We interrupt our regularly scheduled blog posting to repost an answer we put up the other day on "Linkedin," a professional networking site we recently joined. A vice president of a commercial bank asked, "Is it better for us to keep dealing in paper-based currencies and economies, or to redefine our monetary and financial systems?" Our answer received the comment that we had given "valuable comment with lots of valuable information to absorb and learn from."
The other answers to the question were all good — given the definition of "money" currently in use by economists and policymakers. It would be better, however, to replace the current definition of "money" used by economists and policymakers. The understanding of money in all the systems based on the tenets of the "British Currency School" — which include Keynesian, Monetarist, and Austrian schools of economics — assume that this thing called "money" is effectively a purchase order issued by the State or State-authorized agency. Implicit in this understanding is the assumption of State omnipotence and ultimate ownership of everything (and everyone) in the State, just as Thomas Hobbes asserted in Leviathan.
A definition of money that adheres more closely to the demands of human dignity and respects humanity's natural rights, especially the natural right to be an owner, is that used by the lawyers: "anything (repeat, anything) that is used in settlement of a debt." This is based on the tenets of the British Banking School, and embodies the real bills doctrine that we have covered in a number of previous postings. Briefly, the real bills doctrine is that money can be created as needed without inflation or deflation if (and only if) it is linked directly to the discounting of "real bills" (that is, claims on something with actual present value) by commercial banks for capital projects, that is, projects the generate their own repayment out of future profits.
Limiting the concept of money to government-issued or authorized paper, gold, credit cards, and so on, ad infinitum, does not address the basic problem with today's monetary systems. That is, unless whatever we use as "money" represents a conveyable (transferable) private property interest in something with a present value, it is, as Paul Samuelson admitted, "legal counterfeiting."
A sound money supply, whether based on paper, gold, or elephants (as, once upon a time, it was in Sri Lanka), requires that whatever you are using not necessarily be valuable in and of itself, but be readily — and freely — exchangeable for something else of value, such as food, clothing, shelter, etc. Thus, while "money" can take any form that people agree to accept, it must be "backed" by something of value.
Nor does the backing of the money have to be gold or silver. It can be any hard asset, that is, anything with a definable present value. As Jean-Baptiste Say pointed out nearly 200 years ago (and I necessarily paraphrase, not having the source in front of me), we do not make our purchases with "money," per se, but with what we ourselves produce by means of our labor, our capital, or our land. "Money," as Aristotle pointed out, is an abstraction, the social tool we use to measure the value of our own productions so that we can exchange them for the productions of others, both being measured in terms of a third thing so as to come to a common measure of valuation.
The proper function of a commercial bank (as opposed to a "bank of deposit") is to create "money." That is, a commercial bank values something a prospective borrower brings to the bank in terms of "money," and gives the borrower "money" — generalized purchasing power backed by the bank's word to make good on it. In exchange, the commercial bank takes a lien on whatever the borrower brought to the bank for financing. For providing this service, assuming that the loan is made for something that generates its own repayment (otherwise you are dealing with usury or riba) the bank properly charges a fee, as well as a risk premium determined by how good a credit risk the borrower is.
As a prudent move, the bank also usually demands collateral — a store of existing wealth that the bank can take should the borrower not pay back the loan of money so that the money can be canceled. Kelso and Adler point out that the demand for collateral can be replaced with capital credit insurance, making it possible for people who are not rich to finance acquisition of capital assets. The State's role in this is not to create the money, but to set the standard of value and make certain that no one creates money that deviates from that standard, plus ensuring that the assets behind the money exist.
This is only the briefest outline of a very complex subject. For the proper way to manage the currency, read The Formation of Capital (1935) by Dr. Harold G. Moulton, if you can find one of the rare copies sometimes offered for sale. Book II of Adam Smith's The Wealth of Nations also gets into this, as does a rare book published in 1845, by John Fullarton, The Regulation of the Currencies of the Bank of England. An updated treatment can be found in Louis Kelso and Mortimer Adler's The New Capitalists: A Proposal to Free Economic Growth from the Slavery of Savings (1961). Don't bother with Keynes, Friedman, or the Austrians — they all use a definition of money based on the Currency School, and differ only in details. Also see Capital Homesteading for Every Citizen by Dr. Norman G. Kurland.