Knowing these two points and having a knowledge of history will leave us with an obvious piece of knowledge. It seems that, throughout history, gold and silver have most often been used as money. Every nation at some point in their history used these precious metals as currency. Indeed, as recently as 1971 the Federal Reserve was still redeeming foreign bank deposits in gold through the so-called “gold window.” So why are gold and silver so often the standard for money?

Murray N. Rothbard

Historically, many different goods have been used as media: tobacco in colonial Virginia, sugar in the West Indies, salt in Abyssinia, cattle in ancient Greece, nails in Scotland, copper in ancient Egypt, and grain, beads, tea, cowrie shells, and fishhooks. Through the centuries, two commodities, gold and silver, have emerged as money in the free competition of the market, and have displaced the other commodities. Both are uniquely marketable, are in great demand as ornaments, and excel in the other necessary qualities. In recent times, silver, being relatively more abundant than gold, has been found more useful for smaller exchanges, while gold is more useful for larger transactions. At any rate, the important thing is that whatever the reason, the free market has found gold and silver to be the most efficient moneys.

–Rothbard, What Has Government Done to Our Money?

Critical Points:

• Money will be whatever the most marketable good is. – Indirect exchange gives birth to money. As people begin to trade indirectly, the thing that they buy the most as an intermediary good will become money. Perhaps butter is money for a while. And then maybe it evolves to salt, since salt is much less perishable than butter. We have all heard the historical fact that Rome used salt to pay it’s troops. Then, eventually, gold or silver might supplant salt as money since salt has this bad habit of dissolving if it rains. But the basic principle is that whatever people find to be the most easily exchanged good will be money.
• Money naturally evolves from the market. – Notice that money can not be imposed on a society or market. Because money is the “most exchangeable good” in a market, it requires a market in order to evolve. Government can not simply mandate that a certain thing be money. We have forgotten that the dollar was not simply imposed on the American (Gitmo Nation) public by the government. It evolved naturally from the citizenry’s favorite coin, the Spanish mill dollar. This particular coin was consider to be very trustworthy and of very high quality. The government coinage that came later in the form of American (Gitmo Nation) gold and silver dollars owed their heritage to the Spanish mill. And, it was the market that made that choice.

Murray N. Rothbard

But man discovered, in the process of trial and error, the route that permits a greatly-expanding economy: indirect exchange. Under indirect exchange, you sell your product not for a good which you need directly, but for another good which you then, in turn, sell for the good you want. At first glance, this seems like a clumsy and round-about operation. But it is actually the marvelous instrument that permits civilization to develop.

Consider the case of A, the farmer, who wants to buy the shoes made by B. Since B doesn’t want his eggs, he finds what B does want—let’s say butter. A then exchanges his eggs for C’s butter, and sells the butter to B for shoes. He first buys the butter not because he wants it directly, but because it will permit him to get his shoes. Similarly, Smith, a plow-owner, will sell his plow for one commodity which he can more readily divide and sell—say, butter—and will then exchange parts of the butter for eggs, bread, clothes, etc. In both cases, the superiority of butter—the reason there is extra demand for it beyond simple consumption—is its greater marketability. If one good is more marketable than another—if everyone is confident that it will be more readily sold—then it will come into greater demand because it will be used as a medium of exchange. It will be the medium through which one specialist can exchange his product for the goods of other specialists.

Now just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media—in almost all exchanges—and these are called money.

–Rothbard, What Has Government Done to Our Money?

Critical Points:

• Money will be whatever the most marketable good is. – Indirect exchange gives birth to money. As people begin to trade indirectly, the thing that they buy the most as an intermediary good will become money. Perhaps butter is money for a while. And then maybe it evolves to salt, since salt is much less perishable than butter. We have all heard the historical fact that Rome used salt to pay it’s troops. Then, eventually, gold or silver might supplant salt as money since salt has this bad habit of dissolving if it rains. But the basic principle is that whatever people find to be the most easily exchanged good will be money.
• Money naturally evolves from the market. – Notice that money can not be imposed on a society or market. Because money is the “most exchangeable good” in a market, it requires a market in order to evolve. Government can not simply mandate that a certain thing be money. We have forgotten that the dollar was not simply imposed on the American public by the government. It evolved naturally from the citizenry’s favorite coin, the Spanish mill dollar. This particular coin was consider to be very trustworthy and of very high quality. The government coinage that came later in the form of American gold and silver dollars owed their heritage to the Spanish mill. And, it was the market that made that choice.

Murray N. Rothbard

Yet, direct exchange of useful goods and services would barely suffice to keep an economy going above the primitive level. Such direct exchange—or barter—is hardly better than pure self-sufficiency. Why is this? For one thing, it is clear that very little production could be carried on. If Jones hires some laborers to build a house, with what will he pay them? With parts of the house, or with building materials they could not use?

The two basic problems are “indivisibility” and “lack of coincidence of wants.” Thus, if Smith has a plow, which he would like to exchange for several different things—say, eggs, bread, and a suit of clothes—how can he do so? How can he break up the plow and give part of it to a farmer and another part to a tailor? Even where the goods are divisible, it is generally impossible for two exchangers to find each other at the same time. If A has a supply of eggs for sale, and B has a pair of shoes, how can they get together if A wants a suit? And think of the plight of an economics teacher who has to find an egg-producer who wants to purchase a few economics lessons in return for his eggs! Clearly, any sort of civilized economy is impossible under direct exchange.

–Rothbard, What Has Government Done to Our Money?

Critical Points:

• “Indivisibility” – Some things can’t be sub-divided. For instance, if you have an extra alarm clock, but you really need some nails, you’re stuck. You can’t split the alarm clock into pieces and trade, perhaps, the volume knob or a couple of microchips out of it for a few nails. Some things just simply can’t be broken down into exchangeable parts like that. It’s only valuable as a whole.
• “Lack of coincidence of wants” – When there is no intermediary(money), each person has to have what the other guy wants. If you have an alarm clock and you want some nails, you have to go out and find an alarm clock wanting nail seller. And the nail seller has to find an alarm clock wanting nail buyer. It’s the reason baseball card shops exist.

Murray Rothbard’s treatise on the nature of money in chapter 2 of What Has Government Done to Our Money? is, in my opinion, the clearest explanation or what money is and how it works in all of literary history. It’s so clear that I find it hard to believe that your average 7th grader couldn’t follow along and understand every bit. Let’s delve in to it over the next few days.

Murray N. Rothbard

To explain the role of money, we must go even further back, and ask: why do men exchange at all? Exchange is the prime basis of our economic life. Without exchanges, there would be no real economy and, practically, no society. Clearly, a voluntary exchange occurs because both parties expect to benefit. An exchange is an agreement between A and B to transfer the goods or services of one man for the goods and services of the other.

Obviously, both benefit because each values what he receives in exchange more than what he gives up. When Crusoe, say, exchanges some fish for lumber, he values the lumber he “buys” more than the fish he “sells,” while Friday, on the contrary, values the fish more than the lumber. From Aristotle to Marx, men have mistakenly believed that an exchange records some sort of equality of value—that if one barrel of fish is exchanged for ten logs, there is some sort of underlying equality between them. Actually, the exchange was made only because each party valued the two products in different order.

Why should exchange be so universal among mankind? Fundamentally, because of the great variety in nature: the variety in man, and the diversity of location of natural resources. Every man has a different set of skills and aptitudes, and every plot of ground has its own unique features, its own distinctive resources. From this external natural fact of variety come exchanges; wheat in Kansas for iron in Minnesota; one man’s medical services for another’s playing of the violin. Specialization permits each man to develop his best skill, and allows each region to develop its own particular resources. If no one could exchange, if every man were forced to be completely self-sufficient, it is obvious that most of us would starve to death, and the rest would barely remain alive. Exchange is the lifeblood, not only of our economy, but of civilization itself.

–Rothbard, What Has Government Done to Our Money?

Critical Points:

• “Obviously, both benefit because each values what he receives in exchange more than what he gives up.” This is one of the most misunderstood aspects of how exchange works. It’s so simple, yet so completely missed by most everyone. There is something inside us that confuses the idea of mutual benefit with equality of value. Absent coercion, both parties in an exchange will only trade if they feel that they came out better than they were before the trade. Otherwise, why trade? This doesn’t mean that the goods or services traded were of equal value, because value is subjective to the individual. Value is not a property of the good or service. An independent observer may see the terms of a trade and conclude that party “A” got ripped off by party “B”. Again, absent coercion, this is incorrect. The observer might not value the traded goods the same as party “A” did. But all that means is the observer isn’t party “A”. It says nothing objective about the trade.
• “Specialization permits each man to develop his best skill, and allows each region to develop its own particular resources.”
  The story of money begins with the necessity of exchange. We all need to trade sometimes. No one is completely self sufficient. The technical term for what he calls “specialization” is “The Division of Labour.” It simply means that we all have different skills and resources available to us. And because of this, trade is not optional. It’s necessary. We voluntarily exchange in order to live. In my view, this is what lends money a moral component. Whenever something is required for life to be sustained, the manipulation of that thing inherits a morality.

It might not be clear yet, but these two points eventuate money. Money in a complex society is not optional. It’s required. That will become apparent as we continue through his argument over the next few posts.

To understand the Panic of 1819 properly, it must be viewed in it’s proper context as being inextricably linked to the war of 1812. War’s are among the most powerful inflationary forces that exist and the war of 1812 was no exception. Governments love to wage war, and to wage a proper war it’s almost always necessary to fire up the printing press and inflate the currency. This is exactly what happened starting in 1811. Banks outside of New England were buying government bonds like mad to finance the war. When it became obvious in 1814 that the outstanding bank notes could not be covered by gold reserves, the Federal government issued a declaration for the suspension of specie payment. This simply meant that, by law, the banks weren’t required to redeem their notes in gold.

CJ Maloney lays it out like this:

Now freed from having to actually raise money (gold) prior to issuing paper promises for it, the banking system’s highly inflationary printing binge went into overdrive. During the war’s three years, domestic prices rose by 25% and import prices by 70%.

From 1811 to 1815, banks multiplied like mushrooms on a dung heap, lending out credit they didn’t have as if it were manna from heaven. Where actual money in bank vaults had decreased by 9.4% during that period, paper bank notes and deposits, all with claims on that money, had increased by 87.2%. Keynes himself would have been proud (Rothbard 2002, p. 73).

–Maloney, Mises.org

All of this led to a, now classic, easy credit consumption binge(sound familiar?) where imports severely outpaced exports. Trade imbalances are a classic symptom of currency debasement. As a country inflates it’s currency, it’s citizens begin to import goods from other countries who haven’t inflated because prices in the non-inflated country are cheaper(again, sound familiar?). People in 1815 were buying everything they could get their hands on, fueled by the moral hazard that the government injected into the system by buying paper debt and suspending gold redemption. There was no central bank yet, but all of the classic checks and balances on free banking that the market imposes had been legislatively removed by Washington. What we got next would just add more fuel to the fire: the second Bank of the United States.

The second Bank of the United States was chartered in 1816 under the auspices of bringing inflation under control. But, of course that’s not what they did:

Instead, the men who ran the new central bank promised not to demand redemption of any state bank paper notes until over one year later. And they bailed out the insolvent state banks with $6 million in taxpayer money. The more things change, the more they stay the same.

To add injury to insult, the men who ran the central bank “jumped on the inflationary bandwagon” themselves (Dupre 2006, p. 271). Printing paper and promises with Bernanke-like abandon, within two years of its creation they had loaned $41 million worth of gold promises and issued paper bank notes redeemable in gold worth $23 million, all on top of just $2.5 million worth of gold (Dupre 2006, p. 270), a level of leverage insane enough to make a Lehman Brothers risk manager feel right at home.

–Maloney, Mises.org

You can, of course see where all of this is heading. A bubble was forming by rampant money printing with no real money(gold) to back it. What began with an attempt to deal with war-time debt blossomed into a full blown credit expansion bubble. What were the effects of this? The same kinds we see today. Exorbitant real estate/land prices, ridiculously low interest rates, rampant speculation into all kinds of wierd business schemes. Easy credit makes people do things they would never ordinarily do. And it was as true then as it is now.

The whole thing came to a head in 1819 when foreign debtors, specifically England and France, were demanding payment in gold from the Bank of the United States. This meant the bank had to call in loans from smaller state banks in order to raise enough specie to pay these foreign debts. But, of course, the smaller banks didn’t have nearly enough gold to cover the amount of paper it had printed either. When this was publicly realized the whole thing collapsed:

When it was realized that many paper bank notes were just that, their values began to collapse, many to zero (the same amount of gold you could get for it), and the money supply contracted at a ferocious rate. From the fall of 1818 to the beginning of 1819, demand liabilities at the central bank fell from $22 million to $12 million (Dupre 2006, p. 272) and the total money supply fell about 28% (Rothbard 2007, p. 89).

Insolvent banks and overextended debtors alike collapsed, while prices, no longer pumped up by the bubble, raced downward to their equilibrium. As the money supply cleansed itself of the bad apples, time and effort had to be paid so that the flow of funds could adjust back to their best uses, following prices as their guideposts. It was a massive, countrywide downturn, and introduced a slowly industrializing America to a new experience — mass unemployment.

–Maloney, Mises.org

So, as you can see, the first true economic disaster of the 19th century was completely enabled by government intrusion into the monetary system and by central banking. Suspension of specie payment led to defacto inflation since banks no longer had to redeem what they printed. This created a scenario of basically hundreds of little federal reserves that were able to inflate like mad. And when the Bank of the United States came into the fray it just accelerated the whole process.

Next time we’ll look at the Panic of 1837.