Can a Commodity-Money Economy Co-Exist with a Fiat-Money Economy?

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[Editor’s Note: In this selection from “Is the Virus of International Macroeconomic Interventionism Infectious? An ABCT Analysis” in the newest issue of Quarterly Journal of Austrian Economics, the authors analyze how a commodity-money-based economy would be effected by neighboring economies still using fiat money. The authors note that the government interventions in the fiat money economy (“country B”) would negatively affect the economy with free-market money (“country A”). But, the more laissez-faire economy would still fare better, even if “infected” by the distortions of interventionist economies next door.]

Although a commodity money economy would be largely insulated from monetary disturbances generated in fiat money economies, Cantillon effects would occur from the residual asset price inflation in the commodity money country. The consequences for real production processes, however, depend on entrepreneurial anticipations. Entrepreneurs with superior foresight in the lines of production experiencing Cantillon effects will be less prone to malinvest capital and misallocate resources. They will assess more accurately the extent of asset price inflation and exhibit proper restraint in expanding capital capacity and resource use in production during the boom so as to avoid the losses during the bust. By cutting off the spread of rising entrepreneurial demand for resources and capital capacity at the source, the malinvestment and misallocations associated with the boom-bust cycle can be contained within a narrow scope in country A. Moreover, during the course of the boom-bust cycle, resources and capital capacity tend to move out of the hands of the less insightful and into the hands of those more able to anticipate the future course of events. The less insightful entrepreneurs malinvest capital capacity during the boom and liquidate during the bust. The more insightful ones, by restraining from malinvestment during the boom, put themselves in a position to acquire capital capacity cheaply as the less insightful entrepreneurs liquidate their assets during the bust.

This market process of transferring command over resources and capital capacity away from less insightful and toward more insightful entrepreneurs could be institutionalized into a system of “private enterprise protection.” But, here, “protectionism” would take on a very different meaning than that usually accorded to this policy. Entrepreneurs in A would be the agents offering protection to others from the losses of the boom started by B. In contrast with bureaucrats who rely on the ability of the state to punish those who do not comply with regulations, entrepreneurs persuade others to join them in their ventures by finding and offering them mutually advantageous terms for their cooperation. In this case, they would offer protection by persuading others to join them in sustainable lines of production and to avoid the harm to those who might otherwise succumb to the temptation to participate in the boom. Entrepreneurs could form voluntary trade associations to increase the incentives to refrain from short-term gains so as to avoid malinvestments. Voluntary unions among workers could reinforce the entrepreneurs’ decisions to avoid participation in B’s boom. During the boom, entrepreneurs who refrain from increasing production and expanding capital capacity, can still earn profit from higher output prices and equity from the asset price inflation. By forestalling misallocation of resources and malinvestment of capital investment, they can also largely avoid the losses and consequent liquidations of the bust. And although economic calculation is made more difficult by credit expansion elsewhere, movements in foreign exchange rates between the inflated monies and the commodity money provide information that entrepreneurs can use to aid economic calculation which would not be available in absence of at least one country using commodity money. Entrepreneurs have a firmer basis on which to form anticipations of the lines of the boom that might tempt residents of country A into making malinvestments of their capital and misallocations of their resources. Adherence to a free market regime of commodity money would be critical for entrepreneurs to sharpen their anticipations to judge between the lines of production and investment that will prove to be sustainable and those that will not.

Even accounting for “private protection” from the ill effects of monetary inflation and credit expansion generated externally, some residual effects of the boom-bust will remain in the laissez faire territory. The final issue, then, is whether or not the residual misallocation of resources and malinvestment of capital investment occurring in A constitutes a market failure.

The main “players” in the market failure literature are monopoly, externalities, public goods, and informational asymmetries. The question now arises: does the fact that economic “infection” can indeed infect economy A constitute a market failure? We deny that this is the case. Why? It is simple. It is not market failure that undermines the economy of A. Rather, it is the government failure of B that leads to this result.

Even with the success of voluntary associations to moderate the malinvestments and misallocations arising from Cantillon effects, entrepreneurial errors will occur in A. Some residual malinvestments and misallocations will remain. We agree with Hayek that a country whose economy is an integral part of the world’s cannot be entirely isolated from inefficiencies emanating outside its borders. However, what impairs efficient production in country A is not a market phenomenon but rather one of government intervention in the economy in B, in this case. It is a general conclusion of economic theory that entrepreneurs economize on the use of resources for consumers as best they can in the face of barriers established by government intervention. The reaction by entrepreneurs to government obstacles result in the secondary effects that Mises (1998) demonstrated lead to the tendency for government interventions to accumulate. If the overall result of government intervention and the ensuing entrepreneurial reaction is sub-par compared to the laissez faire starting point, the fault lies with the government in B, not the market, in A.

A similar claim can be made about monetary inflation and credit expansion within a given country. It is not a market failure that entrepreneurs in A, striving to economize anew in the face of a B central bank driven credit expansion malinvest capital and misallocate resources. The former are, to the contrary, economizing as best they can, given the barriers to doing so instituted by B’s central bank policy. Because having a money independent of the inflationary and expansionary process of the central bank would allow them to economize even more fully, entrepreneurs, if given the freedom to choose would establish their own sound money system to insulate their operations somewhat from the ill-effects of expansionary monetary policy. One of the key insights of this paper is that, at times, the blame does not rest on the government of the country that feels the ill effects, A in this case. In some circumstances, one must be willing to look abroad to find the original government failure.

Assume that areas C and D both have a policy of total free trade on a unilateral basis. Whereupon D suddenly imposes protectionist measures on imports from C. Will the economy of C be negatively impacted by this unwise measure? Of course it will be. Specialization and the division of labor will no longer be as thorough and all-encompassing as they once were, before protectionism was introduced by D. Would we then acknowledge that “market failure” had overcome C? Of course not. Matters would be clear. We would maintain, instead, that the reason for C’s economic plight had nothing to do with free markets. Rather, we would lay the blame at the door of D, the originator of tariffs and other interferences with full free trade. In like manner, we arrive at the same conclusion for A and B, and the monetary inflation and credit expansion of the latter. Both of these were examples of government failure, not market failure.

Just as unilateral free trade results in the most economizing use of resources for a country adopting it within an international economy of protectionism in other countries, unilateral movement to commodity money will insulate a country as much as possible within an international economy of fiat money inflation and credit expansion. Such monetary reform improves the economizing operation of the market economy within the country that adopts it.

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