torsdag, november 13, 2008

 

Debentures and banknotes

Today I would like to continue my examination of Murray Rothbard's little pamphlet The Case for a 100% Gold Dollar. I start with a quotation from Murray Rothbard's preface to a later edition of the pamphlet.

"In my original essay, I called upon the banks to start to issue debentures of varying maturities, which could be purchased by the public and serve as productive channels for genuine savings which would neither be fraudulent nor inflationary."

In my opinion this quotation substantiates that Rothbard is in contradiction with his own logic, his teacher Ludwig von Mises and that he had completely misunderstood the whole issue of what is called fractional reserve banking.

In order to explain why I hold this view I would like to start with a brief definition of the word debenture. What is a debenture?

A debenture is a certificate where the issuer or the debtor promises to pay a specific amount to the creditor once the debt is mature. In the meanwhile the debtor or the issuer also promises to pay a fixed interest. Of course there is no absolute guarantee that the issuer will be able to fulfill his contractual obligations, but he has obliged himself to do his very best. The creditor is aware of the risk that the debtor might not be able to fulfill his obligations, but is obviously willing to take that risk because of the interest he has the prospect of earning. He might become an insolvency creditor and is aware of that risk.

Another important feature of a debenture is that it, at least in most cases, is transferrable. That means that the original creditor is free to hand over the debenture to another person who in that case, legally, takes the place of the original creditor.

In order to avoid future misunderstandings I would like to stress that I believe that this obligation to pay in accordance with the contractual obligation is that which is described by Ludwig von Mises with the following words.

"to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract".

Nobody could reasonably argue that a breach of contract is a criminal offence. But, of course, if the debtor deliberately cheats his creditor the debtor is guilty of some kind of fraudulent behaviour.

Now I wish to return to the quotation from Rothbard. He argues that the kind of debentures he favours are neither inflationary nor fraudulent. I do agree that they are not fraudulent as long as the debtor has no intention to cheat the creditor. But I do only half-heartedly agree that they are not inflationary.

Every issuance of credit gives birth to a claim to the amount lent. If the amount lent is one ounce of fine gold and the gold is lent against the issuance of a debenture, the creditor holds a claim against the debtor. Since debentures in most cases are transferrable, the issuance of the debt has in a way given birth to an additional and, yes, inflationary purchasing power. Once the creditor has lent the gold ounce to the debtor, he can hand over the debenture to anyone who is willing to accept it in exchange for goods or services.

I think that that was what Ludwig von Mises meant when he wrote the following words.

"The begetter of the credit expansion was the banker, not the authority."

However, the inflationary effect is of limited duration. Once the loan has been repaid, the additional purchasing power created through the issuance of debt has been extinguished. I am also aware of the fact that the price level would have been lower in terms of gold had less gold been extracted from mines. I just think that the price level ought to be determined by market forces, and that gold mining as well as the banking business are honourable occupations, though or rather because they tend to lower the purchasing power of gold. Growing potatoes lowers the purchasing power of potatoes.

In my next text I hope to be able to show why Rothbard was mistaken and in disagreement with himself when he argued in favour of a prohibition against fractional reserve banking. The title chosen for this text might, as I now see, be a little bit misleading since it does not treat the subject of banknotes.

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