A Review of Mises' Theory of Money and Credit IV/VII

- Compiled by Chinedu Okoye 

The Redemption of Fiduciary Media:

Money-substitutes have a value as great as the sums of money to which they refer. However there have been banks whose solvency werent called into question "even the day before it's collapse.

And as long as these events aren't erased from memory, "it must evoke some difference between the valuation of money and that to claims of money payable at any time". Such events create a lack of certain confidence in money-substitutes which could result in money-substitutes having a lower value than money.

These doubts to fiduciary media, however are untenable these days.

The complete equivalence of money and secure claims (substitutes), give rise to a consequence that has immediate bearings on the entire monetary system.

 As exchanges, typically made through the money medium aren't always based on the transfer of money, but also the transfer or assignment of claims to money, which completely performed all the functions of money, so long as the confidence in the bank is unshaken or to the extent that the bank doesn't issue more money.

The body issuing fiduciary media is charged therefore, with maintaining their equivalence to the sums of money to which they refer, and must be able to redeem them promptly when the holders have t make payments or convert them to money in demand.

This he says is the only way which a difference in value between money and money-substitutes (Bank notes and deposits) can be avoided.

So, if an issuing body (Bank) wishes to "secure equivalence between its fiduciary media and the money to which they refer, it should take precautions so as to be able to redeem those fiduciary media that are returned to it through lack of confidence on the part of the holders".

This means everyone must be confident in the capacity of circulation of fiduciary media else it doesn't exist at all. Any bank that is forced to suspend redemption of Fiduciary media where everyone begins to present notes for redemption or withdraw deposits is powerless against panic and no policy can help it.

Thus, the equivalence of Fiduciary media to money depends on the promise of conversion on demand, but more so on the fact that proper precautions are taken by the bank to ensure this. But this is "an impossibility" according to Mises as banks can hardly keep all its loans perfectly liquid (neither can they guarantee them). If confidence is lost, immediate redemption is impractical.

The relevance of Banking:

The recognition of this vulnerability led to calls by some writers for the prohibition of the issue of fiduciary media, without "metallic backing". However the fiduciary media taps into a lucrative revenue source for the issue that "enriches the person that issues them and the community that employs them".

Prohibition of all notes would lead to the without a full backing would completely suppressing the notes issue and strangle the cheque and clearing system.

It would also lead to a suppression of commercial activity given the expediency to which these money-substitutess settle commerce.

But if notes are still to be issued then someone must be found who is prepared to bear uncompensated loses involved.

However, Mises' points out the rationale for the introduction of payments through banking mediation, as there's difficulty in determining weight and fitness of coins by individual merchants in enterprise, costs of storage and transportation of large sums of money, and the handiness of the use of money substitutes.

As such, banks, despite this call for the prohibition of the issue of fiduciary media, would still maintain their relevance.

The existence of surplus cash reserve components of the economy (high Networh Individuals) and their desire to accumulate returns on their excess cash reserves, cements the idea of the necessity of the issuers of fiduciary media –Banks.

The Redemption Fund:

"A person who holds money-substitutes and wishes to transact business with persons to whom these money-substitutes are unfamiliar and therefore unacceptable in lieu of money is obliged to change the money-substitutes into money".

So whoever issues these money substitutes is never able to "put more of them into circulation than will meet the needs of his customers" and it is not possible for a bank to issue more money-substitutes than it's customers can use. All excesses will be returned to it as long as it is an issue of money-certificates. But an excessive issuance of Fiduciary media is catastrophic.

This is because, with money-certificates, money supply is not expanded beyond the banks base money as each certificate refers to an amount of money in the banks possession or backed by gold —the base money.

Whereas, with Fiduciary media, not all money-substitutes are backed by the base money (Central reserves or gold), and can be issued in excess of the base money making it more catastrophic however desirable.

It follows that banks should never issue more media than will meet the requirements of its customers (ie not issue more credit than is demanded), but the practicality of this maxim he says is difficult as there is no way to determining the extent of the markets needs.

The bank has to rely on uncertain empirical procedures which may lead to mistakes. But he concedes even then, that "prudent and experienced Bank directors —and most Bank directors are prudent and experienced– usually manage pretty well with it".

Banks tend to extend the circulation of Fiduciary media as far as possible and if they issue more than their customer base can absorb such that these money-substitutes are presented for redemption, they can procure resources from the central bank.

The Central Banks have no such support however and are totally reliant on their own resources. So they must shape policy accordingly. They must also make sure that there is no more money-substitutes in circulation than the needs of their customers (banks), another difficult evaluation to make as in the case of commercial banks.

Solvency and Liquidity Of Banks:

Mises differentiates both terms with regards banking. For solvency, he said that "a bank may be said to be solvent when it's assets are so constituted in a way that a liquidation would necessarily result at least in complete satisfaction of its Creditors".

For liquidity, he says "is a condition that a banks asset will meets it's liabilities, not merely in full, but also int time". In time here means on the stipulated time for which the bank is expired to meet it's obligations.

Though particular type of solvency, it is not the same thing, for a "liquid" Bank may not be able to satisfy all its Creditors should a liquidation occur. But a solvent bank would.

Ancient commercial law he says, "has imposed on everybody the obligation to have regard to liquidity throughout the whole conduct of business.

But for "credit issuing banks, regard to this fundamental rule of prudent conduct is an impossibility". It lies in the nature of banking to "build upon the fact that a proportion – the larger proportion – of the fiduciary media remains in circulation and that the claims arising from them will noot be enforced, or at least not simultaneously.

This is to say, that they do not expect all bank deposits, to be liquidated at once, and can for the the time being cover the current demand. Banks therefore do not have the luxury of aiming for "liquidity" and they must aim for solvency.

Categories of Banks:

"In most States two categories of Banks exist as far as public confidence the employ is concerned."

The Central Bank, the only banks able to issue more, and commercial banks.. the Central Bank enjoys more reputation, as it is the only bank that has right of issue. Credit-issuing banks risk more for the sake of profit than they can be responsible for.

Because these commerical or credit issuing banks can obtain credit from the central bank when their liquidity is shaken by a sudden surge in liquidation, if they have sufficient reserves required by the Central Bank for such advances a bank is sad to be liquid if it's it's liabilities are balanced by the assets held in the Central Bank reserves, upon which such advances could be drawn.

 

 

Credit and Interest:

This chapter aims to establish the connexion between amount of money in circulation and the rate of interest. So far only the relationship between money and consumption goods have been investigated by Mises, leaving out the account (save for my additions), the exchange-ratio between money and production goods.

Capital goods or productions goods derive their value from their prospective products. He states that "the margin by which the value of capital goods falls short of that of their expected expected products constitutes interest; it's origin lies in the natural difference between present and future goods.

If price variations due to monetary determinants affect production goods and consumption goods in different degrees, then they would lead to a change in the rate of interest.

The question that confronts us from the above are as follows;

1. Can the rate of interest be affected by banking credit policy?
2. Are banks able to depress the rate of interest charged by them?

Entrepreneurs looking to begin the process of production must first have money to purchase production goods. This includes equipment, labor and raw materials. Entrepreneurs who do not have enough capital goods at their disposal will therefore demand not production goods but money to procure these goods.

The demand for capital then takes on the form of the demand for money. Scarcity or abundance of money is felt through the objective exchange-value of money. As the utility of these monies depends on the purchasing power.

Every increase in the rate of discount gives rise to complaints about the legislators rules constraining the powers of banks to grant credit.

However accepted this view might have been, Mises' points that the stock of capital has no influence on the level of interest as this is determined by the demand and supply of credit.

Mises investigated the influence of the creation of fiduciary media on the determination of the objective exchange-value of money and on the level of interest rates. But first addresses the "relationship between variations in the quantity of money and variations in the rate of interest"

The connexion between variations in yhe Ratio between the Stock of Money and the Demand for Money and Fluctuations in the Rate of Interest:

Variations in the ratio between the stock (or supply) of money and the demand for it exerts an influence on interest rates. But this he states, occurs in different ways from popular imagination.

He argues that there is no direct connection between both but an indirect one expressing itself "in a roundabout way through the displacement in social distributions of wealth which occur as a consequence of variations in the objective exchange-value of money."

This is to say that the effect of a change in the ratio of money stock to money demand affects interest rates and the amount of money held by individuals through the changes exerted on the value of money.

This is to say that;

The effect on interest rates is dependent on the wealth distribution from the ratio of money supply to demand, and where it happens that supply increases more than demand, interest rates fall discouraging savings.

Wealth shifts to the recipients of the new money (banks, asset holders etc) and away from the owners of capital (savers). Savings are discouraged as real returns fall from the excess supply.

In the same vein, where the demand for money is higher it could induce more savings (and credit by extension). The former exerts upward pressure on interest rates, and the latterexerts downward pressure on rates.

Here, the value of money increases and wealth shifts to those holding cash or liquid assets and savings become attractive as interest rates rise as businesses struggle to access credit.

Mises concludes this part stating that "a change in the ratio between the stock of money and the demand for money and other economic goods, can only exert a direct influence on the rate of interest only when metallic money is employed".

Thus, the variations in the change of interest rates do not occur as an immediate consequence of variations in the ratio between the demand for money and the stock for it." As has been the general consensus.

This relationship is only produced by the displacements in social distribution of property that accompany the fluctuations in the objective exchange-value of money that is evoked by the variations of the stock and demand for money.

 

A Keynes' Rebuttal:

This overlooks the liquidity preference theory that Keynes would later introduce into the monetary theory discussion, me places too much emphasis on the objective exchange-value of money and wealth distribution.

Interest rates are primarily determined by liquidity preferences as if people expect borrowing costs to rise they may hold more cash and invest less, further increasing borrowing costs. This negates the wealth distribution argument.

Also, interest rates are set by the Central Bank and this can affect savings when policy is excessive leading to wealth loses from inflation. Should money shift to the first recipients, if those recipients hoard the cash, if there's a high liquidity preference, the money stock increase doesn't lead to lower rates but the opposite.

Metallic Money is also outdated as interest rates under Fiat modern systems is determined by central bank policy which hinges on expectations and policy objectives.

Connexion between Equilibrium Rate and Money Rate of Interest:

An increase in money supply due to fiduciary media causes a displacement of social distribution of property in favor of the issuer. Meaning issuers (Banks) employs additional wealth that it receives solely for productive purposes. This is done either directly (carrying out the production process) or indirectly (lending to producers).

An increase in the supply of fiduciary media therefore causes a fall in interest rates. However there is no direct arithmetic relationship between both.

As the redistribution of property causes economic agents to take different individual decisions than they would normally take.

A new issue of fiduciary media indirectly gives rise to a variation in the rate of interest (the difference between the value of consumption and production or capital goods). By causing displacements in the social income distribution.

However the new fiduciary media on the loan market have a direct impact on the rate of interest as they are indeed an additional supply of present goods in monetary terms, causing the rate of interest to fall.

Orthodox principles however assumed that banks cannot issue more Fiduciary media than is demanded by the public. Mises faults this view.

Faulting the Orthodox theory then, that a bank cannot issue more fiduciary media than is demanded, and banks have not the ability to grant credit "gratuitously", he argues that banks, by reducing interest rates charged on loans, can consequently increase the demand for credit.

Drawing from Wicksell, a distinction was made between the Natural and Money Rate of Interest. The Natural rate is determined by supply and demand if capital goods were lent without the mediation of money. Money rates appy to interest charge on loans.

Though banks can adjust their money rates, eventually money raes must meet the natural rate. This means money rate of interest will eventually capture the value the represent which is what the natural rate of interest essentially means, as dents are settled in non-monetary commodities).

When money rates fall below natural rates ,an increase in money rates by banks is bound to follow (as demand for credit would increase). He further posits that a general rise in commodity prices should necessitate an increase in interest (money) rates.

This Mises argues against as he sees no need why a rise in prices which leads to increased demand for loans would make banks increase interest rates stating that under Wicksel's assumptions, "it is impossible to see why rising prices and an increasing demand for loans should induce them to raise the rate of interest the charge for loans".

Influence of Interest Policy of Credit Issuing Banks on Production:

Now it's established that it is within the powers of banks to stimulate the demand for capital by reducing interest rates barring limitations imposed on them by the Central Bank. One credit issuing bank indices the rest to do the same.

However like earlier mentioned in previous notes, and earlier chapters, the issue of fiduciary media is only possible because the banks enjoy the full confidence of the public. Also, all credit issuing banks extend the issuance of fiduciary media as much as possible with only legal restrictions acting as limitations, not any public resistance.

Thus; "if there were no artificial restrictions of the credit system at all, and if individual credit-issuing banks could agree to a parallel procedure,  then the complete cessation of the use of money would only be a question of time".

Mises moves forward with this assumption that Fiduciary media would replace money entirely absent restrictions. However, there seems to be a neglect of the self preservation and prudential actions of these credit-issuing banks, as bad loans do exist, and so does the aversion to it, prompting risk management strategies thatimita the banks exposure to excessive Fiduciary media.

Under this assumption the limit is discarded and the changes in the  objective exchange-value of money bruhht about by this issuances is determined only by the banks running cost.

General Economic Consequences of Divergence between the Natural and Money Rate of Interest:

So, it's been established that competition makes banks act in a uniform manner somewhat. And with that Mises proceeds with the case in which money rates fall below natural rates, as a case of the reverse would simply mean the institution gets priced our of the market.

He states that "the level of the natural rate is limited by the productivity of that lengthening period of production which is just justifiable economically and that of tht additional lengthening of the period of production which is just not justifiable."

By this he means that;

If banks lower rates artificially, businesses see cheaper credit and invest for longer periods of time, however these investments are only justified up to the point where additional increase or lengthening of the production still increases productivity as the economy has a limit to how kong production processes can be extended while remaining efficient.

Just Justifiable - longest time period for which production expansion still makes sense and returns on investment justify the waiting time.

Just Not Justifiable - The period when extending production further nonlonher yields sufficient returns to justify the longer wait.

So interest rates according to Mises should always reflect the real productivity of capital (ie the natural rate), and when they're lowered the economy is emcouraged to take excessive risk leading to capital misallocations and economic cycles.