Understanding the True Nature of Inflation : Legal Tender Laws

Jörg Guido Hülsmann, The Ethics of Money Production

Chapter 9 : Legal Monopolies

1. Economic Monopolies Versus Legal Monopolies

For example, the legal monopoly might provide that only silver may be used as money, or that only the bank X may offer checking accounts, or that only banknotes of the bank Y or coins of the mint Z may be used in payments.

Legal monopolies … entail inflation by the very fact that they shield the privileged products from competition. The monopoly makes the privileged products relatively less costly to acquire (in comparison to competing products) than they otherwise would have been. The market participants therefore tend to use more of them than they otherwise would have used; and as a consequence they also tend to produce more of them than would otherwise have been produced. This inflation works out to the benefit of the producers and first recipients of additional units of the monopoly product, and to the detriment of producers and users of alternative products, which would have been fabricated and used in the absence of those legal privileges. Thus we encounter again the phenomenon that fiat inflation (of the privileged monies or money certificates) goes hand in hand with fiat deflation of other monetary products.

Monetary monopolies are especially harmful when combined with legal tender laws.

2. Monopoly Bullion

Such monopolies have for example been created in Germany and France after the war of 1870-71, when both countries adopted a gold standard and prevented the minting of silver coins (except as tokens for gold). It is true that the bullion monopoly in these cases went hand in hand with a coin monopoly. Still a pure bullion monopoly is conceivable. It creates a greater demand for the privileged metal and crushes the demand for all other metals. Thus we have here again the familiar double phenomenon of fiat inflation and fiat deflation.

Historically, the establishment of monopoly bullion has been an important step in the consolidation and centralization of national monetary systems under government control. The outlawing of silver paved the way to an inflation of fractional-reserve certificates backed by gold. The reason is twofold.

On the one hand, fractional-reserve certificates can be a vehicle for short-run adjustment to the fiat deflation of silver. With silver disappearing from circulation the market participants turn to the remaining alternatives such as gold. Because the gold supply cannot be easily extended, the increased demand would entail a drop of gold prices or, in other words, an increase of the purchasing power of gold. But this is a problem for those who operate on debts and who were not shrewd enough to anticipate the drop in prices. These people therefore turn to substitutes for gold that can be easily multiplied, such as the notes issued by fractional reserve banks.

On the other hand, and quite apart from this short run problem, silver is no longer available as a competitor for gold and thus money users have less possibilities to protect themselves against the inflation of gold-backed money substitutes. Moreover, it is for technical reasons impossible to replace silver coins with gold coins of the same purchasing power because in general the latter would have to be so small as to be impracticable. … In such circumstances the silver currency is therefore not in fact replaced by a gold currency, but by a currency of gold substitutes. These substitutes might initially be fully backed by gold. However, as we have already argued, it is much easier to turn fully backed money substitutes into fractional reserve substitutes than it is to debase coins. Hence, the doors are now wide open for inflation.

3. Monopoly Certificates

Certain coins enjoyed a legal monopoly — monopoly coins.

Notice that monopoly coinage per se cannot entail inflation on any quantitatively significant level. This is most certainly so in the case of sound coins. But even in the case of debased coins, inflation is likely to be very limited. The reason is that monopoly privileges “merely” outlaw alternative monies or money certificates. They cut down the menu from which money users may choose, but they do not prevent them from evaluating the monopoly monies as they see fit. In the case of debased coins, this means that monopoly laws leave the people at liberty to distinguish between old coins (which contain more fine metal) and the new debased coins. There might then be two price systems or, if it proves to be too cumbersome to distinguish old and new coins in daily trade, the market participants might just as well decide to melt down the old coins or sell them abroad. It follows that there is no inflationary effect whatever (if anything, a slight deflationary effect is more probable).

From the point of view of the debaser — the government — the entire exercise is therefore more or less pointless. He might for some time manage to cheat his customers into thinking that no debasement is going on. But this deception cannot last for any considerable length of time. As soon as the market participants realize what is going on, they will buy and sell the new coins at different nominal prices, so as to leave the real exchange ratios (in precious metal weights) unchanged. No additional revenue can thus be gained for the debaser. This is of course the reason why debasement has never been orchestrated under the mere protection of monopoly privileges. In practice, debased government coins have always been protected by the additional privilege of legal tender laws.

[…] In the nineteenth century, most Western governments established banknote monopolies, which were granted to banks with especially close ties to the government. These banks operated on a fractional reserve basis and created a considerable amount of banknote inflation. But just as in the case of debased coins, the monopoly alone was not the enabler of that inflation. The simple reason is, again, that the monopoly privilege merely suppresses competing products, but does not prevent people from evaluating the monopoly banknotes as they see fit. A banknote monopoly does not therefore prevent the market participants from rejecting these banknotes altogether and conducting their business only in coins (cash). Thus as in the case of coins, we must conclude that monopoly privileges for banknotes are inherently harmful and socially disruptive, but that their quantitative impact is likely to be rather small.

Chapter 10 : Legal-Tender Laws

1. Fiat Equivalence and Gresham’s Law

Indeed, legal-tender laws typically establish a legal or “fiat” equivalence between the privileged money (the privileged money certificate) and other monies and money certificates. […]

The aforesaid fiat equivalence works like a price control that establishes a legal or fiat price. As long as the fiat price coincides with the market price, everything is good and fine. But as soon as the two prices differ, people stop using the metal that in reality is more valuable than it is according to the letter of the law.

Suppose for example that both gold and silver are legal tender in Prussia, at a fiat exchange rate of 1/20. Suppose further that the market rate is 1/15. This means that people who owe 20 ounces of silver may discharge their obligation by paying only 1 ounce of gold, even though they thereby pay 33 percent less than they would have had to pay on the free market. Prussians will therefore stop making any further contracts that stipulate silver payments to protect themselves from the possibility of being paid in gold; rather they will begin to stipulate gold payments right away in all further contracts. And another mechanism operates to the same effect. People will sell their silver to the residents of other countries, say England, where the Prussian fiat exchange rate is not enforced and where they can therefore get more gold for their silver. The bottom-line is that silver vanishes from circulation in Prussia; and only gold continues to be used in domestic payments. The overvalued money (here: gold) drives the undervalued money (here: silver) out of the market. This phenomenon is called “Gresham’s Law.”

3. Legal-Tender Privileges For Money Certificates

Legal tender privileges do have a significant quantitative impact when they are given to false certificates. Above we have noticed that the mere legalization of false money certificates could not per se lead to large scale inflation as long as the market participants were free to abandon the use of the false certificates and switch to better ones, or demand payments in bullion. Even the introduction of monopoly privileges does not open the floodgates for inflation, because the monopoly does not impair the ability of the market participants to evaluate them as they see fit. Yet all these barriers to inflation collapse when false money certificates benefit from legal tender laws.

[…] Before the institution of legal-tender laws, the Red Bank had operated on a 20 percent reserve ratio. Now the government makes its notes legal tender and thus artificially increases the demand for Red Bank notes; in other words, the owners of these notes redeem them less frequently. Suppose that as a consequence of the reduced demand for redemption, the cash reserves of the Red Bank increase by 2,000 ounces of gold. At the reserve ratio of 20 percent, this means that the Red Bank can issue additional banknotes for 10,000 ounces of gold.

The operation of the market process is perverted. Whereas on a free market there is a tendency for the best available products to be used, legal tender laws combined with false certificates incite a race to the bottom. Since all money certificates are equal before the law, and because the legal-tender provision overrules private contract, no money user has an interest in paying the higher price for a genuine certificate. And as a consequence no producer has an interest in fabricating such certificates; each one of them now tries to operate at the lowest possible costs. Sooner or later everybody pays with debased coins and fractional-reserve notes. Bullion disappears altogether from public use; it is held back — “hoarded” — or sold abroad. […]

It is true that fractional reserve banking protected by legal-tender laws is a race to the bottom. Every banker has an incentive to reduce his reserves — to inflate the quantity of his notes — as far as possible. But there is a logical stopping point before the total dissolution of monetary exchanges. Every single banker can stay in business only as long as he is able to redeem his notes. Because his customers have the right to demand redemption of his notes into bullion, and because some of them exercise this right, he must keep his note issues within more or less prudent narrow limits.

7. Monopoly Legal Tender

Legal tender privileges for the banknotes of one bank do not prevent a race to the bottom, in the course of which each of the other banks attempts to reduce its reserves as far as possible. Assume for example that the pound bank reduces its reserves to 30 percent of its nominal issues. This in no way prevents the mark bank and the franc bank from reducing their reserves even further, say, to 20 percent. Quite to the contrary, there are very powerful incentives for the banks to do precisely that. We have noticed further that fractional-reserve banking systems labor under moral hazard. Each bank has an incentive to be especially reckless in diminishing its reserves (issuing further notes without coverage) because it can rely on the other banks as some sort of a safety net. This incentive is just as present if only one bank enjoys legal-tender privileges. All the other banks then have the tendency to use the notes of this bank, which all market participants are obliged to accept in lieu of specie, to cover their own note issues. Thus we see that, when legal tender privileges are accorded to just one bank, the cartelization and centralization of the banking industry crystallizes quite naturally around the privileged bank, thus turning it into the central bank.

8. The Ethics of Legal Tender

Legal monopoly, as we defined it, diminishes the full use of one’s property. It deprives the citizens of options they would otherwise have had. It reduces the menu open for choice. However, it does not attack choice per se. The acting person is still free to choose among the remaining alternatives.

By contrast, legal-tender privileges attack individual choice at its very root. They overrule any contractual agreement that a person might make in respect to money. The government imposes the use of some privileged money or money certificate. It coerces the citizens into using these means of payments, even though they might have other contractual obligations and contractual rights.

This entry was posted in Economics and tagged . Bookmark the permalink.