own well-being ( humans act selfishly)

A human conducts an action in order to get from status A to status B. The action is performed because he/she perceive status B as more favorable than status A. The desire to improve ones
status must inevitably stem from a certain degree of uneasiness. As Mises puts it: "The incentive that impels a man to act is always some uneasiness. A man perfectly content with the state of his affairs would have no incentive to change things. He would have neither wishes nor desires; he would be perfectly happy. He would not act; he would simply live free from care." (Mises, Human Action)

All human action and economic activity aims at improving ones status, "gaining profit".

For every human being, an action is preceded by an idea. Ultimately it is an idea that determines what the action is going to be.

Every idea is influenced by and refined based on constraints.

To sum it up: Human beings permanently try to improve their status until they are satisfied. The attempt to improve a status is conducted by performing an action. An action is the outcome of an idea which is conceived and refined under certain constraints.

It is this basic behavior that determines production, distribution, and consumption of goods and services and therefore the state of the economy.

Examples:

• I see a report on how kids are starving in Brazil and how they can't even afford the most basic things. This makes me feel uncomfortable. I want to improve my status from this feeling of uncomfort to something better. My idea is to sign up with an organization that supports these kids and pay money on a regular basis. I have constraints of a certain disposable income per month. Based on that I make my decision on how much getting rid of this feeling of uncomfort is worth to me and take an action by signing up for the charity organization. I now feel much better than before and have improved my status according to my selfish human needs. (On more information about welfare in the unhampered free market, please read Mises, Human Action, Part 6, Chapter XXXV, "The Welfare Principle Versus The Market Principle")
  

• I am hungry. I know that I can improve my situation by getting from the status "hungry" to the status "content" by eating something. So my broad idea would be to obtain some food. Let's assume I am under the following constraints: my neighbor has a warehouse piled up with bread that he produced himself, also there is no other food within 50 square miles. I could refine my idea as follows: I could sneak into my neighbors warehouse, steal some bread and consume it. However I happen to know that he recently injured a guy who sneaked into his house to steal and that he is guarding his property. I am facing the constraint of a potential black eye, maybe more. Based on the possibility of transitioning to a status "starving and hurting" which is even worse than my current status "starving only" I discard that idea refinement. However, I have a better idea: I happen to be well versed and experienced in crafting wooden furniture and among other things have produced an extra table that I don't have any need for and that I am willing to exchange for 10 loafs of bread. The 10 loafs of bread are worth more to me than the table, simply by the virtue of the fact that I don't have any need for the table but at the same time am in dire need for food. My neighbor happens to have demand for a table because it helps him bake more bread. Hence, I perform an action: I go to my neighbors house and make him the according offer. He agrees and a transaction takes place. I consume the bread I obtained and have improved my status from hungry to consent. I have "gained profit" by exchanging something I perceive as less valuable for something I perceive as more valuable. How much that profit exactly is is not measurable yet because in this barter economy money has not been invented yet.

• I produce and sell wooden furniture. Every week I sell 5 pieces at 2 loafs of bread each. I can survive by doing so but at times still feel hungry during the week. I would like to have some more bread improve my status and not feel hungry anymore. I would like to get from the status "10 loafs/week" to "20 loafs/week" My idea is to increase the price of a piece by 100% to 4 loafs of bread. I perform an action and change my terms of service accordingly. People start getting upset about my business practices. An entrepreneur sees an opportunity and starts offering wooden furniture at 3 loafs per piece. I am facing the constraint of competition. People start buying the competitor's furniture and the number of pieces I sell goes down to 2 pieces. My status has gone from "10 loafs/week" to "8 loafs/week". I need to refine my initial idea to get to a status better than 10 loafs/week. Instead of 4 loafs I also start demanding 3 loafs per piece. This increases the number of pieces per week to 4. This way I now make 12 loafs/week and have finally improved my status.

• I am now in competition with another furniture selling entrepreneur and I have realized, based on my initial action and the outcome of that action, that I can't just raise the price as much as I want and expect the same number of customers. However I still want to improve my status which is currently 12 loafs/week. I am wondering how I can sell more than 3 pieces of furniture per week without lowering the price. I understand that there are some complaints about the quality of furniture that both my competitor and I sell. Some tables move and occasionally some parts of my chairs break. I have an idea: I realize there is an opportunity to improve my furniture by refining the production process. I find someone who specializes in improving processes, a consultant. I hire the consultant, he demands 9 loafs of bread for the process optimization. I pay the consultant with 9 loafs, which means that I must have earned them but don't consume them, I save 9 loafs, and make an equal investment of 9 loafs. I perform an action and improve the quality of my furniture by applying a better production process from now on. My tables stop moving and my chairs don't break at all. I am now able to sell 5 pieces per week at a price of 3 loafs/piece. I am now at 15 loafs/week. My investment is paid off within three weeks and from now on I earn more bread per week. My status has improved.

In these three examples one can see how the subjects who are part of this economy take actions based upon ideas that are conceived under certain constraints with the ultimate objective to improve their status.

Please note that it is not only me who improves his status in these examples but ALL participants in the economy. Example: By producing better quality furniture me AND my customers benefit in the long run.

The examples also show how the natural constraints of the free market constantly give humans an incentive to improve their products and services.

Improvement of Status

In my three example I merely outlined one type of status improvement: The improvement of status via production and services.

In fact, there are three ways humans can improve their status:

• Production and Services: The production of goods and the rendering of services that are demanded by other people who in return provide other goods and services. Status is improved by exchanging goods or services that are less valuable to me for goods or services that are more valuable to me.
• Homesteading: The acquisition and usage of undiscovered land.
• Expropriation: The forceful obtainment of someone else's property.

All ideas that people conceive with the objective of improving their status and their subsequent actions must be derived from one of these three categories.


All economic activity is performed by human beings based on the simple rules I outlined in this article. I will use them as reference in future articles, especially when I analyze the actions that government officials take, the ideas they conceive and the constraints they find themselves under in democratic societies.

Big Government

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Up until about 200 years ago great accomplishments were made in the field of political liberation. The statist hegemonic bonds were broken up and governments were confined in exercising their power. Private ownership of the means of production has brought about unprecedented wealth and progress. The average American worker enjoys amenities for which Croesus, Crassus, the Medici, and Louis XIV would have envied him.

Ever since things have been heading in the other direction again. Governments have increased the tax burden on people (in relative as well as in absolute terms), increased public debt, created excess money and inflation, assumed more and more power, and driven up the number of wars and civil disorders to levels the world has never ever seen before.

Let's take for example the development of taxes and government spending in the United States over the past 50 years. (source: www.taxpolicycenter.org)

Total (Federal + State + Local) Tax Revenue As Percentages of GDP (1947 - 2003)




Total (Federal + State + Local) Government Expenses As Percentages of GDP (1947 - 2003)


I have not been able, as of yet, to find %age data that goes back to the 19th century. If anybody has something please let me know, I'd be happy to update these charts accordingly.

However, I believe that after looking at this we can all conclude: There haven't been any tax cuts. Maybe taxes went up and down a little bit within shorter periods, but overall the tax burden has increased over the past 50 years. This also means that there is no so-called "neoliberalism".

I assume that most people agree that, at least to a certain degree, something seems to be wrong in our political system today, and that there are problems that need to be fixed.

Taking into consideration the numbers and facts presented here, and applying pure common sense, I assume that most people would unanimously agree to at least the following:

We do NOT need any more taxes or bigger government to solve our economic policy problems. If, in fact, government keeps increasing in size and people keep accepting it, or even calling for it, these problems will only be aggravated.

Those of us who are not part of the governmental body and yet assert that we need government spending in order to ensure a sufficient supply of basic goods and services that the poor and unfortunate people couldn't afford in a free, unhampered market, are either walking around with blinkers, or have given in to statist welfare propaganda and lack the intellectual capacity to accept and process basic principles of human action and praxeology.

But the lack of aprioristic reasoning and conceptualization (praxeology) does not seem to be the only problem here. In addition to that we see a lack of ex-post understanding of history.

The belief in the necessity of government ensuring supply of basic (or so called public) goods would, if applied consistently, imply that we need government to take care of the production of basic goods, such as food and clothes in order to avoid shortages. It is commonly agreed that a human in modern society needs those goods at the very least in order to be able to survive.

Reading this, the welfare state proponent should pretty quickly notice that we actually appear to have a more than sufficient supply of those particular goods in our western societies and that government intervention doesn't seem to be necessary here.

Moving on, the welfare state proponent has to accept the fact that it is precisely in the domain of the so called "public goods", such as government schools, domestic security, and highways where we constantly see shortages. Kids are not properly educated in schools (especially in the poor areas), our cities are everything else but safe (again, especially in the poor areas) and we constantly complain about traffic jams. And what is the reason for these problems according to the welfare state propagandist? It is of course that the state does not have enough money and needs more of the same to provide its services in a sufficient manner. According to him, we have a "shortage" of public funds.

But haven't I shown in the beginning of this article that this clamor for more money has been more than constantly addressed over time? Is there any reason to believe that the welfare state propagandists will one day stop asking for more?

It is clear that this will never happen. I have never seen a government anywhere in the world that was content with its pecuniary affairs and had its finances under control. They will keep asking for more and, as long as taxpayers comply, will keep spending more and I can assure you one thing: It won't help a bit.

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Government

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What is government?

First of all, it is an organization. An organization is a group of people intentionally organized to accomplish an overall, common goal or set of goals.

In my article "Negative Impacts of Inflation" I described government using our simple 5 people economy. Government would be person A who provides services to all other participants of the economy. This in itself does not yet essentially distinguish A from the other participants in the economy, since they all provide services to each other.

What distinguishes A is the fact that he is granted the privilege to establish forceful rules that impact the freedoms of the other participants in the economy. In particular, A has the privilege to determine how much of the money that the participants in the economy earn, they need to pay to him on a regular basis.

This is indeed a notable distinction. A, as opposed to all other participants is granted the privilege to constantly force everyone else to follow his/her rules.

In fact, there is only one type of institution that has throughout history, by the virtue of law, had the ability to impose their force on people: government.

As far as this fact is concerned, I am not making any difference between dictatorships, communist, monopolist, democratic, fascist, Islamic or authoritarian governments or whatever other labels there are to attach to governmental institutions.

The extent to which governments exercise their power, impose their force upon people, and cause inefficiencies and misallocations differ from one to another in different systems. Also the ways governments get to power differ from one to another. However, what does not differ from one government to another is the basis of their existence: compulsion and coercion.

There is no other, publicly accepted, organization that can expropriate people by forcing them to pay money for services.

A company that provides services to an individual can stop providing those services once that person does not pay anymore. If that individual would like to resume consuming the company's services he would have to start paying again.

One could assume that if I really was in dire need for the services government provides and I were to stop paying taxes, government could just stop providing its services to me in order to make me pay again.

Which brings us back to my initial question:

What is government?

Government is the social apparatus of compulsion and coercion.

The means that different people pursue or have pursued in order to get in power and form governments differ significantly.

In ancient times, they used to do it by recruiting the clerical class and making the case for a "divine law" which they supposedly merely exercised in the name of god.
Some have done it or still do it by using force, guns, and military power.

Over time, people have fought countless struggles for liberty and freedom. The outcome of those is democratic government. In a perfect democratic society the social apparatus of compulsion and coercion is elected by the people. The people are the ultimate sovereign. Government shall ensure that society functions by figthting aggressors, viz. people who try to infringe on others' freedoms.

Government's operations need to be strictly confined by rules, bills of rights, and laws. This shall ensure that it doesn't abuse its power. All the benefits brought about by the struggles for liberty stem from the confinement of government meddling with the market economy.


As Mises puts it:

"Government is in the last resort the employment of armed men, of policemen, gendarmes, soldiers, prison guards, and hangmen. The essential feature of government is the enforcement of its decrees by beating, killing, and imprisoning. Those who are asking for more government interference are asking ultimately for more compulsion and less freedom." (Mises, Human Action, Chapter XXVII, Part 2)

As Rothbard puts it:

"The State is a group of people who have managed to acquire a virtual monopoly of the use of violence throughout a given territorial area. In particular, it has acquired a monopoly of aggressive violence, for States generally recognize the right of individuals to use violence (though not against States, of course) in self-defense.5 The State then uses this monopoly to wield power over the inhabitants of the area and to enjoy the material fruits of that power. The State, then, is the only organization in society that regularly and openly obtains its monetary revenues by the use of aggressive violence; all other individuals and organizations (except if delegated that right by the State) can obtain wealth only by peaceful production and by voluntary exchange of their respective products. This use of violence to obtain its revenue (called "taxation") is the keystone of State power. Upon this base the State erects a further structure of power over the individuals in its territory, regulating them, penalizing critics, subsidizing favorites, etc. The State also takes care to arrogate to itself the compulsory monopoly of various critical services needed by society, thus keeping the people in dependence upon the State for key services, keeping control of the vital command posts in society and also fostering among the public the myth that only the State can supply these goods and services. Thus the State is careful to monopolize police and judicial service, the ownership of roads and streets, the supply of money, and the postal service, and effectively to monopolize or control education, public utilities, transportation, and radio and television." (Rothbard, War, Peace, and the State)

Ramifications of Inflation

Inflation occurs when people in an economy are supplied with more money than they need. How much money do they need? The real demand for money is whatever the people in our economy demand when they approach Z.

The economy is supplied with $10 because A approaches Z and demands money. In my example Z acts completely "demand driven".

If that economy was supplied with more money than it needed the value of money would decline and in most cases prices would go up. This includes not only consumer goods but also assets like stocks, bonds and real estate.

What is the negative impact of the inflation that we are facing? One could think that if people are supplied with more money it should not hurt them if prices go up, since they now have more money to spend.

This would actually be true if the money was supplied evenly to all individuals. In that case inflation would not be a problem.

Problems arise if the exuberant money supply is only provided to one group of people. That group of people would then be an inflation beneficiary while the individuals not supplied with money would be inflation losers.

(Please note that an excessive money supply indicates that the entity that is providing the product money is failing to do its job. In a fair and free market, if someone does not do his/her job right or provides bad products or services people start looking at other providers of that service. In today's world central banks are by law the only entity that have the permission to print and provide money for the people living within the respective country's borders. This is enforced by federal law and forced upon people. Hence, there are few ways for individuals to avoid the negative impacts of inflation and there is no natural market mechanism forcing the central bank to do a good job.)

The process of supplying economies with money is in reality a little more complicated than what I described in the article "Money". However, that description gave you a very good understanding of what the purpose of money is, why it exists, what value it provides to people using it and how it could possibly be introduced as an innovative product into a rudimentary economy for the first time.

The Process of Supplying Money

In all major industrial countries central banks provide money by buying government bonds. What does this mean exactly?

Understanding this requires a detailed understanding of government finances.

The entity government has two ways of financing itself: taxes and debt. Lets say in our 5 people economy person A says:

"I will provide services that benefit everyone and I need money to pay for this." Lets assume all other participants trust A. Lets also assume people trust A so much, they give him/her the permission to create rules that everyone needs to abide by. A creates tax laws that state that everyone has to pay him/her a portion of the money they make by providing products/services. The first thing A pays for with the tax money is a strong person that makes sure people follow his/her rules, that person represents police. It is now clear to everyone that A will not have a hard time making enough money at any time as long as he/she is able to enforce his/her rules.

In addition A establishes a rule stating that Z shall be under his/her supervision, be paid out of the tax money and make decisions "independently" and claims that Z's main job shall be providing the participants of the economy with money in case they need money.

In addition to taxes A (who represents government) can borrow money from individuals. It does so by selling a government bond to an individual that entitles that individual to a certain stream of payments. For example, government receives $10 from individual B and promises to pay $0.45 a year and pay the $10 back at the end of the 3rd year. Government has now borrowed money by issuing a 3 year treasury note at 4.5% and at a value of $10. Government debt is now $10.

The $10 treasury note that B owns is a very safe investment and the likelihood of default is very low because government has the ability to force individuals to pay taxes and can adjust the amount of taxes people have to pay. Hence, the treasury note is a safe investment as long as government can force individuals to pay taxes and individuals produce just enough to live and to pay their taxes.

Please note that individual B has already created value before in order to be able to afford the $10 treasury note. The common word for value created but not used for consumption is "savings".

Now lets say individual B wants to buy something that someone else produced that costs $10 but does not have any more money. What B has is the treasury note worth $10. B would now sell the note on the open market. In case there is no other individual who wants to buy the note, in other words, if the economy's money demand exceeds its money supply, person Z (who represents the central bank) would print money and buy the note from person B for $10.

Z would now be entitled to the annual payments of $0.45 and the payoff of the face value of $10 at the end of the 3rd year after issuance of the note. Whenever money gets back to Z this means that money is pulled out of the circulation and discreated. Z does NOT use the money to consume, all he/she is supposed to do is providing the service of printing money and injecting it into or pulling it out of the circulation. He/she is paid for this job separately out of tax earnings.

Up to now nothing has gone wrong. A seems to be providing services the participants of the economy demand, people are paying their taxes, and Z increases money supply only when money is needed and acts "demand driven". There is no inflation in this example.

How does inflation arise?

Lets go back to individual B owning the $10 treasury note. Lets now assume B does not want to buy anything and there is no supply that matches any of B's demands. Person Z, because for some reason he/she thinks the economy needs to be supplied with more money, now approaches B and wants to buy the treasury note. This is the way central banks act, backed by the virtue of law and all governmental forces available. They don't react to demand for money but rather declare and supply a certain amount of money they think is appropriate.

(For a centralized institution, at any point in time, it is virtually impossible to determine the exact demand for money ex ante, just as it is impossible to determine the exact demand for computers, cars, bread or movies or any other products that are produced in a more or less free market. We are all more or less convinced that the regulatory collectivist governments of the soviet union have failed due to this very reason. We accept that government should not produce computers, cars, bread or movies but that it should rather be up to private, forceless organizations or individuals to deliver these products or services. Yet, we still fail to understand that the product money is still being provided in the most centralized and collectivistic manner possible: central banking.)

Because B does not see any reason to sell the note, Z needs to offer B more money for it than $10. Z offers B $12 for the note, B gladly agrees and the deal is closed.

The economy as a whole now has $12 excess in money supply. At the same time the value of a 3 year $10 treasury note that pays $0.45 a year for 3 years plus $10 at the end of year 3 has now gone up to $12 on the open market. This means that the annual interest rate it pays has now gone down to $0.45/$12 = 0.0375 = 3.75%.

B now has $12 in cash that he/she does not need and that he/she is looking to reinvest safely. B has real demand for savings. The reason why people demand savings is that they want to make sure they can retire once they turn older and become incapable of producing.

What is government most likely going to do now? Currently government has borrowed $10 cash and owes Z (the current holder of the 3 year note) $0.45 a month and $10 at the end of year 3. Government can now raise more cash at a lower rate. It will issue a new 3 year note that pays $0.45 a year and $10 at the end of year 3 and sells it to B for $12. B has invested his $12 safely at the current market rate for 3 year notes, 3.75%. His/her overall nominal situation has not changed. B still receives $0.45 a year and $10 at the end of year 3 after issuance of the note.

Government in total has now raised $22 in cash. Please note that $12 out of those $22 are not matched by any supply on the market. Government however has to and wants to do something with this money and in reality governments never have problems spending money. Governments naturally do not have demand for savings because they don't need to save. Governments can always raise money by forcing people to pay taxes and naturally do not need to worry about savings.

Government will purchase an existing product on the market. The price for that product will inevitably go up afterwards because as we determined there is no additional supply matching the excess money. Wealth has been shifted to government. All other participants in the economy are worse off because prices increased without them having more money in their pockets.

This would not have happened, had Z not supplied the economy with money it did not need based on its natural development and expansion.

We have now gone through the process of printing money and we have seen how new money ultimately ends up in the hands of government. We have determined in the beginning that inflation causes problems if excess money is not provided evenly but rather to a certain group of people.

In our example this group of people is represented by government. Government is the main inflation beneficiary while all other participants are inflation losers. Governments all over the world keep increasing their debt while central banks are providing more and more money.

In my simple example here I assumed that government is represented by ONE individual.
We all know that government in reality consists of a multitude of people, paid with the money government makes by raising taxes and issuing government notes and bonds. It is very important to understand that we have to differentiate between the entity government itself and its representatives and officials. Those individuals are paid with government money, personally they do not have any obligation to the people government borrowed money from. The entity government itself still remains liable for all its debt while its officials don't. Government officials are the people who make the decisions on what to do with the money. The burden is ultimately on all those people who are not enriching themselves as government officials by paying themselves excess money, ultimately it is on the taxpayer whose tax payments serve as a collateral for all government debt.

I will write a separate detailed article about this but my general point of view is: Checks and balances in governments usually fail because bureaucrats have accomplished a governmental structure where government is not removed in case it pursues substantially flawed politics.

Governments, once elected, generally stay in power for a certain term and the way they finance themselves is widely accepted. Governments are controlling most of the economic information published and relentlessly exploit the fact that people mostly do not have enough knowledge about money, inflation, and government finances.

As long as people do not understand that central banks are the root cause of inflation or even become comfortable with the fact that there is inflation and that we have to live with it governments can stay in power and pursue inflationary policies and benefit from it.

There are certain means that enable mainstream economists and politicians to achieve the aforementioned:

• Using a wrong inflation indicator: Mainstream economists and politicians like to use a certain set of product prices (basket) as inflation indicator that usually stays at around 2%-5%. This leads people to believe that there is no significant inflation. They even come up with indicators like the "core inflation" that for some reason omits oil prices. How about we just remove all products from the basket and luckily announce that we have finally achieved a permanent 0% inflation?

• Keeping the inflation within certain limits: In order to avoid a hyperinflation which entails a so called bank run and a complete collapse of the monetary system and hence of governmental power, inflation has to stay just below a certain level. This way people rather accept that they have to live with it. This requires certain times where the central bank slows down the growth of money supply. These are the times where the central bank appears to bravely step up to the plate in order to fulfill its solemn duty of "fighting inflation". This procedure entails a period of declining prices, for example on the stock markets or in real estate, and of an overall decline in the in the growth of the number and value of products produced. Assets or products that were previously overvalued due to the previously exuberant money supply are now beginning to lose value due to the slowdown in money supply. The artificial demand for products and assets declines, people start losing their jobs, especially in the fields that were mostly affected by inflation. A good example is just ahead: we will see this very soon in the real estate industry. Overall production growth slows down. This period is called a "recession".
  

Consequences of Inflation

In the following I will describe the main problems that arise if central banks and governments keep pursuing inflationary policies. These problems would not occur if the central bank actually did what it is supposed to do and if it did not base and justify its existence on forceful laws.

Unfair shift of wealth

Inflation beneficiaries can buy products and assets at low prices. After that fact, prices for those products would go up reflecting the now lower supply. The inflation beneficiaries own products and investments that are now worth more while inflation losers are facing higher prices and a lower life standard because they cannot afford products they were able to afford before.

Misallocation of resources

Because prices for certain products and assets are rising people realize that there is money to be made. These are what I call "inflation adaptors". They start doing work that deals with selling products with rising prices.

An example would be the stock brokers during the inflationary boom prior to the stock market crash in 1929. An excellent current example is the real estate industry. The housing sector, which typically represents just 5% of the total economy, accounted for 50% of the overall growth in the U.S. economy in the first half of 2005. More than half of the private payroll jobs created since the fall of 2001 were in housing-related sectors.

People start working in sectors and providing services that they would not provide if there was no artificially created demand for those products due to exuberant money supply.

Business cycles

Due to the ever instable nature of today's process of money production and supply we have massive ups and downs in the amount and value of products and services provided by individuals and entities. This entails a permanent cycle of boom and recession along with ever changing numbers of unemployment and growth.

People have been conditioned to accept this as a "natural" inevitable phenomenon that is inherent in the nature of the economy. Mainstream economists and politicians tend to blame problems on "the overall economic circumstances" during bad times, again exploiting the fact that most people do not have sufficient knowledge about money, inflation, and government finances. (Other popular scapegoats for these governmental failures are evil speculators on financial markets, mean big corporations that greedily jack up prices to make more money, mean big corporations who fire people because they enjoy doing it, foreigners who dare to have the indecency to not buy our products anymore, terrorists, communists, capitalists etc... whatever is convenient to pick at a particular point in time.)

This point of view implies that "the economy" is an entity, if not a creature of its own that permanently changes its state of mind if not its mood for no particular reason.

If however you trace these problems back in an elaborate and thorough manner you will realize that government, in particular the central bank itself is the very reason for these instabilities.

Frustration

People who do not benefit from or adapt to inflation do not understand why wealth can be a result of a lucky investment and why the dollars they earn with hard work buy them less and less.

The main problem here is that people are not informed about the root cause. So they begin blaming random or seemingly obvious scapegoats that are presented to them by government.

The apparently unfair redistribution of wealth naturally causes frustration and a climate of uncertainty and rivalry which again affects overall economic conditions, people's lives, their relations amongst each other and their well-being.

Vicious inflation cycle

The only times your hear mainstream economists and politicians complain about the central bank are when the growth of money supply is slowed down in order to avoid hyperinflation. The majority of people follow accordingly, not knowing the true circumstances and the reasons why this is happening in the first place.

As Mises puts it:

"As human nature is, everyone is prone to overrate his own worth and deserts."

Hence, people tend to take credit for money they make during inflationary times, instead of realizing the true reason is the policy of the central bank. Then, in times of recession people see that the central bank slows down monetary growth and blame the recession solely on the insufficient supply of money.

This ensues a vicious cycle. Instead of realizing that the reason for the recession is the preceding inflation, people call for more inflation in order to end the recession.

More power to government

Government, as the main inflation beneficiary, has created an environment where there is always demand for its government bonds.

We have seen that it has the ability, at the expense of the private sector, to make more money by persuing inflationary policies and hence stabilize its power of forceful rule over people from the private sector.

I will get into this in detail in a separate article: We should never forget that when governments first started inflation, it was because they had to find a way to finance their bloody and forceful wars. No one would finance those on a voluntary level so goverments found a simple solution: printing money out of thin air, of course at the expense of the inflation losers.

Ultimately, inflation takes freedoms and liberties away from people and fosters a more and more unethical and forceful establishment of government, government agencies, and government contractors.

Money

This site has moved to http://www.economicsjunkie.com/history-of-money/

"With the possible exception of international trade, no topic in economics contains more myths than monetary theory." (http://www.mises.org/story/2057)

I am amazed by the fact that the most important thing that this world and our life seems to evolve around is still the most misunderstood economic topic at the same time.

A thorough discussion about economic issues is impossible though, if you haven't understood the way money functions.

First of all we have to be clear about why money was invented.

The Origins of Money

When society started evolving humans realized very quickly that they can't live in a self sufficient manner.

The crucial need for exchange of products and services and the division of labor arose because humans realized that the best way to improve their standard of living is letting everyone do what they do best and exchange products and services that one party deems less valuable for products and services it deems more valuable.

The reason why division of labor started evolving naturally is the fact that every human has different talents and abilities and that different geographical regions provide different circumstances for production and exploitation of natural resources.

A human being who tries to live in a completely self sufficient manner would be doomed to die from starvation with a very high certainty. Humans need to interact in order to stay alive and improve their status.

At a very early stage humans realized that if party A provides services or products to party B , party B does not always provide services or products that party A has demand for, however party B might be providing services to party C the next day and receive products or services that party A has demand for. Or, vice versa, party A might produce a product that no party in its vicinity has a demand for right away, but at a later point in time.

• Products and services needed to be channeled to their ultimate consumers in the most efficient manner
• In addition, differing time preferences of different parties needed to be bridged

The need for a medium of exchange, money, was born.

People started using products that would ultimately be used for consumption as mediums of exchange. For example, party A would produce a table, give it to party B, but instead of demanding a product that A would consume, A would rather ask for a product that he/she could give to someone else at a later point in time for exchange against a consumer product.

People started using different things as mediums of exchange, such as cattle, tobacco, tea, beans, or coffee. People started using products that made good mediums of exchange as such.

What are the requirements for a good medium of exchange?

• It has to be easily divisible
• It has to be easily measurable in a certain unit
• It has to be relatively scarce, so there is just enough for everyone to use it
  
• It should be relatively durable
• It should be homogeneous (same units should not differ in quality, e.g. two different pieces of it, both 1 ounce should have equal quality)
• It should be as widely accepted as possible

For example most people needed to eat, so cattle was accepted as medium of exchange. However, there were certain limitations as to how cattle could be used as money. For example it was not very divisible. Also different bulls could have different quality. Tea was very divisible, however, there was still the problem that one ounce of tea might be of worse quality than a different ounce of it.

This makes it clear that money is nothing but a product. A product that enables exchange which society has a natural desire for. It is not very different from answering questions, such as:

What makes a good lunch dish? (non-poisonous, healthy, pleasant taste, etc.)
What makes a good vehicle? (an object with wheels, etc...)
What makes a good material to build houses?( firm and solid structure, yet easy to apply inbetween bricks)

Individuals in a free market figure out the answers to those questions pretty quickly.

Over the centuries, in a free market, people tried lots of different products as money. Different commodities with more or less moneyish attributes competed against each other. Finally, over time people found that there was one commodity that fulfilled the requirements for a good medium of exchange best.

• It was easily divisible because it could be easily smelted and made solid again
• It was measurable in units of weight
• It was available just sufficiently not to lose value but could be used by everyone
• It was infinitely durable
• It was more homogeneous than any other potential medium of exchange
• It was widely accepted as an ornament and people enjoyed its beauty

The commodity that I am talking about, the one that prevailed as the best money in a free, unhampered society was gold. In addition to gold there was another metal that was not quite as scarce but also fulfilled all the requirements for a good medium of exchange: silver. Silver was mainly used for smaller transactions.

Again: People in a free, unhampered exchange market, tried lots of different moneys until the BEST moneys, gold and silver, prevailed. The value of products and services in gold units was determined based on the simple and efficient laws of supply and demand.

Gold Warehouses

People, over centuries, have always stored widgets and commodities in warehouses because they did not need them at that particular point in time but later. Also they did not always want to carry heavy things with them

They would receive a paper ticket from that particular warehouse which represented a claim for the item deposited.

The same was the case for gold.

People would deposit their gold in gold warehouses and receive a paper ticket that served as a claim for the amount of gold (in weight units).

Currency units, such as "Dollar", "Mark", "Pound Sterling" used to be nothing but another way of stating a particular amount of gold. The "Dollar" for example, was defined as 1/20 of a gold ounce, the pound sterling as slightly less than 1/4 of a gold ounce, and so on. This meant that the "exchange rates" between the various national currencies were fixed, not because they were arbitrarily controlled by government, but in the same way that one pound of weight is defined as being equal to sixteen ounces.

Because those paper tickets were claims to gold, people started using those instead of gold as a medium of exchange, always knowing that they could exchange them for the precious metal at any time and at a ratio stated on the paper ticket and stipulated contractually.

Gold warehouses started accepting paper tickets from other respected gold warehouses as a service to their customers. They would then approach the original issuers of those tickets and redeem the tickets for gold and by doing so take that burden away from their customers, of course demanding a price for that service.

Soon the gold warehouse owners would notice that they would always have a certain amount of gold available that would not leave their vaults. Hence they would create more paper claims to gold than they actually had gold lend them s to other people as loans and earn interest money on them.

By doing so they were violating their contractual obligation to their clients. They were committing fraud and thereby violating one of the most basic rules of ethics. At the same time they were causing inflation with its negative effects as outlined in "Negative Impacts of Inflation". Of course their clients were not stupid.

As it is in every type of business in the free market, customers will swiftly notice that something is wrong and switch to a better service provider. In the gold warehouse business, customers would notice that the value of the paper tickets was depreciating and quickly redeem them for gold at the ratio stipulated. Those gold warehouses that printed too many paper tickets would pretty soon be bankrupt and go out of business - a just punishment for their unethical and harmful practices.

The free market puts severe limits on malpractice in any type of business, and so it did in the money storage business. There is a history of bankruptcies of gold warehouses, or "deposit banks" as they would soon be called ("Deposit banking" significantly differs from "loan banking", back then the two proffessions were performed by different types of institutions, but that's a different story.) Bankruptcies, that were the well deserved result of malpractice and low quality service.

Soon it would become a major success determinant for banks to be widely trusted and to make sure their paper tickets don't lose value. It was in their own best interest not to perform malpractice. The forces of the free market ensured that banks would have a natural incentive to make sure their customers could redeem their paper tickets for gold.

The period during which this system flourished in the United States was called the classical gold standard. It was the era between 1815 and 1914. During that period, the USA swiftly became one of the most prosperous and advanced countries in the world. Unprecedented growth and technological progress were achieved, such as the application of electricity, the build up of railroads, and the invention and implementation of telecommunication systems.

As Rothbard puts it: "The international gold standard meant that the benefits of having one money medium were extended throughout the world. One of the reasons for the growth and prosperity of the United States has been the fact that we have enjoyed one money throughout the large area of the country. We have had a gold or at least a single dollar standard with the entire country, and did not have to suffer the chaos of each city and county issuing its own money which would then fluctuate with respect to the moneys of all the other cities and counties. The nineteenth century saw the benefits of one money throughout the civilized world. One money facilitated freedom of trade, investment, and travel throughout that trading and monetary area, with the consequent growth of specialization and the international division of labor." (http://www.mises.org/money/4s1.asp)

Government Meddling

Governments pursue the profession of exercising power over people in a forceful and coercive manner. Unlike in other professions and organizations, competition amongst governments leads to bloody and fierce battles. Over history governments have always tried to find convenient ways to finance their wars. Taxes were one option, however back then people were aware of the fact that governments don't spend money responsibly. Any slight increase in taxes would lead to fierce resistance and rebellions that even the police or the military could not withstand easily.

Another option was to obtain loans from industrials and banks. This was a great opportunity for those banks who intended to print more paper tickets than they had gold in their vaults. A fateful collaboration between private banks and governments evolved.

Some banks would print paper tickets out of thin air and supply those as loans to governments. This ensued all the typical effects that inflation has on society. What happened to the blessing forces of the free market? Of course people who were using these banks to store their gold would recognize that their paper tickets were losing value and that they would probably not be able to redeem them for gold ("redeem them in specie"). This would lead to a so called "bank run".

What did the banks do? Usually, in a free, non-coercive market they would not stand a chance, they would go bankrupt and be out of business. However, since they now had the support of a powerful, coercive, and arms-bearing organization, namely government, they sought for help with it. Following the principle "You scratch my back and I'll scratch yours", governments would now permit their banks to refuse specie redemption to their customers. - Probably the most fateful violation of property rights in all of history. Resistances would be crushed violently and people had to accept the fact that they would not be able to redeem in specie. After a precedence was set, governments all over the world would occasionally, and with all their power of arms and police, grant banks that financed their wars the permission to suspend specie redemption.

Banks would always try to pursue inflationary practices if they could. They would be amongst the inflation beneficiaries and could maximize their income that way. As we have seen, the free, non-coercive market system put strict limits on these ambitions. However, as soon as governments started meddling with the money market, banks realized the opportunities that this entailed. Those "private" banks that were working in tandem with the government, were the strongest proponents for the establishment of a central bank. Why?

We have seen that some banks have tried to maximize their profit by printing more paper tickets than they had gold in their vaults. We have also seen that this malpractice was prevented in a free money system. Example: If a customer C were to own accepted paper tickets from bank A, but redeemed them with bank B because it is the only bank within its vicinity, ultimately bank B would approach bank A for specie redemption. Any exuberant issuance of paper tickets by bank A would immediately result in bankruptcy of bank A's business, as soon as bank B would approach them for redemption.

If not the customers themselves redeemed their paper tickets in specie with the original issuer, ultimately bank A would approach bank B to redeem tickets from bank B in specie.

Hence, in order to avoid these market pressures different banks occasionally tried to partner up and form cartels were they agreed to inflate the paper ticket supply but not approach each other for specie redemption. However, cartels or monopolies can't exist for a long time in a free , non-coercive market, no matter how large they are. Free market competition, entrepreneurs , and a dynamic venture capital market would always quickly put and end to their practices. In addition, as the paper ticket supply would ultimately lead to hyperinflation, the customers themselves would approach the original issuers and put them out of business.

The Central Bank

The only way for a monopoly to persist in the long run is by teaming up with an entity that specialized in the unethical profession of exercising force and coercion, namely government. This would enable the monopolists to ultimately use the forceful power of arms and police in order to make people accept the way it operates. In addition, government could always force people to accept a suspension of specie payment if needed.

A government supported central bank would give banks the opportunity to finally enjoy government's benign aegis and protect them from the bothersome forces of the free, unhampered money market.

This is how it would work:

• Government would inaugurate a law that would state that only paper tickets from one bank, the central bank, shall be accepted as claims to gold and as mediums of exchange
• The central bank would store gold and provide paper tickets as claims for gold evenly to all private banks
• Private banks would then inflate their paper ticket supply by providing more paper tickets or even just demand deposits (also called checking accounts) to its customers on top of the gold-backed paper tickets (fractional reserve banking)
  
• People who were not willing to accept the depreciating paper tickets in exchange for products or services were deemed criminals and violently forced by law to accept them
• Whenever an exuberant supply of paper tickets would lead to a bank run, government would grant the central bank permission to suspend specie payment

The establishment of this system would make life a lot easier for inflationary banks and debt-hungry governments. Banks were now virtually protected against free market forces and the threads of bankruptcy and competition; governments had found a convenient way of exploiting productive individuals in a more subtle and harder to unveil manner than taxation.

However, they still weren't satisfied. The biggest problem for them was now the bothersome dependency of paper currency on real money. In order to completely free themselves from any dependency they desired to change the system in a way that allows them to print paper currency without any ties to gold or silver. They desired to be able to print paper out of thin air and completely free themselves from any obligation to redeem in specie. This would finally free them from all remaining checks and balances.

All over the world, sooner or later governments would make their central banks go "off gold". Most of the time this happened with the argument of avoiding monetary "inelasticity". However, it was clear that the ultimate reason was the incentive for government and banks to establish a permanently inflationary system.

This system in essence means that government steps in and forces people to accept a lower quality money instead of a money that has prevailed in the free, unhampered market. Coincidentally, government itself happens the producer of this low quality money.

The exact equivalent of this a market, such as the automotives market, would mean that government produces one brand of cars and does not permit any competition within its borders. This is what the governments of the former Soviet Union experimented with. I think this makes it a little more obvious how devastiating the effects of a 100% government controlled paper money system will ultimately be.

The United States were the last country to go off gold in 1970 under president Nixon subsequent to the collapse of the Bretton Woods system.

This is how we got to the monetary system of today, as described in the article "Negative Impacts of Inflation".

This system can only persist under a strong, forceful and coercive government that constantly violates the most basic ethical guidelines. Over centuries, the centralization and the monopolization of the money market went hand in hand with an ever growing and powerful government.

The government imposed central banking system has reshaped the money market from a decentralized, efficient, and fair system to a centralized, inefficient, and unethical one that allows for major violations of property rights where malpractice is not punished by the natural forces of the free, non-coercive market.