Law of reflux

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The law of reflux asserts that unwanted money will reflux to its issuer. When coins are in short supply, the owner of a mint will find it profitable to buy silver bullion and stamp it into a coin. Alternatively, people who are in need of coins will bring silver to the mint and pay a fee to have it stamped into a coin. If coins should become too abundant, then people will find it profitable to melt those coins. Unwanted coins will reflux to silver bullion. An important implication is that private mints will automatically provide the community with the right amount of coins, since mints will profit by minting new coins when they are needed and melting them when they are not.

A common source of confusion centers on the question of what happens when mints issue too many coins. For example, a careless application of the quantity theory of money might lead one to think that if the quantity of coins were increased by 20%, then the price of groceries would rise by 20%, since there is more money chasing the same goods. But as long as each dollar coin contains 1 ounce of silver, a dollar must be worth 1 ounce, except for some small allowance for the cost of minting or melting. Thus the likely result of a 20% increase in the quantity of coins is that 20% of the coins will be melted, leaving the quantity of coins, and the price of groceries, unaffected.

Coins are inconvenient to carry, easily counterfeited, and they wear out. In a practice known as clipping, people grind coins to remove a few flecks of metal that will not be noticed, effectively stealing a little metal from each coin. If clipping becomes widespread, coins can eventually be ground down to a small fraction of their original weight. If the mint then tries to mint new coins of full weight, people will hoard the new coins and only spend the old, worn coins. This problem is known as Gresham’s Law: Bad money drives out good money.

A good remedy for these problems is for the mint to issue paper bank notes instead of coins. When people bring 1 ounce of silver to the mint, they will be issued a $1 bank note instead of a $1 coin. The 1 ounce of silver, rather than being stamped into a coin, is kept in the vault, safe from clippers. The paper bank notes are easier to use than coins, harder to counterfeit, and if they wear out they are easily replaced with new notes.

The law of reflux works the same for bank notes as it does for silver coins. If business is booming and people need more cash, they will bring silver to the mint (which is now a bank) and get paper dollars in exchange. If business slows and people need less cash, they will return their paper dollars to the bank in exchange for the silver that the bank holds in its vault. Unwanted paper money refluxes to its issuer. This principle was well-understood by note-issuing bankers in the 1800s, as shown in the testimony of a British banker (Mr. Stuckey) before Parliament in 1819:

"(Sir T. Fremantle.) The advance which you make to the agriculturists is an advance of capital, whether it is paid to them in your own notes, or Bank of England notes or gold?

(Mr. Stuckey) Yes; the advance is generally made to agriculturists in our own notes.

(Fremantle) But if the state of the country is such as not to require an increase of your own issues, you are quite sure that those notes will come back to you in the course of a short time?

(Stuckey) Exactly." (Tooke, 1844, pp. 40–41.)

An interesting corollary is that the dollars issued by the bank could be issued in many other forms besides printed pieces of paper called bank notes. They could, for example, be issued in the form of transferable bookkeeping entries called checking account dollars. This means that the law of reflux applies as much to checking account dollars as to paper dollars.

It might happen that a customer comes to the bank wanting a $1 bank note, but rather than offering the bank 1 ounce of actual silver, the customer offers various goods or securities that are worth (at least) 1 ounce of silver. The banker would have no reason to object to this, especially if the stuff offered to the bank is easier to store than silver. For example, a customer might offer bonds or real estate deeds that are worth 1 million ounces of silver, in exchange for the bank issuing $1 million of its bank notes to the customer.

Once the bank holds other assets in addition to silver in its vault, it is a fractional reserve bank. For example, the bank might hold 20 ounces of actual silver, plus bonds worth 80 ounces, as backing for $100 of its bank notes. Just as in the previous cases, fractional reserve banks will automatically provide the community with the right amount of money, since the bank will profit by issuing bank notes when they are needed and by allowing its notes to reflux when they are not. Under fractional reserves, the bank can trade its bank notes either for silver or for the other stuff in its vault, both when notes are issued and when they reflux.

In the bank’s day-to-day operations, it is both expensive and unnecessary for the bank to maintain convertibility of its notes into silver. If the public needs another $30 of notes, the bank can easily issue those notes in exchange for 30 ounces worth of bonds. If the public no longer wants those notes, the bank can sell the 30 ounces worth of bonds in exchange for $30 of its notes, and retire the notes it receives. As long as the bank stands ready to redeem its notes for bonds, metallic convertibility can be suspended for long periods, even for centuries, without inconvenience.

The suspension of metallic convertibility can give the false impression that bank notes are fiat money: that they are no longer backed by the assets of the issuing bank. One often hears, for example, that if you present a paper dollar to the Federal Reserve and ask for a certain weight of gold, they will only give you another dollar in return. This makes it seem as if Federal Reserve notes are not backed by the Federal Reserve’s assets. People who believe this forget that the Federal Reserve backs its paper dollars with both gold and bonds, and the Federal Reserve routinely uses its bonds to buy back the paper dollars it has issued. This means that there are at least two channels through which dollars might reflux to the Federal Reserve: the gold channel and the bond channel. The closing of the gold channel can be irrelevant as long as the bond channel remains open. One might still object that the Federal Reserve’s bonds are nothing but claims to still other dollars. The right answer to this objection is that a US Treasury bond can be used to pay tax obligations to the US government, so the Federal Reserve’s bonds are ultimately backed by the government’s ability to take resources from people through taxation.

Another common misunderstanding of the law of reflux asserts that the value of money is preserved by the reflux itself, as opposed to the backing of money. Mark Blaug, for example, claims that the law of reflux “assures the impossibility of inflation produced by overexpansion of bank credit” (Blaug, 1978). The error of this statement becomes apparent when we consider a mint issuing full-bodied coins. It is clear that the value of the coin is preserved by its metallic content. The fact that coins can reflux to bullion by melting is of secondary importance. The same is true of banknotes, except that in this case the backing is held in the bank’s vault, rather than in the coin itself. The point is explained by Michael Sproul:

What maintains the value of the shilling? Is it reflux or is it backing? Clearly it is backing that is of primary importance. Without assets backing the shillings, the government is not capable of buying them back, and no reflux is possible. But reflux also matters, since it is only through some kind of reflux (i.e., some kind of convertibility) that the assets backing a currency can ever be paid to currency holders. This means that restrictions on reflux can have the same effect as a loss of backing. For example, if the closing of some reflux channel puts 10% of previously available assets permanently out of reach of all currency holders, then the bank has effectively defaulted on 10% of its obligations, and its currency must lose 10% of its value.[1]

References[edit]

  1. ^ Sproul, Michael (2010). "The Law of Reflux". Retrieved 15 July 2013. 

Blaug, Mark, Economic Theory In Retrospect, 3/e. Cambridge : Cambridge University Press, 1978

Fullarton, John, Regulation of Currencies of the Bank of England (second edition), 1845. Reprinted by Augustus M. Kelley, New York: 1969.

David Glasner: The Real-Bills Doctrine in the Light of the Law of Reflux, History of Political Economy 1992, p867.