As Read’s notes in the margin indicate Lane’s thoughts are not exactly correct. The letter contains many fallacies regarding money but it also shows that Lane was a brilliant thinker in her own right. After all she was not an economist and is approaching this topic without any training on the subject. Still, the letter is worth reading for young aspiring economist if only to see where her thoughts went wrong and what she got right.

The main problem with Lane’s position is that she approaches the subject from the wrong starting point. She views money as a measure of value instead of a medium of exchange. It is true that money is a measure of value – money has an objective exchange value, however, the ability to measure this exchange value is not why money is money. Money is money because it is generally accepted throughout society – it is a commonly accepted medium of exchange. Barter, or direct exchange, contains a major flaw in that it requires a double coincidence of wants. If person A wants what person B is selling, person B must want what person A is selling. In our modern economies, where we are highly specialized in the division of labor, this will often be a problem. Thus money emerges as a way of indirect exchange; i.e. it is through a commonly accepted medium of exchange that the problem of the double coincidence of wants is solved.

The process in which money emerges is spontaneous and can be seen through Carl Menger’s (the founder of the Austrian School of Economics) story of the emergence of money. This is in complete opposition to Lane’s position. She gets the starting point wrong because the measure of the objective value of money is not why money is money. She is right that value is subjective but it should not be the cause of concern she makes it out to be. The only measure of value comes from the individual by comparing two economic goods. For exchange, one does not need to know what exactly the other person values for that good in a numeric term, he only needs to know that there is a double coincidence of wants, and that’s all! Money helps provide this double coincidence of wants by being a commonly accepted medium of exchange.

So, how else do you think Lane went wrong? How was she right? There is a lot in this short letter. Share your thoughts in the comments.

Download the Lane to Read Letter of September 16, 1950 here.

(I would like to thank my colleague Simon Bilo for help working through a better understanding of Lane’s position.)

This clearly seems like a complicated issue but in many ways its actually quite simple. F.A. “Baldy” Harper, an economist from Cornell University who worked for FEE in its first years and then founded the Institute for Humane Studies, wrote this 1951 pamphlet on inflation. For him, “inflation can be prevented. Failure to do so is purely and simply a matter of negligence.” And the way to prevent it is clear, “Inflation means too much money. The way to prevent inflation, then, is to close down the money factory. It is that simple.”

The issue is not how much money the government should print but is an institutional one. Economists define institutions as rules that constrain human behavior. Our current monetary system fails to constrain the government from the over printing of money. Currently the government has a monopoly over the monetary system; as Harper points out, if you don’t believe this just try and make your own money. The government wishes to hold this monopoly in order to cover what it spends in excess of its income, i.e. tax revenue. In essence, inflation is simply a hidden tax on every dollar we hold. The government thus has the incentive to print as much money that will maximize its revenue. It is similar to the government basically having an incentive to consistently water down a bowl of punch.

A monopoly in money essentially boils down to a planned monetary system. As Carl Menger, the founder of the Austrian school of economics, showed money did not emerge from the state but through a spontaneous order brought about by the complex interaction of many individuals. In the past, money, usually gold, was produced through a competitive process. Anyone could produce it. By allowing our monetary system to instead be “planned” by the government we have created what economist Gordon Tullock called a social dilemma. Society would be better off if the government did not inflate the money supply but the government gains from doing it, thus, just like a prisoner’s dilemma, we end up with a non-socially optimal outcome.

Maybe the situation is not as simple as Harper suggests. It is after all no simple task to remove the government monopoly on money. But as Harper points out, we are left with only two options, “the only escape from the consequences of these laws would seem to be for the citizens to ignore them. This means lawlessness, technically, in the form of black market operations and all the other forms of evasion. This places the honest citizen who favors human liberty in a strange dilemma. He must choose between practicing lawlessness in the technical sense, or supporting a socialist-communist regime.” What is simple is that the government has forced planning in our monetary system upon us. This makes Harper’s pamphlet extremely relevant even today.

Download F.A. “Baldy” Harper’s pamphlet on Inflation here.

In this letter dated September 1974, Leonard Read thanks Hayek for inspiring him to write his Freeman article “Those Things Called Money.” In the article Read comes to the conclusion that “if money is to be useful to traders as a medium of exchange then the decisions as to what shall serve as money must be worked out by traders in the market, voluntarily, rather than by governmental edict.” What he is doing is applying Hayek’s idea of spontaneous order to money. As Read says, “When millions of people are free to act creatively as they choose, an unimaginable wisdom is the consequence. To assert that it is a billion times greater than exists in any discrete individual would be a gross understatement.” The same principle operates in Read’s famous essay, I, Pencil: Essentially the market is much better at coordinating the dispersed knowledge then any single planner.  That, in turn, comes straight out of Hayek’s 1945 paper (reprinted in the Freeman in June 1961), “The Use of Knowledge in Society.”

Hayek eventually came to the same conclusion as Read, as illustrated by his 1976 monograph The Denationalization of Money. Still, one can find instances of Hayek arguing the exact opposite. For example, in The Constitution of Liberty, published in 1960, Hayek argues that leaving money to spontaneous forces is not only impracticable but also undesirable. Hayek in 1960 was unable to see what Read saw until later.

It’s useful to point this out, not to impugn Hayek in any way, but to show how important Hayekian ideas are for freedom. Read’s article would have seemed very radical and maybe impractical to Hayek in 1960. Indeed the article probably seems radical and impractical to many people today. This doesn’t, however, make it any less correct. Without Hayekian ideas there would be a much weaker case for market-created money. And with government control of money comes a great chance of runaway inflation and disruptions in the market. So, what we should learn from this is that taking Hayekian ideas to their logical conclusion might just make the world more free and prosperous.

Download the Read To Hayek September 1974 letter here.

The difference is in the desire to achieve such an end. Lenin wanted the fall of the Capitalist system in order to usher in the Communist revolution. Hazlitt, on the other hand, makes the point that Lenin was right more as a warning. During this time the currency, in bank deposits and outside currency, was growing and Hazlitt warns readers of the hidden costs of such a monetary policy. The point is very similar to his main thesis in his book Economics in One Lesson,

“The art of economics consists of looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

Hazlitt wanted to show the hidden costs of monetary interventions into the market system and how they are particularly destructive.

The other interesting aspect of this rough draft, and relevant today given the current crisis, is how the whole first page is a paraphrase of John Maynard Keynes. The article can be seen as an attack on the Keynesian system. Keynesians wanted to steer the economy in the short run which ignores Hazlitt’s one lesson. After all, Hazlitt was no fan of the Keynesian system and he still uses Keynes’ own words to make a large part of his argument. It goes to show how far Keynes went from The Economic Consequences of the Peace to the General Theory.

Download “Lenin Was Right”.

The mercantilists of the 1600s raised this error to the pinnacle of national policy. Always bent upon heaping up hoards of gold and silver, they made war on their neighbors and looted their treasures. If England was richer than France, it was, according to the mercantilists, because England had more precious metals in its possession, which usually meant in the king’s coffers.

It was Adam Smith, in The Wealth of Nations, who exploded this silly notion. A people are prosperous to the extent they possess goods and services, not money, Smith declared. All the money in the world—paper or metallic—will still leave one starving if goods and services are not available.

The “money is wealth” error is the affliction of the currency crank. From John Law to John Maynard Keynes, great populations have hyperinflated themselves to ruin in pursuit of this illusion. Even today we hear cries of “we need more money” as the government’s monetary authorities crank it out at double digit rates.

The good economist will recognize that money creation is no short-cut to wealth. Only the production of valued goods and services in a market which reflects the consumer’s wishes can relieve poverty and promote prosperity.

Those words are still true, if only because our political and financial “leaders” want us to believe that they can end the current recession if the Federal Reserve System creates “liquidity.”  Thus, we see the Fed doing whatever it can to push more money into the economy.

One reason that the “money is wealth” fallacy has thrived for so long is that many people – including academic economists – fall prey to another fallacy, the fallacy of composition (discussed last week).  In the case of money, it is especially pernicious.

Assume, for example, that I had a printing press in my house which could crank out undetectable counterfeit money.  I could print huge amounts and purchase whatever I pleased.  No doubt, I would be better off (as long as the authorities did not discover what I was doing), but others would be made worse off.

First, and most important, is the nature of money.  Money is a good that is used to trade for other goods, and by making trade easier (and more abundant), it is a productive asset.

However, as Adam Smith understood, money itself is not wealth; instead, it is a good that we use in order to obtain wealth.  (Pieces of government-produced green paper do not qualify as historical “money.”  Government’s monopoly on money has led to its debasement.)

Second, money follows the same economic laws that govern all other goods.  The more money created, the less its marginal value.  (In other words, money is subject to the Law of Decreasing Marginal Utility.)  Many economists have missed this point.

In typical academic classes, money is described as a quantity variable.  Double the amount of money and the “price level” doubles as well, but the monetary increase has brought about no real harm.  Other academic models note that an increase in the amount of money will increase the amount of wealth (call it “Gross Domestic Product”), even if it also raises the “price levels.”

While such models are easy to teach (and to use for solving math problems), nonetheless they are inaccurate at best and dangerous at worst.  They do not demonstrate what really happens when the amount of money in an economy is increased.  If the process of creating more and more money by fiat (called inflation) goes on unchecked, as it did during the past decade, then not only does the value of money on the margin fall, but its growth triggers an unsustainable boom that ultimately collapses in a bust.

This process has repeated itself time and again, which demonstrates that most policy makers do not understand that money is not wealth.  The lesson still has not been learned.

Next Week: The Fallacy of Production for its Own Sake