Monday, July 18, 2011

Economic Recovery, Part XII: The Formation of Capital (7)

The current debt crisis, perhaps oversimplified somewhat as a conflict between raising the debt ceiling v. cutting costs, reveals the weakness inherent in the Currency Principle of finance. The Currency Principle defines "money" as a general claim on all the wealth in the economy. Keynesians, Monetarists and Austrians disagree on the source of money (e.g., the State or the private sector) and how or if it should be managed, but all agree that coin, currency, demand deposits and some time deposits constitute the money supply.

There are a number of problems with the Currency Principle. As regular readers of this blog are aware, we've been attempting to deal with these problems, but keep coming up against the problem of definition. Nevertheless, let's make another attempt to clarify matters.

First, let's look at the definition of money used: "a general claim on all the wealth in the economy." The most obvious error here is the evident confusion between "general" and "fungible." Currency Principle adherents mistake the fact that one unit of currency is legally indistinguishable from any other unit, with the belief that the terms of the contract that creates money does not have any specific "matter" — that the terms of the contract presumably change with circumstances surrounding a particular transaction.

We can deal with this confusion easily enough. The fact that a financial instrument can be conveyed to a holder in due course in a transaction without indorsement (as is the case with a coin or banknote) in no way negates the obligation of the original issuer of the instrument to make good on that instrument when presented for redemption by a holder in due course. Depending on the specific terms of the contract, the issuer must redeem the instrument in some way when it is presented.

Even the U.S. government pledges to accept Federal Reserve Notes, that it backs with its "full faith and credit," in payment of debts. The notes are not convertible, that is, the holder in due course does not have the right to demand the specific "assets" (government debt paper) that back the notes and demand deposits. Nevertheless, the United States government, the de facto issuer of the notes and creator of the demand deposits, must accept its own obligations to redeem debts due to it, although the specific form — i.e., Federal Reserve Note, personal check, or credit card — may vary. The form is irrelevant, as long as whatever instrument is used is redeemable (if not necessarily redeemed) in Federal Reserve Notes that are backed by government debt.

The case is slightly different under the Banking Principle, where private sector hard assets instead of government debt back the notes and demand deposits. In that case, the original issuer is obligated to "make good" on the notes by repaying the loan — redeeming the bill of exchange — that created the money in the first place. In a sound and properly run economy, the note is redeemed out of the profits realized by producing marketable goods and services with the capital that was financed with the proceeds of the loan.

Thus, currency is not "general," but "fungible" — something entirely different, but which evidently confuses a great many people. No issuer of a currency or anything else used as money can enter into the contract unilaterally — that is, impose a general obligation on persons who are not parties to the original contract. The issuer of a currency can, however, make the obligation fungible, that is, every promise, regardless who the holder in due course may be, must be redeemed by the issuer when promised.

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