Monday, December 27, 2010

Central Banking for Dumbos, Part II: How to Debauch a Currency

In the previous posting in this series, we learned how the State (allegedly) makes a profit by issuing money. The face value of a note or a coin says one thing, and the intrinsic value (the value of the material out of which the note or coin is made) is less, sometimes even negligible compared with the face value. This difference is a profit to the issuer of the money . . . right?

Wrong. The difference, called "seniorage" or "agio," was usually booked as a profit and (when the minting authority was more or less honest) used to defray the cost of issuing the currency. It is not, however, a profit, that is, income. Rather, agio is a liability. Treating agio as if it is income is similar to taxing people for Social Security . . . and then using the Social Security collections for other purposes, replacing the funds with government bonds — bonds that must be redeemed out of other, future tax revenues. All that's been done by collecting FICA is to tax people twice for the same thing. This is because he government still has to come up with the money to redeem those bonds when the Social Security claims come due.

Had Solon the Lawgiver been an accountant instead of a politician when he instituted his plan to reform the Athenian currency and charge an inflation tax to pay for it, he would have seen the problem immediately. Take a look at the "accounting equation": assets = liabilities + owners' equity. In the case of a silver coin with less silver in it than it says on the face, the coin is an asset of whoever owns it. A coin is, in fact, a type of contract. It says on the face, "One Cent" or whatever the denomination happens to be, and bears some statement as to the issuing/certifying authority. The issuer is certifying that the coin-contract conveys a private property right worth one cent.

When the coin contains the full face value of metal, there is no problem. When the coin contains less than the face value of metal, however, the issuer has agreed by the fact of issuing the coin and certifying its value to make good the deficiency when the coin-contract is presented to the issuer for redemption. That deficiency — the agio — is not part of owners' equity, accumulated in "retained earnings" through net income. To construe agio as a profit assumes that the issuer owes the difference between the face value and the intrinsic value of the currency not to the bearer of the currency, but to himself! Given the institution of private property as a natural right, this assumption is clearly ludicrous. The proper classification of agio is a liability on which the issuer has promised to make good to the bearer in due course of the coin or other form of money.

Unfortunately (returning to Solon's little error), the silver wasn't there to hand over to the bearer in due course. It had been spent as if it were a profit — just as FICA collections are typically spent after being replaced with government bonds. Consequently, each "money drachm" became worth less than a "weight drachm." Depending on how far the amount of metal in the coin strayed from the face value, somebody might have to pay, say, two drachma in money to purchase a one drachm weight of silver — inflation. Inflation is thus a "hidden tax" that reduces purchasing power to the advantage of whoever has pocketed the value misclassified as a profit rather than a liability.

A private citizen can't get away with making promises — entering into contracts — and delivering less than what is agreed upon in the terms of the contract, unless he or she has a really big club or a lot of guns to back up such offers that others can't refuse. The State, however, having a legitimate monopoly over the instruments of coercion, can — and does — get away with this form of fraud every time it issues or authorizes the issuance of money backed by nothing more than the State's promise to pay out of something that it doesn't own . . . such as the "general wealth of the economy."

This sort of money manipulation might have been okay for the small, localized economies of the Middle Ages, where the petty ruler probably owned everything in sight anyway. After all, if the local king or baron kept debauching the coinage, he was either only cheating himself, or cheating people — such as another baron or a king — who could get him excommunicated, hanged, or something. Coinage wasn't used much in any event, since most economies were extremely localized, with foreign trade being restricted almost exclusively to luxury goods — for which merchants demanded (and got) good gold and silver coin, or there would be no more luxury goods to show off in front of the neighbors.

Depreciation and devaluation of the coinage was therefore, in most cases, gradual. Added to that, any ruler, like Henry II of England, who wanted (or needed) to gain instant popularity could reform the coinage, chop off a few dishonest mintmasters' hands (or heads for a second offense) and be regarded as a virtual financial savior for refusing to engage in monetary chicanery, or making good on that of previous rulers.

Consequently, after the "fall" of the Roman Empire (that's another subject), the first rapid devaluation of coinage in the west didn't occur until the exaggerated claims of the State came in with the Tudors. If anything exceeded Henry VIII's appetite for eating, drinking, wenching, and contracting syphilis, it was his talent for spending enormous sums of money that he didn't have. Numismatists tear their hair out trying to assemble a representative "type set" of Bluff King Hal's coinages. He devalued the coinage so fast that the die cutters couldn't keep up. Some of "Old Coppernose's" coin portraits, especially in Ireland, are barely recognizable as human . . . although maybe the king's debauched life had something to do with that.

England during the Tudor dynasty saw a change in the perception of the role of the State — and thus the general understanding of private property and the derivatives of private property: money and credit. The role of the State was expanded from its legitimate one of regulating the currency, to the illegitimate role of creating money. This matched the shift in the idea of sovereignty that developed at the same time — that the State or the ruler receives its authority not from the people, as the Medieval scholastic philosophers taught, but directly from God: the theory of "divine right," a complete overthrow of the Aristotelian/Thomist concept of the natural moral law.

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