18: Redemption of Fiduciary Media
The value of fiduciary media is based on the faith that the party to whom credit has been extended will make payment. There is no party whose capacity to make payment is beyond all doubt, and even financial institutions that collapse are often regarded as being entirely sound and reliable, even the very day before they declare bankruptcy. So it stands to reason that there should be at least a small difference between the value of money and the value of a money substitute as a result of the level of doubt that they may ultimately be redeemed by the bearer.
Various measures can be taken to provide a guarantee of redemption, not the least of which is the bank itself, who guarantee that fiduciary media will be redeemed by the bank regardless of whether the debtor on whose credit the fiduciary media are based makes good on his payment of his debt to the bank. In effect, the bank absorbs the risk of redemption.
But more to the point, fiduciary media and money both act as tokens in exchanges. While a transaction involves money, the buyer of a good seeks to have possession of the good, and the seller seeks to gain profit that he can then use to purchase other goods. Thus, whether the currency used in the market is salt or gold or debt contracts, the actual value of the currency is of derived importance: so long as it can be used in transactions in a market, it has value as a token in any specific transaction.
Specifically, when a bill (fiduciary media) is accepted in a transaction, the receiver of the note does not mean to redeem it, but to continue to use it in other transactions. Ultimately, it is expected that the bill will fall into the hands of someone who means to redeem it, so it will lose its value in trade if the bank that backs a given bill becomes insolvent.
The author seems to repeat something from an earlier chapter: that a bank need not have the financial reserves to redeem all the fiduciary media it has issued because these bills remain in circulation for an indefinite period of time, and the bank is generally in a position to create new fiduciary media at an equal or faster rate than fiduciary media that has previously been issued are redeemed.
The Return of Fiduciary Media Due to Lack of Confidence
A common view is that, in order to preserve the value of fiduciary media, the issuer must be prepared to redeem it for money when individuals express doubt as to its value. In effect, this redemption provides proof of value that will decrease doubt and preserve the value of the fiduciary media.
Von Mises finds it "impossible to subscribe to this view," as the very nature of fiduciary media is in its basis in credit: the issuer had the funds in stock to redeem a bill on demand, it would not be fiduciary media at all, but a money certificate. The very notion of fiduciary media is based on institutions not having the funds present, but that the institution will have the funds in future.
It is in the very nature of credit to obtain funds immediately in exchange for a promise of future payment. It would not be reasonable or acceptable for a creditor, after having agreed to loan money for the span of a year, to demand payment in full the very next day, not would any just court side with a creditor who made such a demand.
And yet, this very phenomenon of demanding payment in advance of its due date that has expedited, if not caused, the failure of banks: when holders of fiduciary media begin to lose confidence, they seek immediate redemption, exhausting the bank's capital reserves and making the bank incapable of redeeming its fiduciary media.
Hence, the immediate redemption of fiduciary media is not only inadvisable, it is often entirely possible.
(EN: I have some misgivings about this meditation, though it may stem from my own inexperience with fiduciary media, as it is not involved in most commercial transactions of the present day. That said, my sense is that if a certificate is imprinted with a date, and it's clear to the bearer when it can be redeemed, there should be no problem if the bank holds to that requirement - it may, at its discretion, elect to voluntarily repay a debt ahead of schedule, but if it hasn't the means, it should be able to insist upon respect for the agreed-upon date of redemption. It could be argued that a certificate that is worthless until a given date might be less appealing in commercial transactions, hence fiduciary media would be valued less than money - but that seems to me a natural and acceptable consequence of the factual reality that a debt certificate reflects. The acceptor of a certificate is well aware of the conditions of its redemption, and may factor this in his consideration of its value.)
The Case Against Fiduciary Media
Historical incidence of bankruptcy has given rise to the notion that the use of fiduciary media should be prohibited entirely. This is largely an attempt to rationalize the emotional reaction to disaster, that regret and fear lead to over-reaction without consideration of the details and other possible causes of failure in a specific instance, which is all too common in politics.
The author lists some of the benefits of fiduciary media, primarily in the ability to bring future capital into present use and this increase the welfare of society at large. In essence a ban on fiduciary media would be a ban on borrowing altogether, if not literally than practically, as banks would be less able to borrow capital were they required to keep the very same amount in reserve to redeem the loan. In effect, a loan could only be made to a party whose capital resources would make a loan unnecessary.
It is further suggested that money itself is not without risk. Even if a money certificate is backed by funds on deposit, there are still risks of redemption - the certificate may be destroyed, the bank may be robbed of the money, etc. So the suggestion that a commodity-backed note is entirely risk-free is a misconception. The use of fiduciary media, based on the judicious extension of credit, adds only a margin of additional risk to a purely certificate-based economy, and that fiduciary media are accepted in commerce can be taken as a vote, by means of the act of acceptance, in its soundness.
It's also implied that the profit made on fiduciary media is a source of revenue for banks. Were banks limited to storing money and issuing certificates, there would be need to charge a fee for storage to cover the expenses of the bank, which would make banking unprofitable and unappealing to depositors.
However, it must be conceded that "prohibition of fiduciary media would by no means imply a death sentence upon the banking system." There would remain the business of negotiating credit and loans, clearing claims and counterclaims, and other services that a bank could offer, though at less profit to itself as well as less interest paid to its depositors.
The Redemption Fund
To trade with a person who does not wish to accept fiduciary media (lack of confidence or familiarity with the source) must be able to exchange the fiduciary media for something the other party will accept - namely, money. This is essentially similar to the exchange of foreign for domestic currencies, though fiduciary media must typically be redeemed by the issuer.
This is the bearer's perspective on the phenomenon previously described: a bank's need to have the ability to redeem fiduciary media on demand. And it carries with it the same peril for the bank: because the funds are not in storage to back fiduciary media, there remains the possibility that the bank will be called upon to redeem more fiduciary media than it has funds in stock to redeem.
As such, it is a sound business practice for a bank to make a reasonable estimate of the amount of fiduciary media that will be acceptable in transactions when estimating its necessary cash reserves. It seems precarious, but it's noted that bank directors who are "prudent and experienced" usually manage this estimation well.
It's also generally true that banks extend credit only to persons within the same political boundaries - force of law being the ultimate remedy when a debt is not repair, though in some instances credit is extended across political boundaries, and greater risk to the bank.
This is also a matter of concern for the bearers of fiduciary media - that the issuing bank be proximate and familiar, as well as being subject to local laws in a court that will give fair treatment to the welfare of the bearer in the instance of any dispute.
There is also a differentiation to be made between central banks (which have a monopoly or near-monopoly on the issue of notes) and branch banks, which primarily deal with fiduciary media in a competitive environment. The value of the central bank is as a regulator of currency and a guarantor if the validity, availability, and redeemability of its notes.
Where central banking is practiced, the branch banks rely upon the central bank to ensure the availability of money, but the central bank has no such institution backing itself, and as such must be more rigorous in its issue of fiduciary media.
In terms of international trade, the demand for money differs among nations, which has previously been discussed in terms of encouraging the exchange of money (from nations that have money) for goods (from nations that need money) ant an exchange value derived from the poignancy of their respective needs.
It's also noted that the nature of exchange between nations is not one-sided, which gives rise to the absurd but entirely plausible notion that a ship carrying gold from America to Britain might pass another ship bearing the exact same quantity of gold from Britain to America. Had the nations traded in fiduciary media, the two crews could have remained safely at home while the parties in those exchanges swapped certificates of ownership to gold on their own shores.
(EN: It briefly occurred to me that this may well be true of other goods, but considerations of quality interfere with that. Only where the goods are uniform, such as gold or salt, is this feasible feasible.)
To take this example a step further: if 100 pounds were bound from America to Britain and 50 were coming the other way, the matter could still be handled by paper rather than metal if the central bank of Britain would extend credit for fifty pounds to America in addition to swapping ownership of the common sum. (EN: Though it would stand to reason that trade would have to eventually balance out, or gold would eventually need to be shipped from one nation to the other in satisfaction of the credit extended.)
And while the credit balance remained outstanding, fiduciary media could remain in circulation in the debtor nation, satisfying the domestic need for a money by means of a substitute that could be used in commercial transactions until such time as the debt would be repaid among the central banks. The result of this would be greater price stability in each of the nations, and at the same time the satisfaction of each market's demand for money as a medium of exchange.
Hence, through the central banking system, international trade is facilitated by the exchange of money and credit among banks that provide money substitutes to the markets, rather than having to be coordinated in the exchanges between millions of individuals in their separate transactions.
There remains the idea that fiduciary media must be restricted artificially because there is no natural restriction upon it. That is to say, there must be a regulating authority to prevent banks from writing themselves as much credit as they care to take on, without consideration of their ability to repay. This idea, which is used to justify political intrusion into the economic system, pointedly ignores the notion of creditworthiness: that a bank does not write its own credit, but must negotiate with a lender who must be willing to extend this credit, and said willingness is based on the creditor's estimation of the debtor's capacity to make repayment.
Just as a person would be unwilling to extend yet another loan to debtor who has no apparent means of making payment - or who has already taken out a quantity of loans to which this new debt would be added - so would a bank be reluctant to accept the fiduciary media of another bank that has overextended itself.
There is no need for legal interference (which is done under the guise of assistance), other than to ensure that a debtor does not misrepresent its financial status to its would-be creditors.
Essentially, the arbitrary limitation of fiduciary media sets a limit on the amount of money that is available to a given market that is more likely to be too low, and could possibly be too high, for the actual demands of the market in question. That is, the arbitrators are endowed with no greater perception or judgment than the banks they seek to control.
Cover for Fiduciary Media
The terms "solvency" and "liquidity" are mistakenly used interchangeable, but there is a significant difference that should be resurrected in considerations of fiduciary media.
- Solvency describes a situation in which a debtor has sufficient capital to settle his debts: if all creditors demanded payment at once, he could sell his assets to satisfy them.
- Liquidity describes a short-term situation in which a debtor has sufficient money to service his debts - that is, to make payments as they come due.
And it follows that a perfectly solvent individual may not have sufficient liquidity to service his debts (though he could liquidate capital assets to do so), whereas a person who has liquidity to service his debts is not necessarily (or even usually) entirely solvent.
The two qualities are not entirely independent of one another - a person's solvency has no direct bearing on their liquidity, but given that the individual leverages the capital assets that contribute solvency in order to achieve liquidity, the latter tends to correlate to, though not necessarily derive entirely from, the former.
Creditors seek liquidity among their debtors. A borrower's overall financial status is of less concern than his ability to pay their debt as it comes due. The same attitude should remain true of a bearer or acceptor of fiduciary media in regard to the issuing organization.
And to draw another correlation: it would be unusually for an individual person to have the ability pay off his entire debt immediately, and unreasonable for a creditor to demand he liquidate his capital assets to make payments ahead of the agreed-upon schedule. And it would likewise be unreasonable for the bearers of fiduciary media to expect the issuer to be able to redeem all its credit immediately by the same means.
The ability of a bank to pay its creditors is linked to its ability to collect from its debtors, and managing the timing of debts owed and payments due is central to the business of banking. In a legal system in which a bank is required to be perfectly solvent in satisfying its own debts on demand, the bank would necessarily have to set the same conditions of the loans it extends to its own customers: that payment in full could is due immediately upon demand.
Hence, the expectation or demand for a bank to be perfectly solvent, rather than merely maintaining sufficient liquidity to service its debts by agreed-upon terms, is no more reasonable than to make the same demand of an individual debtor - a stipulation to which few elected officials would be willing to agree.
Short-Term Cover
At times, the banking industry has been required by law to restrict the duration of its loans to shorter terms, in order to protect the bank balances of the citizens against risk, but it is patently unnecessary: "neglect has always avenged itself."
Many retail banks that issue credit tend to prefer short-term loans and investments, which provide them greater flexibility in managing their day-to-day supply of funds in reaction to the deposit and withdrawal activity of their own customers.
It's also noted that short-term loans are generally made in smaller amounts, and as both of which mitigate the risk to the bank, they are offered at lower interest rates. As such, they are to be favored for practical reasons by banks whose clientele deal with small amounts of money over short periods of times, and legislation is unnecessary.
However, it's noted that short-term loans are a poor basis for the issue of fiduciary media: fiduciary media count on a loan balance that will remain outstanding for a longer period of time - so that the fiduciary media can remain in circulation over a longer period of time. The cost of issuing and redemption of short-term fiduciary media would be unprofitable, or would serve to increase the interest demanded of borrowers for short-term loans.
Security of the Investments of Credit-Issuing Banks
Ensuring the soundness of fiduciary media is a relatively straightforward matter: a bank must be prudent in the issue of its loans, and set aside some portion of its own capital to cover the risk of loss from bad loans. The greater the risk of a loan, the more capital a bank must set aside to mitigate that risk.
There is a brief mention, as an aside, of the issuance of alloyed currency, in which the value of the metal contained within a coin is less than the face value of the coin. Such coinage can be seen as a mitigated risk to the bearer: the fractional amount of precious metal ensures that the bearer will have some of the value, even if the coin itself becomes invalid at its full face value.
There remains the question of what may be used as "cover" for fiduciary media: precious metals, money, and even the bank's physical assets (the value of the bank building as real estate) are all assets that can reasonably be used to back the level of risk. Though it needs be said that the expectations of an individual who redeems fiduciary media are for prompt payment, and there is less confidence in the media if the bearer will be paid at some uncertain date when the bank can liquidate a capital asset.
Overlooking the expectation of prompt redemption has been the flaw of various "experiments" to issue fiduciary media based on non-liquid assets, such as mortgages. If the money substitute is to be confidently accepted as being equivalent to money, it must be redeemable promptly for money - and if it is not, it is unlikely to be acceptable as a substitute for money in commercial exchange. That is, it may be refused, or accepted at less than its face value, due to the delay and risk in order to redeem it.
(EN: The specific mention of mortgages as backing for fiduciary media is of particular importance in the present day, where the crisis in real estate has damaged the world economy - in part due to unsound mortgage lending criteria, but also in part because of mortgage-backed securities being treated as fiduciary media by institutional investors. It has been argued that mortgage brokers were unscrupulous, or that investors did not consider the risk of buying such vehicles - and I expect that both are true to some degree.)
Foreign Bills as a Component of the Redemption Fund
Special consideration is given to the use of foreign currency, especially credit-based foreign currency, as a component of the redemption fund. It is common practice among banks, especially those in nations whose economy and political system are unstable, to maintain a reserve of foreign currency to mitigate the risk of domestic instability.
A person who lacks confidence in his domestic economy may seek to hold foreign notes as a means to protect himself against domestic instability, but in doing so must forego the immediate use of those funds in the domestic market (except in rare instances, he must exchange foreign notes for domestic in order to make purchases in his local market.) It is also noted that, in situations of an economic collapse in a given nation, that foreign currency often is used in domestic trade in the period between collapse and reconstruction.
The same may be said of banks who maintain reserves of foreign currency: it reduces their ability to make payment in domestic funds, but reduces their risk of loss in the instance of an economic collapse.
And returning to the previous notion of prompt redemption, the speed at which these foreign notes can be converted into domestic currency in order to satisfy the redemption of fiduciary media dictate the degree to which they can be used as a component of the redemption fund. If the exchange can be made promptly, there is no issue in using foreign bills.