The True Money Supply

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The money supply in a country is the total nominal value of money ready to be spent in its respective territory. Money is a medium of exchange. This is its ultimate purpose. All other so called money functions, like value storage medium, measure of utility, etc. are nothing but derivatives of this function. More precisely, money is that medium which is accepted by virtually everyone as a medium of payment in exchange for products and services rendered.

As explained in 'Credit Expansion', the major business cycles, booms and recessions are caused by an increase and subsequent slowdown in money supply, respectively.

If one carefully tracks the true stock of money and its growth or contraction over time, one can make fundamental assessments and predictions about the state of the economy and the outlook for asset and consumer prices in general.

The Federal Reserve Bank employs two measures for the money supply: M1 and M2. It also supplies other data, called 'Other Memorandum Items' which in its opinion is not part of the money supply.

We shall analyze each component of the data provided, and figure out whether or not it should be included in the money supply.

A lot has been written about the true money supply. There are completely different views on this matter. However, the solution to the question is pretty simple so long as one agrees that the definition of money is that it is the medium of exchange accepted by everyone.

Each component simply has to pass the following test: Is this item accepted by virtually everyone as a medium of exchange?

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M1: Currency + Traveler's Checks + Demand Deposits + Other Checkable Deposits

Currency: This is cash money in the pockets, lockers, mattresses, or hands of individuals. Cash, when printed and used by the federal reserve to purchase assets and thus channeled into circulation increases the nominal amount of media of exchange available in society. Virtually everybody accepts cash as payment. It is without a doubt a component of the money supply.

Traveler's Checks: Traveler's checks are issued by American Express and other credit institutions. A traveler's check has to be purchased in exchange for currency or checking deposits. Money is transferred from the purchaser's account to the company issuing the traveler's check. When used, money is transferred from the issuing company's deposits to the person redeeming the check. Hence, traveler's checks do not add to the overall availability of media of exchange, they are merely a means to facilitate the transfer of actualy money. Traveller's checks are not commonly accepted as a means of payment inside the US. They are not to be included in the money supply.

Demand Deposits: Demand deposits are checking accounts. Additional checking account money can be created in different ways: When people deposit cash money in exchange for demand deposits, the overall money supply does not change. However, if we observe both figures, then all cash deposits will reduce the 'Currency' account, and increase the 'Demand Deposit' account. Another way of creating demand deposits is when the central bank issues new demand deposit money instead of printing new money, and purchases bank assets with it. In addition to that, banks may issue credit themselves by making out loans that are not fully backed by deposits. This money will appear on the loan recipient's checking account. Checks can be written against them. Virtually everyone accepts payment in demand deposit money. Demand deposits are thus to be included in the money supply.

Other Checkable Deposits: These are savings deposits that can be drawn upon when demand deposits are overdrawn. But a savings deposit is not part of the money supply. A savings deposit does not function as a medium of exchange. When someone deposits money in a savings account the bank turns around and invests the money in credit instruments. It will then appear on the checking account of the seller of the credit instrument. The does not change when the savings deposit can be partially drawn upon. A buyer of a good cannot write a check against his savings deposits. At the best he writes a check against demand deposits that he is going to obtain after liquidating a fraction of his savings deposits. It would be rather impossible to try and use one's savings deposits as a means of payment. No one would accept a payment 'in savings deposits'. This even applies to that portion of it which can immediately be turned into checking account money. The recipient of a check written against the checkable portion of a savings deposit still demands checking account money as final means of payment. Thus the payer's savings deposit dollars need to be converted into checking deposit dollars settling the transaction. (If this was NOT the case, savings deposits and other checkable deposits would indeed be a part of the money supply.) Other checkable deposits are hence not part of the money supply.
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M2: M1 + Savings Deposits + Small-Denomination Time Deposits + Retail Money Funds

Savings Deposits: As explained above under 'Other Checkable Deposits', savings deposits don't function as media of exchange. Nobody would accept a payment from someones savings deposit straight to his savings account. But our definition of money is that is is precisely that medium which is broadly accepted as payment. Savings deposits are hence not part of the true money supply.

Small-Denomination Time Deposits: These are deposits where the depositor contractually commits to not withdrawing the money for a fixed time frame. Time deposits cannot be used as media of exchange and are hence not part of the true money supply, even less so than savings deposits.

Retail money funds invest in short-term debt, such as US Treasury bill and commercial paper. They are not used or accepted as media of exchange, and are hence not part of the true money supply.
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Other Memorandum Items: Demand Deposits at Banks Due To Foreign Commercial Banks and Foreign Official Institutions + Time and Savings Deposits Due To Foreign Commercial Banks and Foreign Official Institutions + U.S. Government Deposits + IRA and KEOGH Accounts

Demand Deposits at Banks Due To Foreign Commercial Banks and Foreign Official Institutions: These are checking account deposits held by foreign banks and institutions at American banks. Foreigners hold funds in checking accounts of other countries in order to cover expenditures in those same countries. These expenditures are covered using that contry's medium of exchange, money. They clearly are to be added to the true money supply.

Time and Savings Deposits Due To Foreign Commercial Banks and Foreign Official Institutions: As already explained above, time and savings deposits are not to be included in the true money supply.

U.S. Government Deposits: These are demand deposits held by institutions of the the U.S. Government at commercial and the Federal Reserve Bank. It is a curious fact that they have been excluded from the official money supply data. The money does not disappear from circulation. If A pays taxes to government entity B the funds are merely transferred from one account to another. The funds are used to cover expenses during day to day operations, pay employees, etc. and are hence a part of the true money supply.

IRA and KEOGH Accounts: These are, like savings and time deposits, merely investments in credit instruments and other investment vehicles and are not part of the true money supply.

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Retail Sweeps

One more important item to be mentioned are so called bank 'retail sweeps'. Retail sweeps were introduced in January of 1994 when the Federal Reserve Board allowed commercial banks to use a software that classifies certain portions of customers' checking account deposits as money market deposits accounts (MMDAs). Researchers at the regional Federal Reserve Bank of St. Louis have summarized it as follows:

"At its start, deposit-sweeping software creates a “shadow” MMDA deposit for each customer account. These MMDAs are not visible to the customer, that is, the customer can make neither deposits to nor withdrawals from the MMDA. To depositors, it appears as if their transactionaccount deposits are unaltered; to the Federal Reserve, it appears as if the bank’s level of reservable transaction deposits has decreased sharply. Although computer software varies, the objective is the same: to minimize a bank’s level of reservable transaction deposits, subject to several constraints."

This means that customers don't notice the slightest change to their demand deposit account. In effect, their behavior doesn't change at all, no matter whether or not their checking deposit has been reclassified. Retail sweeps are nothing but an accounting fiction that enable banks to lower their minimum reserves and lend out more money.

But this means that the statistics on demand deposit accounts have been inaccurate since 1994. That portion which has been reported as MMDA when it was actually demand deposit money to customers needs to be included in the money supply. The Federal Reserve Bank of St. Louis provides a monthly estimate on this number. Retail Sweeps are part of the true money supply.
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Conclusion: Thus the true money supply ( we shall call it M(t) ) is defined as follows:

M(t) = Currency + Private Demand Deposits + Demand Deposits Due to Foreign Banks and Institutions + Government Demand Deposits + Government Federal Reserve Deposits + Retail Sweeps

Below please find the development of the true money supply in the USA since 1960:



Click on image to view it in full size.

Antitrust and Monopolies

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The Objectives of Antitrust Intervention

Public opinion believes that the societal apparatus of compulsion and coercion, the government, should protect society from monopolies: Monopolies restrict the supply of products and harm the welfare of the common man. The government has to step in and put and end to this injustice. It's intervention is supposed to foster free enterprise and fair competition and protect the poor and hapless from powerful corporations.

The term monopoly needs to be defined more precisely here. There are two types of monopolies which, from a praxeological perspective, have completely different implications.

The supporter of antitrust enforcement by the government does not make a distinction between the two and hence arrives at completely flawed conclusions.

There are the 'Coercive Monopoly' and the 'Market Monopoly'.

The Coercive Monopoly is simply a monopoly based upon aggression or the threat thereof. It is not the monopoly that we need to discuss here.

The type of monopoly in question is the 'Market Monopoly': Antitrust proponents claim that an unhampered free market produces market monopolies and that it is the government's job to prevent this from happening.

The Market Monopoly

The market monopoly is a company that operates on the free market, meaning a market unhampered by aggression. A company in that environment is a group of people that jointly works towards withdrawing factors of production (raw materials, labor, etc.) from the market in voluntary contracts, and combines them in lines of production where they create products/services that are, from the consumer's point of view, worth more than where the factors were employed prior to withdrawal (which is implicitly expressed in a price premium).

This in itself is nothing but the schoolbook definition of a company on the free market, seeking to make a profit. The particular thing about a company that holds a market monopoly is that there is no other company that sells the same product. (The fact that every company in that sense has a monopoly over its own products, shall be passed in silence, and is a fact that antitrust proponents would not even bother looking into. For our purposes it shall suffice to consider similar products.)

But this does not change the fact that, based upon the law of marginal utility, the market monopoly company has to lower the price for every additional unit it sells to the consumers, in order to increase its profit. It also does not change the fact that it has to produce a useful product that satisfies a consumer demand. It also does not change the fact that this whole process is completely voluntary and peaceful on the part of the seller, as well as on the part of the buyer. It also does not change the fact that venture capital always stands ready to provide capital to entrepreneurs who are completely free at any time to identify cheaper processes and sell at cheaper prices and/or better quality, outstripping the previous monopoly, and ultimately reaping a profit to satisfy the profit-seeking venture capitalists, while at the same time improving the consumer's situation.

Yet, for the sake of the antitrust proponents' argument, we shall pass in silence all these facts and inquire as to what effects the government's antitrust intervention will have regardless.

The Antitrust Intervention

What antitrust proponents now ultimately suggest is that the social apparatus of compulsion and coercion, the government, impose a maximum number of products to be sold by this monopoly company, and step in with police force if the company dares to satisfy more consumers than allowed by its decree. The fact that the company, as well as the consumers, are merely acting voluntarily towards what they consider to be their best choice, does not interest the antitrust proponents: In their minds, the fact that the people, in their role as consumers with every penny and every dollar, are casting a conscious vote, by choosing to purchase the product they seek, is a mere expression of the ignorance and the gullibility on the part of the public. The government is omniscient, its will supreme. Its decree has to be followed and enforced when violated. How dare the consumers make the decision who to buy from!

Usually the government employs market share statistics, based on the revenue generated from the products in question. It decrees, for example, that company XYZ, is not allowed to sell more than the equivalent of 40% market share worth of its, say, operating system software ABC. Why exactly 40%? Why not 39.95% Why not 40.1%? There is no logic whatsoever behind this approach. It is so blatantly arbitrary that the antitrust doesn't even bother to justify it on scientific, or at least somewhat logical, grounds.

The Consequences of Antitrust Intervention

After the government steps in and limits the supply of the product in question, who ultimately suffers? The marginal consumers, who would have purchased the additional unit of the product whose supply has been cut off. How this attains the objective of fostering free enterprise and fair competition and protecting the poor and hapless (those who cannot afford it at higher prices until their margin is met) from powerful corporations, is yet to be answered by antitrust proponents. (Term explained: Marginal Utility) In fact, the policy attains the exact opposite.

True, after the government has intervened, sooner or later a new entrepreneur will step in and fill the gap with a similar product. (The fact that this can occur just as likely without any restriction of the market monopoly company shall be passed in silence.) However, he will not be under any pressure from from the previous market monopoly company. He merely stepped in to fill the gap, because the police intervened and outlawed by force any more sales from the market monopoly company. At this point, his position is not threatened at all. Due to his inexperience and lack of competitive pressure, his product will most likely be inferior to the previous market monopoly's product. It will take him much longer to get to a point where his product can measure up to the previous market monopoly company's product. Economies of scale will set in at a much later stage for this entrepreneur, so as he increases production, his prices will not drop as fast as previously. Marginal consumers will have to do with his inferior product for the time being.

The fact that a new entrepreneur steps in to fill the gap will not in the slightest make the market more competitive or fair. Quite the opposite: The coercive intervention creates a less competitive environment with less competitive pressure and the consumers ultimately suffer.

The policy of antitrust intervention is bound to fail.

Credit Expansion

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Objectives of Credit Expansion

Credit expansion is the activity where the authority or the business producing money (be it by mining gold or by printing paper money and making it legal tender by force) channels additional currency into the market by purchasing merchant bills, government bills or bonds or other credit instruments. In a monetary system based on gold there exist strict limits for money producers when it comes to credit expansion, due to the natural scarcity of the precious metal. In a system based on paper money (fiat money) there are no natural limits on the amount of additional curreny printed and used to purchase credit instruments.

The effect of credit expansion is that the interest rate charged for additional credit instruments drops.

Credit expansion is the policy that central banks pursue. It is broadly accepted as a measure to make society prosperous.

When the Federal Reserve Bank lowers the discount rate it really begins purchases of bills and bonds on the market, until the interbank interest rate is at its desired level. The lowering of the discount rate by itself has no effect because banks hardly ever draw upon this source of money.

It is its declared objective to make credit abundant. New credit channeled into the system is said to spur business activity, capital becomes inexpensive, entrepreneurs can borrow more money for investments, commerce flourishes and soon all of society is permeated by the magical boon that the additional credit boom bestows upon it. Everyone is supposed to enjoy all the products and services they have been longing for under the stingy policy of tight credit.

This idea is based on the substantially flawed assumption that capital can be created out of nothing. Capital can only exist if factors of production are available for use. Every investment necessitates the use of factors of production that turn out more or more valuable products after a roundabout process rather than consuming fewer or less valuable products immediately. Factors of production can only exist if people have generated savings. Savings are generated if one forgoes immediate consumption for the prospect of future consumption. Foregoing present consumption can only be feasible if a person considers the future remuneration he gets in return more valuable than the immediate consumption he sets aside. This is what is called time preference. Time preferences are expressed on the market in the form of interest rates. (Terms explained: capital, factors of production, interest, value, money)

This causality ensures that market interest rates always provide an indication of the availability of factors of production and individuals' time preferences. While prices give entrepreneurs an indication as to what products are desired or needed, interest rates provide a measure as to when they are desired or needed. It creates an environment where entrepreneurs have an incentive to fulfill demands based on value judgments and time preferences at any given point in time.

The Effects of Credit Expansion

It is now necessary to examine what the process of credit expansion entails. The central bank that creates money does not own any capital, it does not create factors of production. The only thing it channels into the market is pure fiat money, money that is enforced via legal tender laws.

Before examining the purchase of credit instruments it makes sense to take an intermediary step and look at the simple purchase of consumption goods. For example, if it were to purchase bread with the newly printed money, its governing board could decide to supply the bread to all its officials. They will be able to enjoy the bread while its price rises and bread will not be available to other would-be buyers who would have purchased it at a lower price that would have represented their value preferences. While on the market people can only buy things if producing things in return, and while all transactions are based on voluntary exchange and value judgments, the central bank does not act under these constraints. It skews the natural price of bread that would usually be based on voluntary value preferences and supply and demand. The result of this will be that entrepreneurs' judgment of value preferences will be skewed. Because it suddenly appears more profitable than before they will begin producing bread instead of another commodity that is located higher on the actual value scale of the actors in the market. The outcome is precisely that consumers on the market are not supplied with products as their voluntary value preferences mandate. What happens instead is that the supply of surplus bread is triggered by an arbitrary action on the part of a few central bank officials.

(As a side note: It is commonly understood that this inflationary purchase of present goods by printing money would be an unacceptable procedure of government arbitrariness. It was the method used by kings and emperors to subtly tax the populace and enriching themselves.)

The equivalent, however, occurs in the sphere of time preference if the central bank purchases bills or other credit instruments on the market. Providing a loan to someone is nothing but the obtainment of future goods. People demanding capital on the open market issue credit instruments such as merchant bills, governments issue government bonds and bills. The credit instruments purchased by the central bank will go up in price after each additional purchase, interest rates drop. Other providers of capital on the market whose time preferences were matched by the credit instruments offered will abstain from obtaining the corresponding credit instrument. Now the central bank has withdrawn future products from the market that would have gone to those who were outbid by it in the process of purchasing the loan contracts. They were not able to enter into a transaction that would have represented their time preferences. On top of that, the interest rates for the loan contracts purchased drop below the market rate that represents actual time preferences. This entails that the entrepreneurs' assessment of time preferences is skewed. They think that present goods against future goods are valued less than actual voluntary time preferences warrant. Those roundabout projects, that were not being embarked upon, because interest rates indicated time preferences in favor of less roundabout projects (whose goods would be consumable earlier) now appear to be feasible. Entrepreneurs begin embarking upon more roundabout projects that yield a produce in the farther future. At the same time they set aside those less roundabout projects which the market interest rates would have induced them to begin, had the credit expansion not taken place. The result is now precisely that consumers are again not supplied with products as desired as per their time preference.

The Credit Boom

Since no additional capital has been created via real savings, prices for factors of production used for the longer term will rise. The stock market, it being the main market for factors of production, will see a price increase, primarily in those stocks for companies whose projects yield a later produce. In particular, a lot of companies incorporate, that are currently not producing anything yet, nor plan to produce immediately, but are rather aiming to turn out goods a few years down the road, after spending time on roundabout research and production processes. As a tendency, the labour force of society becomes employed in roundabout long-term projects.

The Credit Crunch

The labour force, however, at the same time represents the bulk of the consumers whom those products are intended to be produced for. But their time preferences have not changed in reality. While being employed in very roundabout projects and processes, they still desire present goods over future goods more strongly than the entrepreneurs expected based on their assessment of interest rates. After the credit expansion is completed, consumer spending and saving habits will not be in line with those expectations. They demand more present products than are available and hence bid up their prices. Due to their shortage, an overall tendency towards rising prices for present consumption goods, such as food and gasoline, ensues. Market interest rates will now readjust in accordance with real time preferences again, based on savings generated. They will move up to the market level again. Incorporation of companies with overly roundabout projects will decline. Some entrepreneurs, who are in the middle of overly roundabout projects will not immediately realize this. They will keep employing resources in these projects. However, when they announce their new earnings expectations they will have to take the true time preferences into consideration. The products that were expected to be turned out in the farther future are not demanded by the consumers as expected. They will have to let the owners of the factors of production, the capitalists, know that their capital will not yield the return expected. This will cause a downward pressure on the prices of those factors of production used for overly roundabout processes. Correspondingly the prices for shares in such companies decline. They will be sold at prices that reflect true time preferences again. However, the time that resources have been employed in overly roundabout projects has been wasted. The true yield of their produce did not match the capitalists' expectations. The capitalists have suffered a loss.

Some of the factors of production can be easily channeled into new lines of production, in particular the factor labour. Others however, those which are fixed and specific to one particular project and are merely half finished may be forever lost, in particular this will be the case for huge construction or manufacturing projects that involve the erection of factories, machinery, etc. which have turned out to be useless.

Depending on the amount of surplus credit channeled into the market and depending on the duration of the credit expansion, the repercussions can be anything between mild and disastrous.

If this process of readjustment is not hampered with, the problems caused by the credit expansion will be within limits. The market will quickly recover, albeit, at a level that is less desirable than where it could have been at without credit expansion.

Conclusion

The objective of credit expansion, namely to ensure that more capital is generated in order for the market to provide more of what consumers demand, fails. In fact, it has the opposite effect. It skews the entrepreneurs' judgment and makes them align resources to produce products that consumers are not demanding and makes them use factors of production for processes that turn out products later than consumers are demanding them while withdrawing them form those production processes that would have been in compliance with consumers' time preferences.

Historical Relevance

The policy of credit expansion has been pursued by governments time and time again. It has become prevalent in the United States under President Woodrow Wilson after the inauguration of the Federal Reserve Act during the Christmas Holiday of December 1913. Since then, it has caused major credit booms and crunches in the form of stock market and real estate booms and subsequent crashes and economic booms and subsequent recessions. In particular this has been the case in the years of 1929, 1987, and 2001. It has always precipitated precisely the effects outlined above. Its workings and effects have been fully explained by this theory of the business cycles. No one has ever refuted the correctness of this theory.

Yet, to date economists and politicians appear completely riddled as to what causes booms and crashes. It is claimed to still be a matter of discussion amongst experts. It has been attempted to impute it on humans' greedy nature and natural exuberance. Whenever a crisis emerges the greatest supposed experts, central bank representatives, and politicians call in meetings and try and regulate the market to stave off the impending crunch. They forget or don't have the intellectual capacity to understand that it has been their own policy that has caused the crisis in the first place. As long as the central banks keep pursuing this policy, there is no need to be surprised when the next credit crunch occurs.

Economic Principles

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The Scope of Economics

Economics is a subset of the science of Human Action. Human Action is the science of purposeful human behavior.

It is divided into two branches: Praxeology and History

Praxeology

Praxeology's main tenet is: At any time, in acting, humans choose in a purposeful manner between options at their disposal in order to remove felt uneasiness. Each human being decides for himself what he considers a removal of uneasiness (, meaning value judgments as to what ends to attain cannot be contested via scientific analysis). The only judgments that Praxeology can render is whether or not a chosen option will attain the end sought and whether or not it will lead to a state that is even less desirable than the current one from the point of view of the acting man or men.

Praxeology does not examine how an idea to perform an action came into existence. It takes the action and its consequences as such. The science that deals with the emergence of ideas in the human mind is Psychology. Praxeology starts where Psychology ends.

Economics, as a subset of Praxeology analyzes those actions that are triggered by and that lead to changes in money prices of products, factors of production, and services. All actions analyzed within the scope of Economics can also be explained on a higher level by Praxeology. However, there are actions that Praxeology can explain but that Economics is not concerned with. Hence, Economics is a subset of Praxeology.

Other branches of Praxeology, viz those actions and ends sought that are not connected with monetary values, are not very well developed yet and leave a lot of room for research and literature.

History

History is the science that deals with purposeful human actions as they occurred in the past. It uses all records and information at its disposal in order to reconstruct actual datums. However, it also needs to resort to a measure that is unusual in science: Understanding (in German: Das Verstehen der Geisteswissenschaften). It needs to attach meaning to the actions performed. It needs to speculate what goals the actors in question were trying to attain and interpret actions and consequences based upon concepts rendered by Praxeology.

If it weren't for the tool of Understanding, historical events would be nothing but a meaningless juxtaposition of events involving human beings. It would not be substantianlly differnent from physics or mechanics where the behavior of atoms and elements and their impact on one another is observed, noted down, and used in order to determine causal relations and constant factors.

There is no such thing as constant factors in Praxeology and History. There are causal relations, but the extent to which one action precipitates a certain effect cannot be determined apriori.

People often make the mistake of trying to come up with general economic laws based on historical events. This is a serious blunder. Economic laws can only be conceived by the means of clear ratiocination, logic and reasoning and have to be refuted in the same manner.


Economic Concepts and Terms

Value

Each man juxtaposes all products and services available and decides which ones are more and which ones are less valueable to him, meaning which ones he feels remove more and which ones he feels remove less felt uneasiness, or, to put it different, which ones make him more or less happy. He places them, as it were, on a relative ordinary scale. Values are always relative and always spring out of the human mind.

Exchange

Voluntary exchange is a purposeful action. People exchange things when they feel that what they receive removes more uneasiness than what they set aside. An exchange between two people can only occur if each party deems the thing that the other party will provide more valuable than what he will give away. Economics in particular examines those exchanges that can be expressed in monetary terms.

Division of Labour

Humans have evolved from a system of autarky to a system of division of labour. Where in the past they used to homestead, till the soil, feed the cattle, harvest the crops and prepare their own food, they have started producing goods for other people and obtain other goods in exchange. This is a direct outcome of the concept of value preferences and judgments. If what people can obtain in exchange is to them worth more than what they produce for themselves they will enter into an exchange. The system of division of labour makes people specialize in certain fields and by that increases their labour's value to others who in return specialize in other fields. This system is hardly opposed by anyone. Its merits to society have been so obvious that it can hardly be imagined to ever be abolished. Even the socialist theory has adapted the concept of the division of labour as a necessity for a societal organization that provides what people need.

Money

The term money is tantamount to the term medium of exchange. A medium of exchange is a thing that people posess in order to exchange it for another product at a later point in time. More on money in the article History of Money.

Prices

A price occurs during an exchange. It is the direct outcome of the acting individuals' value preferences. It expresses how much of one thing a person is asking for in order to set aside another, eg. a seller of bread sells one loaf of bread for 5 tomatoes. In this transaction the price of the loaf of bread in terms of tomatoes would be 5 tomatoes. The price for a tomato would be 1/5 loaf of bread. As the division of labour intensifies and people begin accepting one common medium of exchange, one money, all prices are implicitly expressed in terms of money. They can only be made public and function in a society where people can exchange products and services based upon their own value judgments. They are the focal indicator of human value judgments and preferences in society.

Marginal Utility

The formation of prices on the open market does not occur at once and it never rests lastingly. The price a man is willing to accept for something, eg. a loaf of bread, is initially infinite. He then notices that he has to lower the price in order to find an exchange partner whose value judgments are being expressed by it. In doing so he may at one point arrive at, say, 10 tomatoes for one loaf of bread. He might want to sell more than 1 loaf of bread in order to obtain more tomatoes. He will then have to lower the price again in order to find the next highest bidder and so on. He will keep doing this until the additional number of tomatoes he could obtain from selling one additional loaf of bread (his marginal utility) does not suffice and does not represent his value preferences.

Inflation

Inflation is an increase in money prices of products that is due to an increase in the supply of money. It can be explained by consistently applying the theory of price formation to money. Producers of money have to lower the price for money expressed in other goods if they wish to sell additional quantities of their money.

Economic Goods

Because economics is only concerned with goods that have prices, it deals with scarce goods. The land that nature has bestowed upon us and the labour available are not infinite. All land, land transformed into factors of production, labour, and ultimately consumption goods are by necessity limited in number. It is the our task to find out which system of societal organization ensures the largest number of people are supplied with the largest number of demanded goods possible, always under the constraint that land, labour and factors of production are limited.

Interest

The true source of the formation of interest rates is the fact that all men, everything else being equal, prefer a product now to a product received in the future. Where prices establish an indication of value preferences at any point in time, the originary interest establishes an indication of time preferences. When a man enters into a contract where he provides 10 tomatoes now for 12 tomatoes in exchange in one year, the annual interest rate would be 20%. In a money economy, where one common medium of exchange has been accepted by everyone, interest rates are the subject of monetary loan contracts, viz the provision of money now in exchange for money in the future.

What has been said about the formation of prices applies accordingly to the originary interest. It emerges based on considerations of the marginal utility for each additional loan contract. It emerges in a different way for different contract durations. Thus we have different originary interest rates for durations of 3 months, 1 year, 3 years, etc.

In addition to the originary interest based on time preferences comes a risk premium. The person providing money now adds an amount to the money paid back that makes up for the fact that there is a certain risk that the money may never be paid back.

Thus the final rate of interest for each loan contract is determined by a) the originary interest based on the individuals' time preferences and b) the risk premium.

Consumption Goods

Consumption goods, or goods of the first order, are products or services that are used for the immediate satisfaction of wants. They are not transformed any further and are not used for anything else other than consumption. Their prices are established on the market based upon individuals' value judgments and preferences, as explained above. Example: Milk, Bread, Paintings.

Factors of Production

Factors of production, or goods of the higher order, are products or services that do not immediately fulfill any needs or wants. They are transformed or used up in order to turn out consumption goods in the future. They will only be demanded if the future produce they can turn out makes up for the foregoing of immediate consumption in their place, based on individual time preferences. Their prices are determined based on the prices of the future consumption goods that they are expected to turn out. Example: Labour, machinery, cattle, shares in a company.

Capital

The value of factors of production can be expressed in monetary terms. The monetary expression of the value factors of production is called capital. The total amount of capital available in a society represents the total value of factors of production available. Captial can only be formed by savings, meaning the foregoing of immediate consumption. Everyone who works and does not consume the full produce of his laobour adds to the capital stock available. He provides more than he withdraws from society. The total savings surplus in a society is necessarily used for additional factors of production as there is no equivalent consumption that uses up the surplus products or services.

Economic Roles

Economic roles describe modes of acting in society. They are abstract concepts to explain individuals based on their actions. In reality, they do not have to be separated from person to person. One person can embody several or all of these economic roles at once:

Entrepreneur

The entrepreneur realizes that a certain demand for a certain product or service exists in society. He estimates the prices that consumers would be willing to pay for this product or service based on their value preferences. He also estimates the number of people who would be willing to purchase the product or service. He then goes on the open market and tries to find out if factors of production are available that currently fulfill less urgent needs or satisfy fewer people than he expects to satisfy, meaning they cost less than he expects to earn from putting them into use. He then borrows the factors of production or funds to acquire them from the capitalists, combines them and turns out the products and services that he expects a demand for. If he was right, and his project improves the well being of more people than before or satisfies more urgent needs for the same number of people, he earns a profit, the entrepreneurial profit. He returns the factors of production to the capitalists that he has borrowed them from. This whole process can go on over a very long period and can be performed repetitively. All actions that the entrepreneur performs are geard towards this profit. It is his objective to maximize it at any point in time. All the decisions he makes in arranging factors of production, employing people, appointing managers are nothing but a means to maximize his profit. The entrepreneurial profit is the remuneration for an improvement in the standard of living in society. If the entrepreneur fails to make a profit, it means that he has withdrawn factors of production from lines of production where they would have fulfilled more urgent needs or satisfied more people. He is punished for this action by suffering a loss. If he consistently fails to make a profit he will have to give up his activity as entrepreneur and enter kinds of work where he is of better use to society.

Capitalist

The capitalist owns capital. He has acquired it by foregoing immediate consumption: savings. The capital he owns represents factors of production. He appraises these factors of production based upon the expected prices of the goods that they can turn out. He makes them available to the hightst bidding entrepreneurs when demanded.

Labourer

The labourer sells the service of performing work and in return receives a guaranteed payment from the entrepreneur. Different kinds of labour are of different use for different projects. Like for all other factors of production the entrepreneur has to offer his labourers a price that is derived from the price that consumers will be willing to pay for products turned out. If the labourer is remunerated higher in his current job he will decline. The more labourers for the same kind of work the entrepreneur wants to withdraw from the market, the higher a price he will have to pay per additional labour contract.

Consumer

The consumer purchases the consumption products sold by the entrepreneur. He is free to arrange his value preferences at his whim. All economic activity starts with the consumer who demands consumption goods. All prices for consumption goods and factors of production are ultimately the outcome of the value judgments of consumers. As has been said above, in the real world multiple roles can be embodied by one person. It is a known fact that virtually everyone in a free society is a consumer.

Equilibrium

Equilibrium is a theoretical construct. It is the state where no further changes can occur. It is the state where every single person is completely satisfied with what he has and does and does not desire anything in addition to that. Under equilibrium humans would not be required to act anymore as there would be no need to remove uneasiness. All humans would be perfectly happy. Economic equilibrium is never lastingly attained in reality. Everywhere and at any point in time do people desire change. It is true that they seek to attain equilibrium. However, this equilibrium is in constant flux. The market always moves towards equilibrium but the equilibrium always changes its parameters. It is the entrepreneurs' activity that at any point in time, unwittingly or not, moves the market closer to this equilibrium.


Violence

Violence is an act where one individual forces another individual to do something against his own will. It is in stark contrast to voluntary exchange.

Government

A government is an organization that, in last resort, can only exist by exercising violence over a certain definite territory. It needs to employ policemen and purchase armaments to supply them with. It forces the individuals that are under its supervision to pay a certain amount of money and hence withdraws goods from the market in order to maintain its existence.

Beauraucracy

Beauraucracy is a form of directing resources and putting them into use. It is in stark contrast to profit management as described under Economic Roles >> Entrepreneur. The bureaucrat gets allocated a certain amount of money beforehand. He then has to purchase whatever factors of production he thinks are necessary and make their produce available to the target market. The main challenge of bureaucracy is the fact that products are not sold at prices determined by consumers. It is hence impossible for the bureaucrat to determine whether or not the factors of production he has withdrawn are being put into better use. It is all based on his own value judgments, not on the consumers' value judgments.

Bureaucratic management is the mode of management that governments have to use. This is because government raises money based on arbitrarily determined taxes, not based on the market value of the services it is seeking to provide. If this were the case, governments would be able to bill people for the services provided at market prices. This is obviously not the case because most of the services that government provides are outlawed or highly regulated on the free market.

Ownership

Ownership in the economic sense is exercised by a man over a thing or a number of things. It means control over their location in time and space. The owner only decides what happens with the owned things. Ownership must have emerged out of initial occupation of land, where land refers to whatever nature has to provide. In the early days men would homestead land, build their homes on it, cut down trees, till the soil and produce their own food, hence own the land they transformed and the produce it yielded. From then on, ownership could be transferred to others, either voluntarily or by violent occupation. It is true that in early days most land was swiftly occupied by the strongest men and their initial owners turned into serfs who had to turn over most of the produce to the occupiers and new owners. This was the system of feudalism.

Capitalism

Capitalism is the societal organization under the private ownership of the means of production. All factors of production are traded freely amongst the capitalists based upon their expected yield, and hence upon consumers' value judgments and preferences.

Freedom

Freedom in the economic sense means absence of violence. It necessitates that the government is solely dedicated to the task of protecting the individuals property from violent intrusion. It necessitates that the police is dedicated to nothing but staving off any violence directed from one man towards another. It requires an absence of arbitrary violence from private individuals just as much as from government officials. The struggle of mankind, from the early days up until today, has been nothing but a struggle for freedom. All the societal advancements that we hold dear and hope to maintain today, like representative government, bills of rights, equality of every man before the law, congressional oversight, are nothing but a means to curb the government officials' arbitrary abuse of their power. Because the government's main skill is the exercise of force and coercion, freedom is by necessity a thorn in its side. The people in the executive branch of every government wish that there was no oversight, or if there is one, that it would not ask uncomfortable questions. For those peoples who have accepted freedom as their principle, it has always been considered the most precious thing to be preserved. Freedom can only permeate all of society if its merits are understood and realized by the broad mass, by public opinion. Freedom is not for granted. It is always at risk. If it is desired to be preserved, it is in every individual's best interest to be sceptical of what its government does, and by electing candid represetatives whose intention is to limit any arbitrariness that might be in opposition to peoples' individual value judgments.

Democracy

The idea of democracy is the outcome of the human desire for freedom. Democracy is a form of appointing government officials. The officials are elected by the majority. Recurring election cycles constantly ensure that different people be entrusted with the management of the societal apparatus of compulsion and coercion. Even under democracy a minority of people exercises power over the majority of people. Its objective is not to ensure at any point in time that the will of every single person is represented by the acting officials. This would be impossible. Just as a consumer cannot direct every action the entrepreneur takes, a voter cannot completely control the elected official's actions. Democracy's objective is rather that, to the extent possible, the government officials are always being questioned and monitored, that their arbitrariness be curbed as much as possible, and that they are always under the risk of being removed from power. Democracy's main merit is inner peace. Governments are replaced in a peaceful manner, rather than via violent subversion.


Socialism

Socialism is the societal organization of the division of labour under public ownership of the means of production. This means that all factors of production are put into use by a person or assembly that represents all people in society. The individuals' value judgements and preferences don't count. Because factors of production cannot be traded or owned by private individuals there can be no prices for factors of production. The central planning authority, when gathering its factors of production has no way of knowing if the factors it withdraws from other lines of production are currently fulfilling more urgent needs than their prospect employment will. The objective of supplying all of society with the maximum demanded produce possible, has to fail under socialism due to the absence of prices necessary for economic calculation. The only reason why in the Soviet Union prices could emerge was because the government used the prices of equivalent goods abroad which were turned out in capitalistic countries. They would completely disappear if the concept of socialism was consistently expanded around the whole globe.

Interventionism

Interventionism is, like capitalism, a system of division of labour under private ownership of the means of production. However, under this system, the government assumes certain responsibilities which would usually be assumed by private individuals. Also, the government tries to use force to declare prices that deviate from the market prices. The government expands its scope beyond the task of protection. This is the system of our age. All around the globe it has been adapted as the system of choice. It is said to combine the best of both worlds, socialism and capitalism. Economists have long proven that every attempt to improve peoples' well-being by intervening and exercising force will fail and precipitate results that are even less desirable than the current state of affairs from the point of view of the person or the group who intervenes or whomever they represent. Their analyses have never been refuted. It is the main objective of this blog to analyze different types of government interventions and determine whether or not the end sought will be attained.

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.