Money and Credit

by Faustino Ballvé

Direct and indirect exchange. Barter and money. The history of money. Monetary theories. The money market. Credit and interest. Inflation and deflation. The price of money. Stable money. The gold standard.

At least since the time of Xenophon attempts have been made to formulate a completely integrated and coherent theory of money that would provide a comprehensive explanation of its value and its fluctuations. But what renders this difficult, not to say impossible, is not only the twofold function of money as both a medium of exchange and a commodity with a value of its own but also the interference of psychological and political factors in monetary affairs. Economists have been able to ascertain the causes of the value of money in relation to other monetary systems or to other things and services, but they have not been able to discover and are hardly likely to discover any single formula that can explain all these phenomena.

Logically and doubtless also historically, the originary form of the market and of the division of labor is barter. Direct exchange is converted into indirect exchange when the owner of something perishable or having but an intermittent or sporadic utility seeks to trade it directly for something more durable and more likely to be a regular item of consumption (salt, wheat, oil, cotton, etc.), in order to obtain with it, at an opportune time, other things or services that he may need. The commodity that is procured in the first of these transactions acquires the character of a medium of exchange. This medium of exchange is then perfected in the form of money.

Originally anything that was simply rare—and whose acquisition therefore involved a certain amount of labor on the part of whoever obtained it directly from Nature—like the shells of certain molluscs or the eyeteeth of certain animals, served as money. Later precious metals were used for this purpose, having a utility in themselves as well as in their capacity as media of exchange. Since it was both difficult and dangerous to lay up a great store of these metals, they were entrusted in the Middle Ages to goldsmiths, who issued receipts for the amount left with them on deposit. These receipts would then pass from hand to hand as their holders used them in payment for goods and services. Hence arose the business of banking. Instead of giving receipts for the sums placed on deposit with them, the bankers issued bank notes whose bearers could convert them into metallic money at the bank of issue, which backed them with the deposits.

In this way money accumulates in banks, and as depositors do not normally need to have all their money at their immediate disposal, banks pay them interest (with certain exceptions), the amount being smaller in the case of demand deposits, which can be withdrawn by the depositor at any time without prior notice, and larger in the case of time deposits, which are not payable before a definite date. Keeping on hand only what is needed to provide for anticipated withdrawals, the banks lend the surplus, charging the borrowers a higher rate of interest in order to earn a profit and cover their risk, and extend credit to those who merit their confidence or pledge a certain amount as security. Thus, bank accounts and checks, which are given and accepted in lieu of money, make their appearance.

And it is at this point that two kinds of governmental interference thenceforth take place. First, in order to prevent fraud in regard to the quality and the quantity of the precious metals serving as money, the practice of assaying and monetizing them is established, whereby they are certified as to weight and purity, stamped into coins of various denominations having a face value fixed by law (so many mills of fine metal for every one thousand of the alloy), and carefully minted. Then the government proceeds to establish a control over the banks in order to prevent them from issuing more fiduciary media (i.e., money-substitutes) than they have in cash on deposit. This control is entrusted to the central bank, to which the government grants a monopoly over the issuance of bank notes redeemable in metallic money. More recently, these bank notes have been rendered irredeemable and declared legal tender, and the central banks have been authorized to issue more notes than correspond to their reserves of precious metal or cash holdings. Then too, many countries have established an embargo on gold and silver and have withdrawn them from circulation, reserving them solely for the use of the government or of the central bank, except in amounts destined for nonmonetary uses. The final step is taken when the government is free to determine, more or less under the control of the legislative power, the amount of fiat money in circulation, i.e., paper money that is backed by nothing more in the way of reserves or security (even though an attempt may be made to hold in the central bank the greatest possible amount of specie or of foreign exchange in good repute) than the credit of the government or the confidence of the people in its fiscal and monetary policy.

This, briefly, has been the sad history of money—a history that has not been lacking in miracle-workers who profess to see in it happy auguries full of promise.

---

Let us now turn our attention to the theories of money. These, in the order in which they have appeared historically, can be reduced to three: the quantity theory, the qualitative theory, and the theory of the neutrality of money.

The quantity theory of money was first formulated by Jean Bodin, a Frenchman (also known as Bodinus, 1520–1596), whom many regard as the founder of scientific economics. Impressed, no doubt, by the enormous rise in prices in sixteenth-century Spain consequent upon the importation of precious metals from the New World, Bodin held that the value of money in a country is inversely proportional to the supply of goods on the market: the more money and the fewer goods, the less value (i.e., purchasing power) money has, and vice versa. The core of truth in this doctrine is the fact that money is a medium of exchange and, in relation to the goods and services that can be bought or sold, is subject to the law of supply and demand. Even today this theory cannot be entirely rejected, but it suffers from two defects:

1.  It is based on the assumption of an autarkic economy, i.e., that the money in question circulates only in one country and can purchase only the commodities for sale in that country; whereas in fact money, as well as commodities, has an international circulation, so that a country with an abundant supply of money and a scarcity of goods can be a rich country if outside its borders there is a scarcity of money and an abundance of goods.

2.  It is based, moreover, on the assumption that money is nothing but a medium of exchange, and that its only role in the market is as a means of payment for goods and services. But money, as we shall see, has other functions besides, which give it, as it were, a life of its own, and which appreciably influence its value according to the supply of and the demand for it.

The qualitative theory, which appears to have been formulated by John Locke (1632–1704), holds that the value of money is the intrinsic value of the metal it contains or represents. In this theory as well there is a core of truth that cannot be disregarded today, but it too fails to give an exhaustive explanation of the causal factors that determine the value of money. According to it, the Mexican peso, with the modest gold reserves in the Bank of Mexico, should be worth much less than what it is worth today, and, on the other hand, the dollar, with fifty per cent of the world’s gold in Fort Knox, should be worth much more.¹

The theory of the neutrality of money, attributed to another great Englishman, David Hume (1711–1776), was later held by John Stuart Mill and has since been accepted by many other economists up to the present day. According to them, money is merely a token of the value of things, or a means of calculating their value, without there being any reciprocal influence between money, on the one hand, and goods and services, on the other.

This doctrine goes astray because it is founded on a purely theoretical and provisional assumption, to which economics has recourse solely as an heuristic device to facilitate the study of the phenomena of the market, namely, that all exchange is essentially barter. But this methodological postulate, framed merely as a means of rendering an understanding of the market easier by isolating it, for specific purposes, from all other economic phenomena, in no way corresponds to what actually takes place. In the real world, there is interposed, between the goods exchanged on the market, another commodity, viz., money. Things are not exchanged for things, but for money, and the relation between every commodity and money is subject to the law of supply and demand: a thing is dear or cheap according as it costs more or less money. There is thus a fundamental difference between barter and the market properly so called. Barter is direct and bilateral, whereas the market, as expressed in money prices, is indirect and multilateral. Hence, it follows that money, as a commodity that is exchanged for things, has a value of its own that is determined by market factors, and in particular by its better or poorer quality and by its abundance or scarcity. More or fewer goods are sold for money according to the value attributed to it. One money is preferred to another. It is valued more highly if it is scarce and less highly if it is abundant. This does not mean that it therefore ceases to be a token of payment, but it is not only that; it is also a commodity in its own right, with a utility derived from its material and its function and a price determined by the demand for it and the supply of it.

Thus, none of the three theories of money that we have summarized is adequate in itself; all three must be taken together. Each one of them explains only a part of the truth, and perhaps something still remains to be explained. In any case, money is a medium and a token of exchange, as the theory of its neutrality asserts. It also has an intrinsic value as money by virtue of its material content as well as its specific utility, e.g., in making hoarding possible, as the qualitative theory holds. And, as the quantity theory recognizes, the purchasing power of money stands in a more or less mathematical relation to the supply of and the demand for goods on the market.

---

This brings us to the concept of the money market, about which there likewise prevails a good deal of confusion. People speak of money as abundant or scarce, as cheap or dear, without making any distinction between money and credit, although the two are altogether different from each other in their mechanism.

When businessmen speak of money as scarce or abundant, as “tight” or “easy,” they are not, in fact, referring to money at all, but to credit, especially bank credit, or the loan market. Thus, not long ago it was reported that the Bank of England had raised the discount rate on short-term (i.e., ninety-day) loans. This brought about an increase in the price of money—i.e., the rate of interest—another matter about which a fundamental error has prevailed since even before the days of the classical economists.

It is commonly said that “money begets money.” Indeed, some economists have gone so far as to assert that interest is the specific product of money, and that a loan is the renting of money. He who needs money hires it; that is to say, he borrows it and pays the lender, by way of rent, if not all, then a part of the product that the money will yield him. But the fact is that money is sterile. What is productive is labor in the broadest sense of the word: the labor of the entrepreneur, aided by the other factors and means of production. One of these is circulating capital. Now it sometimes happens that there is a scarcity of capital, so that the entrepreneur has to wait for a longer period for the final proceeds. He could then buy, with the money obtained from the sale of the product—a sum that he has not so far been able to get—raw materials enabling him to produce and sell more. With more money he could buy more machines and factors of production and expand his business. Now he has to wait. If he can find the money, he can have today what otherwise he must wait for until tomorrow. Thus, when he obtains a loan, he does not hire money; he hires time. The interest that he pays is the price of the advantage that he gains in having today what otherwise he would not have until tomorrow.

The value of a present good is always greater than that of a future good. For this reason the most common form of commercial loan is the discount. When the holder of a bill of exchange collectible in ninety days presents it for discount at the bank, he is advanced the amount of its face value less a deduction based on the discount rate, i.e., the prevailing rate of interest. The businessman pays this interest if it is worth less to him than the advantage of having immediately available the remaining amount of the face value of the bill in order to be able to employ the cash for the purchase of means of production. The same holds true for whoever lends money, whether a bank or a private individual, over the long or the short term. It is an advantage to have cash on hand. With this money one can, at any given moment, buy something that one wants or avail oneself of a good business opportunity that may arise in the future; or even in normal, peaceful times one can hope that prices may fall and one’s money may be worth more. But in the meanwhile the money is idle and produces no income. If someone offers for its use, by way of interest, an amount that seems to the owner of the money to be worth more than the aforementioned advantages of hoarding it, he will put it out on loan, because he prefers the immediate gain to the future gain. He too discounts time.

What, then, gives rise to the rate of interest, or the price of money? Nothing more nor less than the supply of it and the demand for it. Whoever has cash on hand demands, in exchange for the loan of it, a rate of interest that will yield him a greater advantage than he expects to gain by keeping the money. Whoever borrows money offers for it, by way of interest, an amount that he finds it less burdensome to pay than to wait until he obtains his own money. The outcome of the co-ordination of these mutual desires is the rate of interest.

What we have just described is the mechanism in the individual case. However, as there is not just one person who has money and one who needs it, but many who have it and many who would like to have it, and since nobody will lend money to anybody else at a rate of interest lower than what a third party is prepared to pay, and vice versa, the market rate of interest is determined in the same way as all other prices on the market. This is, in any case, the essence of the process, even though in actual practice other factors do play a role: some psychological, like the increase in the demand for money during a boom, when producers wish to take advantage of all possibilities and are ready to pay a high rate of interest; others of an institutional nature, like the intervention of the government’s central bank, which rediscounts the credit operations of private banks at a rate that to some extent affects their own discount rate.

---

All this refers to money loaned on credit, i.e., money considered as an auxiliary means of production and made available in what is called—according to whether the loan is for a short or a long term—the money market or the capital market (even though the two are not strictly the same; for money on loan, in spite of running a certain risk, does not run the specific risk of the capital of the entrepreneur or of the stockholder: it does not share in his gains or losses in direct proportion to the success or failure of the enterprise in which it is invested). But the primary function of money properly so called is to serve as a medium of exchange, and in that capacity it gives rise to other problems, such as its national and international exchange rate, its purchasing power, and the general influence it exercises on the market and on business by virtue of the phenomena of inflation and deflation. These problems have such a close bearing on economic—and especially monetary—policy that we shall reserve their detailed investigation for a later chapter, limiting ourselves here to but a brief explanation.

As we have seen, it is through the medium of money that goods and services are exchanged in the market. As the supply of commodities in the market is limited, the quantity theory of money is, on the whole, correct in holding that if the quantity of money in the hands of purchasers increases or decreases, they will be able to buy, with the same money, a lesser or a greater quantity of goods and services. The quotient represented by the total supply of available commodities divided by the total quantity of available money is, other things being equal, the purchasing power of the latter. An increase in the supply of money without any corresponding increase in the supply of commodities is called inflation; the contrary phenomenon is called deflation. Inflation occurs whenever the exploitation of gold mines results in an increase in the quantity of money relatively to the total supply of goods and services; and deflation occurs whenever there is an increase in the population, and technical progress produces an abundance of commodities without any corresponding increase in the quantity of money in circulation.

There is a widespread belief that inflation is bad and that deflation is good, because the former diminishes the purchasing power of the consumers and makes foreign products more expensive, whereas deflation has the contrary effect. However, this mode of reasoning is not correct, because for the economy as a whole it makes no difference whether imported or domestic products cost more if more money is available and less if the opposite is the case. The national economy (if we may, for the moment, provisionally assume its existence) neither gains nor loses by inflation or deflation. In the long run the entire population consumes what it produces, either directly or by way of imports purchased with the foreign exchange made available by its exports and with other income from abroad, as from tourism, freightage for the cargoes transported by the national merchant marine, the proceeds from foreign investments, etc. As long as inflation and deflation occur in the normal course of events, their effects are produced slowly, their extent is small in comparison with the total amount of international trade, and the necessary adaptations can be made quite easily. But when they are abnormally produced—that is to say, when they are produced by the intervention of the government—they have mischievous consequences, for they take from some in order to give to others.

It is to these phenomena of government intervention that people are really referring, albeit unwittingly, when they inveigh against the evils of inflation in particular. Our present-day inflation is of this kind. It is produced when the government, in need of money, has recourse to the printing press. It costs the government no more to issue paper money than the expense of printing it. Yet this cheap money, now at the disposal of the government, is placed on a par with what the citizens have earned with their own labor. The supply of available commodities, not having increased concomitantly with the products of the government’s printing presses, now has to be divided between the old money and the new. The whole process is very much like diluting wine with water. The government pours water into its citizens’ wine and then appropriates a share of the watered wine for itself. With this it pays its expenses: the salaries of more or less unnecessary bureaucrats, the cost of machinery and materials for more or less unnecessary public works, and frequently the costs of wars that it has not succeeded in avoiding. All these payments are made in reality with the share of the good wine that the government has taken from its citizens by the process of pouring water into it, leaving each citizen with the same quantity of “wine,” but of thinner consistency, and keeping the rest for itself. The whole procedure is hardly a whit better, morally, than clandestinely tapping an electric cable to draw off a part of the current for oneself without having it recorded on the meter and being obliged to pay for it. By such means governments arbitrarily dispose of the fruits of their citizens’ laborious efforts to lay by a reserve for their old age and then redistribute the proceeds “for the benefit of the underprivileged.” In fact, however, it is precisely the poor who are harmed the most by such a policy, in the first place because depriving a millionaire of thirty per cent of his possessions is not the same as taking a like amount from a worker or an employee of modest means, and in the second place because the upward adjustments in wages that are made in the course of an inflation never keep pace with the rise in prices and the cost of living. Otherwise, the government would not gain any advantage from the inflation.

It has been said in defense of inflation that it is beneficial to debtors because it permits them to pay off with money of inferior quality debts contracted in terms of good money. But the belief that all debtors are poor and all creditors are rich is a myth. Both rich and poor are to be found in each of these classes, and, in fact, it seems more likely that most debtors are rich, because nobody lends money to a person who is insolvent. It is always people of substance that are granted bank credit. On the other hand, their creditors, at least indirectly, are the banks’ shareholders and the depositors, who are drawn from the great mass of people with small savings.

It is also an obvious error to say that deflation (or, in this case, the withdrawal of money from circulation by an act of government intervention) counteracts the bad effects of inflation by causing prices to decline. We have already stated that, for the economy as a whole, this is of no importance. What happens in the individual case is the following: During the course of the inflation debtors pay in bad money the amounts they have received in good money. If new debts are then contracted, payable in bad money, and if deflation ensues, they have to be paid in good money. Thus, the new debtors have to pay for the sins of the old. One injustice is heaped upon another.

For this reason some have advocated stable money as the ideal medium of exchange. However, the realization of this ideal is impossible, because, like every other commodity, money is essentially unstable. Even aside from government intervention, there are many unpredictable factors that influence its value. It is desirable, nevertheless, that money be as stable as possible, or, at least, that its fluctuations be kept within moderate bounds so that their repercussions may not be too sudden or severe. But how is this to be accomplished? People talk of keeping the money in circulation proportional to the volume or circulation of goods. But no one has succeeded in finding the formula of this equilibrium or the means of applying it. Such a policy requires a constantly flexible regulatory action that cannot be effected by laws or controlled by the power of the legislature, whose members neither have sufficient knowledge nor are able to stay in session day and night throughout the year. There is no other alternative than to give plenary powers to the executive and to charge him with the responsibility of regulating the supply of money with the aid of his technical advisers. This is what the executive authorities of most of the countries in the world say must be done today, and the unhappy results of such a policy are everywhere to be seen. It was not without reason that Lord Acton said, “All power corrupts, and absolute power corrupts absolutely.”

This explains why people who have begun to see these matters in a clear light have turned anew to the idea of metallic money and are asking that gold come out of the depositories and vaults of the central banks and return to the pockets and purses of private individuals, for gold is the only really sound money with intrinsic value. The desire for a return to gold is understandable, and we hope to see it realized some day, although the argument in favor of the gold standard is not always stated in a valid way. The distinctive function of gold money does not consist in its intrinsic value or in the constancy of that value, which fluctuates even in the absence of government intervention. The excellence of metallic money in free circulation consists in the fact that it renders impossible the abuse of the power of the government to dispose of the possessions of its citizens by means of its monetary policy and thus serves as the solid foundation of economic liberty within each country and of free trade between one country and another.