I cannot decide which is worse, the politician or the banker,they both spring from the same swamp,but one thing is clear.They both continue to enable each other,and always to the detriment of the people.
THE CREATURE FROM JEKYLL ISLAND
A Second Look at the Federal Reserve
by G. Edward Griffin
Chapter Eight
FOOL'S GOLD
The history of paper money without precious metal
backing forced on the public by government
decree; the emergence of our present-day
fractional-reserve banking system based on the
issuance of a greater amount of receipts for gold
than the bank has in gold to back them up.
We previously have broken down the concept of money into
four categories: commodity, receipt, fiat, and fractional. In the last
chapter we examined commodity and receipt money in some
detail. In doing so, we also established certain monetary principles
which apply regardless of their form. We shall now turn to the
remaining two categories, both of which are represented by paper
and which are at the root of almost all of modern man's economic
woes.
FIAT MONEY
The American Heritage Dictionary defines fiat money as "paper
money decreed legal tender, not backed by gold or silver." The two
characteristics of fiat money, therefore, are (1) it does not represent
anything of intrinsic value and (2) it is decreed legal tender. Legal
tender simply means that there is a law requiring everyone to
accept the currency in commerce. The two always go together
because, since the money really is worthless, it soon would be
rejected by the public in favor of a more reliable medium of
exchange, such as gold or silver coin. Thus, when governments
issue fiat money, they always declare it to be legal tender under
pain of fine or imprisonment. The only way a government can
exchange its worthless paper money for tangible goods and
services is to give its citizens no choice.
The first notable use of this practice was recorded by Marco
Polo during his travels to China in the thirteenth century. The
famous explorer gives us this account:
The Emperor's mint then is in this same City of Cambaluc, and the
way it is wrought is such that you might say he hath the Secret of
Alchemy in perfection, and you would be right!...
What they take is a certain fine white bast or skin which lies
between the wood of the tree and the thick outer bark, and this they
make into something resembling sheets of paper, but black. When
these sheets have been prepared they are cut up into pieces of different
sizes. The smallest of these sizes is worth a half tornesel.... There is
also a kind worth one Bezant of gold, and others of three Bezants, and
so up to ten.
All these pieces of paper are issued with as much solemnity and
authority as if they were of pure gold or silver; and on every piece, a
variety of officials, whose duty it is, have to write their names and to
put their seals. And when all is prepared duly, the chief officer
deputed by the Kaan smears the Seal entrusted to him with vermilion
and impresses it on the paper, so that the form of the Seal remains
stamped upon it in red; the money is then authentic. Any one forging
it would be punished with death. And the Kaan causes every year to
be made such a vast quantity of this money, which costs him nothing,
that it must equal in amount all the treasures in the world.
With these pieces of paper, made as I have described, he causes all
payments on his own account to be made, and he makes them to pass
current universally over all his Kingdoms.... And nobody, however
important he may think himself, dares to refuse them on pain of death
And indeed everybody takes them readily.1
1- Original from Henry Thule's edition of Marco Polo's Travels, reprinted in WVissering, On Chinese Currency: Coin and Paper Money (Leiden: E.J. Brill, 1877), reprinted 1968 by Ch'eng-wen Publishing Co., Taiwan, as cited by Anthony Sutton, The War on Gold (Seal Beach, California: '76 Press, 1977), pp. 26-28.
One is tempted to marvel at the Kaan's audacious power and
the subservience of his subjects who endured such an outrage; but
our smugness rapidly vanishes when we consider the similarity to
our own Federal Reserve Notes. They are adorned with signatures
and seals; counterfeiters are severely punished; the government
pays its expenses with them; the population is forced to accept
them; they—and the "invisible" checkbook money into which they
can be converted—are made in such vast quantity that it must
equal in amount all the treasures of the world. And yet they cost
nothing to make. In truth, our present monetary system is an
almost exact replica of that which supported the warlords of seven
centuries ago.
THE COLONIAL EXPERIENCE
Unfortunately, the present situation is not unique to our
history. In fact, after China, the next place in the world to adopt the
use of fiat money was America; specifically, the Massachusetts Bay
Colony. This event has been described as "not only the origin of
paper money in America, but also in the British Empire, and almost
in the Christian world."1
1- Ernest Ludlow Bogart, Economic History of the American People (New York: Longmans, Green and Co., 1930), p. 172.
In 1690, Massachusetts launched a military raid against the
French colony in Quebec. She had done this before and, each time,
had brought back sufficient plunder to more than pay for the
expedition. This time, however, the foray was a dismal failure, and
the men returned empty handed. When the soldiers demanded
their pay, Massachusetts found its coffers empty. Disgruntled
soldiers have a way of becoming unruly, so the officials scrambled
for some way to raise the funds. Additional taxes would have been
extremely unpopular, so they decided simply to print paper
money. In order to convince the soldiers and the citizenry to accept
it, the government made two solemn promises: (1) it would redeem
the paper for gold or silver coin just as soon as there was sufficient
tax revenue to do so, and (2) absolutely no additional paper notes
would ever be issued. Both pledges were promptly broken. Only a
few months later, it was announced that the original issue was
insufficient to discharge the government's debt, and a new issue
almost six times greater was put into circulation. The currency
wasn't redeemed for nearly forty years, long after those who had
made the pledge had faded from the scene.
A CLASSIC PATTERN
Most of the other colonies were quick to learn the magic of the
printing press, and the history that followed is a classic example of
cause and effect: Governments artificially expanded the money
supply through the issuance of fiat currency. This was followed by
legal tender laws to force its acceptance. Next came the disappearance
of gold or silver coins which went, instead, into private hoards
or to foreign traders who insisted on the real thing for their wares.
Many of the colonies repudiated their previous money by issuing
new bills valued at multiples of the old. Then came political discontent and civil disobedience. And at the end of each cycle
there was rampant inflation and economic chaos.
In 1703, South Carolina declared that its money was "a good
payment and tender in law" and then added that, should anyone
refuse to honor it as such, they would be fined an amount equal to
"double the value of the bills so refused." By 1716, the penalty had
been increased to "treble the value." 1
1 Statutes at Large of South Carolina, II. 211,665, as cited by George Bancroft, A Plea for the Constitution (Originally published by Harpers in 1886. Reprinted in Sewanee, Tennessee: Spencer Judd Publishers, 1982), p. 7.
THE PRINTING PRESS AND INFLATION
Benjamin Franklin was an ardent proponent of fiat money
during those years and used his great influence to sell the idea to
the public. We can get some idea of the ferment of the times by
noting that, in 1736, writing in his Pennsylvania Gazette, Franklin
apologized for its irregular publication, and explained that the
printer was "with the Press, labouring for the publick Good, to
make Money more plentiful."2 The printing of money was apparently
a major, time-consuming operation.
2. Leonard W. Labaree, ed., The Papers of Benjamin Franklin (New Haven: Yale University Press, 1960), Vol. 2, p. 159.
In 1737, Massachusetts devalued its fiat currency by 66%,
offering one dollar of new currency for three of the old. The
promise was made that, after five years, the new money would be
fully redeemed in silver or gold. The promise was not kept. 3
3. Province Laws , II. 826, cited by Bancroft, p. 14.
By the late 1750s, Connecticut had price inflated by 800%. The
Carolinas had inflated 900%. Massachusetts 1000%. Rhode Island
2300% 4 Naturally, these inflations all had to come to an end and,
when they did, they turned into equally massive deflations and
depressions. It has been shown that, even in colonial times, the
classic booms and busts which modern economists are fond of
blaming on an "unbridled free market" 5 actually were direct
manifestations of the expansion and contraction of fiat money which no longer was governed by the laws of supply and demand.
4. Ron Paul and Lewis Lehrman, The Case for Gold (Washington, D.C.: Cato Institute,
1982), p. 22. Also Sutton, The War on Gold, p. 44.
5 See Donald L. Kemmerer, "Paper Money in New Jersey, 1668-1775,' New
Jersey Historical Society, Proceedings 74 (April 1956): pp. 107-144, as cited by Paul
and Lehrman, The Case for Gold, p. 22.
By this time, coins had completely disappeared from the scene.
Some were in private hoards, but most of them had been exported
to other countries, leaving the colonies with little choice but to use
fiat money or barter. Merchants from abroad were interested in
neither of those, however, and international trade ground almost to
a halt.
A BLESSING IN DISGUISE
The experiment with fiat money was a calamity to the colonists,
but it was also a thorn in the side of the Bank of England. The bank
had used its influence with the Crown to forbid the colonies to mint
their own coins or to establish local banks. This meant that, if the
colonists wanted the convenience of paper money, they would be
forced to use the notes issued by the Bank of England. No one had
anticipated that the colonial governments would be so inventive as
to create their own paper money. So, in 1751, Great Britain began to
pressure the colonies to redeem all of their currency and withdraw
it from circulation. This they eventually did, and at bargain prices.
By then, their fiat money was heavily discounted in the market
place and the governments were able to buy back their own
currency for pennies on the dollar.
The decree from the British Parliament, although heavily
resented by the colonists, turned out to be a blessing in disguise.
The paper notes of the Bank of England never did become a
primary medium of exchange. Probably because of their recent bad
experience with paper money, the colonists merely brought what
few gold and silver coins they had out of hiding and returned to a
true commodity-money system. At first, the doomsdayers predicted
this would spell further ruin for the colonial economy.
"There isn't enough money" was the all-too-familiar cry. But there
was, indeed, quite enough for, as we have already seen, any
amount is sufficient.
TOBACCO BECOMES MONEY
There was, in fact, a period in which other commodities became
accepted as a secondary medium of exchange. Such items as nails,
lumber, rice, and whisky filled the monetary void, but tobacco was
the most common. Here was a commodity which was in great
demand both within the colonies and for overseas commerce. It
had intrinsic value; it could not be counterfeited; it could be
divided into almost any denominational quantity; and its supply could not be increased except by the exertion of labor. In other
words, it was regulated by the law of supply and demand, which
gave it great stability in value. In many ways, it was an ideal
money. It was officially adopted as such by Virginia in 1642 and a
few years later by Maryland, but it was used unofficially in all the
other colonies, as well. So close was the identity of tobacco with
money that the previous fiat currency of New Jersey, not a tobacco
growing state, displayed a picture of a tobacco leaf on its face. It
also carried the inscription: "To counterfeit is Death." Tobacco was
used in early America as a secondary medium of exchange for
about two-hundred years, until the new Constitution declared that
money was, henceforth, the sole prerogative of the federal government.1
1. Galbraith, pp. 48-50.
The primary currency at that juncture, however, was still gold
and silver coin, or specie, as it is called. And the immediate result of
returning to a sound monetary unit was a rapid recovery from the
economic stagnation previously inflicted by the booms and busts of
fiat money. Trade and production rose dramatically, and this, in
turn, attracted an inflow of gold and silver coin from around the
world, filling the void that had been created by years of worthless
paper. The law of supply and demand was visibly at work. For a
while, Massachusetts had returned to specie while Rhode Island
remained on fiat money. The result was that Newport, which had
been the trade center for the West Indies, lost its trade to Boston
and became an empty port.2 After the colonies had returned to
coin, prices quickly found their natural equilibrium and then stayed
at that point, even during the Seven Years War and the disruption
of trade that occurred immediately prior to the Revolution. There
is no better example of the fact that economic systems in distress
can and do recover rapidly if government does not interfere with
the natural healing process.3
2. Paul and Lehrman, pp. 22-23.
3. "The Colonial Monetary Standard of Massachusetts/' by Roger W. Weiss, Economic History Review, No. 27, November, 1974, p. 589.
WAR BRINGS A RETURN
OF FIAT MONEY
The War for Independence brought all of this to a sudden halt.
Wars are seldom funded out of the existing treasury, nor are they
even done so out of increased taxes. If governments were to levy taxes on their citizens fully adequate to finance the conflict, the
amount would be so great that many of even its most ardent
supporters would lose enthusiasm. By artificially increasing the
money supply, however, the real cost is hidden from view. It is still
paid, of course, but through inflation, a process that few people
understand.
The American Revolution was no exception. In order to pay the
bill for independence, both the Confederation and the individual
states went heavily into the printing business. At the beginning of
the war in 1775, the total money supply stood at $12 million. In
June of that year, the Continental Congress issued another
$2 million. Before the notes were even put into circulation, another
$1 million was authorized. By the end of the year, another
$3 million. In 1776, another $19 million. $13 million in 1777.
$64 million in 1778. $125 million in 1779. And still more: the
Continental Army issued its own "certificates" for the purchase of
supplies totalling $200 million. A total of $425 million in five years
on top of a base of $12 million is an increase of over 3500%. And, in
addition to this massive expansion of the money supply on the part
of the central government, it must be remembered that the states
were doing exactly the same thing. It is estimated that, in just five
years from 1775 to the end of 1779, the total money supply
expanded by 5000%. By contrast, the amount raised in taxes over
the five-year period was inconsequential, amounting to only a few
million dollars. 1
1- Quoted by Albert S. Bolles, The Financial History of the United States (New York: D. Appleton, 1896,4th ed.), Vol. I, p. 132.
AND A MASSIVE INFLATION
The first exhilarating effect of this flood of new money was the
flush of apparent prosperity, but that was quickly followed by
inflation as the self-destruct mechanism began to operate. In 1775,
paper Continentals were traded for one dollar in gold. In 1777, they
were exchanged for twenty-five cents. By 1779, just four years from
their issue, they were worth less than a penny. The phrase "Not
worth a Continental" has its origin in this dismal period. Shoes sold
for $5,000 a pair. A suit of clothes cost a million.
It was in that year that George Washington wrote, "A wagon
load of money will scarcely purchase a wagon load c#provisions."
Even Benjamin Franklin began to see the light. In a mood of
sarcasm, he wrote:
This Currency, as we manage it, is a wonderful machine. It
performs its Office when we issue it; it pays and clothes Troops and
provides Victuals and Ammunition; and when we are obliged to issue
a Quantity excessive, it pays itself off by Depreciation. 1
1. Letter to Samuel Cooper, April 22,1779, quoted by Albert Henry Smyth, ed., The Writings of Benjamin Franklin, (New York: Macmillan, 1906), Vol. VII, p. 294.
When speaking of deficit spending, it is common to hear the
complaint that we are saddling future generations with the bill for
what we enjoy today. Why not let those in the future help pay for
what will benefit them also? Don't be deceived. That is a misconception
encouraged by politicians to calm the public. When money
is fiat, as the colonists discovered, every government building,
public work, and cannon of war is paid out of current labor and
current wealth. These things must be built today with today's labor,
and the man who performs that labor must also be paid today. It is
true that interest payments fall partly to future generations, but the
initial cost is paid by those in the present. It is paid by loss of value
in the monetary unit and loss of purchasing power for one's wages.
INFLATION IS A HIDDEN TAX
Fiat money is the means by which governments obtain instant
purchasing power without taxation. But where does that purchasing
power come from? Since fiat money has nothing of tangible
value to offset it, government's fiat purchasing power can be
obtained only by subtracting it from somewhere else. It is, in fact,
"collected" from us all through a decline in our purchasing power.
It is, therefore, exactly the same as a tax, but one that is hidden from
view, silent in operation, and little understood by the taxpayer.
In 1786, Thomas Jefferson provided a clear explanation of this process when he wrote:
Every one, through whose hands a bill passed, lost on that bill what it lost in value during the time it was in his hands. This was a real tax on him; and in this way the people of the United States actually contributed those... millions of dollars during the war, and by a mode of taxation the most oppressive of all because the most unequal of all 2
2. Thomas Jefferson, Observations on the Article Etats-Unis Prepared for the Encyclopedia, June 22, 1786, from Writings (New York: G.P. Putnam's Sons, 1894), Vol. IV, p. 165.
In 1786, Thomas Jefferson provided a clear explanation of this process when he wrote:
Every one, through whose hands a bill passed, lost on that bill what it lost in value during the time it was in his hands. This was a real tax on him; and in this way the people of the United States actually contributed those... millions of dollars during the war, and by a mode of taxation the most oppressive of all because the most unequal of all 2
2. Thomas Jefferson, Observations on the Article Etats-Unis Prepared for the Encyclopedia, June 22, 1786, from Writings (New York: G.P. Putnam's Sons, 1894), Vol. IV, p. 165.
ENTER PRICE CONTROLS
AND LEGAL TENDER LAWS
As prices skyrocketed, the colonies enacted wage and price
controls, which was like plugging up the whistle on a tea kettle in
hopes of keeping the steam from escaping. When that failed, there
followed a series of harsh legal tender laws. One law even invoked
the specter of treason. It said: "If any person shall hereafter be so
lost to all virtue and regard for his Country as to refuse to receive
said bills in payment-he shall be deemed, published, and treated
as an enemy in this Country and precluded from all trade or
intercourse with the inhabitants of these colonies."1 [first form of mark of the beast ?DC]1. David Ramsay, History of the American Revolution (London: Johnson and Stockdale, 1791), Vol. II, pp. 134-36. *
Rhode Island not only levied a heavy fine for non-acceptance of its notes but, upon a second offense, an individual was stripped of citizenship. When a court declared the act unconstitutional, the legislature called the judges before it and summarily dismissed the offenders from office.
ENTER ECONOMIC CHAOS
AND INSURRECTION
If the ravages of war were a harsh burden for the colonies to
bear, the havoc of fiat money was equally so. After the war,
inflation was followed by deflation as reality returned to the
market place. Prices fell drastically, which was wonderful for those
who were buying. But, for the merchants who were selling or the
farmers who had borrowed heavily to acquire property at inflated
wartime prices, it was a disaster. The new, lower prices were not
adequate to sustain their fixed, inflated mortgages, and many
hard-working families were ruined by foreclosure. Furthermore,
most people still did not understand the inflation process, and
there were many who continued to advocate the "paper money
cure." Several of the states were receptive to the pressure, and their
printing presses continued to roll. Historian Andrew McLaughlin recalls a typical scene in Rhode Island at that time as witnessed by a visiting Frenchman:
A French traveler who passed through Newport about this time gives a dismal picture of the place: idle men standing with folded arms at the corners of the streets; houses falling to ruins; miserable shops offering for sale nothing but a few coarse stuffs;...grass growing in the streets; windows stuffed with rags; everywhere announcing misery, the triumph of paper money and the influence of bad government The merchants had closed their stores rather than take payment in paper; farmers from neighboring states did not care to bring their produce. 2
2. Merrill Jensen, The New Nation (New York: Vintage Books, 1950), p. 324.
Idleness and economic depression also led to outbursts of
rebellion and insurrection. In 1786, George Washington wrote to
James Warren: "The wheels of government are clogged and.. we
are descending into the vale of confusion and darkness." Two
years later, in a letter to Henry Knox, he said: "If... any person had
told me that there would have been such formidable rebellion as
exists, I would have thought him a bedlamite, a fit subject for a
madhouse." 1
Fortunately, there is a happy ending to that part of the story. As
we shall see in a subsequent chapter, when the state delegates
assembled to draft the Constitution, the effects of fiat money were
so fresh in their minds they decided to put an end to it once and for
all. Then, the new republic not only rapidly recovered but went on
to become the economic envy of the world—for a while, at
least—until the lesson had been forgotten by following generations.
But that is getting ahead of our story. For now, we are dealing with
the topic of fiat money; and the experience of the American
colonies is a classic example of what always happens when men
succumb to its siren call.2
2. Harry Atwood, The Constitution Explained (Merrimac, Massachusetts: Destiny Publishers, 1927; 2nd ed. 1962), p. 3.
1. Andrew C. McLaughlin, The Confederation arid the Constitution (New York: Collier Books, 1962), pp. 107-08. .
2. Harry Atwood, The Constitution Explained (Merrimac, Massachusetts: Destiny Publishers, 1927; 2nd ed. 1962), p. 3.
NATURAL LAW NO. 3
Let us pause at this point and observe another of those lessons
derived from centuries of experience. That lesson is so clear and so
universal and so widely seen throughout history that it may be
stated as a natural law of human behavior:3
3. Ibid., p. 4.
LESSON:
Fiat money is paper money without
precious-metal backing and which people are required by law
to accept. It allows politicians to increase spending without
raising taxes. Fiat money is the cause of inflation, and the
amount which people lose in purchasing power is exactly the
amount which was taken from them and transferred to their
government by this process. Inflation, therefore, is a hidden tax.
This tax is the most unfair of all because it falls most heavily on
those who are least able to pay: the small wage earner and those
on fixed incomes. It also punishes the thrifty by eroding the
value of their savings. This creates resentment among the
people, leading always to political unrest and national disunity.
Therefore,
In addition to the goldsmiths who stored coins, there was another class of merchants, called "scriveners," who loaned coins. The goldsmiths reasoned that they, too, could act as scriveners, but do so with other people's money. They said it was a pity for all that coin to just sit idle in their vaults. Why not lend it out and earn a profit which then could be split between themselves and their depositors? Put it to work, instead of merely gathering dust. They had learned from experience that very few of their depositors ever wanted to remove their coins at the same time. In fact, net withdrawals seldom exceeded ten or fifteen per cent of their stockpile. It seemed perfectly safe to lend up to eighty or even eighty-five per cent of their coins. And so the warehousemen began to act as loan brokers on behalf of their depositors, and the concept of banking, as we know it today, was born.
That's the way many history books describe it, but there is more involved here than merely putting idle money to work. First of all, sharing the interest income with the owners of the deposits was not part of the original concept. That only became general practice many years later after the depositors became outraged and needed to be reassured that these loans were in their interest as well. In the beginning, they didn't even know that their coins were being loaned out. They naively thought that the goldsmiths were lending their own money.
Neither Charlie nor any of the players have the right to loan those dollars, because they are being held in escrow, so to speak, pending completion of the contract between Charlie and his guests. Those dollars no longer even exist as money. They have been replaced—in concept at least—by the poker chips. If any of us are so touched by Larry's story that we decide to loan him the money ourselves, we would have to do it with other dollars or cash in our chips for the dollars in the shoe box. In that case, of course, we could no longer stay in the game. We cannot spend, loan, or give away the deposit and also consider the chips to be worth anything.
If you are a member of an organization and have given your proxy to a friend to vote in your absence at the annual meeting, you cannot then show up and cast your own vote in addition to your proxy. Likewise, in the beginning of banking, the certificates which were circulated as money were, in effect, proxies for the coins. Consequently, those coins were not available for lending. Their monetary value had been assigned to the certificates. If the certificate holders had wanted to lend out their coins, they should have retired the certificates first. They were not entitled to hold spendable paper money and also authorize their banker to lend that same money as coins. One cannot spend, loan, or give away the coins and also consider the certificates to be worth anything.
All of this is just common sense. But there is another dimension to the problem which has to do with honesty in business contracts. When the bankers used those coins as the basis for loans, they were putting themselves in a position of not having enough coin in the vault to make good on their contracts when it came time for depositors to take their money home. In other words, the new contracts were made with the full knowledge that, under certain circumstances, they would have to be broken. But the bankers never bothered to explain that. The general public was led to believe that, if they approved of putting these supposedly idle funds to work, they would be helping the economy and earning a little profit besides. It was an appealing proposal, and the idea caught on like wildfire.
1. 100 units of gold divided by 185 certificates equals .54
None of this shortfall, unfortunately, was ever explained. The bankers decided that it would be better not to discuss reality where the public could hear. These facts became the arcane secrets of the profession. The depositors were never encouraged to question how the banks could lend out their money and still have it on hand to pay back on an instant's notice. Instead, bankers put on great airs of respectability, stability, and accountability; dressed and acted serious if not stern; erected great edifices resembling government buildings and temples, all to bolster the false image of being able to honor their contracts to pay on demand.
It was John Maynard Keynes who observed:
A "sound" banker, alas! is not one who foresees danger, and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can readily blame him. It is necessarily part of the business of a banker to maintain appearances, and to confess a conventional respectability, which is more than human. Life-long practices of this kind make them the most romantic and the least realistic of men.
1. As quoted by Lever and Huhne, Debt and Danger: The World Financial Crisis (New York: The Atlantic Monthly, 1986), p. 42.
When the banks abandoned this practice and began to issue receipts to borrowers, they became magicians. Some have said they created money out of nothing, but that is not quite true. What they did was even more amazing. They created money out of debt.
Obviously, it is easier for people to go into debt than to mine gold. Consequently, money no longer was limited by the natural forces of supply and demand. From that point in history forward, it was to be limited only by the degree to which bankers have been able to push down the gold-reserve fraction of their deposits.
From this perspective, we can now look back on fractional money and recognize that it really is a transitional form between receipt money and fiat money. It has some of the characteristics of both. As the fraction becomes smaller, the less it resembles receipt money and the more closely it comes to fiat money. When the fraction finally reaches zero, then it has made the complete transition and becomes pure fiat. Furthermore, there is no example in history where men, once they had accepted the concept of fractional money, didn't reduce the fraction lower and lower until, eventually, it became zero.
No bank can stay in business for very long with a zero reserve. The only way to make people accept such a worthless currency is by government force. That's what legal-tender laws are all about. The transition from fractional-reserve money to fiat money, therefore, requires the participation of government through a mechanism which is called a central bank. Most of the balance of this book will be devoted to a study of that Creature, but, for now, suffice it to say that the euphoria of being able to create money without human effort is so great that, once such a narcotic is taken, there is no politician or banker who can kick the habit. As William Sumner observed: "A man might as well jump off a precipice intending to stop half way down.'
LESSON: Fractional money is paper money which is backed by precious metals up to only a portion of the face amount. It is a hybrid, being part receipt money and part fiat money. Generally, the public is unaware of this fact and believes that fractional money can be redeemed in full at any time. When the truth is discovered, as periodically happens, there are runs on the bank, and only the first few depositors in line can be paid. Since fractional money earns just as much interest for the bankers as does gold or silver, the temptation is great for them to create as much of it as possible. As this happens, the fraction which represents the reserve becomes smaller and smaller until, eventually, it is reduced to zero. Therefore,
LAW: Fractional money will always degenerate into fiat money. It is but fiat money in transition.
So much for the overview and generalities. In the next chapter we shall see what history has to say on this process. And what a history it is!
Fractional money is defined as paper money with precious metal backing for part, not all, of its stated value. It was introduced in Europe when goldsmiths began to issue receipts for gold which they did not have, thus only a fraction of their receipts was redeemable. Fractional money always degenerates into pure fiat money.
Banks of deposit first appeared in early Greece, concurrent with
the development of coinage itself. They were known in India at the
time of Alexander the Great. They also operated in Egypt as part of
the public granary system. They appeared in Damascus in 1200 and
in Barcelona in 1401. It was the city-state of Venice, however, which
is considered the cradle of banking as we know it today.
In spite of these precautions, however, the largest bank at that time, the house of Pisano and Tiepolo, had been active in lending against its reserves and, in 1584, was forced to close its doors because of inability to refund depositors. The government picked up the pieces at that point and a state bank was established, the Banco della Piazza del Rialto. Having learned from the recent experience with bankruptcy, the new bank was not allowed to make any loans. There could be no profit from the issuance of credit. The bank was required to sustain itself solely from fees for coin storage, exchanging currencies, handling the transfer of payments between customers, and notary services.
The formula for honest banking had been found. The bank prospered and soon became the center of Venetian commerce. Its paper receipts were widely accepted far beyond the country's borders and, in fact, instead of being discounted in exchange for gold coin as was the usual practice, they actually carried a premium over coins. This was because there were so many kinds of coin in circulation and such a wide variance of quality within the same type of coin that one had to be an expert to evaluate their worth. The bank performed this service automatically when it took the coins into its vault. Each was evaluated, and the receipt given for it was an accurate reflection of its intrinsic worth. The public, therefore, was far more certain of the value of the paper receipts than of many of the coins and, consequently, was willing to exchange a little bit more for them.
Unfortunately, with the passage of time and the fading from memory of previous banking abuses, the Venetian Senate eventually succumbed to the temptation of credit. Strapped for funds and not willing to face the voters with a tax increase, the politicians decided they would authorize a new bank without restrictions against loans, have the bank create the money they needed, and then "borrow" it. So, in 1619, the Banco del Giro was formed, which, like its bankrupt predecessor, began immediately to create money out of nothing for the purpose of lending it to the government. Eighteen years later, the Banco della Piazza del Rialto was absorbed into the new bank, and history's first tiny flame of sound banking sputtered and died.
Throughout the fifteenth and sixteenth centuries, banks had been springing up all over Europe. Almost without exception, however, they followed the lucrative practice of lending money which was not truly available for loan. They created excess obligations against their reserves and, as a result, every one of them failed. That is not to say that their owners and directors did not prosper. It merely means that their depositors lost all or a part of their assets entrusted for safekeeping.
For a century after its founding it functioned usefully and with notably strict rectitude. Deposits were deposits, and initially the metal remained in storage for the man who owned it until he transferred it to another. None was loaned out. In 1672, when the armies of Louis XIV approached Amsterdam, there was grave alarm. Merchants besieged the bank, some in the suspicion that their wealth might not be there. All who sought their money were paid, and when they found this to be so, they did not want payment. As was often to be observed in the future, however desperately people want their money from a bank, when they are assured they can get it, they no longer want it.1
1. Galbraith, p. 16.
The principles of honesty and restraint were not to be long lived, however. The temptation of easy profit from money creation was simply too great. As early as 1657, individuals had been permitted to overdraw their accounts which means, of course, that the bank created new money out of their debt. In later years enormous loans were made to the Dutch East Indies Company. The truth finally became known to the public in January of 1790, and demands for a return of deposits were steady from that date forward. Ten months later, the bank was declared insolvent and was taken over by the City of Amsterdam.
That is the end of the short story of honest banking. From that point forward, fractional-reserve banking became the universal practice. But there were to be many interesting twists and turns in its development before it would be ready for something as sophisticated as the Federal Reserve System.
In 1707, the recently created Bank of England was given the responsibility of managing this currency, but the bank found more profit in the circulation of its own banknotes, which were in the form of fractional money and which provided for the collection of interest, not the payment of it. Consequently, the government bills gradually passed out of use and were replaced by banknotes which, by the middle of the eighteenth century, became England's only paper money.
It must be understood that, at this time, the Bank of England was not yet fully developed as a central bank. It had been given a monopoly over the issue of banknotes within London and other prime geographic areas, but they were not yet decreed as legal tender. No one was forced to use them. They were merely private fractional receipts for gold coin issued by a private bank which the public could accept, reject, or discount at its pleasure. Legal tender status was not conferred upon the bank's money until 1833.
Meanwhile, Parliament had granted charters to numerous other banks throughout the empire and, without exception, the issuance of fractional money led to their ultimate demise and the ruin of their depositors. "Disaster after disaster had to come upon the country," says Shaw, because "of the indifference of the state to these mere private paper tokens."1 The Bank of England, however, was favored by the government above all others and, time after time, it was saved from insolvency by Parliament. How it came to be that way is an interesting story.
1.W.A. Shaw, Theory and Principles of Central Banking (London & New York- Sir I 1 itman & Sons, Ltd., 1930), pp. 32-32.
2- Groseclose, Money and Man, p. 175. 176
There were two groups of men who saw a unique opportunity
arise out of this necessity. The first group consisted of the political
scientists within the government. The second was comprised of the
monetary scientists from the emerging business of banking. The
organizer and spokesman of this group was William Paterson from
Scotland. Paterson had been to America and came back with a
grandiose scheme to obtain a British charter for a commercial
company to colonize the Isthmus of Panama, then known as
Darien. The government was not interested in that, so Paterson
turned his attention to a scheme that did interest it very much, the
creation of money.
The two groups came together and formed an alliance. No, that is too soft a word. The American Heritage Dictionary defines a cabal as "A conspiratorial group of plotters or intriguers." There is no other word that could so accurately describe this group. With much of the same secrecy and mystery that surrounded the meeting on Jekyll Island, the Cabal met in Mercer's Chapel in London and hammered out a seven-point plan which would serve their mutual purposes:
1. The government would grant a charter to the monetary scientists to form a bank;
2. The bank would be given a monopoly to issue banknotes which would circulate as England's paper currency;
3. The bank would create money out of nothing with only a fraction of its total currency backed by coin;
4. The monetary scientists then would loan the government all the money it needed;
5. The money created for government loans would be backed primarily by government I.O.U.s;
6. Although this money was to be created out of nothing and would cost nothing to create, the government would pay "interest" on it at the rate of 8%;
7. Government I.O.U.s would also be considered as "reserves" for creating additional loan money for private commerce. These loans also would earn interest. Thus, the monetary scientists would collect double interest on the same nothing.1
1. For an overview of these agreements, see Murray Rothbard, The Mystery of Banking (New York: Richardson & Snyder, 1983), p. 180. Also Martin Mayer, The Bankers (New York: Weybright & Talley, 1974), pp. 24-25.
The circular which was distributed to attract subscribers to the
Bank's initial stock offering explained: "The Bank hath benefit of
interest on all the moneys which it, the Bank, creates out of
nothing."2 The charter was issued in 1694, and a strange creature
took its initial breath of life. It was the world's first central bank.
Rothbard writes:
2. Quoted by Carroll Quigley, Tragedy and Hope: A History of the World in Our Time (New York: Macmillan, 1966), p. 49. Paterson did not benefit from his own creation He withdrew from the Bank over a policy disagreement within a few months after its formation and then returned to Scotland where he succeeded in selling his Darien scheme. Frugal Scots thronged to buy stock and to book passage to the fever-ridden land. The stock became worthless and almost all the 1200 colonists lost their lives.
In short, since there were not enough private savers willing to finance the deficit, Paterson and his group were graciously willing to buy government bonds , provided they could do so with newly-created out-of-thin-air bank notes carrying a raft of special privileges with them. This was a splendid deal for Paterson and company, and the government benefited from the flimflam of a seemingly legitimate bank's financing their debts.... As soon as the Bank of England was chartered in 1694, King William himself and various members of Parliament rushed to become shareholders of the new money factory they had just created.1
1.Rothbard, Mystery, p. 180.
2- See R.D. Richards, Ph.D., The Early History of Banking in England (New YorkAugustus M. Kelley, original edition 1929, reprinted 1965), pp. 148-50.
An honest loan of their £720,000 at 8% would have yielded £57,600 interest. But, with the new secret science, they were able to earn 8% on £1,200,000 given to the government plus an estimated 9% on £720,000 loaned to the public. That adds up to £160,800, more than 22% on their investment. The real point, however, is that, under these circumstances, it is meaningless to talk about a rate of interest. When money is created out of nothing, the true interest rate is not 8% or 9% or even 22%. It is infinity.
In this first official act of the world's first central bank can be seen the grand pretense that has characterized all those which have followed. The Bank pretended to make a loan but what it really did Was to manufacture the money for government's use. If the government had done this directly, the fiat nature of the currency would been immediately recognized, and it probably would not have been accepted at full face value in payment for the expenses of war. By creating money through the banking system, however, the process became mystifying to the general public. The newly created bills and notes were indistinguishable from those previously backed by coin, and the public was none the wiser.
The reality of central banks, therefore—and we must not forget that the Federal Reserve System is such a creature—is that, under the guise of purchasing government bonds, they act as hidden money machines which can be activated any time the politicians want. This is a godsend to the political scientists who no longer must depend on taxes or the good credit of their treasury to raise money. It is even easier than printing and, because the process is not understood by the public, it is politically safe.
The monetary scientists, of course, are amply paid for this service. To preserve the pretense of banking, it is said they collect interest, but this is a misnomer. They didn't lend money, they created it. Their compensation, therefore, should be called what it is: a professional fee, or commission, or royalty, or kickback, depending on your perspective, but not interest.
When banks cannot honor their contracts to deliver coin in return for their receipts, they are, in fact, bankrupt. They should be allowed to go out of business and liquidate their assets to satisfy their creditors just like any other business. This, in fact, is what always had happened to banks which loaned out their deposits and created fractional money. Had this practice been allowed to continue, there is little doubt that people eventually would have understood that they simply do not want to do business with those kinds of banks. Through the painful but highly effective process of trial and error, mankind would have learned to distinguish real money from fool's gold. And the world would be a lot better because of it today.
That, of course, was not allowed to happen. The Cabal is a partnership, and each of the two groups is committed to protect each other, not out of loyalty, but out of mutual self interest. They know that, if one falls, so does the other. It is not surprising, therefore that, when there was a run on the Bank of England, Parliament intervened In May of 1696, just two years after the Bank was formed, a law was passed authorizing it to "suspend payment in specie. By force of law, the Bank was now exempted from having to honor its contract to return the gold.
It is commonly observed in modern times that criminals often are treated lightly when they rob their neighbor. But if they steal from the government or a bank, the penalties are harsh. This is merely another manifestation of the Cabal's partnership. In the eyes of government, banks are special, and it has been that way even from the beginning of their brotherhood. For example, Galbraith tells us: In 1780, when Lord George Gordon led his mob through London in protest against against the Catholic Relief Acts, the Bank was a principal target It signified the Establishment. For so long as the Catholic district's of London were being pillaged, the authorities were slow to react. When the siege of the Bank began, things were thought more serious. Troops intervened, and ever since soldiers have been sent to guard the Bank by night.
The result of this flood of new money—how many times must history repeat it?-was even more inflation. In 1810, the House of Common s created a special committee, called the Select Committee on the High Price of Gold Bullion, to explore the problem and to find a solution. The verdict handed down in the final report was a model of clarity. Prices were not going up, it said. The value of the currency was going down, and that was due to the fact that it was being created at a faster rate than the creation of goods to be purchased with it. The solution? The committee recommended that the notes of the Bank of England be made fully convertible into gold coin, thus putting a brake on the supply of money that could be created.
1 David Ricardo, The Works and Correspondence of David Ricardo: Pamphlets 1825- 1823, Piero Sraffa, ed. (Cambridge : Cambridg e University Press , 1951), Vol. IV, p. 58.
Almost everyone in government agreed with Ricardo's assessment, but, as is often the case, theoretical truth was fighting a losing battle against practical necessity. Men's opinions on the best form of money were one thing. The war with Napoleon was another, and it demanded a constant inflow of funding. England continued to use the central-bank mechanism to extract that revenue from the populace.
1- Roy W. Jastram, The Golden Constant (New York: Wiley, 1977), p. 113.
In 1821, after the war had ended and there was no longer a need to fund military campaigns, the political pressure for a gold standard became too strong to resist, and the Bank of England returned to a convertibility of its notes into gold coin. The basic central-bank mechanism was not dismantled, however. It was merely limited by a new formula regarding the allowable fraction of reserves. The Bank continued to create money out of nothing for the purpose of lending and, within a year, the flower of a new business boom unfolded. Then, in November of 1825, the flower matured into its predestined fruit. The crisis began with the collapse of Sir Peter Cole and Company and was soon followed by the failure of sixty-three other banks. Fortunes were wiped out and the economy plunged back into depression.
When a similar crisis with still more bank failures struck again in 1839, Parliament attempted to come to grips with the problem. After five more years of analysis and debate, Sir Robert Peel succeeded in passing a banking reform act. It squarely faced the cause of England's booms and busts: an elastic money supply. What Peel's Bank Act of 1844 attempted to do was to limit the amount of money the banks could create to roughly the same as it would be if their banknotes were backed by gold or silver. It was a good try, but it ultimately failed because it fell short on three counts: (1) It was a political compromise and was not strict enough, allowing the banks to still create lending money out of nothing to the extent of £14,000,000; in other words, a "fractional" amount thought to be safe at the time; (2) The limitation applied only to paper currency issued by the Bank. It did not apply to checkbook money, and that was then becoming the preferred form of exchange. Consequently, the so-called reform did not even apply to the area where the greatest amount of abuse was taking place; and (3) The basic concept was allowed to remain unchallenged that man, in his infinite political wisdom, can determine what the money supply should be more effectively than an unmanaged system of gold or silver responding to the law of supply and demand.
Groseclose continues the story:
Ten years later, in 1857, another crisis occurred, due to excessive and unwise lending as a result of over-optimism regarding foreign trade prospects. The bank found itself in the same position as in 1847, and similar measures were taken. On this occasion the bank was forced to use the authority to increase its fiduciary [debt-based money] issue beyond the limit imposed by the Bank Charter Act....
Again in 1866, the growth of banking without sufficient attention to liquidity, and the use of bank credit to support a speculative craze...prepared the way for a crash which was finally precipitated by the failure of the famous house of Overend, Gurney and Co. The Act of 1844 was once more suspended....
In 1890, the Bank of England once again faced crisis, again the result of widespread and excessive speculation in foreign securities, particularly American and Argentine. This time it was the failure of Baring Brothers that precipitated the crash. 1
1. Groseclose, Money and Man, pp. 195-96.
The Bank of England was formed in 1694 to institutionalize fractional-reserve banking. As the world's first central bank, it introduced the concept of a partnership between bankers and politicians. The politicians would receive spendable money (created out of nothing by the bankers) without having to raise taxes. In return, the bankers would receive a commission on the transaction—deceptively called interest—which would continue in perpetuity. Since it all seemed to be wrapped up in the mysterious rituals of banking, which the common man was not expected to understand, there was practically no opposition to the scheme. The arrangement proved so profitable to the participants that it soon spread to many other countries in Europe and, eventually, to the United States.
next
THE MANDRAKE MECHANISM
LAW:
A nation that resorts to the use of fiat money has
doomed itself to economic hardship and political disunity.
FRACTIONAL MONEY
Let us turn, now, to the fourth and final possible form of
money: a most intriguing concept called fractional money. And, to
understand how this functions, we must return to Europe and the
practice of the early goldsmiths who stored the precious metal
coins of their customers for a fee. In addition to the goldsmiths who stored coins, there was another class of merchants, called "scriveners," who loaned coins. The goldsmiths reasoned that they, too, could act as scriveners, but do so with other people's money. They said it was a pity for all that coin to just sit idle in their vaults. Why not lend it out and earn a profit which then could be split between themselves and their depositors? Put it to work, instead of merely gathering dust. They had learned from experience that very few of their depositors ever wanted to remove their coins at the same time. In fact, net withdrawals seldom exceeded ten or fifteen per cent of their stockpile. It seemed perfectly safe to lend up to eighty or even eighty-five per cent of their coins. And so the warehousemen began to act as loan brokers on behalf of their depositors, and the concept of banking, as we know it today, was born.
That's the way many history books describe it, but there is more involved here than merely putting idle money to work. First of all, sharing the interest income with the owners of the deposits was not part of the original concept. That only became general practice many years later after the depositors became outraged and needed to be reassured that these loans were in their interest as well. In the beginning, they didn't even know that their coins were being loaned out. They naively thought that the goldsmiths were lending their own money.
DEPOSITS ARE NOT
AVAILABLE FOR LENDING
In the second place, we need to consider whether the coin in the
vault was even available for lending—regardless of whether or not
the depositors received a part of the profit. Let us suppose that we
are playing a game of poker at the home of Charlie Smith. Each of
us has given $20 to Charlie who, acting as the banker, has put our
money into a shoe box and given us, in return, twenty poker chips.
It is the understanding that, anytime we want to go home, we can
get back a dollar for each chip we have at that time. Now let us
suppose that Charlie's brother-in-law, Larry, shows up, not to play
poker, but to borrow some money. Since six of us are playing and
each has put in $20, there is a total of $120 in the shoe box, and that
turns out to be perfect for Larry's needs. You can imagine what
would happen if Charlie decided to lend out the "idle" money. It is
not available for lending. Neither Charlie nor any of the players have the right to loan those dollars, because they are being held in escrow, so to speak, pending completion of the contract between Charlie and his guests. Those dollars no longer even exist as money. They have been replaced—in concept at least—by the poker chips. If any of us are so touched by Larry's story that we decide to loan him the money ourselves, we would have to do it with other dollars or cash in our chips for the dollars in the shoe box. In that case, of course, we could no longer stay in the game. We cannot spend, loan, or give away the deposit and also consider the chips to be worth anything.
If you are a member of an organization and have given your proxy to a friend to vote in your absence at the annual meeting, you cannot then show up and cast your own vote in addition to your proxy. Likewise, in the beginning of banking, the certificates which were circulated as money were, in effect, proxies for the coins. Consequently, those coins were not available for lending. Their monetary value had been assigned to the certificates. If the certificate holders had wanted to lend out their coins, they should have retired the certificates first. They were not entitled to hold spendable paper money and also authorize their banker to lend that same money as coins. One cannot spend, loan, or give away the coins and also consider the certificates to be worth anything.
All of this is just common sense. But there is another dimension to the problem which has to do with honesty in business contracts. When the bankers used those coins as the basis for loans, they were putting themselves in a position of not having enough coin in the vault to make good on their contracts when it came time for depositors to take their money home. In other words, the new contracts were made with the full knowledge that, under certain circumstances, they would have to be broken. But the bankers never bothered to explain that. The general public was led to believe that, if they approved of putting these supposedly idle funds to work, they would be helping the economy and earning a little profit besides. It was an appealing proposal, and the idea caught on like wildfire.
FRACTIONAL-RESERVE BANKING
Most borrowers wanted paper money, of course, not bulky
coins, so, when they received their loans, they usually put the coins
right back into the vault for safekeeping. They were then given
receipts for these deposits which, as we have observed, were readily
accepted in commerce as money. At this point, things began to get
complicated. The original depositors had been given receipts for all
of the bank's coins. But the bank now issued loans in the amount of
eighty-five per cent of its deposits, and the borrowers were given
receipts for that same amount. These were in addition to the original
receipts. That made 85% more receipts than coins. Thus, the banks
created 85% more money and placed it into circulation through their
borrowers. In other words, by issuing phony receipts, they artificially
expanded the money supply. At this point, the certificates
were no longer 100% backed by gold. They now had a backing of
only 54%/ but they were accepted by the unsuspecting public as
equal in value to the old receipts. The gold behind all of them,
however, now represented only a fraction of their face value. Thus,
the receipts became what may be called fractional money, and the
process by which they were created is called fractional-reserve
banking. 11. 100 units of gold divided by 185 certificates equals .54
None of this shortfall, unfortunately, was ever explained. The bankers decided that it would be better not to discuss reality where the public could hear. These facts became the arcane secrets of the profession. The depositors were never encouraged to question how the banks could lend out their money and still have it on hand to pay back on an instant's notice. Instead, bankers put on great airs of respectability, stability, and accountability; dressed and acted serious if not stern; erected great edifices resembling government buildings and temples, all to bolster the false image of being able to honor their contracts to pay on demand.
It was John Maynard Keynes who observed:
A "sound" banker, alas! is not one who foresees danger, and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can readily blame him. It is necessarily part of the business of a banker to maintain appearances, and to confess a conventional respectability, which is more than human. Life-long practices of this kind make them the most romantic and the least realistic of men.
1. As quoted by Lever and Huhne, Debt and Danger: The World Financial Crisis (New York: The Atlantic Monthly, 1986), p. 42.
CREATING MONEY OUT OF DEBT
Let us step back for a moment and analyze. In the beginning,
banks served as warehouses for the safe keeping of their customers'
coins. When they issued paper receipts for those coins, they
converted commodity money into receipt money. This was a great
convenience, but it did not alter the money supply. People had a
choice of using either coin or paper but they could not use both. If
they used coin, the receipt was never issued. If they used the
receipt, the coin remained in the vault and did not circulate. When the banks abandoned this practice and began to issue receipts to borrowers, they became magicians. Some have said they created money out of nothing, but that is not quite true. What they did was even more amazing. They created money out of debt.
Obviously, it is easier for people to go into debt than to mine gold. Consequently, money no longer was limited by the natural forces of supply and demand. From that point in history forward, it was to be limited only by the degree to which bankers have been able to push down the gold-reserve fraction of their deposits.
From this perspective, we can now look back on fractional money and recognize that it really is a transitional form between receipt money and fiat money. It has some of the characteristics of both. As the fraction becomes smaller, the less it resembles receipt money and the more closely it comes to fiat money. When the fraction finally reaches zero, then it has made the complete transition and becomes pure fiat. Furthermore, there is no example in history where men, once they had accepted the concept of fractional money, didn't reduce the fraction lower and lower until, eventually, it became zero.
No bank can stay in business for very long with a zero reserve. The only way to make people accept such a worthless currency is by government force. That's what legal-tender laws are all about. The transition from fractional-reserve money to fiat money, therefore, requires the participation of government through a mechanism which is called a central bank. Most of the balance of this book will be devoted to a study of that Creature, but, for now, suffice it to say that the euphoria of being able to create money without human effort is so great that, once such a narcotic is taken, there is no politician or banker who can kick the habit. As William Sumner observed: "A man might as well jump off a precipice intending to stop half way down.'
NATURAL LAW NO. 4
And so, once again, we come to one of those natural laws that
emerge from centuries of human experience. It can be stated as
follows: LESSON: Fractional money is paper money which is backed by precious metals up to only a portion of the face amount. It is a hybrid, being part receipt money and part fiat money. Generally, the public is unaware of this fact and believes that fractional money can be redeemed in full at any time. When the truth is discovered, as periodically happens, there are runs on the bank, and only the first few depositors in line can be paid. Since fractional money earns just as much interest for the bankers as does gold or silver, the temptation is great for them to create as much of it as possible. As this happens, the fraction which represents the reserve becomes smaller and smaller until, eventually, it is reduced to zero. Therefore,
LAW: Fractional money will always degenerate into fiat money. It is but fiat money in transition.
So much for the overview and generalities. In the next chapter we shall see what history has to say on this process. And what a history it is!
SUMMARY
Fiat money is paper money without precious-metal backing
which people are required by law to accept. The first recorded
appearance of fiat money was in thirteenth century China, but its
use on a major scale did not occur until colonial America. The
experience was disastrous, leading to massive inflation, unemployment,
loss of property, and political unrest. During one period
when the Bank of England forced the colonies to abandon their fiat
money, general prosperity quickly returned. The Revolutionary
War brought fiat money back to the colonies with a vengeance. The
economic chaos that resulted led the colonial governments to
impose price controls and harsh legal tender laws, neither of which
were effective. Fractional money is defined as paper money with precious metal backing for part, not all, of its stated value. It was introduced in Europe when goldsmiths began to issue receipts for gold which they did not have, thus only a fraction of their receipts was redeemable. Fractional money always degenerates into pure fiat money.
Chapter Nine
THE SECRET SCIENCE
The condensed history of fractional-reserve banking;
the unbroken record of fraud, booms, busts,
and economic chaos; the formation of the Bank of
England, the world's first central bank, which
became the model for the Federal Reserve System.
THE BANK OF VENICE
By the year 1361, there already had been sufficient abuse in
banking that the Venetian Senate passed a law forbidding bankers
to engage in any other commercial pursuit, thus removing the
temptation to use their depositors' funds to finance their own
enterprises. They were also required to open their books for public
inspection and to keep their stockpile of coins available for viewing
at all reasonable times. In 1524, a board of bank examiners was
created and, two years later, all bankers were required to settle
accounts between themselves in coin rather than by check. In spite of these precautions, however, the largest bank at that time, the house of Pisano and Tiepolo, had been active in lending against its reserves and, in 1584, was forced to close its doors because of inability to refund depositors. The government picked up the pieces at that point and a state bank was established, the Banco della Piazza del Rialto. Having learned from the recent experience with bankruptcy, the new bank was not allowed to make any loans. There could be no profit from the issuance of credit. The bank was required to sustain itself solely from fees for coin storage, exchanging currencies, handling the transfer of payments between customers, and notary services.
The formula for honest banking had been found. The bank prospered and soon became the center of Venetian commerce. Its paper receipts were widely accepted far beyond the country's borders and, in fact, instead of being discounted in exchange for gold coin as was the usual practice, they actually carried a premium over coins. This was because there were so many kinds of coin in circulation and such a wide variance of quality within the same type of coin that one had to be an expert to evaluate their worth. The bank performed this service automatically when it took the coins into its vault. Each was evaluated, and the receipt given for it was an accurate reflection of its intrinsic worth. The public, therefore, was far more certain of the value of the paper receipts than of many of the coins and, consequently, was willing to exchange a little bit more for them.
Unfortunately, with the passage of time and the fading from memory of previous banking abuses, the Venetian Senate eventually succumbed to the temptation of credit. Strapped for funds and not willing to face the voters with a tax increase, the politicians decided they would authorize a new bank without restrictions against loans, have the bank create the money they needed, and then "borrow" it. So, in 1619, the Banco del Giro was formed, which, like its bankrupt predecessor, began immediately to create money out of nothing for the purpose of lending it to the government. Eighteen years later, the Banco della Piazza del Rialto was absorbed into the new bank, and history's first tiny flame of sound banking sputtered and died.
Throughout the fifteenth and sixteenth centuries, banks had been springing up all over Europe. Almost without exception, however, they followed the lucrative practice of lending money which was not truly available for loan. They created excess obligations against their reserves and, as a result, every one of them failed. That is not to say that their owners and directors did not prosper. It merely means that their depositors lost all or a part of their assets entrusted for safekeeping.
THE BANK OF AMSTERDAM
It wasn't until the Bank of Amsterdam was founded in 1609 that
we find a second example of sound banking practices, and the
results were virtually the same as previously experienced by the
Banco della Piazza del Rialto. The bank only accepted deposits and steadfastly refused to make loans. Its income was derived solely
from service fees. All payments in and around Amsterdam soon
came to be made in paper currency issued by the bank and, in fact,
that currency carried a premium over coin itself. The burgomasters
and the city council were required to take an annual oath swearing
that the coin reserve of the bank was intact. Galbraith reminds us: For a century after its founding it functioned usefully and with notably strict rectitude. Deposits were deposits, and initially the metal remained in storage for the man who owned it until he transferred it to another. None was loaned out. In 1672, when the armies of Louis XIV approached Amsterdam, there was grave alarm. Merchants besieged the bank, some in the suspicion that their wealth might not be there. All who sought their money were paid, and when they found this to be so, they did not want payment. As was often to be observed in the future, however desperately people want their money from a bank, when they are assured they can get it, they no longer want it.1
1. Galbraith, p. 16.
The principles of honesty and restraint were not to be long lived, however. The temptation of easy profit from money creation was simply too great. As early as 1657, individuals had been permitted to overdraw their accounts which means, of course, that the bank created new money out of their debt. In later years enormous loans were made to the Dutch East Indies Company. The truth finally became known to the public in January of 1790, and demands for a return of deposits were steady from that date forward. Ten months later, the bank was declared insolvent and was taken over by the City of Amsterdam.
THE BANK OF HAMBURG
The third and last experience with honest banking occurred in
Germany with the Bank of Hamburg. For over two centuries it
faithfully adhered to the principle of safe deposit. So scrupulous
was its administration that, when Napoleon took possession of the
bank in 1813, he found 7,506,956 marks in silver held against
liabilities of 7,489,343. That was 17,613 more than was actually
needed. Most of the bank's treasure that Napoleon hauled away
was restored a few years later by the French government in the
form of securities. It is not clear if the securities were of much value
but, even if they were, they were not the same as silver. Because of
foreign invasion, the bank's currency was no longer fully convertible into coin as receipt money. It was now fractional money, and
the self-destruct mechanism had been set in motion. The bank
lasted another fifty-five years until 1871 when it was ordered to
liquidate all of its accounts. That is the end of the short story of honest banking. From that point forward, fractional-reserve banking became the universal practice. But there were to be many interesting twists and turns in its development before it would be ready for something as sophisticated as the Federal Reserve System.
EARLY BANKING IN ENGLAND
In England, the first paper money was the exchequer order of
Charles II. It was pure fiat and, although it was decreed legal
tender, it was not widely used. It was replaced in 1696 by the
exchequer bill. The bill was redeemable in gold, and the government
went to great lengths to make sure that there was enough
actual coin or bullion to make good on the pledge. In other words,
it was true receipt money, and it became widely accepted as the
medium of exchange. Furthermore, the bills were considered as
short-term loans to the government and actually paid interest to the
holders. In 1707, the recently created Bank of England was given the responsibility of managing this currency, but the bank found more profit in the circulation of its own banknotes, which were in the form of fractional money and which provided for the collection of interest, not the payment of it. Consequently, the government bills gradually passed out of use and were replaced by banknotes which, by the middle of the eighteenth century, became England's only paper money.
It must be understood that, at this time, the Bank of England was not yet fully developed as a central bank. It had been given a monopoly over the issue of banknotes within London and other prime geographic areas, but they were not yet decreed as legal tender. No one was forced to use them. They were merely private fractional receipts for gold coin issued by a private bank which the public could accept, reject, or discount at its pleasure. Legal tender status was not conferred upon the bank's money until 1833.
Meanwhile, Parliament had granted charters to numerous other banks throughout the empire and, without exception, the issuance of fractional money led to their ultimate demise and the ruin of their depositors. "Disaster after disaster had to come upon the country," says Shaw, because "of the indifference of the state to these mere private paper tokens."1 The Bank of England, however, was favored by the government above all others and, time after time, it was saved from insolvency by Parliament. How it came to be that way is an interesting story.
1.W.A. Shaw, Theory and Principles of Central Banking (London & New York- Sir I 1 itman & Sons, Ltd., 1930), pp. 32-32.
THE BANK OF ENGLAND
England was financially exhausted after half a century of war
against France and numerous civil wars fought largely over
excessive taxation. By the time of the War of the League of
Augsberg in 1693, King William was in serious need for new
revenue. Twenty years previously, King Charles II had flat out
repudiated a debt of over a million pounds which had been lent to
him by scores of goldsmiths, with the result that ten-thousand
depositors lost their savings. This was still fresh in everyone's
memory, and, needless to say, the government was no longer
considered a good investment risk. Unable to increase taxes and
unable to borrow, Parliament became desperate for some other
way to obtain the money. The objective, says Groseclose, was not to
bring "the money mechanism under more intelligent control, but to
provide means outside the onerous sources of taxes and public
loans for the financial requirements of an impecunious government."2 2- Groseclose, Money and Man, p. 175. 176
The two groups came together and formed an alliance. No, that is too soft a word. The American Heritage Dictionary defines a cabal as "A conspiratorial group of plotters or intriguers." There is no other word that could so accurately describe this group. With much of the same secrecy and mystery that surrounded the meeting on Jekyll Island, the Cabal met in Mercer's Chapel in London and hammered out a seven-point plan which would serve their mutual purposes:
1. The government would grant a charter to the monetary scientists to form a bank;
2. The bank would be given a monopoly to issue banknotes which would circulate as England's paper currency;
3. The bank would create money out of nothing with only a fraction of its total currency backed by coin;
4. The monetary scientists then would loan the government all the money it needed;
5. The money created for government loans would be backed primarily by government I.O.U.s;
6. Although this money was to be created out of nothing and would cost nothing to create, the government would pay "interest" on it at the rate of 8%;
7. Government I.O.U.s would also be considered as "reserves" for creating additional loan money for private commerce. These loans also would earn interest. Thus, the monetary scientists would collect double interest on the same nothing.1
1. For an overview of these agreements, see Murray Rothbard, The Mystery of Banking (New York: Richardson & Snyder, 1983), p. 180. Also Martin Mayer, The Bankers (New York: Weybright & Talley, 1974), pp. 24-25.
2. Quoted by Carroll Quigley, Tragedy and Hope: A History of the World in Our Time (New York: Macmillan, 1966), p. 49. Paterson did not benefit from his own creation He withdrew from the Bank over a policy disagreement within a few months after its formation and then returned to Scotland where he succeeded in selling his Darien scheme. Frugal Scots thronged to buy stock and to book passage to the fever-ridden land. The stock became worthless and almost all the 1200 colonists lost their lives.
In short, since there were not enough private savers willing to finance the deficit, Paterson and his group were graciously willing to buy government bonds , provided they could do so with newly-created out-of-thin-air bank notes carrying a raft of special privileges with them. This was a splendid deal for Paterson and company, and the government benefited from the flimflam of a seemingly legitimate bank's financing their debts.... As soon as the Bank of England was chartered in 1694, King William himself and various members of Parliament rushed to become shareholders of the new money factory they had just created.1
1.Rothbard, Mystery, p. 180.
THE SECRET SCIENCE OF MONEY
Both groups within the Cabal were handsomely rewarded for
their efforts. The political scientists had been seeking about
£500,000 to finance the current war. The Bank promptly gave them
more than twice what they originally sought. The monetary
scientists started with a pledged capital investment of £1,200,000.
Textbooks tell us that this was lent to the government at 8%
interest, but what is usually omitted is the fact that, at the time the
loan was made, only £720,000 had been invested, which means the
Bank "loaned" 66% more than it had on hand.2 Furthermore, the
Bank was given the privilege of creating at least an equal amount of
money in the form of loans to the public. So, after lending their
capital to the government, they still had it available to loan out a
second time. 2- See R.D. Richards, Ph.D., The Early History of Banking in England (New YorkAugustus M. Kelley, original edition 1929, reprinted 1965), pp. 148-50.
An honest loan of their £720,000 at 8% would have yielded £57,600 interest. But, with the new secret science, they were able to earn 8% on £1,200,000 given to the government plus an estimated 9% on £720,000 loaned to the public. That adds up to £160,800, more than 22% on their investment. The real point, however, is that, under these circumstances, it is meaningless to talk about a rate of interest. When money is created out of nothing, the true interest rate is not 8% or 9% or even 22%. It is infinity.
In this first official act of the world's first central bank can be seen the grand pretense that has characterized all those which have followed. The Bank pretended to make a loan but what it really did Was to manufacture the money for government's use. If the government had done this directly, the fiat nature of the currency would been immediately recognized, and it probably would not have been accepted at full face value in payment for the expenses of war. By creating money through the banking system, however, the process became mystifying to the general public. The newly created bills and notes were indistinguishable from those previously backed by coin, and the public was none the wiser.
The reality of central banks, therefore—and we must not forget that the Federal Reserve System is such a creature—is that, under the guise of purchasing government bonds, they act as hidden money machines which can be activated any time the politicians want. This is a godsend to the political scientists who no longer must depend on taxes or the good credit of their treasury to raise money. It is even easier than printing and, because the process is not understood by the public, it is politically safe.
The monetary scientists, of course, are amply paid for this service. To preserve the pretense of banking, it is said they collect interest, but this is a misnomer. They didn't lend money, they created it. Their compensation, therefore, should be called what it is: a professional fee, or commission, or royalty, or kickback, depending on your perspective, but not interest.
FROM INFLATION TO BANK RUNS
The new money created by the Bank of England splashed
through the economy like rain in April. The country banks outside
of the London area were authorized to create money on their own,
but they had to hold a certain percentage of either coin or Bank of
England certificates in reserve. Consequently, when these plentiful
banknotes landed in their hands, they quickly put them into the
vaults and then issued their own certificates in even greater
amounts. As a result of this pyramiding effect, prices rose 100% in
just two years. Then, the inevitable happened: There was a run on
the bank, and the Bank of England could not produce the coin. When banks cannot honor their contracts to deliver coin in return for their receipts, they are, in fact, bankrupt. They should be allowed to go out of business and liquidate their assets to satisfy their creditors just like any other business. This, in fact, is what always had happened to banks which loaned out their deposits and created fractional money. Had this practice been allowed to continue, there is little doubt that people eventually would have understood that they simply do not want to do business with those kinds of banks. Through the painful but highly effective process of trial and error, mankind would have learned to distinguish real money from fool's gold. And the world would be a lot better because of it today.
That, of course, was not allowed to happen. The Cabal is a partnership, and each of the two groups is committed to protect each other, not out of loyalty, but out of mutual self interest. They know that, if one falls, so does the other. It is not surprising, therefore that, when there was a run on the Bank of England, Parliament intervened In May of 1696, just two years after the Bank was formed, a law was passed authorizing it to "suspend payment in specie. By force of law, the Bank was now exempted from having to honor its contract to return the gold.
THE PATTERN OF
PROTECTION WAS SET
This was a fateful event in the history of money, because the
precedent has been followed ever since. In Europe and America
the banks have always operated with the assumption that their
Partners in government will come to their aid when they get into
rouble. Politicians may speak about "protecting the public," but
the underlining reality is that the government needs the fiat money
produced by the banks. The banks, therefore-at least the big ones - must not be allowed to fail. Only a cartel with government protection can enjoy such insulation from the workings of a free market. It is commonly observed in modern times that criminals often are treated lightly when they rob their neighbor. But if they steal from the government or a bank, the penalties are harsh. This is merely another manifestation of the Cabal's partnership. In the eyes of government, banks are special, and it has been that way even from the beginning of their brotherhood. For example, Galbraith tells us: In 1780, when Lord George Gordon led his mob through London in protest against against the Catholic Relief Acts, the Bank was a principal target It signified the Establishment. For so long as the Catholic district's of London were being pillaged, the authorities were slow to react. When the siege of the Bank began, things were thought more serious. Troops intervened, and ever since soldiers have been sent to guard the Bank by night.
BOOMS AND BUSTS
NOW GUARANTEED
Once the Bank of England had been legally protected from (lie
consequences of converting debt into money, the British economy
was doomed to a nauseating roller-coaster ride of inflation, booms,
and busts The natural and immediate result was the granting of
massive loans for just about any wild scheme imaginable. Why not?
The money cost nothing to make, and the potential profits could be
enormous. So the Bank of England, and the country banks which
pyramided their own money supply on top of the Banks supply,
pumped a steady stream of new money into the economy. Great
stock companies were formed and financed by this money. One
was for the purpose of draining the Red Sea to recover the gold
supposedly lost by the Egyptians when pursuing the Israelites.
£150,000,000 were siphoned into vague and fruitless ventures in
South America and Mexico. The result of this flood of new money—how many times must history repeat it?-was even more inflation. In 1810, the House of Common s created a special committee, called the Select Committee on the High Price of Gold Bullion, to explore the problem and to find a solution. The verdict handed down in the final report was a model of clarity. Prices were not going up, it said. The value of the currency was going down, and that was due to the fact that it was being created at a faster rate than the creation of goods to be purchased with it. The solution? The committee recommended that the notes of the Bank of England be made fully convertible into gold coin, thus putting a brake on the supply of money that could be created.
IN DEFENSE OF THE
GOLD STANDARD
One of the most outspoken proponents of a true gold standard
was a Jewish London stockbroker by the name of David Ricardo.
Ricardo argued that an ideal currency "should be absolutely
invariable in value."1 He conceded that precious metals were not
perfect in this regard because they do shift in purchasing power to
a small degree. Then he said: "They are, however, the best with
which we are acquainted." 1 David Ricardo, The Works and Correspondence of David Ricardo: Pamphlets 1825- 1823, Piero Sraffa, ed. (Cambridge : Cambridg e University Press , 1951), Vol. IV, p. 58.
Almost everyone in government agreed with Ricardo's assessment, but, as is often the case, theoretical truth was fighting a losing battle against practical necessity. Men's opinions on the best form of money were one thing. The war with Napoleon was another, and it demanded a constant inflow of funding. England continued to use the central-bank mechanism to extract that revenue from the populace.
DEPRESSION AND REFORM
By 1815, prices had doubled again and then fell sharply. The
Corn Act was passed that year to protect local growers from
lower-priced imports. Then, when corn and wheat prices began to
climb once more in spite of the fact that wages and other prices
were falling, there was widespread discontent and rebellion. "By
1816," notes Roy Jastram, "England was in deep depression. There
was stagnation of industry and trade generally; the iron and coal
industries were paralyzed.... Riots occurred spasmodically from
May through December."1 1- Roy W. Jastram, The Golden Constant (New York: Wiley, 1977), p. 113.
In 1821, after the war had ended and there was no longer a need to fund military campaigns, the political pressure for a gold standard became too strong to resist, and the Bank of England returned to a convertibility of its notes into gold coin. The basic central-bank mechanism was not dismantled, however. It was merely limited by a new formula regarding the allowable fraction of reserves. The Bank continued to create money out of nothing for the purpose of lending and, within a year, the flower of a new business boom unfolded. Then, in November of 1825, the flower matured into its predestined fruit. The crisis began with the collapse of Sir Peter Cole and Company and was soon followed by the failure of sixty-three other banks. Fortunes were wiped out and the economy plunged back into depression.
When a similar crisis with still more bank failures struck again in 1839, Parliament attempted to come to grips with the problem. After five more years of analysis and debate, Sir Robert Peel succeeded in passing a banking reform act. It squarely faced the cause of England's booms and busts: an elastic money supply. What Peel's Bank Act of 1844 attempted to do was to limit the amount of money the banks could create to roughly the same as it would be if their banknotes were backed by gold or silver. It was a good try, but it ultimately failed because it fell short on three counts: (1) It was a political compromise and was not strict enough, allowing the banks to still create lending money out of nothing to the extent of £14,000,000; in other words, a "fractional" amount thought to be safe at the time; (2) The limitation applied only to paper currency issued by the Bank. It did not apply to checkbook money, and that was then becoming the preferred form of exchange. Consequently, the so-called reform did not even apply to the area where the greatest amount of abuse was taking place; and (3) The basic concept was allowed to remain unchallenged that man, in his infinite political wisdom, can determine what the money supply should be more effectively than an unmanaged system of gold or silver responding to the law of supply and demand.
THE ROLLER COASTER CONTINUES
Within three years of the "reform," England faced another crisis
with still more bank failures and more losses to depositors. But
when the Bank of England tottered on the edge of insolvency, once
again the government intervened. In 1847, the Bank was exempted
from the legal reserve requirements of the Peel Act. Such is the
rock-steady dependability of man-made limits to the money
supply. Groseclose continues the story:
Ten years later, in 1857, another crisis occurred, due to excessive and unwise lending as a result of over-optimism regarding foreign trade prospects. The bank found itself in the same position as in 1847, and similar measures were taken. On this occasion the bank was forced to use the authority to increase its fiduciary [debt-based money] issue beyond the limit imposed by the Bank Charter Act....
Again in 1866, the growth of banking without sufficient attention to liquidity, and the use of bank credit to support a speculative craze...prepared the way for a crash which was finally precipitated by the failure of the famous house of Overend, Gurney and Co. The Act of 1844 was once more suspended....
In 1890, the Bank of England once again faced crisis, again the result of widespread and excessive speculation in foreign securities, particularly American and Argentine. This time it was the failure of Baring Brothers that precipitated the crash. 1
1. Groseclose, Money and Man, pp. 195-96.
THE MECHANISM SPREADS
TO OTHER COUNTRIES
It is an incredible fact of history that, in spite of the general and
recurring failures of the Bank of England during these years, the
central-bank mechanism was so attractive to the political and
monetary scientists that it became the model for all of Europe. The
Bank of Prussia became the Reichsbank. Napoleon established the
Banque de France. A few decades later, the concept became the
venerated model for the Federal Reserve System. Who cares if the
scheme is destructive? Here is the perfect tool for obtaining
unlimited funding for politicians and endless profits for bankers.
And, best of all, the little people who pay the bills for both groups
have practically no idea what is being done to them.
SUMMARY
The business of banking began in Europe in the fourteenth
century. Its function was to evaluate, exchange, and safeguard
people's coins. In the beginning, there were notable examples of
totally honest banks which operated with remarkable efficiency
considering the vast variety of coinage they handled. They also
issued paper receipts which were so dependable they freely
circulated as money and cheated no one in the process. But there
was a great demand for more money and more loans, and the
temptation soon caused the bankers to seek easier paths. They
began lending out pieces of paper that said they were receipts, but
which in fact were counterfeit. The public could not tell one from
the other and accepted both of them as money. From that point
forward, the receipts in circulation exceeded the gold held in
reserve, and the age of fractional-reserve banking had dawned.
This led immediately to what would become an almost unbroken
record from then to the present: a record of inflation, booms and
busts, suspension of payments, bank failures, repudiation of currencies,
and recurring spasms of economic chaos. The Bank of England was formed in 1694 to institutionalize fractional-reserve banking. As the world's first central bank, it introduced the concept of a partnership between bankers and politicians. The politicians would receive spendable money (created out of nothing by the bankers) without having to raise taxes. In return, the bankers would receive a commission on the transaction—deceptively called interest—which would continue in perpetuity. Since it all seemed to be wrapped up in the mysterious rituals of banking, which the common man was not expected to understand, there was practically no opposition to the scheme. The arrangement proved so profitable to the participants that it soon spread to many other countries in Europe and, eventually, to the United States.
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THE MANDRAKE MECHANISM
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