Capital Goods and Capital

The Tale of Two Islands Part II

"The first aim of monetary policy must be to prevent governments from embarking upon inflation and from creating conditions which encourage credit expansion on the part of banks. But this program is very different from the confused and self-contradictory program of stabilizing purchasing power."

"What the expansionists call the defects of the gold standard are indeed its very eminence and usefulness. It checks large-scale inflationary ventures on the part of governments. The gold standard did not fail. The governments were eager to destroy it, because they were committed to the fallacies that credit expansion is an appropriate means of lowering the rate of interest and of "improving" the balance of trade."

Human Action

By Ludwig von Mises

On the island of Calgary the people traded grain for other goods and it became a form of money accepted by everyone. Because not everyone was a farmer anymore, they kept their grain in large grain bins that various private businesses had set up for this purpose. Some of the grain was merely stored and the owners paid a fee for its safekeeping. Other grain was lent to the grain storage companies for a set time and interest rate. The grain storage companies would then lend out this grain to other companies and individuals who would in turn invest it in businesses to get a return on investment.

Grain as money had a few problems. It was bulky and hard to transport. It could rot or be eaten by rats. Its value would fluctuate according to the grain harvest that year, or even according to the weather. It had different values according to the grade of grain.

The grain storage companies noticed all these difficulties as well. One day one of the younger employees of the local grain Storage Company said, "why do we use grain for trading? Why don’t we use some other commodity with fewer problems for trading?" This was obviously a bright young woman. The managers of the company said why not indeed. The next question was then which commodity should be used. Any other food commodity had as many or more problems than grain. Building commodities such as lumber or concrete would be even more bulky and problematic. "What about diamonds?" someone said. Diamonds were valuable in small quantities and durable but the different grades of diamonds may cause a problem, as well as the danger of counterfeiting as well as they were not easily divisible. "What about metals?" said another employee. Now they were onto something. Not all metals were suitable. Iron was too bulky to transport any large amount of wealth. Copper and aluminum had almost the same problem. Gold, silver, platinum and palladium were all metals that were very valuable in small quantities and were very durable as well as they were all one grade if they were pure. Silver was still too bulky in large transactions and platinum and palladium were both very rare. So it was decided to try gold as a trading commodity instead of grain.

So the company set up a gold storage warehouse and advertised their intentions. They began to get a few customers who agreed with their assessment of the situation in regards to grain versus gold as a tradable commodity. So the customers traded their grain for gold and brought the gold to the new gold warehouse for storage or lending. The gold Warehouse Company would issue a receipt to the depositor for the weight of gold that they had deposited. Soon the receipts themselves were used to purchase or invest with rather than the actual gold, which was safely stored in the warehouse. As time went on, the receipts of various warehousing companies were used as money. Agreements were made between the various warehouse companies to honor each other’s receipts. If some of the receipts found their way to a warehouse other than where they were issued, that warehouse would have the actual gold transferred to their own warehouse. This tended to limit the temptation of some unethical individuals to issue more gold receipts than they had gold to cover, or to lend out gold that they were only contracted to store. The thought of spending time in prison for fraud was a sufficient deterrent for most owners of warehouses. This system of money made the economy run smoother. People could be sure that their gold would not rot or be eaten by rats. The value of the gold would not vary to a great extent like grain. And by using receipts (which could be made payable only to certain individuals if the owner so desired) they did not have to fear theft of their gold.

Meanwhile on Ottawa, they too used grain as a tradable commodity. (Ottawa’s economy had progressed substantially since our last tale, mainly because of foreign investment from Calgary.) On Ottawa the government decided to setup a warehouse company to store gold similar to what was being done in Calgary. The islanders began to trade in their grain for gold and deposit it in the government warehouse for safekeeping. The government managers issued receipts for the gold that was deposited, just like the gold warehouse companies in Calgary. This gold warehouse thing looked like it would be a success just like the system in Calgary. It didn’t take long for the government managers to notice that very few people actually came to retrieve their gold. The receipts circulated in the place of gold and the vast majority of people were happy to leave the actual gold in the warehouse. Since the government had a monopoly of gold warehousing, there were no other warehouses to demand gold be transferred to their warehouse. The government gold warehouse also lent out gold for interest just like the Calgary warehouses did. The managers saw an opportunity to make some extra money and perhaps get a promotion for their efforts. They would take gold that was being stored with them and lend it out at interest. They would not even have to lend out the actual gold most of the time because most people didn’t want the gold, so they would simply print up receipts for non existent gold and lend them out at interest. The managers all thought this was a great idea. "It increases wealth without any effort! Why hasn’t anyone thought of this before?" they said.

So began the great credit boom in Ottawa, where wealth was created with a printing press instead of with labour and intelligence. The warehouse managers began to print the extra receipts and lend them out to businesses and people. Soon they found that the more they lent, the lower the interest rate they had to offer because of the increase in credit that was available. More of any good or service without a corresponding increase in demand will result in a lowering of the price of the good or service, which in this case meant a lowering of the interest rate on the credit that the warehouse was offering. (They also began to offer lower interest rates to their customers who lent money to them, because now that they were simply printing the gold receipts they didn’t really need anyone to lend gold to them.) This phenomenon caused a few other things to happen. The lower interest rate caused more businesses to invest in ventures that had a lower return and higher risk than they would under normal circumstances. Economic activity started to boom. The receivers of the new credit took their new money and began to buy up labour and material to build their new businesses, in the process of doing so they bid up the prices of labour and material as they competed with other businesses for them. Prices began to rise faster and faster, causing enormous problems for creditors and savers. This price rise also caused problems for the accounting systems of businesses, which counted on the stability of the value of money. Anyone who was on a fix income rapidly became unable to afford the goods and services they once enjoyed.

The lower interest rate also caused the citizens of Ottawa to save less because there was less financial incentive to save. As terms came due for gold that had been lent to the gold warehouse the loans were not rolled over and the gold was withdrawn. It soon became clear to the managers that if this trend continued they would soon be out of gold. To solve this problem the government simply passed a law that prevented people from withdrawing their gold and declaring "the receipts" to be the official money and gold was no longer to be used as money. This would surely solve all their problems. But it didn’t.

As it became apparent that many of the investments that had been made with the newly printed money were actually "malinvestments" and were money losers rather than moneymakers the boom came to an end. Many businesses began to go broke and loans were not repaid. People began to lose their jobs and were not able to make payments on personal loans. The construction of new buildings and factories came to a halt. Half finished structures dotted the landscape. Social unrest grew. Money became scarce. The only ones who seemed to have done well out of all of this was the government owned "gold" warehouse.

To counter this problem the government simply printed more money and spent it themselves on various "public works" projects. This would surely solve the problem of the collapsing economy. Roads were built, dams were constructed, and hospitals were built. Many people were able to find employment with these projects but the one vital ingredient that all of these projects lacked was a profit potential. No entrepreneur was involved in deciding what project at what cost and where, so if any of these projects actually turned out to be moneymakers it was by sheer luck. This process of spending money on "public projects" was no better than simply wasting the money on hula hoop factories and pet rock quarries, possibly worse because there is a small, paying market for both of these products.

The government of Ottawa in their enthusiasm for their new paper money system had forgotten some basic economic facts. Money is but a veil. The saving of money is the saving of resources or factors of production. The lending of money is the lending of actual factors of production, such as lumber, labour, cement, fuel, etc. However when money is merely paper that is being printed by the truckload it can not represent the factors of production in any realistic way. When the warehouse printed receipts and lent them at a low interest rate, they did not increase the amount of resources that were available. But when the interest rate was lowered, this was the signal that was being given to the various borrowers. All they did was make it possible for inefficient entities to bid away these resources from efficient entities.

After several ups and downs in the activity of the economy caused by the expansion and contraction in the supply of their paper "money", the government of Ottawa decided to hire a consultant from Calgary. The expert listened to the Ottawa government managers as they explained the problems they were having with their economy. Finally after much explaining and many questions, they asked, "what should we do?" The Calgary consultant thought for a moment and then said "its easy, stop printing these warehouse receipts that you are using for money. Just keep the supply of them stable or better yet, revert back to a receipt system backed by 100% gold." The government managers looked astonished.

"That’s it?" they said. "That’s all we have to do?" they said.

"That’s it.," said the consultant. "That’s all you have to do."

But that will cause a great depression if we do that." said the managers.

"It may cause some problems while things adjust, but eventually the economy will straighten its self out, as long as you stopped intervening in the credit market." said the consultant.

The Ottawa government managers didn’t believe him and decided to disregard his advice. They knew better how to manage things than the free market and they would prove that this was so. 

As time went on the people of Ottawa became poorer as their money lost value, there was a constant upward pressure on prices of all kinds because of the oversupply of paper money. More and more citizens of Ottawa moved their savings to Calgary where they knew it hold it's value. During all of this the politicians of Ottawa continued to print more money, blaming the dislocations in the economy to greedy capitalists, or greedy unions, or anyone they could think of.

Sound familiar?