Money within the Market Process

1. Money Production and Prices

The basic economic fact of human life is the universal condition of scarcity. Our means are not sufficient to realize all of our ends. In particular, our time is limited and thus we have to make up our mind how to use it, whether in paid work, in family or communal activities, or in personal leisure. But all other means at our disposal are limited too: our cash holdings, our financial assets, the size and quality of our cars and houses, and so on. Thus whatever we do, we have to choose how to use these resources, which also means that we decide at the same time how not to use them.

Now the use of all means of action is conditioned by the law of diminishing marginal value. According to this law, the relative importance of any unit of an economic good for its owner—or, as economists say, the marginal value of any unit—diminishes as we come to control a greater overall supply of this good, and vice versa. The reason is that each additional unit enables us to pursue new objectives that we would not otherwise have chosen to pursue. Therefore, these objectives are necessarily less important for the acting person than the objectives that he would have pursued with the smaller supply. It follows, for example, that the marginal value of an additional mouthful of water is very different for a person travelling in a desert than for the same person swimming in a lake. And the marginal value of a 200 square-foot room added to our house is very different, depending on whether the present size of our house is 500 or 5,000 square feet. Similarly, the marginal value of an additional dollar depends on how many dollars its owner already holds in his cash balance.

It follows that the production of any additional unit of money makes money less valuable for the owner of this additional unit than it would otherwise have been. In particular, it becomes less valuable for him as compared to all other goods and services. As a consequence, he will now tend, as a buyer of goods and services, to pay more money in exchange for these other goods and services; and as a seller of goods and services, he will now tend to ask for higher money payment.

In short, money production entails a tendency for money prices to increase. This tendency will at first show itself in the prices paid by the money producer himself. But then it will spread throughout the rest of the economy because those individuals who sold their goods and services to the money producer now also have larger cash balances than they otherwise would have had. For them too, therefore, the relative value of money will decline and they too will therefore tend to pay higher prices for the goods and services that they desire. It follows that still other people will have higher cash balances than otherwise and thus a new round of price increases sets in, and so on. This process continues until all money prices have been adjusted to the larger money supply. It is true that, for reasons that are too special to warrant our attention at this place, some prices might decrease in this process. But the overall tendency is for prices to increase. Thus the overall tendency of money production is to increase prices beyond the level they would otherwise have reached. This implies in turn that the purchasing power of any unit of money diminishes.

Let us emphasize again that the process through which money production tends to increase the price level is spread out in time. It therefore affects the different prices at different points of time—there is no simultaneous increase of all prices. Furthermore, there is no reason why prices should change uniformly or in some fixed proportion to the change of the money supply. Hence, money production entails a tendency for prices to increase, but this increase occurs step by step in a process spread out through time and affects each price to a different extent.^[1]

2. Scope and Limits of Money Production

How much money will be produced on the market? How many coins? How many paper certificates? The limits of mining and minting, and of all other monetary services are ultimately given through the preferences of the market participants. As in all other branches of industry, miners and minters will make additional investments and expand their production if, and only if, they believe that no better alternative is at hand. In practice this usually means that they will expand coin production if the expected monetary return on investments in mines and mint shops is at least as high as the monetary returns in shoe factories, bakeries, and so on.

The returns of the various branches of human industry ultimately depend on how the individual citizens choose to use the scarce resources that they own. In their capacity as consumers, the citizens choose to spend their money on certain products rather than on other products, thus determining the revenue side of all branches of industry. In their capacity as owners of productive resources (labor, capital, land), the citizens choose to devote these resources to certain ventures rather than in other ventures, thus determining the cost side of all branches of industry. Ultimately, therefore, it is the individual citizens who through their personal choices determine the relative profitability of all productive ventures. Each citizen engages in cooperation with some of his fellows, and by the same token he also withholds cooperation from others. This selection process or market process encompasses all productive ventures and therefore creates a mutual interdependence between all persons and all firms.

On a free market, the production of money is fully embedded in this general division of labor. Additional coins are made as long as this production offers the best available returns on the resources invested in it. It is curtailed to the extent that other branches of industry offer better prospects.

Moreover, just as the choices of individual citizens determine the relative extent of the production of money, as compared to other productions, they also determine the number of different coins that will be produced. Above we stated that money was a generally accepted medium of exchange. It is not merely conceivable that several monies will be in parallel use; this has been in fact the universal practice until the twentieth century. In the Middle Ages, gold, silver, and copper coins, as well as alloys thereof, circulated in overlapping exchange networks. At most times and places in the history of Western Europe, silver coins were most widespread and dominant in daily payments, whereas gold coins were used for larger payments and copper coins in very small transactions. In ancient times too, this was the normal state of affairs.

The parallel production and use of different coins made out of precious metals is therefore the natural state of affairs in a free economy. Oresme constantly warned of altering coins, but he stressed that the introduction of a new type of coins was not such an alteration so long as it did not go in hand with outlawing the old coin.^[2]

3. Distribution Effects

When it comes to describing the distribution effects resulting from money production, economists ever since the times of Nicholas Oresme and Juan de Mariana typically cite just one such effect. They point out that the increased money supply brings about a tendency for the increase of all money prices—a fall of the purchasing power of money. Then they argue that the reduced purchasing power benefits debtors, because the amount of debt they have to pay back is now worth less than before, and that this benefit therefore necessarily comes at the expense of the creditors.

This way of presenting things is not fully correct. It is true that an increased money supply tends to bring about higher money prices, and thus diminishes the purchasing power of each unit of money. But it is not true that this process necessarily operates in favor of the debtor and to the detriment of the creditor. A creditor may not be harmed at all by a 25 percent decrease in the purchasing power of money if he has anticipated this event at the point of time when he lent the money. Suppose he wished to obtain a return of 5 percent on the capital he lent, and that he anticipated the 25 percent depreciation of the purchasing power; then he would be willing to lend his money only for 30 percent, so as to compensate him for the loss of purchasing power. In economics, this compensation is called “price premium”—meaning a premium being paid on top of the “pure” interest rate for the anticipated increase of money prices. This is exactly what can be observed at those times and places where money depreciation is very high.^[3]

A creditor might actually benefit from lending money even though the purchasing power declines. In our above example, this would be so if the depreciation turned out to be 15 percent, rather than the 25 percent he had expected. In this case, the 30 percent interest he is being paid by his debtor contains three components: (1) a 5 percent pure interest rate, (2) a 15 percent price premium that compensates him for the depreciation, and (3) a 10 percent “profit.”

The same observations can be made, mutatis mutandis, for the debtors. They do not necessarily benefit from a depreciating purchasing power of money, and they can even earn a “profit” when money’s purchasing power increases if the increase turns out to be less than that on which the contractual interest rate was based. It all depends on the correctness of their expectations.

There is however another distribution effect of the production of money. This effect is far more important than the one we have just described because it does not depend on the market participant’s expectations. It is an effect that the market participants cannot avoid by greater smartness or circumspection.

To understand this distribution effect we must consider that exchange and distribution are not disconnected activities. In the market process, they are but one and the same event. Brown sells his apple for Green’s pear. After the exchange, the distribution of apples and pears is different from what it otherwise would have been. Every exchange thus entails a modification of the “distribution” of resources that would otherwise have come into being. It follows that any production of additional goods and services is bound to have such an impact on distribution. The new supply of product redirects the distribution of wealth in favor of the producer.

Consider the case of money production. Here too the additional quantities that leave the production process, when sold, first benefit the first owner: the producer. He can buy more goods and services than he otherwise could have bought, and his spending on these things in turn increases the incomes of his suppliers beyond the level they would otherwise have reached. But the additional money production reduces the purchasing power of money. It follows that it also creates losers, namely, those market participants whose monetary income does not rise at first, but who have to pay right away the higher prices that result when the new money supply spreads step by step into the economy.

Money production therefore redistributes real income from later to earlier owners of the new money. As we have pointed out, this redistribution cannot be neutralized through expectations. Even the market participants who are aware of it cannot prevent it from happening. They can merely try to improve their own relative position in it, supplying early owners of the new money, preferably the money producer himself.

This distribution effect is a key to understanding monetary economies. It is the primary cause of almost all conflicts revolving around the production of money. As we shall see in more detail, it is therefore also of central importance for the adequate moral assessment of monetary institutions.

To avoid possible misunderstandings, however, let us emphasize that the distribution effects springing from production are not per se undesirable. They are an essential element of the free market process, which puts a premium on continual production in the service of consumers and does not reward inactivity.

4. The Ethics of Producing Money

Aristotle emphasized the beneficial character of monetary exchanges, which facilitate and extend the division of labor. He merely denounced the practice of turning money into a fetish and desiring it for its own sake.^[4] The scholastic writers of the Middle Ages adopted by and large the same point of view, but they also went beyond Aristotle, who focused on the ethics of using money, by discussing the ethics of money production.^[5]

The scholastics did not question the legitimacy of producing money per se. As in the case of using money, however, they stated that money production had to respect certain ethical rules. Nicholas Oresme and others stressed that all coins should be clearly distinguishable from one another. In particular, it would not be licit that a minter produces coins that by their name, imprint, or other features resemble other coins that contain more precious metals.^[6] In other words, the benefits of competition in coinage result from a strict application of the Ninth Commandment: “You shall not bear false witness against your neighbor.”

This is the reason why coins up to the early modern period traditionally had weight names such as mark and franc. But this proved to be an improvident choice because coined metal, as we have seen, has by the very nature of things a different value than bullion metal.^[7] The word “ecu” for example was on the one hand used in the same sense in which we use today the word “ounce”—it was the name of a weight. But it was also the name of a gold coin that (originally) was supposed to be the equivalent of one ounce of silver. Just imagine what it would mean if, today, we had a silver currency consisting of 1-ounce silver coins that we called “ounces.” The expression “ounce” would then be unsuitable to be used in setting up contracts because it is ambiguous. It makes a difference whether we are talking about certified weights, as in coins, or uncertified weights as in gold nuggets. One would therefore have to specify in each contract whether payment is to be made in weight-ounces or coin-ounces. But then the practice of using weight names for coins loses its point. The mere weight name as such is not specific enough.

This does not mean, of course, that the weight contents of fine metal should not be imprinted on the coin. Quite to the contrary, this is exactly what successful minters have done in the past, what they do now, and what they will do in the future. The point is that it makes no sense to call a coin after its content of fine metal; such a name does not reduce ambiguities, but increases them.

Coinage in a competitive system would have to rely on a scrupulous differentiation of the coin producers. It would not be sufficient that each minter print on his coin something like “this coin contains five grams of fine silver” because, as we have seen, some minters would offer additional services such as the exchange of used for new coins. At the very least, therefore, the name of the minter and any supplementary information needed to identify him would be required. Present-day gold coins such as the Krugerrands, the Eagles, and the Maple Leafs already fulfill this requisite: they feature both a unique name and they state the weight of fine gold contained in the coin.

5. The Ethics of Using Money

The Catholic tradition warned in the strictest terms against abuses of money, but it did not deny that, if practiced within the right moral boundaries, the use of money and the paying and taking of interest were natural elements of human society.^[8] Jesus himself, when explaining the rewards given to the faithful in the coming Kingdom of Heaven, used an illustration involving the positive use of money and banking. He stated that the Kingdom of Heaven would parallel the reward given for good stewardship of money, and that hell would wait for those who made no use of money at all. Two stewards who used the money entrusted to them in trade and made a 100 percent profit, found the praise of the master and were invited to share in his joy. But one steward who buried the money given to him in the ground was severely chided as “wicked” and “lazy.” The master pointed out that he could have turned the money into some profit by simply putting it in a bank: “Should you not then have put my money in the bank so that I could have got it back with interest on my return?” He therefore commanded his other servants to take the money away from this servant and to throw him out of the house: “And throw this useless servant into the darkness outside, where there will be wailing and grinding of teeth” (Matthew 25: 26–30).

Thus the use of money and banking may very well be considered legitimate from a Christian point of view. In any case, in the present work we are primarily interested in the economics and ethics of producing money rather than of using money in credit transactions.^[9] We can therefore avoid discussing one of the most vexatious problems of Catholic social doctrine, namely, the problem of usury. In very rough terms, usury is excessively high interest on money lent. This raises of course the question how one can distinguish legitimate from illegitimate “excessive” interest. Theologians have pretty much exhausted the range of possible answers. Some medieval theologians went so far as to claim that any interest was usury. Others such as Conrad Summenhardt held that virtually no interest payment that the market participants voluntarily agreed upon could be considered usury.

The teaching office of the Catholic Church has repudiated the former opinion without taking a position on the latter. It rejects “usury” but allows the taking of “interest” on several grounds that are independent of (extrinsic to) the usury problem.^[10] It does not endorse on a priori grounds just any credit bargain made on the free market. It affirms that taking and paying interest is not per se morally wrong, but at the same time retains the authority to condemn some interest payments as usurious. This concerns especially the case of consumer credit, because taking interest might here be in violation of charity. Similarly, while interest on business loans is per se legitimate, some business loans might be illegitimate because of particular circumstances. Below we will follow Bernard Dempsey in arguing that interest payments deriving from fractional-reserve banking are tantamount to “institutional usury.”^[11]