Money, Banking, and the Federal Reserve

June 12, 2009

“The bold effort the present central bank had made to control the government … are but premonitions of the fate that await the American people, should they be deluded into a perpetuation of this institution or the establishment of another like it.” – President Andrew Jackson,
upon abolition of the Second Bank of the United States.

Have you ever wondered just why it is that green pieces of paper, of all things, are used as payment for goods and services? Have you ever wondered what it means for these green pieces of paper to lose their “value?” Just where does the “value” of these pieces of paper come from in the first place?

The nature of money has been so distorted over the course of the last one hundred years that even the meaning of the word “dollar” itself has been almost completely lost to history.

In the early sixteenth century, some of the first gold coins were minted by the Count of Schlick, from the Bohemian city of Joachimsthal. The unit weight denoting the amount of gold in each of these coins came to be known as the “Joachimsthaler,” later abbreviated as “thaler.” This abbreviation was then translated into “dollar” when the currency was adopted in Spain. The word “dollar” itself, then, refers to a specific unit weight of gold, and is no different than any other word that refers to a measurement of unit weight—just like the words ounce, pound, or gram, it refers to a measurement of something–in this case, gold. So how did the word “dollar” come from referring to a unit weight of gold to referring simply to a green piece of paper, and why have the origins of the word been so forgotten?

In order to explain this it is first necessary to back up and explain what money itself actually is; that is, what its economic function is, as well as how and why it arises in society.

In his Theory of Money and Credit, economist Ludwig von Mises explained why money historically never did, and logically could not possibly, arise by government fiat or decree. Rather, it arises inevitably as a result of natural economic forces that exist in a state of barter.

Suppose, in a primitive barter economy, that Bob has eggs which he wishes to exchange for milk. The milkman, Joe, however, is only willing to exchange his milk for wheat. A third individual, George, has wheat, which he is willing to trade for eggs. Bob cannot directly exchange his eggs for Joe’s milk, but he can accomplish his tradeindirectly, by exchanging his eggs for George’s wheat and then trading that wheat for the milkman’s milk.

The wheat, in this example, has performed the function of a medium of exchange. Notice what has happened in just this one simple exchange, however: the wheat was used in two transactions—first, as a medium of exchange; and second, for its own sake. Wheat is now demanded in this primitive barter economy both as a medium of exchange as well as for its own sake. The obvious tendency, then, is for the demand for any good that is used as a medium of exchange to increase, thereby making it increasingly more desirable for use as a medium for further exchanges. A particular good is chosen as a medium of exchange for its high demand, and much like a snowball rolling down a hill, every use of that good as a medium for exchange further increases the demand that made it desirable as a medium of exchange in the first place. Eventually, a good is accepted as a medium of exchange so often that it becomes valued more as a medium of exchange than it is actually valued for its own sake. It is at this point that the good in question becomes not just a medium for particular exchanges, but a widely-accepted “money.”

Historically, gold has been the good most frequently established as a money commodity through free market exchange. There are several notable reasons for this: first, it is highly durable–it does not fall apart, and it cannot be damaged by fire or water. Second, it is highly divisible into small quantities, to be used for small purchases; and yet, its value is not so low that anyone would ever have to carry a wheelbarrow full of gold around in order to make larger purchases. Three, it is of uniform quality–that is, any given ounce of gold is identical to any other ounce. These qualities all boil down to the fact that the market establishes as money whatever is most convenient for that particular society to use as money, and gold’s many positive qualities make it extremely convenient for use as a money commodity.

“For more than two thousand years gold’s natural qualities made it man’s universal medium of exchange. In contrast to political money, gold is honest money that survived the ages and will live on long after the political fiats of today have gone the way of all paper.” ~ Hans F. Sennholz

Throughout history, however, people have also found it convenient to keep their money stored in a warehouse, for security–thus the origin of banking in human society. The earliest banks were simply warehouses which offered to store people’s gold in safe deposit. These banks made their earnings the same way any other warehouse does: by collecting fees from depositors, and from loaning out their own capital. When a person deposited a given quantity of gold into such a warehouse, he was in return given a receipt stating the amount of gold he held in deposit. These paper receipts increasingly came to be used as a medium of exchange instead of the gold itself— andthis was the origin of the use of pieces of paper as a medium of exchange. Thus, a note that said “20 dollars” was a warehouse receipt, literally, for 20 dollars of gold. It is important to recognize that the value of these notes was not in any way intrinsic to the paper; it existed only because these notes were, in fact, redeemable in something that was of actual exchange value: gold.

This is the answer to our first question, then–how the word “dollar” went from referring to a specific unit weight of gold to referring to mere pieces of paper. However, we have not yet yet answered our second question–how the word came to be divorced from its original meaning.

The first answer lies in understanding the nature of what is called fractional-reserve banking.

These early warehouse banks came to notice that (say) if they were holding $10,000 of gold in deposit in a given month, only (say) 4/5ths of this total–$8,000–was withdrawn over that period of time. Realizing that, unlike (say) a furniture warehouse, they had no obligation to give any person his own gold back upon demand, but only to give back the amount that was demanded, they did not have to keep all $10,000 in reserve at all times. The warehouse bankers realized that they could write an additional (say) $4,000 in dollar receipts and then loan them out, with a low statistical probability of anyone finding out that there were now a total of $14,000 in receipts and only $10,000 worth of gold actually in the bank. This is the origin of the name “fractional-reserve” banking; only a “fraction” of the gold receipts in circulation are actually backed by “reserves” of gold in a fractional-reserve bank.

However, if there are more notes stating that they are “redeemable in gold at all times” than there is actually gold held in the bank, this statement is nothing but outright fraud, as these notes are not in fact reedemable in gold at all times—rather, they are only redeemable so long as no more than 4/5ths of those with gold deposits in the bank actually redeem their gold in any given month. If everyone with a note that said “redeemable in gold at all times” came to redeem their gold at once, the fractional-reserve bank could only redeem the gold of 4/5ths of those who came—the other 1/5th would simply be out of luck. Thus the early warehouse bankers committed fraud against their depositors, and made profit off of the interest from loans of completely fraudulent receipts.

And so, in the early 20th century in America, those who the banks were committing fraud against figured out the scheme. They realized that, if they were the last to make it to the warehouse, it would be they who would be ripped off by the fraudulent practice of fractional-reserve banking and left without their gold. And thus came the “bank runs” earlier in the last century, as everyone scrambled to the banks to try to get their gold first, so as to not be in the unlucky 1/5th of those with deposits in the bank who would not be able to redeem their receipts in actual gold. [Note the crucially important point that these bank runs are the main reason economists today oppose free banking. But these bank runs were not caused by free banking—they were a problem created by fractional reserve banking, an inherently fraudulent system that is in fact innately opposed to the principles of free banking.]

And what was the banker’s solution to this problem?

The Federal Reserve system.

Instead of condemning the practice of writing notes not backed by gold and then profiting off of interest from loans of unbacked, fraudulent receipts, the solution the bankers proposed was instead of get rid of all the gold from the banks, and operate solely on unbacked receipts. This way, bank runs would be eliminated not because the fraud would be put to an end, but because there would be nothing for anyone to run to the bank for, since the receipts would no longer be redeemable in anything of actual exchange value.

Despite the fact that American history had already seen two central banking systems come and go, each leaving harm and hyperinflation in its wake–the second of which was the Second Bank of the United States, which Andrew Jackson referred to as a “den of vipers and thieves” and whose abolition he made the central focus of his presidency; and despite the fact that Article 1, Section 10 of the U.S. Constitution says, “No state shall emit bills of credit, or make any thing but gold and silver coin a tender in payment of debts,”–the Federal Reserve Act of 1913 was passed, establishing not a federal department (as that name would seem to imply), but instead a private banking monopoly that isn’t even audited by the federal government.

President Herbert Hoover himself, after realizing what the Federal Reserve Act of 1913 actually created, had this to say about his own signing of the bill: “I am a most unhappy man. I have unwittingly ruined my country. A great industrial nation is controlled by its system of credit. Our system of credit is concentrated [in the Federal Reserve System]. The growth of the nation, therefore, and all our activities are in the hands of a few men…We have come to be one of the worst ruled, one of the most completely controlled and dominated governments in the civilized world—no longer a government by free opinion, no longer a government by conviction, but a government by the opinion and duress of small groups of dominant men.”

So what are the functions of the Federal Reserve system? The Federal Reserve has no legitimate economic function whatsoever, as its single function is to print new money into the economy, increasing the total money supply–and unlike an increase in the output of physical goods, no net gain comes to society by an increase in the money supply. As explained in this and the next four paragraphs, increasing the money supply brings harm to society as a whole; not benefit.

The justification for the Federal Reserve system was provided in the 1920s by John Maynard Keynes, a Fabian Socialist who has had a great influence on American macroeconomics, and who had this to say about the merits of State-monopoly banking: “Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. . . Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

Keynes saw the sole merit of State-monopoly banking in the fact that it provided politicians with the means to secretly confiscate wealth from citizens and destroy the value of the currency, thus leading to the eventual destruction of the capitalist system itself. The Fabian Socialists’ philosophy, by the way, was that socialism would better be achieved by gradually introducing socialist policies into an economy step-by-step than it would by violent revolution. Clearly, as evidenced by the above quote, this was Keynes’ idea. Incidentally, the fifth plank of the Communist Manifesto? “Centralization of credit in the banks of the state, by means of a national bank with state capital and an exclusive monopoly.”

When the Federal Reserve prints new paper bills into the economy, the forces of supply and demand act on them just as they do on any other commodity in existence: an increased supply relative to demand brings the overall “price,” or purchasing power, of the dollar down. Thus, anyone who saves, invests, or lives on a fixed income has purchasing power stolen from him through this process–and this purchasing power is in turn effectually transferred to whoever first receives the newly printed dollar bills. Thus the first economic effect of the Federal Reserve is to destroy the value of the currency it prints, punishing the poor as well as anyone who tries to protect his own financial security and further the development of the economy by saving money or investing it in private enterprise.

The second effect of the Federal Reserve printing new money into the economy out of thin air is to cause banks to have more credit in their reserves. As a result of this, banks will lower their interest rates in order to encourage people to take more loans out of their newly increased supply of money.

Now, entrepreneurs and businessmen are trained to keep a careful eye on various measurements of activity in the economy. In a free financial market not dominated by a government-established private monopoly, the interest rate would only lower for one reason: because more people are putting off present consumption in order to save for the future–thereby putting more money in the bank–thereby causing the bank to lower their interest rates in order to encourage loans of this extra money. Entrepreneurs would respond to the interest rate, then, by attempting to coordinate their investments with the time preferences of consumers that interest rates reveal. A high interest rate is a signal that very few individuals are putting off present consumption in order to save for the future; hence, entrepreneurs would respond by redirecting their investments away from capital goods such as housing, and towards consumption goods such as gas, food, and other leisure items. But when the interest rate is lowered this would normally be a signal that individuals are putting off their present consumption in order to save for the future. Hence, entrepreneurs would respond by taking investments out of consumption goods, and into long-term investments and capital goods like automobiles and housing.

When the Federal Reserve increases the money supply by printing fresh dollar bills out of thin air, however, entrepreneurs cannot tell whether and to what degree the interest rate was lowered by this, and not changes in the relative time preferences of consumers; hence, they have little choice but to assume the latter and respond by redirecting investments away from consumption goods and into capital goods. The result of this, if the interest rate was lowered by the Federal Reserve and not by changes in individual’s time preferences, is malinvestment. There is more investment, more development of capital goods (i.e. housing) than consumers need and are able to buy; and because of this there is less investment in the consumption goods that consumers do need.

Once the Federal Reserve finally stops artificially lowering the interest rate by printing new money, it becomes apparent that the over-investment in capital goods is unsustainable–and hence comes the inevitable “bust” end of the business cycle. At the same time, it also becomes apparent that there was too little investment in the consumption goods that people actually do want to buy. Thus, once the Federal Reserve has created a misallocation of capital, the coming recession is something that neither can, nor should, be avoided. It is a necessary readjustment of investment and capital allocation, and the sooner it is allowed to occur (and not prolonged by stimulus packages, bailouts, or continued inflation), the sooner the economy can readjust to the reality that the Federal Reserve’s inflation had previously obscured, and the sooner it can continue developing in tune with consumer’s actual (as opposed to illusory) wants and needs.

Thus the printing of money unbacked by gold or anything else of value by the Federal Reserve damages the economy both by destroying the value of the currency and by dis-coordinating the activities and time preferences of investors and consumers. The Federal Reserve system, fraudulent and unconstitutional, both drains wealth from those who save, invest, or live on a fixed income, and dis-coordinates the development of the economy by artificially lowering the interest rate, redirecting investment away from much-needed consumer goods and into unnecessary and superfluous capital goods; including, for example, unwanted housing; and creating the cycle of booms and busts we see our economy continually going through. The present crisis, with the coupling of rising prices across the board (inflation as a result of freshly printed unbacked dollars rippling through the economy) with excessive investment in capital goods (i.e. the housing boom and bust) is an obvious result of Federal Reserve policies. This is why a stimulus bill, which can only be funded by the Federal Reserve printing yet more new dollars into the economy, will do nothing but prolong and worsen the coming depression.* This is also why the abolition of the Federal Reserve system (and with it, the fraudulent practice of fractional-reserve banking)–as well as a return to the Constitutional idea of commodity money that can’t be deceptively manipulated by politicians–is the only long-term solution to the problems faced by a modern economy.

“With the exception only of the period during which the gold standard was in effect, virtually all governments throughout history have used their exclusive power to issue money as a method to defraud and plunder the people.” – Economist Friedrich von Hayek

“Let me issue and control a nation’s money supply,
and I care not who writes its laws.”
– Mayer Amschel Rothschild