The Neutrality Of Money

By: Ed Bugos | Wed, Nov 6, 2002
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To warm you up for today's editorial, I'd like to share three of the most powerful quotes I've had the pleasure of reading on the subject of gold and money:

The simple statement, that money is a commodity whose economic function is to facilitate the interchange of goods and services does not satisfy those writers who are interested rather in the accumulation of material than in the increase of knowledge. Many investigators imagine that insufficient attention is devoted to the remarkable part played by money in economic life if it is merely credited with the function of being a medium of exchange; they do not think that due regard has been paid to the significance of money until they have enumerated half a dozen further "functions" - as if, in an economic order founded on the exchange of goods, there could be a more important function than that of the common medium of exchange - Mises on the Function of Money (pp 46, The Theory of Money and Credit).

What I believe Mises tried to show in this chapter was that money has only one role, and that all of the characteristics we ascribe to money are what make it preferable and most marketable in exchange for goods. Money is the only commodity that we hoard in order to acquire goods or services that we want. The reason it is a commodity is not due to any restrictionist or deflationist dogma, but because the activities of commerce give rise to it, as opposed to it being the creation of the state.

I think it is very important to understand the difference. A gold standard in the Austrian sense, as far as I understand it, means that without any aid from the government, a monetary standard would spring up on its own, provided the market was left to its own devices. And further, that this would be a more sound if not stable money than we currently use. The other functions for money Mises refers to are mostly rationalizations for government intervention, or its continued monopoly over money.

Next quote:

Mises, Human Action, p. 418. "The notion of a neutral money is no less contradictory than that of a money of stable purchasing power. Money without a driving force of its own would not, as people assume, be a perfect money; it would not be money at all." The fact that money is not neutral is the common denominator of the monetary theories of Mises, Hayek, and others who have written in the Austrian tradition - Roger Garrison, quoting Mises in The Costs of a Gold Standard.

The opposing idea, that money is neutral, is an important assumption in monetarism. It is the driving force behind monetary policy today. Thus, the aim of contemporary monetarist policies is for a stable price level by tinkering with the money stock. The result is money that really is not money at all, because it is designed by the state as opposed to its own "driving force." At any rate, in some parts of the world this policy is achieved under the guise of what's called inflation targeting, while in other more developed monetary regions it is a more covert goal, yet a goal nevertheless.

In his report, Garrison shows the so-called price level could fall due to non-monetary factors, and by altering the monetary variables to induce a corrective rise in this level, in order to stabilize it, would in the process alter the economy's pattern of production, or its optimal capital structure, resulting in what the Austrians refer to as malinvestment. The neutrality of money is a concept that has become widely recognized, assumed, and accepted, but never properly defended or rationalized. Yet, the whole of contemporary monetary policy is predicated on it.

Last quote (almost):

"The different opponents of the gold standard have radically different reasons for wanting to reject gold as money. Some want to harness the monetary forces and put the reigns in the hands of government; others want to nullify the monetary forces that are inherent in any commodity standard. The former like to think of monetary stability as those monetary arrangements that result in full employment; the latter like to think of monetary stability as those monetary arrangements that result in a constant price level. Proponents of the gold standard hold that neither full employment nor a constant price level is an appropriate goal of government policy. Nor is either of these goals consistent with monetary stability. And achieving the goal of stable money, which may well result in both a fuller employment and a more nearly constant price level than would otherwise be possible, requires only that the government refrain from interfering with the commodity money chosen by the market" - Roger Garrison, The Costs of a Gold Standard.

Hear, Hear!! If the market mechanism is the process by which money is determined, and if the market selects gold as its money, time and again, then fixing its price in any way seems like an attempt to harness its power in a more suitable direction, or at a minimum it is an intermediation in the very process that gave rise to it.

An Unrestricted Market Means Unrestricted Discipline Too
My own contention, and it may be wrong, is that this leads to Gold's demonetization for the simple reason that by guaranteeing convertibility at a fixed ratio, it becomes undervalued as long as there is no restriction on the expansion of note issues, which is the case when there is a lender of last resort, which is why a central bank and gold standard cannot coexist. But even without a central bank, the free banking system is prone to lend more than it has in reserves, because it believes the process to be sustainable, and profitable. The convertibility into gold is supposed to be a check on this behavior, but it has proven a weak check, with or without the support of a central bank.

I don't know the answer, but if gold is money, and fixing its price leads to shortages of it (from dwindling investment in production capacity and its disappearance from circulation), which ultimately collides with falling confidence in abundant note issue, then we are going to have these monetary crises over and over again. For if gold weren't money, then these crises would simply fade away, at least in terms of gold. Gold would be just a regular commodity, sought no more than zinc or coffee when the world's largest paper currencies crumble. I'm not so sure that freely traded gold would be as volatile as it is today if the market was unrestricted in its determination, and if it was unrestricted in its discipline, which must be the same thing.

Mo' Money
The absolute biggest, and most damaging monetary lie of the 20th century is that a growing economy needs more money. This point divides world opinion on matters of money and gold into two opposing factions (pro and anti gold) sooner or later. Its mere acceptance leads to the inevitable conclusion that gold ultimately fails as money, because its supply simply can't keep up with the growing needs of a booming economy. Booming inflation is more like it. Nonetheless, the acceptance of this idea has become so pervasive that the world's bankers have become heroes of economic prosperity, growth, and progress for offering us elastic money.

Advocates of an elastic monetary system claim going back to a gold standard would be like crucifying mankind on a cross of gold (to borrow a quote from Democratic nominee William Jennings Bryan's cross of gold speech in 1896), usually for the reason that the scarcity of money would be an unnecessary burden for the economy.

Consistent with this line of thinking is that the Spanish plunder of the Incas, the raid on the Byzantine Empire, Hitler's quest to replenish Germany's gold reserves with its neighbors' gold, etc., are simply more proof that our thirst for gold is just an evil curse, and that the world's bankers indeed are champions of humanity for finally replacing the role of gold - that barbarous relic - as money with currencies like the greenback, euro, and yen. After more than a century of trying, and failing, the greenback has finally become as good as gold, or so goes the lore.

The truth, however, is not that a growing economy requires more money, but rather, that an inflationist monetary system does. In all the examples of historic gold plunder, the plunderers always followed profuse inflation policies at home. The white man's thirst for gold has always been driven by his incessant inflation.

There's always another excuse. In the case of the Incas and Byzantine Empire, it was religion. In the case of Hitler it was anti-Semitism. In the case of the Union after California's gold rush, it was in the name of the emancipation of slaves. In the case of America after World War II it was a reward for helping defeat Hitler. There's always a good reason, but nothing explains these events with more consistency than the fact that in all of these cases, the currency of the plunderer was in dire need of more gold to back it.

The white man's thirst for gold is surpassed only by the crown's need to support the value of its currency, and system of inflation. This is the source of the gold wars. It is not some shortcoming of gold's; it is a shortcoming of our kind. Money is required in any economy that is based on the division of labor. Period. More of it (gold) isn't needed unless the inflationists have already plundered it.

Every crisis in US banking history that has involved a spike in the value of gold was preceded by profuse inflation policies. It is these policies that drive the demand for gold, particularly at times when they break down through a loss in confidence. It is perversely naive to believe that if it weren't for gold, the currency and the economy could grow unfettered. If we destroyed all the gold in the world, the dollar could still not hold its value against most things over the long run.

Money is the medium of exchange the seller of goods most readily accepts for his or her labor. But in a world of absolutely profuse inflation, sooner or later, the medium of exchange devalues relative to goods that are increasingly scarcer. At some point, assuming commercial interests are still kicking, a new medium of exchange may arise. Assuming gold didn't exist, whatever the market chose as money, it would do so at the expense of the discredited currency.

To make matters even more ridiculous, the faction (Monetarists and Keynesians) that argues a growing economy needs more money uses corrupt data for its measure of economic growth. Unfortunately, we're trained to see economic growth as how much more in goods we can produce each year, when in fact:

It consists instead of increases in the quantities of some goods and decreases in the quantities of other goods, improvements in the quality of some goods, and the introduction of new goods. Growth-induced changes in the pattern of output are accompanied by corresponding changes in the pattern of prices. The fact that the price level calculated on the basis of the new pattern is lower than the price level calculated on the basis of the old pattern is strictly incidental. To the extent that each individual change in the pattern of prices can be attributed to non-monetary factors, the issue of monetary non-neutrality does not arise despite the fall in the price level -Roger Garrison The Costs of a Gold Standard

The economic aggregates, such as GDP, include in their calculation the effects of "too much money." It is impossible to calculate what part of the figure is the result of inflation, because inflation is not merely a change in the aggregate price level. The reported changes in this level are government estimates of the inflation.

In fact, though we don't have time for it in this editorial, inflation could cause prices of some goods to rise while causing the prices of other goods to fall, believe it or not. This is the job of dollar policy.

Money Should Be Neutral (I mean policy)
In the ideal version of a capitalist economic system that has allowed sound money to evolve, the prices of things might generally fall rather than rise. That doesn't mean no prices would rise. Any time the demand for a good increases, it causes its price to rise, which signals investors and entrepreneurs to invest their time and resources in producing more of it. A sound system of money doesn't mean that prices won't rise, or that the value of money will be stable (stable money is quite different from a stable value or purchasing power for money). It means that when the price of something rises, or falls, it is due to real shifts in demand and supply, rather than changes in the money stock. In other words, markets are not affected by changes in monetary variables, because they really are neutral, and so, its signals are real, and as Mr. Garrison suggests, movements in the general price level are then incidental.

Arguably, the devastating bust after each boom the US has experienced in the 20th century, or even before, would have been milder if there was some way banks would refrain from engaging in the lending out of money they didn't have. Ideally, the gold standard is supposed to do this job. I contend that fixing the dollar-gold ratio gives the banks a carte blanche to print as many as good as gold dollars as they could get away with. I do think we are closer to a gold standard today than at any other time in history. But instability is likely to continue so long as governments pursue policies that result in volatile gold prices. If it is possible to connect the increasing financial volatility to the inherently unsound banking policies, central or otherwise, it is the job of a gold standard to discipline the free banking system.

But if you accept that gold is money, fixing its price is inconsistent, because for the same reasons that gold is money, a price cannot be fixed. The market determines it to be money, and it does this partly through the price mechanism, as any market.

Moreover, when this process is unfettered, there should be less volatility in the value of money. The same argument holds for cases of price fixing, which were discredited in the seventies for the obvious nature of this truth. Why couldn't money determined by the market be as stable in value as any other commodity where the factors of supply and demand aren't restricted or tinkered with?

In my view, von Mises proved it wasn't desirable to fix prices, while Jean Baptist Say proved it wasn't possible. Say's Law basically says that shortages and surpluses are impossible in a free market. An increase in supply will cause an increase in demand, if the price is allowed to fall. An increase in demand will cause an increase in supply if the price is allowed to rise.

If we fix the price of a good that fits these particular laws, as most probably do (financial asset prices usually exhibit different laws), in the former instance, there will tend to be a surplus of the good, while in the latter circumstance the tendency would be towards a shortage of the good.


Ed Bugos

Author: Ed Bugos

Edmond J. Bugos

Ed Bugos is a former stockbroker, founder of, one of the original contributing editors to and former editor of the Gold & Options Trader. He continues to publish commentary on market and economic trends; and provides gold, economic and mining research to private clients worldwide.

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