The Ethics of Money Production: Chapter 10

Chapter 10: Legal Tender Laws

1. Legal Equivalence and Gresham's Law
Legal tender is a money, that can be used in a transaction against the will of the exchange partner. This might be in itself an inconvenience, but nearly always is also a conversion ratio specified, how is the privileged money to be priced in the units of other monies. The law is passed, to benefit the debtors (like the state) to the loss of the creditors.

For example, let's say the law sets the ratio at 20 ounces of silver for one ounce of gold, but the market price is 15. Any contract or debt in silver can be now paid in gold - and much cheaper. As a result, no one will be willing to enter a contract quoted in silver.

This is called Gresham's Law: that an overvalued money will drive undervalued money out of the market. Or simply, the 'bad money' drives the 'good money' out.

Legal tender laws tend to cause a money to be held and produced in greater amounts, thus they have inflationary tendencies; conversely, they tend to deflate the other monies.

(Hülsmann actually writes, that inflation and deflation is caused by these laws, but here I have to disagree: what if a money was so privileged, but its supply wasn't increased? Then, a higher demand and holding by its users would create a deflation instead. The situation arises only in combination of legal tender laws and inflation - and inflation is much easier with these laws.)

(Here follows a more general note: gold has a much higher purchasing power than silver. It is unpractical for smaller purchases and downright unsuitable for the really small things. Like other effects discussed here, it leads to the usage of more money substitutes, which carries known risks.)

To come back to the general effects of legal tender laws, the suppression of one money by another has immediate effects on people's valuation of affected monies, but their actual exchange takes time. The undervalued money vanishes from the market, bringing down prices quoted in it.

Those still using this money will likely find themselves in trouble, because they made debts and investments under the old price level and expected their incomes to be correspondingly higher.

As said, the exchange of currencies takes time, while the choices of people are impacted immediately. One of the effects will therefore be greater usage of money substitutes. Since they can be produced in great amounts in little time, these laws tend to bring about more fractional reserve banking.

Lastly, ask Hülsmann, why were there so many instances of legal tender laws? Since the 14th century, the effects were far from unknown. It is concluded, that they were passed on purpose.

2. Bimetallism
Bimetallism is a currency system with forced exchange ratios between coins from different metals, usually precious metals. The Gresham's Law is here equally valid and Hülsmann quotes several historical examples, where it has manifested in notable ways (the British currency reform of 1717, the US reforms of 1792 and 1834). In each case was the money exchanged through friendly helpers, in exchange for nothing but a solid profit. Each has also led to a greater proliferation of money substitutes and Fractional Reserve Banking.

3. Legal-Tender Privileges for Money Certificates
Legal tender laws can also prescribe to use money certificates in a certain ration to other monies. As long as they are "real" (100% backed) certificates, it is not much of a problem. The law stimulates demand for the privileged money. Those asking for other monies (like uncoined metals), do so for a reason. Certificates are a matter of trust and trust cannot be mandated. Where trust is lacking or is uneven, the monies can't be really equal. Imbuing a money with legal privilege disturbs the market and has a tendency to disrupt the cooperation between people.

This effect may be negligible in case of real money certificates. From a moral point of view, there is no difference, only the impact becomes larger.

Fake certificates are very empowered by legal tender laws. Because all money certificates are equal before the law, no one is motivated to pay more for the real certificates. Their producers also also aim for the lowest costs. Precious metals will be held ("hoarded") or sold elsewhere and are completely driven out of circulation.

Debased coins: there is no proof, that private minters can't compete well with with governments within a free market. But, there is more than ample evidence, that states have abused legal tender laws many, many times. Legal tender laws make it possible to debase coins, until there is not a trace of precious metal in them. Then they can be produced in massive amounts, until it stops being profitable.

But there are disadvantages for those debasing money in this way: it takes time to exchange the coins. Once the people take notice, they will hoard the better coins and use only the new ones. The supply of coins will, at least temporarily, undergo a deflation, which will create problems for private users as for public finances. This problem will go away, once the coins become purely nominal, without any precious metal. It is one of the reasons why the states keep the debasement in secret like private counterfeiters.

Also, legal tender laws benefit debtors on the cost of lenders (one of the main reasons to enact them in the first place). But the state will be also paid with debased coins. Also, its position as a debtor will worsen, and it will be harder for it to become credit.

Thirdly, these laws disrupt international and national trade and produce chaos in many ways.

Finally, if this privilege is granted to several minters without difference, they will compete in money production until they completely destroy their monies and the people will refuse them. This is why this privilege is so rarely granted. (Hülsmann notes an example from 15th century Austria, with immediate destructive consequences. More on it perhaps later.)

Fractional reserve banknotes don't have the mentioned disadvantages, as they are not physically connected to the precious metal

If it is decided to create more banknotes, the currency does not become heterogeneous and will avoid the deflationary effects. As long as the inflation stays moderate, they can be exchanged for precious metal. Banks are not in immediate danger, as long as they keep sufficient reserves. At least directly, the incomes of the state are not threatened, international trade and the state's creditors are not harmed - and there is still some competition between banks. The bankers are still motivated to inflate, but need to hold certain reserves. The system is highly inflationary, but there are limits.

This is the reason, why the western countries have given up coin debasement and turned to cooperation with fractional reserve banks. This partnership, a blessing for the banks, is not that practical a common citizen. The inflationary effects increase and the resources taken by the state are in equal or greater measure drawn out of the economy.

4. Legal-Tender Privileges for Money Certificates
Credit money will not be very widespread because of its risks. But if the people are forced to use it, its circulation will increase. In might increase even more that other types of money, because it is cheaper.

5. Business Cycles
Like any other form of inflation causes fractional reserve banking protected by legal tender laws a redistribution of wealth since the inflation is high, it can be quite significant. Hülsmann notes here the likeness of a market system to a democracy, with each cent being a vote. If that is so, the bankers and the state have much more votes than they'd have in the free market.

But there is another dangerous effect, the business cycle (the 'boom and bust cycle'). The banks may be unable to pay back the demands of their customers, but that doesn't have to be obvious for a long time (esp. with legal tender laws). Due to high profits and competition are bankers pushed to ever lower reserves... until they go bankrupt one day.

Due to the many connections between banks and companies is the fall of one bank (or a few) likely to cause a collapse of the entire system. This has been often the cause with fractional reserve banking, notably in the 19th century USA. Such a collapse will have further negative consequences for the whole economy, with the usage of and demand for money going down pushing all prices down, including wages. The damage can be even greater, if the businesses are misled about the availability of resources. To bring a project to its end, they can calculate their costs, based on prices and interest rates. But if the interest rates and prices are distorted by the production of inflated money, the businesses will start many projects, which they won't be able to complete. Many of the projects, that appear profitable, will fail and waste their resources. And that, dear children, is the business cycle. (More on it in other places.)

6. Moral Hazard, Cartelization, and Central Banks
A bankruptcy of a fractional reserve bank can cause a systemic collapse, unless the other banks help it out. The bankers are therefore highly motivated to support their coleagues in a time of crisis; the more, the smaller their own reserves are. The less careful bankers know, that somebody else will pick up the tab. They are tempted to undergo even greater risks. This temptation to let others pay for their risk is called moral hazard.

The banks can create cartels, that will grant access to a pool of cash, which their members can draw on in case of problems. In turn, the cartel regulates their banknote emissions and reserves. The actual owner of the pool will havea great influence over the other banks, thus there is a natural tendency for the creation of a "central bank". But voluntary cartels have their weaknesses, which is why banking was mostly cartelised through laws.

The cartelization, centralization and regulation by law are all attempts to solve the problems of fractional reserve banking.

7. Monopoly Legal Tender
What if a single type of money is privileged by legal tender laws, which is usually the case? In case of coins made of precious metal, this currency becomes the standard of debasement for others: it isn't worth to have a lower or higher metal content, since they would be rejected by one or the other side of a transaction. And so become legal tender laws fully functional, with a monopoly. But the disadvantages of the process stay - heterogenous coinage, forced deflation, lower incomes for the state, destruction of the lenders and disruption of international trade.

If a specific type of fractional reserve banknotes is privileged in this way, it will bring about an inflation as well. But here, the other banks are free to inflate even more. The moral hazard is even increased, as they can use the notes of the privileged bank to cover their own emissions. Thus it naturally becomes the central bank.

But exactly because of this has the central bank to keep higher reserves than others and be less profitable. (Complaints of the Bank of England are mentioned.) At the same time, it must follow the inflation of the other banks, or the whole system might fall apart. Finally, it can't lower its reserves forever, or it will suffer the same fate.

The history of banking in the 19th century is a history of searching for ways to defer the unavoidable bankruptcy of this system.

8. The Ethics of Legal Tender
Monopolies (as discussed in the previous chapter) limit the freedom of choice of citizens, but still leave them some freedom. Legal tender laws force the citizens of a state to use its money, overriding any contracts they have or might have. As Oresme put it, they are far worse than usury, because usury is at least based on a voluntary agreement between a debtor and creditor.

To Hülsmann, it is impossible to justify legal tender laws, especially when they are made to protect fractional reserve money and certificates. Here is inflation at its worst, even self-defense is denied to the people. The state and the banks are free to enrich themselves.

Allowing the state to alter money for profit leads to tyranny, ends the discourse a quote from Oresme.