Robert P. Murphy does not understand fiat money

In “Let There Be Money” Robert P. Murphy shows that he does not really understand money. And he gets fiat money specially wrong.

He states that “the market’s classic commodity moneys have been displaced by unbacked State-issued paper”. State-issued paper is not unbacked: it is inconvertible or irredeemable, but it is backed by the assets in the Central Bank’s balance sheet; the quality of the backing may be low, but it is not zero. And paper notes are only a fraction of State-issued liabilities used as money: there are also private bank deposits at the Fed.

Unfortunately, the complaints against State fiat money can be imprecise at times, leading libertarians to form a faulty understanding of how money works. “Fiat money” is not unique to a coercive State. Neither does the State have the power to force its citizens to use something as money.

Here Murphy is right and he himself proves it: his analysis of fiat money is incorrect and he has a faulty understanding of how money works.

Fiat money is unique to a coercive State because that is what fiat means: by State order, decree, law or sanction. It helps to know some latin.

Commodity money is not the opposite of fiat money, and vice versa. A commodity can be fiat money it the State so decrees and manages to enforce that legal tender law.

When gold was embraced the world over as the market’s money, an ounce of gold was an ounce of gold.

And before that and after that, an ounce of gold was, is and will be an ounce of gold. That is not saying much.

When a State printing press takes paper and ink and creates new currency notes, those particular pieces of paper (covered with ink) become additional units of money because of the minting process.

The minting process is not the essential phenomenon. The production of liabilities of a central bank, whatever their form, is.

Privately issued, voluntary fiat monies are theoretically possible.

No, they are not, because they imply a contradiction.

Friedrich Hayek imagined private-sector financial institutions issuing competing currencies. I would also argue that bitcoin is a private-sector fiat currency (though in my view it is not a “money” yet).

Hayek did not call private currencies fiat money. Bitcoin is not fiat.

The term “fiat money” sometimes leads critics to declare that the State can turn something into money “by fiat.”

Fiat implies that the coercion of the State is essentially involved somehow. It does not imply that the State has infinite powers and can always achieve what it intends.

Murphy quotes Mises, who does not get it right either:

In order to avoid every possible misunderstanding, let it be expressly stated that all that the law can do is to regulate the issue of the coins and that it is beyond the power of the State to ensure in addition that they actually shall become money, that is, that they actually shall be employed as a common medium of exchange. All that the State can do by means of its official stamp is to single out certain pieces of metal or paper from all the other things of the same kind so that they can be subjected to a process of valuation independent of that of the rest…. These commodities can never become money just because the State commands it; money can be created only by the usage of those who take part in commercial transactions.

Actually, legal tender laws can do more than that: they can decree that a certain kind of money must or may be accepted for all or some payments (like taxes). Maybe the State is not powerful enough to have that law be respected, or maybe it is. And maybe the State does not need to be omnipotent, perhaps it only needs to provide a marginal advantage to some means of payment.

The existence of legal-tender laws and other regulations complicates the issue, but nonetheless it is possible that next Tuesday, nobody will want to hold US dollars anymore and so their purchasing power will collapse, with prices quoted in US dollars skyrocketing upward without limit. This has happened with various fiat currencies throughout history, and these episodes did not occur because the State in question repealed a regulation that had previously ensured its currency would be the money of the region. Instead, the people using that currency simply abandoned it in spite of the government’s desires, resorting either to barter or adopting an alternative money.

So legal tender laws complicate the issue, and the issue is so complicated that Murphy seems not to understand it. Some Austrians love arguments of the type of “it is possible that”: they do not specify how probable it is “that next Tuesday, nobody will want to hold US dollars anymore”. Fiat currencies do not fail randomly: they fail when they are badly mismanaged and when the State loses all or part of its coercive power.

We can at least imagine privately issued fiat money.

If we have a deeply defective illogical imagination, then yes we can!

Murphy does not even mention one of the main differences between moneys or means of payment: whether they are assets that are nobody’s liability (like a physical commodity or an abstract entity like bitcoin) or if they are assets that are somebody’s liability (credit money, someone’s promises to pay money, debt used as money).

It is possible to consider fiat central bank notes as non-liability money, but it must be done in a way that they can also be considered liability money. In order to understand this apparently paradoxical issue you need good knowledge of money, debt and banking.

Robert P. Murphy does not understand banking

In his article Banks Can Perform Their Two Functions With 100% Reserves, Robert P. Murphy writes:

Let’s start with the basics: There are two functions that banks serve:

(1) They act as credit intermediaries, in which the banks take funds from savers and channel them to borrowers.

(2) They act as warehouses, in which the banks store their customers’ deposits in huge vaults and provide services such as check-clearing and ATMs.

Murphy does not get the basics of banking right. Actually banks perform two main functions: payment managers and financial intermediaries (debt or credit intermediaries). Banks are not money warehouses; deposit contracts are not warehousing contracts. Banks perform their payment management function by issuing their own liabilities (bank notes and demand deposits) and ideally backing them with very short term and very low risk assets. Only a small part of those assets is money proper, therefore banks naturally operate with fractional reserves. Bank liabilities are not money in the strict sense (outside money, probably some commodity) but money substitutes, promises to pay money, fiduciary media (inside money). They are used by their clients because they can be more convenient than using only money. The problem with banks is not fractional reserves, but maturity and risk mismatch between their liabilities and assets (borrowing short and low risk and lending long and high risk).

According to Murphy:

100% reserve banking is possible in a market economy.

It is possible in the same sense that less efficient and competitive agents are possible: in principle they are not impossible, but competition tends to expel them from the market.

100% banking could work, yes: badly.

Martin Wolf and money

Money and banking are relatively complex issues and can be misunderstood in multiple different and sometimes complementary ways: different people understand and misunderstand different parts and then contradict each other. Many intellectuals are right when they criticize the misunderstandings of others, but they are wrong when defending their own views. They seem to think that because they know some cases of how others misunderstand money and the current monetary system, which is often correct, they do actually fully understand money and banking, which is most often not correct. They see errors in others but not their own ones.

Martin Wolf’s latest article (Strip private banks of their power to create money) about money and banking is a good example of how intellectuals and professional economists misunderstand money, banking, finance and the State.

The title is already wrong, as Wolf himself seems to recognize in the article:

Some people object that deposits are not money but only transferable private debts. Yet the public views the banks’ imitation money as electronic cash: a safe source of purchasing power.

Banks do not create money. They create money substitutes, private liabilities or IOUs that are often (almost always) accepted as means of payment, but they are not money in a strict sense. If the public mistakes them for completely safe money, that is the public’s problem: maybe some monetary education would help. That education will hardly come from Wolf.

Banking is therefore not a normal market activity, because it provides two linked public goods: money and the payments network.

Again, banking does not provide money.

Banking is a peculiar market activity, but in the market every activity is not normal in the sense that it is different from every other activity in some aspect.

Wolf seems to be logical and rigorous: he uses words like “therefore” and “because”. In reality he is rather clumsy in his arguments.

Money is not a public good. Money is a social institution and a network good. They are not the same thing, and mistaking them is a serious and disqualifying intellectual error. Money is easily excludable and its consumption is clearly rival. What money is today is a politicized good, highly intervened by the State. And that is why it works so badly.

On one side of banks’ balance sheets lie risky assets; on the other lie liabilities the public thinks safe. This is why central banks act as lenders of last resort and governments provide deposit insurance and equity injections. It is also why banking is heavily regulated. Yet credit cycles are still hugely destabilising.

The first sentence is true and very important: it is risk mismatch, which, although Wolf does not mention it, probably because he believes it is not important, goes together with maturity mismatch. The rest of the paragraph is completely upside down. Credit cycles happen and are hugely destabilising because banks perform maturity and risk mismatch; but they do it because central banks act as lenders of last resort and provide them with cheap refinancing when the market does not, because deposits are theoretically (not really) insured and therefore depositors do not keep an eye on their banks and discipline them, because the State injects equity (bail-outs) instead of having creditors assume losses (bail-ins) or letting imprudent insolvent banks fail, and because banks are heavily and clumsily regulated and supervised by the State.

Wolf compares creating private money (again, this is not the case) with printing counterfeit banknotes: one is legal, the other illegal. Wolf does not see that the counterfeiter is committing fraud; the bank is offering its liabilities as monetary substitutes which in principle nobody should be obligated to accept; unless the State forces them as legal tender, but this would be a problem caused by the State.

Wolf thinks that “the interdependence between the state and the businesses that can do this is the source of much of the instability of our economies”. He never considers eliminating State intervention and letting banks do their job and fail if they do it poorly. And he does not mention one side of the financial interdependence between banks and the State: how the banks buy State debt so that it can obtain cheap financing for its ever growing unsustainable spending.

Wolf understands that “banks create deposits as a byproduct of their lending. In the UK, such deposits make up about 97 per cent of the money supply”. And he thinks this should be terminated.

He does not mention that the problem is the maturity and risk mismatch caused by creating (short term) demand deposits as a byproduct of long term lending. There is no problem in the fact that most means of payment are not actually money but money substitutes: this is what happens when people pay each other with promises to pay, most of which will compensate each other and cancel out, and actual money is only exchanged in order to settle debts that cannot be compensated.

Wolf analyses possible minimal changes to the banking system: tighter regulation and more bank equity or loss-absorbing debt. The problem with this approach is that nobody really knows what regulation is adequate and how much capital is necessary; technocrats think they know, but actually only the market process can partially discover the solutions via trial and error.

Wolf then proposes a maximum response: give the state a monopoly on money creation. The problem is that this already exists: only the central bank can create base money. Base money is not a very good money as gold or silver used to be, but this is what the State has produced. There is no external money, all money is internal to some bank, private or public.

Wolf explores the proposal of the requirement for 100 per cent reserves against deposits (Chicago Plan and other modern versions): but he does not explain what he means with “reserves”, what their nature must be.

Under this proposal the State, not banks, would create all transactions money. Money would not be a free market good. It would be fully based on State coercion. Some people neither mind nor see the problems with this. Maybe they think the State is wise and non-coercive.

Customers would own the money in transaction accounts, and would pay the banks a fee for managing them.

Why should these accounts be in banks? If we are going to nationalize money, why not also the entities that hold those money accounts? What will the fee be? Aren’t there any opportunity costs in holding cash balances?

Banks could offer investment accounts, which would provide loans. But they could only loan money actually invested by customers. They would be stopped from creating such accounts out of thin air and so would become the intermediaries that many wrongly believe they now are. Holdings in such accounts could not be reassigned as a means of payment. Holders of investment accounts would be vulnerable to losses. Regulators might impose equity requirements and other prudential rules against such accounts.

This part seems great: saving and investment seem to be matched. They seem to be because Wolf does not explore the possibility of borrowing short and lending long, or borrowing low risk and lending high risk, which is still open. At least the payments system and the financial intermediation system do not interfere destructively as they do now.

Wolf insists that banks right now are not financial intermediaries and that many wrongly believe them to be so. Wolf is wrong: banks are financial intermediaries; the problem is that they are not only financial intermediaries and that they are imprudent financial intermediaries. Demand depositors are not the only creditors banks have. Yes, banks create deposits when giving loans, but banks also look for other longer term creditors to borrow from them: maybe they sell them the loans they created, or use them as collateral to borrow funds.

How will the money be created, according to this system? Easy:

The central bank would create new money as needed to promote non-inflationary growth. Decisions on money creation would, as now, be taken by a committee independent of government.

Finally, the new money would be injected into the economy in four possible ways: to finance government spending, in place of taxes or borrowing; to make direct payments to citizens; to redeem outstanding debts, public or private; or to make new loans through banks or other intermediaries. All such mechanisms could (and should) be made as transparent as one might wish.

This assumes that the central bank can promote non-inflationary growth. Good luck with that. The independent committees and the transparency sound very well: wish they could be real and competent.

The State is supposed to be all-knowing and good, caring for the welfare of all. It will never abuse its powers to create more money and cause some inflation. It will never make loans to benefit some at the expense of others. It will never devalue its currency competitively against other nations.

Wolf sees the advantage of increasing the money supply without encouraging people to borrow too much, and of ending “too big to fail”. But in order to achieve this all you need is truly free markets in money production (probably gold and silver) and banking. The State is unnecessary and the State is dangerous, specially if it controls money fully.

Our financial system is so unstable because the state first allowed it to create almost all the money in the economy and was then forced to insure it when performing that function.

Again, that story is completely backwards. The State is not “forced” to do anything. The State, incompetent as it is, does what it wants: it protects and saves its allies.

This is a giant hole at the heart of our market economies. It could be closed by separating the provision of money, rightly a function of the state, from the provision of finance, a function of the private sector.

We do not have market economies. At least not free market economies, by a very wide margin. Some people seem unable to notice the difference, and that explains a lot.

Yes, there is a hole in them. Actually, there are many holes in them. But they will not be plugged with wrong advice.

Separating payments management from finance is an important and a good idea. Uniting money and the State even more than they are now is a very bad idea. The provision of money is not rightly a function of the State, but a free market institution. Wolf wants to play the moralist: he knows what is right and wrong; he also fails here.

One last question that comes to my mind: for international trade and investment, what state provided money are we going to use? Or do we need a world government for that?

On private and state paper currency and counterfeiting

Informative, but:

Beginning with Massachusetts in 1690, the colonists pioneered the first government-issued paper money to appear in the Western world.

All the colonists agreed that it would be a good idea that their government issue paper money? Or was it the government which decided (maybe with some popular support) that it would issue paper money?

Convicted counterfeiters generally avoided the gallows, for the simple reason that the demand for money — real or counterfeit — outstripped the supply, and many juries saw counterfeiters as performing a public service.

Demand for real money not different from demand for counterfeit money? How strange that a government is not able to produce enough real money to satisfy the demand. Counterfeiters providing a public service by falsifying debt documents in order to gain wealth at the expense of others naive enough to accept their notes? It looks like popular juries are not always a good idea.

Most of the paper money in circulation came from private banks, not public governments. Counterfeiting was thus a crime aimed at a corporation, not the state. That meant that punishment was even less of a deterrent: a few years in prison, tops. Given that many of the banks issuing paper money were viewed as “legal counterfeiters” by people critical of unsavory banking practices (subprime lending is just the latest chapter in this country’s reliance on shaky credit), juries weren’t too willing to send someone to prison for imitating the notes of a bank whose own right to issue notes was far from accepted.

The state is supposed to defend private citizens from aggressions or breaches of contract, but it does not show much enthusiasm or ability at this task; what it really does is defend itself, and it did not have the monopoly on money issue yet.

If you do not accept the right of a bank to issue notes, just do not accept them yourself and do not try to pass them on to others if you happen to possess them. Also notes from low quality banks would tend to be less trusted, so counterfeiters would not seem to be very intelligent if they forged those notes instead of the ones from trusted banks.

All of this together meant a corruption of commercial ethics. Businessmen had a saying before the Civil War, which more or less went as follows: “Better a good counterfeit on a solid bank than a genuine note on a shaky bank.” What was genuine and what was counterfeit mattered less at this time than whether or not a note could be palmed off on someone else.

This really is corruption: it is better to try to cheat on others than to assume your risks or losses yourself. One of the biggest problems with money is the lack of distributed control of the institution, when individuals do not accept their own responsibility in controlling the quality of the circulating medium of exchange and just hope that others will be as careless as they have been; when the problem gets big enough they might demand that government intervenes in order to regulate money, and the ability to adapt and compete of the free system will disappear.

Counterfeiting contributed to economic growth, pumping much-needed (or much-wanted) credit into the economy, and helping to fuel the era’s breakneck economic growth. Such was especially the case in newly-settled regions of the country, where the demand for a medium of exchange was so great that people handling money were willing to overlook the fact that much of the paper in circulation was bogus.

Fake credit is not the same as real credit (are people still surprised about the current financial crisis?). Growth with fake credit is unsustainable. It might happen that people used fake documents as internal money in a closed area if local banking institutions were absent, but they would have trouble using that counterfeited money for trade with other areas where it would not be accepted. It would also be a highly unstable system, depending on trust that could suddenly vanish and prone to abuses.

When the South seceded from the Union, the North faced a serious funding crisis. Eventually, Lincoln’s administration reached for one of the only options available to them: the printing press. They issued paper money backed by the federal government (though the notes weren’t redeemable in “real money” for several years). These notes were the greenbacks, and for the first time, the nation had a uniform common currency. In time, economic nationalists passed legislation taxing the old system of private banknotes out of existence.

Government money is not a result of the spontaneous working of the free market. In this case it took a war to start the issue and a tax to destroy the private competition.

But the raft of legislation passed during the war gave the old banks an option: they could trade in their state charters for new, federal charters so long as they bought some treasury bonds (thus helping to pay for the war). In exchange, they got the right to issue notes.

The state gets a privilege to issue notes and quickly uses it to finance itself with the help of banks that depend on it. Soon the supply of money could not grow enough because there was not enough government debt to back it up.

These weren’t like the old notes, where banks got to choose the designs. Now, the federal government dictated the design; the only thing that differed in a given denomination of these new “national bank notes” was the name of the bank; everything else was standardized and chosen by the Treasury Department. All this new money was national in appearance: national heroes like the founding fathers were now in vogue.

This surge of nationalism meant a change in the climate of counterfeiting. What had formerly been a crime against often disreputable financiers was now a crime against the federal government. Anyone foolish enough to knock off imitations of the new currency now faced long jail terms and heavy fines.

Money is used as state tool to promote nationalism. Money is not the universal means of exchange any more: now it is enclosed within national boundaries. Financiers could be disreputable and prosecuted; government officials, even though they might occasionally be reputable, are the ones in command of the police, the courts and the jails, and they are not happy if someone interferes with their financial misdeeds.

Once the country began moving down the path of a common national currency, people started looking at money differently. Money became a means of cementing people’s allegiance to the United States: by handling it, you were tacitly putting faith in the fiscal rectitude of the nation.

At the same time, there’s a kind of blind trust that affects how we handle the currency in our wallets nowadays. Our money is so safe (for the most part) that we don’t even inspect it, save for the rare occasion when we get a high-denomination bill. Unlike people before the Civil War, who often spent several minutes inspecting every bill they received, we don’t look at our money. In fact, I suspect that many Americans can’t even remember the bills on which, say, Hamilton, Lincoln, Jackson, Grant, or Franklin appear, much less what shows up on the back of those bills. We trust our money so much now that we’re practically blind to it.

The land of the free becomes the land of the dependent on government, who trust it and believe that it can have fiscal rectitude. Blind trust in any institution destroys it, and that is the basic reason for our current problems with money and finance. Institutions only work if all persons using them contribute to their control.

Money, the dollar and China

Two good articles on money, the dollar and China.

With two serious errors by Nouriel Roubini:

Gold is still a barbaric relic whose value rises only when inflation is high.

Pure keynesianism. Compare with the other article: “In China, many people refer to the dollar as mei jin, or “American gold.”” Why would the Chinese call money “gold”? And, surprisingly, gold seems to be a good hedge against deflation.

Now that the dollar’s position is no longer so secure, we need to shift our priorities. This will entail investing in our crumbling infrastructure, alternative and renewable resources and productive human capital — rather than in unnecessary housing and toxic financial innovation.

The myth of the crumbling infrastructure rises again. Together with “alternative” and “renewable”, which related to energy means the most inefficient ones: solar and wind.

Financial innovation does not have to be toxic: government intervention in finance always is. Government is so incompetent at providing money that it had to outlaw the competition: gold, the barbaric relic.