Summarising Schlichter

Since Detlev Schlichter is discussed frequently around here, I thought it might be interesting to summarise some of the arguments from his book, Paper Money Collapse. Of course I am summarising my understanding of the arguments, so caveats about my fallibility apply; errors and omissions are mine.

He begins with a description of money. It is the medium of exchange. It needs to be something people agree on. Ideally there will be a fixed supply which is infinitely divisible. Precious metals fit the bill. Schlichter distinguishes between exchange value and use value. It is possible to use gold for jewelery and electronic components, so it has use value. But as soon as it is used as the medium of exchange it is the exchange value that dominates. Money has value because it can be exchanged for goods and services.

When people say they want more money, what they usually mean is that they want more goods and services. Nevertheless there is a demand for money as a store of readiness to exchange, in preparation for near-future purchases or unexpected needs. Within the limits of his means, a person can hold exactly the money he wants at any time. If he wants more money, he stops buying stuff and perhaps starts selling it. If he wants less money, he buys goods and services.

If demand for money falls, then more people want to buy goods and services, so prices go up and the purchasing power of a unit of money goes down. This continues until the reduced purchasing power of money causes people to want more money. If the demand for money increases, then more people want to sell goods and services, so prices go down and the purchasing power of a unit of money goes up. This continues until the demand for money is met. In this way, the purchasing power of money changes almost instantly, so the demand for money is met almost instantly. There is no need to create money to meet the demand for money.

Does this cause prices to be volatile? Perhaps, but Schlichter argues that it is impossible for a central authority to control the supply of money quickly enough to counter changes in demand for it. The only way they can measure these changes is by observing prices. By the time the price has changed so that it can be observed, it is too late. He also points to empirical evidence that suggests that prices are more volatile when central banks control the supply of money.

While commodity money has a remarkable record of stability, state fiat monies have, without exception, led to rising inflation and frequently ended in total inflationary meltdown.

In his study Monetary Regimes and Inflation, Peter Bernholz looks at long-run statistics of the cost of living in Britain, Switzerland, France, and the United States. No upward or downward trends are discernible at all from 1750 to 1914. Clear upward trends in the cost of living materialised after 1914, when some governments left the Classical Gold Standard to allow for inflationary war financing. These trends become more marked after 1933 and in particular 1971 , when the United States took the dollar off gold internationally and a complete paper money system was established globally.

And there is the question of what price should be stabilised; what measure of prices should be used? Any average price does not reflect relative prices, so any attempt to stabilize the average price must also change prices relative to one another. So the statistics might look good but an individual will not experience stable prices.

If anything, with commodity money prices will go down as the economy grows because there are more goods and services available and the same amount of money. Isn't deflation bad? Not this kind of deflation. Nobody complains when high definition TVs or computer hard drives get cheaper. Someone who does not want to take investment risks could simply store money and enjoy getting richer as the economy grows. This is an advantage of commodity money.

Now that we understand money, Schlichter goes on to describe the effects of money injection. How might this be done? Money could be injected evenly, instantly and transparently. Everyone's bank balance could be increased by 10% overnight. Because everyone holds exactly the amount of money they want at any time, prices have to increase by 10% to make everybody equally content with their money holding. And so they do, and the money injection simply decreases the value of a unit of money by 10%.

Money could be injected evenly and instantly, but without telling anyone. Consumers will spend the extra money on new goods and services thinking themselves to be richer. Producers won't know whether the new demand is genuine or simply the result of money creation, so they may invest in capital to increase production. All this activity will increase GDP and make the government look good. But as prices start to rise due to the extra money, consumers will stop buying the new goods and services. The new capital is wasted. This is what Schlichter calls a dislocation.

Finally, we can imagine a situation closer to the real one. Money is injected unevenly and without telling anyone. People who get the new money are in luck: they can spend it on shiny things. Shiny thing producers also do very well for a while. Lots of new transactions occur and again there is a temporary spike in GDP. But as the new money disperses, prices will rise, demand for shiny things will decrease, and shiny thing producers will go bust because they have wasted their money on shiny thing making machinery. Some people will see only rising prices and not get any shiny things at all.

To make the model even more realistic, Schlichter introduces savings and interest rates. Left to its own devices, interest rates reflect people's time preference. If people want goods and services now, they are less inclined to lend out their money so interest rates are high. If their immediate needs are met, they look to the future, lend out their money, and interest rates are low. When interest rates are low, producers are more likely to borrow money to spend on capital creation to increase production capacity. The new production is likely to find demand as people spend their savings.

Now, let us imagine we want to create money by making it available on the loan market. To get people to take out the loans we offer them at low interest rates. This encourages producers to borrow money to spend on capital goods such as new tools and machinery. But the money does not come from people who have decided to save. Those people still want consumer goods today, and are still buying them; the resources used to make them have not been freed up. Some producers of consumer goods switch to making tools and machinery to satisfy the increased demand. Production of consumer goods decreases so prices go up. Now people are paying more for what they do want, consumer goods today, and there is a lot of new machinery making things that people don't want. The creation of money has not just increased prices but it has changed prices relative to each other. That is a dislocation. In fact, it is a complete mess.

What should happen next is that producers discover that there is no demand for their increased production capacity, and their projects fail. That would be the market correction. But this looks like a recession, so governments encourage even more money creation to postpone the correction. Each time around, larger and larger money injections are needed.

Now all this money creation got started in the first place so that states could spend more, and this reason has not gone away. Much of the newly created money is used to buy government bonds. When the government borrows money, it is not borrowing from future generations as is often said. It is diverting present day resources to be controlled by the government. This weakens the productive capacity of the economy which again is countered with lowered interest rates and GDP-boosting money injections.

None of this is likely to end any time soon, partly because no government wants to be in charge when the almighty correction does happen, and partly because governments need money to be created so that they can borrow increasing amounts of it to make up for their decreasing tax revenues.

I have missed out lots: historical examples; a whole section on fractional reserve banking and the relationship between banks and the state; the role of professional economists; rebuttals to opposing arguments; and so on. But this is a flavour of the gist of it.