Money Mischief

Episodes in Monetary History

Milton Friedman

• Publisher: Mariner Books
• Year: 1994
• ISBN:
  9780547542225
• Topic: Economia
• Subtopic: Politica monetaria

The Nobel Prize–winning economist explains how value is created, and how that affects everything from your paycheck to global markets. In this "lively, enlightening introduction to monetary history" ( Kirkus Reviews ), one of the leading figures of the Chicago school of economics that rejected the theories of John Maynard Keynes offers a journey through history to illustrate the importance of understanding monetary economics, and how monetary theory can ignite or deepen inflation. With anecdotes revealing the far-reaching consequences of seemingly minor events—for example, how two obscure Scottish chemists destroyed the presidential prospects of William Jennings Bryan, and how FDR's domestic politics helped communism triumph in China—as well as plain-English explanations of what the monetary system in the United States means for your personal finances and for everyone from the small business owner on Main Street to the banker on Wall Street, Money Mischief is an enlightening read from the author of Capitalism and Freedom and Free to Choose, who was called "the most influential economist of the second half of the twentieth century" by the Economist.

Chapter 1

The Island of Stone Money

From 1899 to 1919 the Caroline Islands, in Micronesia, were a German colony. The most westerly of the group is the island of Uap, or Yap, which at the time had a population of between five thousand and six thousand.

In 1903 an American anthropologist named William Henry Furness III spent several months on the island and wrote a fascinating book about the habits and customs of its inhabitants. He was particularly impressed by the islanders’ monetary system, and accordingly he gave his book the title I have given this chapter: The Island of Stone Money (1910).

 

[A]s their island yields no metal, they have had recourse to stone; stone, on which labour in fetching and fashioning has been expended, is as truly a representation of labour as the mined and minted coins of civilisation.

Their medium of exchange they call fei, and it consists of large, solid, thick, stone wheels, ranging in diameter from a foot to twelve feet, having in the centre a hole varying in size with the diameter of the stone, wherein a pole may be inserted sufficiently large and strong to bear the weight and facilitate transportation. These stone “coins” [were made from limestone found on an island some four hundred miles distant. They] were originally quarried and shaped [on that island and the product] brought to Uap by some venturesome native navigators, in canoes and on rafts. . . .

[A] noteworthy feature of this stone currency . . . is that it is not necessary for its owner to reduce it to possession. After concluding a bargain which involves the price of a fei too large to be conveniently moved, its new owner is quite content to accept the bare acknowledgment of ownership and without so much as a mark to indicate the exchange, the coin remains undisturbed on the former owner’s premises.

My faithful old friend, Fatumak, assured me that there was in the village near-by a family whose wealth was unquestioned—acknowledged by every one—and yet no one, not even the family itself, had ever laid eye or hand on this wealth; it consisted of an enormous fei, whereof the size is known only by tradition; for the past two or three generations it had been, and at that very time it was lying at the bottom of the sea! Many years ago an ancestor of this family, on an expedition after fei, secured this remarkably large and exceedingly valuable stone, which was placed on a raft to be towed homeward. A violent storm arose, and the party, to save their lives, were obliged to cut the raft adrift, and the stone sank out of sight. When they reached home, they all testified that the fei was of magnificent proportions and of extraordinary quality, and that it was lost through no fault of the owner. Thereupon it was universally conceded in their simple faith that the mere accident of its loss overboard was too trifling to mention, and that a few hundred feet of water off shore ought not to affect its marketable value, since it was all chipped out in proper form. The purchasing power of that stone remains, therefore, as valid as if it were leaning visibly against the side of the owner’s house. . . .

There are no wheeled vehicles on Uap and, consequently, no cart roads; but there have always been clearly defined paths communicating with the different settlements. When the German Government assumed the ownership of The Caroline Islands, after the purchase of them from Spain in 1898, many of these paths or highways were in bad condition, and the chiefs of the several districts were told that they must have them repaired and put in good order. The roughly dressed blocks of coral were, however, quite good enough for the bare feet of the natives; and many were the repetitions of the command, which still remained unheeded. At last it was decided to impose a fine for disobedience on the chiefs of the districts. In what shape was the fine to be levied? . . . At last, by a happy thought, the fine was exacted by sending a man to every failu and pabai throughout the disobedient districts, where he simply marked a certain number of the most valuable fei with a cross in black paint to show that the stones were claimed by the government. This instantly worked like a charm; the people, thus dolefully impoverished, turned to and repaired the highways to such good effect from one end of the island to the other, that they are now like park drives. Then the government dispatched its agents and erased the crosses. Presto! the fine was paid, the happy failus resumed possession of their capital stock, and rolled in wealth. (pp. 93, 96–100)

 

The ordinary reader’s reaction, like my own, will be: “How silly. How can people be so illogical?” However, before we criticize too severely the innocent people of Yap, it is worth contemplating an episode in the United States to which the islanders might well have that same reaction. In 1932-33, the Bank of France feared that the United States was not going to stick to the gold standard at the traditional price of $20.67 an ounce of gold. Accordingly, the French bank asked the Federal Reserve Bank of New York to convert into gold a major part of the dollar assets that it had in the United States. To avoid the necessity of shipping the gold across the ocean, the Federal Reserve Bank was requested simply to store the gold on the Bank of France’s account. In response, officials of the Federal Reserve Bank went to their gold vault, put in separate drawers the correct amount of gold ingots, and put a label, or mark, on those drawers indicating that the contents were the property of the French. For all it matters, the drawers could have been marked “with a cross in black paint,” just as the Germans had marked the stones.

The result was headlines in the financial newspapers about “the loss of gold,” the threat to the American financial system, and the like. U.S. gold reserves were down, French gold reserves up. The markets regarded the U.S. dollar as weaker, the French franc as stronger. The so-called drain of gold by France from the United States was one of the factors that ultimately led to the banking panic of 1933.

Is there really a difference between the Federal Reserve Bank’s believing that it was in a weaker monetary position because of some marks on drawers in its basement and the Yap islanders’ belief that they were poorer because of some marks on their stone money? Or between the Bank of France’s belief that it was in a stronger monetary position because of some marks on drawers in a basement more than three thousand miles away and the Yap family’s conviction that it was rich because of a stone under the water some hundred or so miles away? For that matter, how many of us have literal personal direct assurance of the existence of most of the items we regard as constituting our wealth? What we more likely have are entries in a bank account, property certified by pieces of paper called shares of stocks, and so on and on.

The Yap islanders regarded as a concrete manifestation of their wealth stones quarried and shaped on a distant island and brought to their own. For a century and more, the civilized world regarded as a concrete manifestation of its wealth a metal dug from deep in the ground, refined at great labor, transported great distances, and buried again in elaborate vaults deep in the ground. Is the one practice really more rational than the other?

What both examples—and numerous additional ones that could be listed—illustrate is how important appearance or illusion or “myth,” given unquestioned belief, becomes in monetary matters. Our own money, the money we have grown up with, the system under which it is controlled, these appear “real” and “rational” to us. Yet the money of other countries often seems to us like paper or worthless metal, even when the purchasing power of individual units is high.

Chapter 2

The Mystery of Money

The term money has two very different meanings in popular discourse. We often speak of someone “making money,” when we really mean that he or she is receiving an income. We do not mean that he or she has a printing press in the basement churning out greenbacked pieces of paper. In this use, money is a synonym for income or receipts; it refers to a flow, to income or receipts per week or per year. We also speak of someone’s having money in his or her pocket or in a safe-deposit box or on deposit at a bank. In that use, money refers to an asset, a component of one’s total wealth. Put differently, the first use refers to an item on a profit-and-loss statement, the second to an item on a balance sheet.

In this book I shall try to use the term money exclusively in the second sense, as referring to an item on a balance sheet. I say “try” because, with use of the term as a synonym for income or receipts so ubiquitous, I cannot guarantee that even I, who have been aware for decades of the importance of distinguishing between the two uses, will not occasionally slip and use the term in the first sense.

One reason why money is a mystery to so many is the role of myth or fiction or convention. I started this book with the chapter on stone money precisely in order to illustrate that point. To make the same point in a way that is perhaps more relevant to the everyday experience of most of us, consider two rectangles of paper of about the same size. One rectangle is mostly green on the back side and has a picture of Abraham Lincoln on the front side, which also has the number 5 in each corner and contains some printing. One can exchange pieces of this paper for a certain quantity of food, clothing, or other goods. People willingly make such trades.

The second piece of paper, perhaps cut from a glossy magazine, may also have a picture, some numbers, and a bit of printing on its face. It may also be colored green on the back. Yet it is fit only for lighting the fire.

Whence the difference? The printing on the five-dollar bill gives no answer. It simply says, “FEDERAL RESERVE NOTE / THE UNITED STATES OF AMERICA / FIVE DOLLARS” and, in smaller print, “THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE.” Not very many years ago, the words “WILL PROMISE TO PAY” were included between “THE UNITED STATES OF AMERICA” and “FIVE DOLLARS.” Did that mean the government would give you something tangible for the paper? No, it meant only that if you had gone to a Federal Reserve bank and asked a teller to redeem the promise, the teller would have given you five identical pieces of paper having the number 1 in place of the number 5 and George Washington’s picture in place of Abraham Lincoln’s. If you had then asked the teller to pay the $1.00 promised by one of these pieces of paper, he would have given you coins, which, if you had melted them down (despite its being illegal to do so), would have sold for less than $1.00 as metal. The present wording—no longer with a “promise to pay”—is at least more candid, if equally unrevealing.

The “legal tender” quality means that the government will accept the pieces of paper in discharge of debts and taxes due to itself and that the courts will regard them as discharging any debts stated in dollars. Why should they also be accepted by private persons in private transactions in exchange for goods and services?

The short answer—and the right answer—is that private persons accept these pieces of paper because they are confident that others will. The pieces of green paper have value because everybody thinks they have value. Everybody thinks they have value because in everybody’s experience they have had value—as is equally true for the stone money of chapter 1. The United States could barely operate without a common and widely accepted medium of exchange (or at most a small number of such media); yet the existence of a common and widely accepted medium of exchange rests on a convention: our whole monetary system owes its existence to the mutual acceptance of what, from one point of view, is no more than a fiction.

That fiction is no fragile thing. On the contrary, the value of having a common money is so great that people will stick to the fiction even under extreme provocation. But neither is the fiction indestructible: the phrase “not worth a Continental” is a reminder of how the fiction was destroyed by the excessive amount of Continental currency the Continental Congress issued to finance the American Revolution.

The numerous inflations throughout history—whether the recent moderate inflations in the United States, Britain, and other advanced countries, or the very large recent inflations in South and Central American countries, or the hyperinflations after World Wars I and II, or the more ancient inflations going back to Roman times—have demonstrated the strength of the fiction and, indirectly, its usefulness. It takes very high rates of inflation—rates well up in double digits that persist for years—before people will stop using the money that is so obviously inflating. And when they do lose faith in the fiction, they do not revert to straight barter. No, they adopt substitute currencies. The substitute currencies in most inflations in history have been gold, silver, or copper specie, often, as during the American Revolution, in the form of coins of foreign countries. What’s more, people may not abandon paper altogether: they may turn instead to paper money that has not been overissued.

Two particularly revealing examples are provided by the American Revolution, more than two centuries ago, and the Russian Revolution of 1918. The Continental currency was overissued. The result was that the promise of redemption in specie was not honored, and Continental currency came to be accepted only at the point of a gun. On the other hand, some of the original thirteen colonies issued their own paper money, which remained limited in amount, and this paper money continued to be used, along with coins of foreign countries. An even more striking example is that provided by the Russian Revolution of 1918, which was followed by a hyperinflation of far greater magnitude than the American revolutionary inflation. When, in 1924, the inflation was ended and a new currency established, one of the new chervonets rubles was exchanged for 50 billion old rubles! These old rubles were the ones that had been issued by the new Soviet government. There also still existed old czarist paper rubles. Since there was small prospect that a czar would return to redeem the promise printed on the czarist rubles, it is remarkable that they were still being accepted as substitute currency and had retained their purchasing power. They retained their value precisely because no new czarist rubles could be created, and hence the quantity available to circulate was fixed.

During the German hyperinflation after World War I, currencies of foreign countries served as a substitute currency. After World War II, the Allied occupational authorities exercised sufficiently rigid control over monetary matters, in the course of trying to enforce price and wage controls, that it was difficult to use foreign currency. Nonetheless, the pressure for a substitute currency was so great that cigarettes and cognac emerged as substitute currencies and attained an economic value far in excess of their value purely as goods to be consumed.

I personally experienced a remnant of the use of cigarettes as money in 1950, by which time monetary stability had been restored to Germany and the paper German mark was again the common medium of circulation. Driving from Paris, where I was spending a few months as a consultant to the U.S. agency administering the Marshall Plan, to Frankfurt, the newly established temporary capital of Germany and also the base of U.S. occupation authorities, I had to refill the gasoline tank of the “Quatre Che-vaux” (a small Renault car) that I was driving. As it happened, I had no marks with me, because I was to get an allotment of them when I arrived in Frankfurt. But I did have dollars, French francs, and British pounds. The German frau who filled my tank would accept none of these in payment—that was illegal, she said. “Haben sie keine wäre [“Have you any goods”]?” was her next remark. We settled amicably when I gave her a carton of cigarettes (for which I had paid $1.00 at the Paris PX—remember, this was a long time ago) for gasoline that she valued at $4.00 at the official exchange rate for marks but that I could purchase at a U.S. PX for $1.00. As she viewed it, she got $4.00 worth of cigarettes in return for $4.00 worth of gasoline. As I viewed it, I got $1.00 worth of gasoline in return for $1.00 worth of cigarettes. And both of us were happy. But, as I used to ask my students, what became of the missing $3.00?

I should add that a few years earlier, before Ludwig Erhard’s 1948 monetary reform—the first step in the remarkable postwar recovery of Germany—a carton of cigarettes would have been valued as the equivalent of a far larger number of marks than the number that, at the then official exchange rate, could have been purchased for $4.00. As currency, cigarettes were typically traded by the pack, or even the single cigarette, not by the carton—that would have been far too high a denomination for most purchases. Foreigners often expressed surprise that Germans were so addicted to American cigarettes that they would pay a fantastic price for them. The usual reply was: “Those aren’t for smoking; they’re for trading.”

As the example of cigarettes (or cognac) suggests, an amazing vari...