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Monetary Policy Is in Turmoil

Monetary policy is in turmoil. Ever since the financial crisis erupted eight years ago,* major central banks have fundamentally reformed the way they create and absorb money. Their activism has failed to extinguish the fires. There are already plans to equip monetary policy with new tools, such as the elimination of cash and “helicopter money” in order to face the challenges of the moment and the near future.

One thing seems to be clear: the monetary policy of tomorrow will still be very different from that of today. The monetary system and the economy of tomorrow will be profoundly different from those of today. Can we predict this future?

The future is the result of the previous choices. Where there are choices, the future is in principle uncertain. But this matter of fact needs to be put into perspective. Monetary history has been forged under the impact of certain forces that tirelessly push for an inflation of the money supply. These forces are at work today as at the dawn of time, and they will not disappear tomorrow. It is therefore interesting to identify them, to imagine their extension into the future and to assess them in the light of economic analysis.

This is what we propose to do in this article. In the first part, we will study the main forces at work in the production of money, as well as the resulting trends. Part two will be devoted to analysing the current situation and shorter-term trends. In conclusion, we will contrast two interpretations of this evolution: the classical vision, anchored in the conviction that the production of money is not a cause of the wealth of nations, and the mercantilist-Keynesian vision, based on the opposite conviction.

Causes and Finality of Inflation

The word inflation is today commonly defined as a sustained increase in the level of money prices (price-inflation). But its etymological root refers to an artificial expansion of the money supply which results most notably from state interventions (see Hülsmann, The Ethics of Money Production, chaps 5 and 7). It is this phenomenon that is at the heart of world monetary history. Always and everywhere, political power seeks to stimulate the production of money for its own benefit. We must therefore first and foremost consider the economic mechanisms that are at work here.

The Root Mechanism: Cantillon Effects

Money is an economic good that is generally used as a medium of exchange. It represents a very liquid and desired purchasing power. Its production is therefore a source of income. Today the most important producers of money are central banks (which create base money) and commercial banks (which create money substitutes). Banks produce money because this production is a source of income for them, just as miners remove silver and gold from the ground because this extraction is a source of income for them.

One might object that this would not hold true if money were strictly neutral with respect to the real economy. For example, suppose that an increase in the money stock of 10 percent eventually leads to an increase in all money prices, also by 10 percent. At the end of this process, all market participants would therefore be in the exact same real situation as at the beginning. Everyone’s money income would have increased by 10%, but costs would have kept pace. Therefore, in this light, it seems that increasing the money stock is in vain, because it cannot create any real income for anyone.

However, it must be taken into account that, following an expansion of the money stock, individual prices do not increase at the same time and in the same proportion, but at different points of time and in different proportions. This effect is called the “Cantillon Effect” after Richard Cantillon who described it at the beginning of the 18th century in his book Essai sur la nature du commerce en général (An Essay on Economic Theory). The uneven impact of money production on individual prices creates winners and losers. Winners are those who sell at prices that increase faster or more sharply than the prices at which they buy; and losers those who suffer the reverse.

This redistribution of income takes place in particular for the benefit of the first owners of the new units produced. Indeed, these can exchange the new units as long as the price level is still at its initial level; while those who use the new units last have to pay higher purchase prices already before they can increase their spending.

The Long-Run Tendency: Forced Socialisation of Money

Whatever the monetary system, any production of money leads to a redistribution of income in favour of the producers and the first users of the new units. But this effect is particularly pronounced in the case of “cheap” monies, which have the form of tokens, banknotes, or accounting money. The only problem is that such monies, precisely because they can be multiplied very easily, do not normally have the confidence that is necessary to give them general circulation. If they do not have political backing, they tend to be rejected by users.

However, with the support of state interventions, it is possible, within certain limits (competition from other currencies, hyperinflation, etc.), to impose them on the market. Then the state benefits, and the agents in charge of the technical execution of this imposition can also profit from this imposition.

There is therefore a general tendency for the state to get ever more involved in the production of money, in order to obtain these benefits. This tendency can be observed in monetary history from antiquity to the present day. It is a tendency. The men and women in political power understood very early on the material advantages that spring from monetary interventions. But their political opposition understood this, too. Accordingly, states have seldom been able to impose overnight a monetary system that leaves them free to increase the money supply as they see fit. The evolution of monetary systems has been made by trial and error around a general trend. Sometimes it was interrupted very abruptly (for example, during the abandonment of the Assignats and Territorial Mandates at the end of the French Revolution), but it immediately continued its expansionist trend.

The Final State of Monetary Interventionism: The Monetary System of the Future

In view of the facts that we have just established, we consider that the general tendency of monetary development is towards the monetary system which provides the greatest liberty of action to political power; or, to say the same thing from the opposite political point of view, towards the monetary system which subjects the population to the most arbitrary choices of political power and which therefore creates the greatest monetary tyranny. In order to form a fairly correct idea of the future of money, it is therefore necessary to imagine such a system. In our opinion, it is distinguished by five characteristic features:

(1) There is only one base money and there are no money substitutes (no secondary currencies).

(2) This money can be produced without cost.

(3) Political power controls the production of money.

(4) Political power is completely free as to how to use any new units: it can give them away, exchange them, or lend them.

(5) Political power can also control, without cost, all the already existing units of money, which are held by the agents of the private sector: individuals, associations and firms.

Such a system could be set up on a national or regional level. In this case, the monetary freedom of the state would still be limited by competition from other monies. But this system can also be achieved globally, and then the monetary freedom of the state would be at its apex.

It is clear that such a system has never existed. However, today, the monetary systems of the civilised world have come closer to it, most notably because of the technical progress of the last fifty years, especially in information and payment systems. Let us therefore take a closer look at current practice, both to assess the gap that still prevails between it and our future monetary system, and in order to anticipate the next steps in monetary development.

The Current Situation

The various monetary systems that exist today in different countries of the world are variants of the same model that has emerged over the last two centuries. This model first appeared in the Anglo-Saxon countries before it spread more widely throughout the West and then around the rest of the world.

The Prevailing Model of a Monetary System at the Onset of the 21st Century

This model is distinguished by strong state interventionism in regard to institutions (central banks and various public banks) and in regard to monetary and financial regulations; by the presence of a hierarchical banking system involving central banks on one side, and commercial banks on the other; by a parallel circulation of base monies, produced by central banks, and multiple money substitutes, produced by commercial banks (notably current accounts created by commercial banks); by the global imposition of fiat monies to the detriment of traditional metallic currencies; by close cooperation between the central banks of the richest regions; by a growing central intelligence of financial flows and a growing hold by central institutions over the monetary and financial assets of citizens; and by the principle of money production by way of credit.

What separates this model from the monetary system of the future that we have sketched above? On the one hand, the political control of the money units that are already in circulation, while quite strong, is not yet fully achieved. On the other hand, and above all, the state’s liberty to produce money is still quite limited, in particular by the principle of money production by way of credit. Let us look at these two points in a bit more detail.

The political control of money held by private agents is already quite firmly entrenched, although it is not yet perfect. Today most of the money stock is produced by private banks, and central banks themselves have a status of relative independence from governments. However, this independence of central banks stands on shaky grounds. It can be abrogated overnight by simple parliamentary majorities, and the appointment of their directors remains subject to political validation. As for the commercial banks, they are already very strongly constrained by financial regulations, and they are dependent on refinancing from central banks. In addition, thanks to advances in information technology, all money units that exist in scriptural form (accounting money), whether in a central bank account or a commercial bank account, are, on a purely technical level, modifiable (in particular taxable) according to the political imperatives of the moment. The only money units which escape this control are those which exist in the form of banknotes, held in a more or less anonymous way in the purses and treasure chests of the private sector.

As far as the liberty to produce money is concerned, the action of banks is always limited, somewhat by competition and much more so by the principle of producing money by way of credit.

In the current situation, there is not just one money. There is a multitude of base monies and an even greater multitude of monetary substitutes. This competition undoubtedly places limits on the liberty of action of each of the central banks. But the increased cooperation between central banks and financial regulation in recent years have created strong tendencies towards the cartelisation of the banking sector, both public and private.

The most important constraint weighing on the production of money lies in the fact that this production must occur, in principle, by way of credit (this is the principle of the banking-style production of money, see Mises, Theory of Money and Credit, chap. 16, section 1). Neither public nor commercial banks are free to create money by unilateral acts. To create money, they must find a borrower. They are therefore constrained by the consent of potential borrowers, respectively by the latter’s capacity to take on more debt.

Traditionally, this constraint has been eased by lowering interest rates to mobilise marginal borrowers who previously were not yet willing to take on debt. But after the onset of the 2008 crisis, central banks pushed interest rates close to zero, yet they struggled to find borrowers.

This constraint of the “zero frontier” of the interest rate is reinforced, on the one hand, by the prudential approach to credit which has traditionally dominated banking practice and according to which bank loans should be granted only in the short term, only to creditworthy counterparties, and only secured by first-rate collateral. On the other hand, this constraint is reinforced by the conventional practice of central banks, which is not to lend directly to governments, but only through the interposition of commercial banks.

It is true that these limitations have been softened in recent years in the context of the fight against the crisis. The central banks of the Eurosystem have started to lend on a longer-term basis, to clearly insolvent firms and states, and against low-quality collateral. They began to lend more directly to governments in the Eurozone, bypassing commercial bank intermediation. They have also circumvented the very principle of banking-style money creation, especially through currency-swap operations with other central banks. Some central banks (notably those of Switzerland, Japan and the United States) have even started buying company shares on the stock markets.

All the same, the principle of money creation by way of credit remains in force. It constrains the liberty of action of central banks and thus slows down the expansion of the money supply. What are the possible solutions? There are two, one which respects the traditional principle of banking-style creation of money, and one which requires its abandonment. The first is that of negative interest rates, the second that of “helicopter money.” Both require a prior elimination of cash and the establishment of a monopoly of accounting money. Let us explain this in more detail.

Negative Interest Rates and the Elimination of Cash

Negative interest rates have long been used (in Switzerland and Japan) to penalise money hoarding. What is new about the current situation is that they are also used to encourage debt. The idea is that a borrower receives 100 euros today to return 98 euros tomorrow. Instead of paying the lender to save, it is the borrower who is paid to get into debt, because this debt goes hand in hand with an expansion of the money supply.

This approach does not pose any particular technical difficulties for central banks. On the one hand, they enjoy a monopoly and their clients are forced to have accounts with them. On the other hand, they can create fiat money—an economic good in its own right and which is not a claim on any underlying good. Since fiat money can be produced almost free of charge, it can also be lent at negative rates (therefore at a loss) without entailing any life-and-death problems for central banks.

Things are much more difficult for commercial banks. These do not have a monopoly position on the market. Above all, they do not create fiat monies, but only money substitutes. The latter are claims on fiat money and can therefore be converted into cash at the simple request of account owners. Commercial banks could grant loans at negative rates only if they could also tax the assets in their customers’ accounts, with even more negative rates. For example, to profitably lend 100 dollars to Smith at -2%, it would be necessary to impose a rate of -3% on Brown’s 100 dollar checking account. However, negative rates on checking accounts are not achievable as long as there is the option of cash withdrawal. Brown, in our example, would simply make a withdrawal. Instead of holding 100 dollars in his bank account, where this sum would be taxed at 3%, he would hold it in cash without paying this tax. For commercial banks, this would have a negative consequence: they would lose the funds they need to make loans.

One could imagine that central banks would fill the void left by fleeing bank customers, by lending generously, at negative rates, to customer-deprived commercial banks. However, as long as there is the possibility of cash withdrawals, this approach would quickly lead to hyper-inflation: any sum borrowed at –3% from the central bank and loaned at –2% to a client would be immediately withdrawn in cash. Customers would be relentlessly asking for new loans—after all, they are being paid to go into debt—and thus the central bank would be forced to increase the money supply at an accelerating rate. The end result would be an inflationary spiral followed by a collapse of the demand for money, and therefore of the monetary system.

This difficulty could be avoided by outlawing cash withdrawals and, ultimately, any use of banknotes and coins. As a result, the customers of commercial banks could no longer avoid being taxed by negative rates on the value of their checking account holdings. Even if they left their bank and opened another account elsewhere, they could not escape the tax. Another advantage of eliminating cash, at least from the point of view of central banks, would be the facilitation of “bail-ins” to save over-indebted commercial banks.

Helicopter Money and the Elimination of Cash

Hence, we see the central role played by the abolition of cash in facilitating the further expansion of money and credit today. But outlawing cash would play an almost equally important role if ever it were decided to throw overboard the principle of money creation by way of credit and adopt what in current jargon is called “helicopter money.”

This expression refers to a famous article by Milton Friedman on the optimal amount of money. Issuing money by the helicopter means issuing money without going through credit. Friedman had in mind to issue new money by way of a gift: drop 1000 dollars in banknotes from a helicopter and that money is going to be collected for free by the people who are luckily standing just below. But fiat money can also be issued by purchasing all kinds of economic goods that are not debt securities. For example, the central bank could simply pay all new money units into the personal accounts of its directors and managers. Or it could give blank checks to the finance ministry which would spend them on public investments or for other purposes.

There are therefore many “non-banking-style” techniques for issuing fiat currency. They were known long before 1969, when Friedman’s article appeared. Indeed, in the 19th century and before, it was not unusual for banknotes, whether convertible or not into precious metals, to be issued in a non-banking-style manner. Perhaps the most famous example is that of the Assignats.

Repealing the principle of banking-style money creation in favour of the principle of non-banking-style money creation would all at once create greater liberty of action for central banks. There would be no more constraints, neither technical, nor commercial, nor legal on the expansion of the money supply. There would only be one technical problem: it would be difficult for central banks to control the money units that are already held by the public. Under the banking-style creation of money, central banks can absorb sums already in circulation, by tightening the conditions for granting credit. Under the principle of non-banking-style money creation, this possibility would no longer exist.

However, this problem could be solved by outlawing cash. If all money units had to be held in bank accounts, then it would be possible to regulate the money stock by taxing the accounts. Thus, we see again the central issue of the elimination of cash at this current moment in monetary history.

How to Assess This Transformation?

We have just analysed the forces at work in the transformation of monetary systems and the resulting trends. The long-term trend is towards greater liberty of action for the state. We have seen that this trend implies, in the short term which is ours, that monetary authorities have an incentive to outlaw cash and also to suppress the principle of the banking-style creation of money.

We have intentionally side-stepped the question how these trends stand up to scrutiny from an overall economic, political, and social perspective. But this question does arise and the answers are very different depending on the schools of economic thought.

From the point of view of present-day standard macroeconomics, which is Keynesian to the core, monetary history is a succession of technical changes to facilitate an increasingly large inflation of the money supply for the benefit of the greatest number, yet without running the danger of hyperinflation, because this would risk destroying the tool of the printing press. From this point of view, monetary policy has the delicate task of finding the transmission channels which allow the greatest increase in aggregate revenue with the least expansion of the money supply and the least increase in the level of prices.

From the perspective of the classical economists and, today, of the Austrian School, monetary history is an ongoing struggle between those who use political power to generate illegitimate incomes and those who oppose any such attempts. In the eyes of the Austrians, the inflation of the money stock does not have a positive overall impact. It stimulates employment and growth only in the short run, and invariably at the cost of capital consumption, which will hurt growth and real wages in the longer run. In addition, the Austrians consider that monetary inflation causes multiple forms of collateral damage at the political, economic and cultural levels. Let us mention some of them in conclusion.

The increased monetary liberty of action of the state necessarily goes hand in hand with the monetary enslavement of the rest of the population. When the state possesses the liberty to control all bank accounts, the citizens do not have the liberty to use their money as they see fit, no matter what. When the state has the liberty to produce as much money as it wishes, then the monetary purchasing power held by citizens is subject to the arbitrariness of government intervention.

The rise of fiat monies reinforces the dependence of money users on banks. The establishment of central banks reinforces the tendencies of political and banking centralisation. It also gives rise to a kind of institutionalised irresponsibility, today called “moral hazard.” Indeed, all market participants are used to the presence of “lenders of last resort” and neglect their own precautions. Under the inflationary expansion of money and credit, the financial system is therefore weakening all the while it is centralising. The appearance of periodic banking crises in the 19th century, and the persistence of these crises until the present day, provides an illustration.

The principle of banking-style money creation has joined at their hips the expansion of the money stock and the growth of the credit market. The consequence is the so-called financialization of the economy, so decried since the 1990s, but already at work in the 19th century. And last but not least, monetary expansionism is at the root of significant income and wealth inequalities.

*. This paper was first published under the title “L’avenir de la monnaie” in “Comprendre la finance,” special issue, Problèmes économiques, hors-série no. 10 (September 2016): 96–103.