That Other Invisible Hand

As Adam Smith explains, the free market brings its wonders to the world by virtue of an invisible hand.  Individuals cooperating under the international division of labor and seeking generally to satisfy their own wants end up promoting the general welfare, often without intending to or without realizing it.

Not to be outdone, government too has developed a systemic hand that is usually not seen.  Unlike the market, when this hand moves, we lose.  Through inflation, government snatches the market’s bounty for its own purposes, enervating our lives accordingly.

As a “stealth tax,” inflation requires no legislation to impose, no agency to collect, and diverts responsibility for damages onto politicians’ favorite whipping boys.  It gives government the ability to buy almost anything for nothing, while creating endless problems that serve as a pretext for intervention.  Inflation is the foundation of arrogant government and a prescription for our own demise.

Government inflates through its central bank, the Federal Reserve System.  The Fed does many other things, but its foremost responsibility is to make the dollar buy less without leaving a trail.

Central banks such as the Fed are engines of inflation.   Inflation is not some curse of capitalism; it is government policy, and it destroys capitalism .  Inflation, economist Judy Shelton explains, chisels

away at the foundation of free markets and the laws of supply and demand. It distorts price signals, making retailers look like profiteers and deceiving workers into thinking their wages have gone up. It pushes families into higher income tax brackets without increasing their real consumption opportunities. [1]

Inflation is alluded to in the Fed’s charter, which calls on it “to furnish an elastic currency.”  [2]  Ben Bernanke once boasted about it: “[T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” [3]

If this sounds like counterfeiting, be advised that almost no one sees it that way, especially government and Fed officials.  According to the MSN Encarta dictionary, a counterfeiter is a person who makes “a copy of something, especially money, in order to defraud or deceive people.”  Does that shoe fit the Fed?  You decide.

The Fed’s inflation is often part of a process called “monetizing the federal debt,” a stultifying expression describing the hocus-pocus used to cover government’s deficits.  In simple language, government puts ink on pieces of paper and calls them “securities,” in response to which the central bank puts ink on pieces of paper, calls it money, and buys the securities (though indirectly).

Like magic, the federal government has new money to spend – thanks to the tooth fairy known as the Fed. 

When government imposed its central bank on us in 1913, pulling money from a hat was more of a challenge than it is now.  If the Fed printed too many paper tickets, people would begin to wonder if the banking system could redeem them in gold on demand, as stated on the tickets.  The fear of a bank run acted as a brake on inflation.

Since inflation is the increase in the money supply, gold imposed a limit on the amount of government debt the Fed could buy, which in turn put restrictions on government spending.  Restrictions on government spending put restrictions on government expansion.  If gold could be eliminated, those restrictions would go away.

When the Fed was being sold to the public, its advocates told people it would prevent panics and recessions by virtue of its power to provide money and cheap credit on demand.  Eight years after its inception the country slid into a recession (1921), and after another eight years the stock market crashed.  By the time a new administration took power in 1933, the economy was on its knees.

Assured the free market had failed them, a bewildered public turned to government for deliverance.  On April 5, 1933 President Roosevelt issued Executive Order 6102, in which he ordered all persons to turn in their gold or face a possible 10-year prison sentence and a $10,000 fine.  He gave them until April 28 to comply. [4]  For this and countless other New Deal interventions, most historians regard Roosevelt as a demigod for “saving” capitalism.

After the gold heist, dollars were no longer redeemable, at least domestically.  Foreigners were allowed (though not encouraged) to swap their dollars for gold until August 15, 1971, when President Nixon repudiated the government’s redemption obligations.

With gold completely severed from the dollar, our monetary system lost its best defense against political caprice.  Not surprisingly, inflation rose to double digits by 1973.  As economist Ludwig von Mises tells us, the gold standard makes the supply of money depend on the profitability of mining gold. [5]  The pure fiat dollar faces no obstacles to its production, other than the integrity of government and Fed officials.

Nevertheless, spokespeople for government’s monetary monopoly assure us the proliferation of printing press dollars helps the economy.  As such, the Fed doesn’t inflate, it accommodates.  Inflation is a dirty word for its “accommodative monetary policies.” [6]

Fed Accommodation

What happens when the Fed “accommodates” us by increasing the stock of money?

First, it reduces the value of the dollar.  More dollars means each one buys less, putting upward pressure on prices.  Technology and improvements in production tend to push prices downward, but because of inflation fewer people can afford admission to the market’s bounty.

As a rough idea of how far the dollar has plummeted, $5,000 in 1913 had greater buying power than $110,000 in 2011. [7]

Second, a depreciating dollar discourages savings.  Why put money away if it’s going to lose value?  Instead, millions of investment neophytes put their funds in the stock market in an attempt to protect themselves against Fed printing presses.  Has this been a successful hedge?

During the biggest bull market in history – 1984 to 2001 – the S&P rose 14.5 percent a year.  But frequent trading by fund managers and high fees reduced the average rate of return to 4.2 percent annually.  According to Vanguard group founder John Bogle, if you include the results of 2002, the average return from equities was under 3 percent per year – less than the inflation rate. [8]

Third,  new injections of money spur a tinsel prosperity, and the Fed keeps injecting new money to feed the boom.  With so much borrowing and spending, prices may rise even faster than the rate of currency inflation.

As the public broods over higher prices, a semantic shift takes place.  Inflation comes to mean not an increase in the money supply, but the rise in prices itself.  [9]  Thus, businesses that charge higher prices become the villains, while government officials  that threaten price controls are the avenging angels.  Most people have no idea what the Fed does, so government can scapegoat business and appear to be defenders of the public weal.  Nor do most people understand that price ceilings create shortages, by encouraging consumption and retarding production.  Shortages, in turn, bring on government-imposed quotas, which foster corruption, black markets, and violent crime.

Fourth, as the influx of dollars drives prices higher some industries find themselves at a disadvantage with foreign competitors, tempting them to lobby Washington for protection from imports.  Protective tariffs and quotas, of course, push prices up further, while sometimes sparking trade wars as other countries retaliate on American exports.  And trade wars can lead to shooting wars.

In June, 1930, with the economy fighting the recession brought on by Fed monetary policies, President Hoover signed the Smoot-Hawley Tariff Act, raising tariff levels to the highest in U.S. history.  Other countries immediately retaliated, markets shut down, and economic conditions worsened worldwide.

Fifth, inflation raises nominal incomes, pushing people into higher tax brackets, which increases government tax revenue.  As people’s wealth goes out the window in depreciating dollars, taxes consume more of what remains.

Sixth, inflation shifts wealth from people who can’t or don’t know how to defend themselves from monetary destruction to those who can.  As a simple example, a person living on a fixed income may find his buying power so depleted he sells a family heirloom to pay for an unanticipated expense.  Or a bank that was part of the lending spree that helped drive prices skyward may foreclose on the homes of some of its borrowers, whose incomes were ravaged by monetary debauchery.

Seventh, the Fed’s “accommodative” measures keep people working much later in their careers because they cannot afford to live off their deteriorating pensions.  Dollar depreciation is a huge reason why both husband and wife work in many families.  

Eighth, because government often gets the new money first, it can fund controversial measures such as war and bailouts without drawing taxpayer ire.  Government simply puts the funding on its charge card, prompting the alchemy of Fed debt monetization.  We get the bill, of course, but this way it’s spread over everything else we buy, so we never see it itemized. 

Ninth, because inflation has an uneven affect on prices, raising some faster or sooner than others, people have a hard time distinguishing illusion from reality.  As cheap credit abounds, business people, investors, and cube dwellers hear the siren call of can’t-miss profit opportunities.  Fortunes are made then lost, and companies that lose money find it harder to keep employees.

Tenth, government may pose as the savior of a group of voters they’ve impoverished, such as the elderly, by subsidizing their medical expenses.  New entitlements create the need for more revenue, which fuels more inflation, pushing the dollar closer to a complete collapse.

Eleventh, as Mises observed, “under inflationary conditions, people acquire the habit of looking upon the government as an institution with limitless means at its disposal: the state, the government, can do anything.” [10]  Through deficit spending the state will devour limited resources trying to maintain this illusion.

If gold is the barbarous relic its many detractors claim it is, we might expect the Fed’s fiat currency to be a better deal.   But even former Fed Chairman Greenspan admits that it isn’t, telling a New York audience in 2002 that prices soared in the decades following the gold heist of 1933. [11]

Lord Keynes, the 20^th century’s guru of deficit spending, never spelled out how deficits should be financed, admitting only that increased taxation was not the answer.  [12]  Perhaps he had pangs of conscience about calling for inflation outright, since he knew it would destroy society in a manner that not one man in a million  could diagnose.  [13]

Political issues dominate the news, but how little we hear about the policies nurturing those issues, one of which is government’s power to confiscate wealth with the Fed’s invisible hand.

We should wipe every trace of the Federal Reserve from our lives and allow the market to freely choose our monetary standard, which most likely would be gold.  In the meantime, the FOMC should be prohibited from purchasing any more “assets.”

References:

1 “Capitalism Needs a Sound-Money Foundation,” Judy Shelton, The Wall Street Journal, February 11, 2009, http://online.wsj.com/article/SB123440593696275773.html

2 The Federal Reserve Act, http://www.federalreserve.gov/generalinfo/fract/

3 Remarks by Governor Ben S. Bernanke, November 21, 2002, “Deflation: Making Sure “It” Doesn’t Happen Here,”

http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm

4 Presidential Executive Order 6102, http://www.the-privateer.com/1933-gold-confiscation.html

5 Mises, Ludwig von, Economic Freedom and Interventionism, http://www.mises.org/efandi/ch43.asp

6  Remarks by Governor Ben S. Bernanke, January 4, 2004, “Monetary Policy and the Economic Outlook: 2004,” http://www.federalreserve.gov/boarddocs/speeches/2004/20040104/default.htm

7 Bureau of Labor Statistics, http://www.bls.gov/data/inflation_calculator.htm

8 Bonner, William and Wiggin, Addison, Financial Reckoning Day: Surviving the Soft Depression of the 21^st Century, John Wiley & Sons, Hoboken, New Jersey, 2003. p. 245

9 Sennholz, Hans F., Age of Inflation, Western Islands, Belmont, Massachusetts, 1979. p. 69

10 Mises, Ludwig von, Economic Policy: Thoughts for Today and Tomorrow, Regnery Gateway, Washington, D.C., 1979, p. 66

11  Remarks by Chairman Alan Greenspan, December 19, 2002, “Issues for Monetary Policy,” http://www.federalreserve.gov/boarddocs/speeches/2002/20021219/default.htm

12 Hazlitt, Henry, “Keynesianism in a Nutshell,” 1982,  http://www.thefreemanonline.org/columns/keynesianism-in-a-nutshell/

13 Keynes, John Maynard, Economic Consequences of the Peace, 1919, http://socserv2.socsci.mcmaster.ca/~econ/ugcm/3ll3/keynes/peace.htm#Ch6

The Triumph of the Bankers

In spite of its success in bestowing wealth on some men while funding an unnecessary war, [1] the National Banking System proved unsatisfactory to financial leaders.  (See “Who Paid for the Civil War?”)  Even with laws discouraging or restricting redemption, crises still occurred, and banks had to contract and deflate to survive.  They were unable to inflate their way out of recession because they lacked a centralized lender who could provide them emergency funding.  In addition, people, especially those who kept their savings outside the banking system, generally saw the notes that circulated as mere substitutes for the real thing, which financier Jay Cooke disparaged as a “musty [relic] of a bygone age,” a sentiment no doubt shared by a certain Scottish adventurer of the early 18th century.  [2] Even if the system had a centralized lender it would still be subject to market retribution because people cannot arbitrarily create gold or silver coin.  Money was still the most marketable commodity, rather than tickets or digits a centralized lender could issue at will, as the Fed does today.  [3]

Another problem the national banks faced was the growing competition of private and state banks, neither of which had the national system’s high capital requirements.  After 1873, total bank deposits were shifting in favor of non-national banks, as were clearings outside of New York.  Furthermore, in 1887, St. Louis and Chicago bumped New York from its monopoly position as the base of the National Banking System’s inverted pyramid, and the two newcomers gained an alarming share of the percentage of total deposits of all three cities from 1880 to 1912. [4]

For bankers and government alike, the ideal monetary situation would seem to be a permanent state of specie suspension; even better would be a world in which everyone thought of money as only paper or deposits redeemable in paper, with specie relegated to the status of a collector’s item.  The ideal in banking would be a government-enforced banking cartel that would ensure a uniform rate of monetary inflation to prevent currency drains and bank runs.  With this power it could inflate its way out of recessions and bail out the big commercial banks as an emergency lender.  And for its part, the government would have a reliable market for its debt in peacetime and war.

To bring this about the big bankers leveraged the rising tide of Progressive ideology.  They began by hiring agents to promote the idea that banking crises were the result of inadequate regulation and an “inelastic” currency.  As Rothbard has written, they formed an alliance with trained economists and other opinion-molders, many of whom already favored bureaucratic control of business from their exposure to Bismarckian statism while acquiring their doctorates in Germany.  In the U.S., the National Civic Federation, founded in 1900, became the chief forum for promoting the “the new ideals of civic cooperation and social efficiency” for the purpose of “correcting” the rampant individualism of American society.

The academics were eager to use the state to license membership into their own professional organizations and thereby restrict competition and raise members’ incomes.  They also saw themselves acquiring lucrative grants and filling vital government posts in running the bureaucracies.  The public already had a deep distrust of Wall Street’s enormous concentration of wealth, and the task facing J. P. Morgan and other banking elites was to get opinion-molders to convince everyone that the big bankers needed public-spirited bureaucrats to reign in their power. [5]

Their push for a central bank, initiated by Morgan and Rockefeller forces, began following Republican William McKinley’s defeat of Democrat William Jennings Bryan in 1896 and ended with passage of the Federal Reserve Act in 1913.  Bryan expunged the laissez-faire heritage of his party with his opposition to sound money and his proposal for a bold inflation of silver, an inflation that circumvented the banking system.  In his famous “Cross of Gold” speech, Bryan said his party was “opposing the national bank currency” and stood “against the encroachments of aggregated wealth.”  McKinley campaign manager Mark Hanna had no trouble raising a record amount of money from the Morgan-Rockefeller alliance to defeat Bryan.

Though the McKinley victory secured the gold standard, gold served mostly as a camouflage behind which the elite bankers could set up a system of inflation they controlled. [6]


A Banker’s Dream Comes True

When the next fractional-reserve breakdown occurred in 1907, Thomas Woodrow Wilson, then president of Princeton, endeared himself to the banking movement by declaring that “all this trouble could be averted if we appointed a committee of six or seven public-spirited men like J. P. Morgan to handle the affairs of our country.” [7]  Colonel Edward Mandell House, a close Morgan associate who served as shadow president when Wilson was elected to the White House, became the “unseen guardian angel of the [banking] bill” that emerged in 1913.  [8]  Originally drafted at a secret meeting of banking elites at Morgan’s hunting lodge on Jekyll Island, Georgia in November, 1910, the Glass-Owen Bill, as it was finally called, overwhelmingly passed the House and Senate on December 22, 1913 and was signed into law by Wilson the following day. [9]  The Fed began operations in November, 1914, with Morgan men occupying key positions.

The new law gave the bankers what they wanted: a monopoly of the note issue.  Commercial banks could only issue demand deposits redeemable in Fed notes or nominally in gold.  National banks were compelled to join the System but had the legal option of becoming state banks, which were not required to join though many state banks chose to do so in 1917 when federal regulations were relaxed.  [10] Critically, gold coin and bullion were moved further away from the public when member banks shipped their gold to the Fed in exchange for reserves.  [11]

The inflationary potential of the system is revealed by its structure: The Fed inflated by pyramiding on its gold, member banks by pyramiding on its reserves at the Fed, and nonmembers by pyramiding on its deposits at member banks. Furthermore, after a few years the Fed began withdrawing fully-backed U.S. Treasury gold certificates from circulation and substituting Federal Reserve Notes instead.  With Fed notes requiring only 40 percent backing of gold certificates, more gold was available on which to pyramid reserves.

Also, with the advent of the Fed, reserve requirements for demand deposits were cut approximately in half, moving from a 21.1 percent average under the National Banking System to 11.6 percent, then lower still to 9.8 percent in June, 1917, after the U.S. had joined the war.  Reserve requirements for time deposits dropped from the same 21.1 percent average to 5 percent, then 3 percent in 1917.  Commercial banks developed a policy of shifting borrowers into time deposits to inflate even further.  [12]

Thus, the country now had a government-privileged central bank called the Federal Reserve.  By hoarding gold as its pyramidal base, the Fed was weaning the public from the use of gold coins, making them easier to confiscate later on.  Through the Fed, member banks would be inflating at a uniform rate to avoid trouble with redemption demands.

Did this new system bring the big bankers in line?   Did the Federal Reserve Act provide “a circulating medium absolutely safe,” as the Report of the Comptroller of the Currency of 1914 stated?  How accurate was the report’s claim that

Under the operation of this law such financial and commercial crises, or "panics," as this country experienced in 1873, in 1893, and again in 1907, with their attendant misfortunes and prostrations, seem to be mathematically impossible. [13]

Did the Morgan men running the banking cartel create a better world for most Americans?

They indeed have if you believe wars, depressions, massive debt, depreciating helicopter money, and unaccountable government constitute improvements in our quality of life.

References:
1. See Thomas J. DiLorenzo, The Real Lincoln: A New Look at Abraham Lincoln, His Agenda, and an Unnecessary War, Prima Publishing, Roseville, CA, 2002
2. Murray N. Rothbard, The Mystery of Banking, Mises Institute, Auburn, AL, 2008, p. 230
3. Carl Menger, Principles of Economics, Mises Institute, Auburn, AL, 2007, pp. 257-260; Ludwig von Mises, The Theory of Money and Credit, The Foundation for Economic Education, Inc., Irvington-on-Hudson, New York, 1971, pp. 30-33.
4. Murray N. Rothbard, “The Federal Reserve as a Cartelization Device,” from Money in Crisis: The Federal Reserve, the Economy, and Monetary Reform, edited by Barry N. Siegel, San Francisco, CA: Pacific Institute for Public Policy Analysis, 1984, pp. 91-93
5. Murray N. Rothbard, The Case Against the Fed, Mises Institute, Auburn, AL, 1994, pp. 84-90
6. Murray N. Rothbard, A History of Money and Banking in the United States: The Colonial Era to World War II, Mises Institute, Auburn, AL, 2002, p. 189
7. G. Edward Griffin, The Creature from Jekyll Island: A Second Look at the Federal Reserve, Fourth Edition, American Media, Westlake Village, CA, 2002, p. 448
8. Ibid, p. 459
9. Ibid., p. 468
10. Rothbard, Money in Crisis, p. 112
11. The Case Against the Fed, p. 119
12. Mystery, pp. 238-239
13. Annual Report of the Comptroller of the Currency, December 7, 1914, Vol. 1, p. 10

Central banking quicksand

In 1903, a lawyer in Germany took out an insurance policy and made payments on it faithfully.  When the policy came due in 20 years he cashed it in and bought a single loaf of bread with the proceeds. [1] He was fortunate.  If he had waited a few days longer, the money he received would have bought no more than a few crumbs.

Germany had been on the usual fractional reserve gold standard prior to World War I, with the Reichsbank, its central bank, expanding the money supply at a “mild” 1-2 percent inflation rate. When war broke out in 1914, government followed the standard policy of deficit spending rather than attempting to raise taxes.  The Reichsbank’s role was to monetize the government debt – that is, pay for new treasury obligations by printing more money.

At the war’s end the number of German marks in circulation had quadrupled and prices had gone up 140 percent.  [2]  But the mark was no worse off than the currencies of other belligerents.  It was weaker than the American dollar but stronger than the French franc, and about the same as the British pound.

Yet five years later, by December, 1923, Germans were paying trillions of marks for ordinary goods, an almost inconceivable situation in a country with a long tradition of education and scholarship, where Americans had once gone to study for advanced degrees.  What happened?

In addition to carrying the economic burdens of the Armistice, the socialist German government had pushed ahead with state funding of health, education, and welfare.  It also had to deal with astronomical deficits from its nationalized industries and demobilization expenses from the war.  From 1914 to 1923, its tax revenues paid for only 15 percent of its expenses; by October, 1923 tax receipts covered only 0.8 percent of government expenditures.

Government’s choices throughout were either to cut spending, borrow from the public, raise taxes, or print more money.  It pursued the latter policy, while vehemently denying it was inflating the money supply.   To the government and its supporters, its paper inflation was a consequence, not a cause.  The real culprit in Germany’s monetary meltdown were the impossible reparation payments and other burdens imposed by the Treaty of Versailles.  Eventually, currency speculators shared the blame, but the official press never placed responsibility for the inflation on the institution actually printing the money.

In a fitting twist of justice, the government’s inflationary policies , in destroying taxable wealth, reduced its revenue.  With the mark collapsing, mortgages, bonds, annuities, pensions and the like were virtually worthless, and tax authorities had almost nothing to tax.  Savers, especially rich ones, had moved their savings to foreign bank accounts and foreign currencies in a massive “flight of capital” to escape the plunder.   With inflation increasing hourly, overall tax revenue fell simply due to the time lapse between taxable transactions and tax payments.  Meanwhile, government expenditures accelerated, pushing deficits higher.  Government printed ever greater quantities of money to meet its liabilities, which created even higher deficits .  Like a man caught in quicksand, each frantic struggle only moved it closer to the end.

As the hyperinflation accelerated people spent money as fast as they got it, on the most durable goods they could afford.  The “flight of capital” was augmented and replaced by the “flight from currency.”  Factory workers were paid twice daily in large bundles of cash, which their spouses or relatives took and rushed off to spend.  People began by buying diamonds, gold, pianos, antique furniture, land and later bought just about anything to get rid of the currency.  They gradually switched from money transactions to barter.  Desperate people began to steal what they couldn’t obtain in trade.  Gasoline was siphoned from cars.  Prostitutes of both sexes walked the streets of Berlin.  But some of the young people found the atmosphere exhilarating.  Their parents had taught them to work hard and save, but clearly this was a time to spend and pay close attention to politics.

The Yugoslavia Meltdown

The German hyperinflation was one of many runaway inflations of the last century.  Hungary, China, Bolivia, Argentina, Peru, Brazil, Russia, Austria, Poland, Greece, and the Ukraine, among others, all experienced hyperinflations in varying degrees.  But the worst case of monetary destruction happened in Yugoslavia from 1993-1994. [3]

The Communist Party running the country had been financing government projects with printing press money, a tradition it inherited from the Tito regime but which it carried to a far greater degree.  The  government ran a network of stores that were supposed to sell goods below market prices, but the stores rarely had anything to sell.  The government’s gasoline stations eventually closed, leaving people dealing with roadside vendors who sold gas at $8 a gallon from plastic cans sitting on the hoods of their cars.  Car owners turned to public transportation but the Belgrade transit authority only had the funds to run 500 of its 1200 buses.  The buses were so overcrowded the ticket collectors couldn’t get aboard to collect fares.

The entire infrastructure was in shambles.  Streets were full of potholes, elevators stopped working, construction projects shut down.  Unemployment rose to over 30 percent.   The government tried to halt rising prices with price controls, but food producers refused to sell their products to the government at its artificially low prices. 

The government modified its edict by requiring merchants to file paperwork every time they wanted to raise prices.  But inflation got worse.  Merchants increased their prices in bigger increments so they wouldn’t have to file forms again so soon.  In October, 1993, in an effort to halt soaring prices, the government issued a new currency unit, the dinar, worth one million of the old dinars.  By early 1995 prices had increased by five quadrillion (5,000,000,000,000,000) percent.

As in other super-inflated economies, people adopted new methods of survival. Thieves robbed hospitals and clinics of needed medicines then sold them in front of the places they robbed.  People postponed paying their bills as long as possible so they could pay them in near-worthless currency.   Postmen were responsible for collecting telephone bills but one postman found it cheaper to pay the bills of 780 customers himself rather than try to collect payment. 

Fractional Reserve Banking

Hidden in all this gruesome detail is a quiet concept mentioned at the beginning, fractional reserve banking.  Fractional reserve banking is the practice of creating money out of thin air, by expanding credit beyond what a bank has in cash holdings.  It is the modern method of inflation.

It has its roots in the West in mid-17^th century England, where merchants began storing their gold with private goldsmiths, who would give them receipts in exchange.  The receipts began to function as money substitutes, being used in daily transactions as if they were gold.  People accepted the receipts because they had unfailing trust that the goldsmiths could redeem them on demand for the gold they represented.

Because of the convenience paper offered, people got into the habit of not redeeming the receipts.  The goldsmiths noticed this.  They always had gold on deposit that no one was claiming.  Eventually they decided to lend out fake receipts for which no gold had been deposited.  As long as they didn’t get too grabby and issue too many counterfeit receipts, they could usually meet the occasional demands for redemption.

The fake receipts circulated side-by-side with legitimate deposit receipts and gold coins.  Not only was the issue of counterfeit receipts fraudulent, it also inflated the money supply.

Yet there were almost no laws to incriminate the goldsmiths – and the deposit banks that followed – for the practice of printing fake deposit receipts.  The first test cases didn’t come until the early 19^th century in England, which ruled in favor of the banks.  Though one of the counsel argued that “a banker is rather a bailee of his customer’s funds than his debtor,” the presiding judge (“Master of the Rolls”), Sir William Grant, ruled that no, that wasn’t true; money deposited with a banker becomes “immediately part of his general assets; and he is merely a debtor for the amount.” [4]

In 1848, in Foley v. Hill and Others, the English judge Lord Cottenham went further, saying that “the money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases . . . he is not bound to keep it or deal with it as the property of his principal.”  Thus, if banks are unable to meet their obligation to redeem on demand, they become merely a “legitimate insolvent instead of an embezzler,” as Murray Rothbard observes. [5]

American banking law has followed Foley faithfully in most key respects.  Rothbard concludes: “To Foley and the previous decisions must be ascribed the major share of the blame for our fraudulent system of fractional reserve banking and for the disastrous inflations of the past two centuries.” [6]

Banks, of course, can pyramid fake receipts or credit on top of any kind of money – whether it’s gold, government fiat paper, or something more exotic.  But their practice is perpetually shaky because they always have more liabilities than assets, more notes or deposits outstanding than they can redeem in cash.  They are subject not only to depositor bank runs, but to daily demands for redemption from other banks.

The free market is very unforgiving of fractional reserve banking.

Central Banking Institutionalizes the Fraud

The ability to create money out of thin air is very heady – and enticing, if you’re the government in need of revenue.  With banks periodically facing insolvency from their inflationary practices, they were in need of government-backed assistance. It is not surprising, then, that banks and government worked out a deal.  Government gave banks the laws they needed in exchange for which banks would buy government debt – with money created from nothing.

The institution that made everything tidy and discreet for both parties was the central bank, which in the U.S. is called the Federal Reserve System.

A major function of the Fed is to monetize government deficits, thus avoiding the risky business of raising taxes or reducing spending.  The Federal Reserve Act, passed by a short-handed Congress on December 23, 1913, endowed the Fed with a deeply inflationary structure so it could expand the money supply at a controlled, even pace at whatever level it wished.

Because of the Fed, the U.S. had the funds to send our boys into the slaughterhouse known as World War I.  A little later it sponsored the boom that led to the Crash.  Since it began operations in 1914, it has ripped away 95 percent of the value of the dollar.

Most people view the Fed as our tireless public servant promoting a stable economy and fighting the curse of inflation.  The truth is the exact opposite.  The Fed is solely responsible for inflation and has caused economic havoc since its inception.  It has created what Rothbard describes as a “chronic, permanent inflation problem, a problem which, if unchecked, is bound to accelerate eventually into the fearful destruction of the currency known as runaway inflation.”  [7]

References

1 The German Hyperinflation, 1923, excerpt from Paper Money by "Adam Smith," (George J.W. Goodman), pp. 57-62,

2 Hyperinflation in Germany, Hans Sennholz

3 Episodes of Hyperinflation, Thayer Watkins

4 Rothbard, Murray N., The Mystery of Banking, p. 61

5 Ibid., p. 61

6  Ibid., p. 62

7 Ibid., p. 108

Inflation, government's WMD

Jorg Guido Hulsmann's 2008 masterpiece The Ethics of Money Production exposes the full extent of the monetary phenomena the Federal Reserve is solely responsible for creating.  Gauging inflation on the basis of a price index is vastly misleading.  Below is an excerpt from my review of Hulsmann's book:

 Inflation’s legacy

Inflation’s standard definition is too narrow to provide an appreciation of the extent of its harm; it is far more than a deterioration of the currency’s purchasing power.  It’s also much more than a “hidden tax.”  Government’s perennial fiat inflation is a subtle WMD.  Consider:

1.  In funding wars, it allows government to ignore the fiscal resistance of its citizens.

2.  It benefits the central government at the expense of secondary and tertiary governments.

3.  It turns moral hazard and irresponsibility into an institution, and guarantees recurring economic crises.

4. By making credit cheap, it encourages businesses to finance their ventures through borrowing rather than equity.  Because of market competition, few firms can resist the offer of low credit, making them more dependent on banks.  As Pius XI noted in 1931, it puts a dictatorship in the hands of lenders who regulate the life-blood of the entire economic system.

5.  Fiat inflation drives people to invest in capital markets where few will have the expertise, time, and inclination to monitor their investments properly.  In former times people could save simply by holding gold and silver coins. 

6.  Under a perennially increasing price level, the average citizen finds his best strategy is personal debt, which weakens self-reliance and independence.

7.  Under chronic fiat inflation, people will tend to choose their employment based on monetary returns.  Money then becomes the prime or only consideration for personal happiness.

8.  Perennial inflation deteriorates product quality.  Industries that cannot overcompensate inflation with technological innovation turn to other means, such as producing an inferior product under the same name.  Lying, which is bound up with fractional-reserve banking, tends to spread like a cancer over the rest of society.

9.   By fueling the exponential growth of the welfare state, fiat inflation fosters the decline of the family.  Families become degraded into “small production units that share utility bills, cars, refrigerators, and especially the tax bill.”  The welfare state drives the family and private charities out of the “welfare market.”

As Hulsmann concludes, “fiat inflation is a juggernaut of social, economic, cultural, and spiritual destruction.”

Selling Fraud

By most accounts, selling a central bank to an educated populace should be a daunting public relations task, if not an impossible one.  Think of trying to convince the Pope to swear allegiance to the devil or getting a politician to resign and get a productive job.  Yet selling lies, even Big Lies, is an area where power lovers have excelled throughout history with unsurpassed brilliance.  Even after the Great Meltdown of 2008, which came as a shock to everyone except those annoying Austrians, the Fed is still regarded as our economic stabilizer and savior, the pacemaker keeping the capitalist system alive.  Bernanke is not the villain, as a handful of troublemakers claim; he’s da Man, the Person of the Year in 2009.  And it was a well-deserved award - it takes genius to dream up TARPS, TAFS, and massive taxpayer-provided bailouts to keep the house of cards standing.

Central banking is regarded as a natural process of evolution in the life-cycle of capitalist economies.  As capitalism begins to collapse from inherent flaws, so interventionists of all stripes argue, it becomes necessary for the pristine state to step in to keep it from cannibalizing itself.  One such intervention, invented by an Englishman, is the creation of a central bank to provide just the right amount of money for an economy to grow at the right pace.  Once established, the need for a central bank is never again questioned, at least not by state-trained economists - central banking is as necessary and permanent as the sun in the sky.  

Oh, sure, we find the occasional anomalies like the central bank of Zimbabwe and the two dozen or so central banks of the twentieth century that hyperinflated their economies into temporary barter societies and wiped out the savings of millions.  But anyone can make mistakes, even central bankers.  Imagine how much more Zimbabweans would have suffered if their central bank hadn’t raised the price of a hamburger to fifteen million dollars.  Imagine if they'd developed a money on their own, as people once did in the Dark Ages of economic development -- or during the emerging prosperity following the central bank’s breakdown.

Recall for a moment what a central bank does.  As a state-sanctioned banking cartel, it keeps alive the fraud of fractional-reserve banking by getting its member banks to create money out of nothing at the same rate.  By keeping monetary inflation relatively uniform, the chances are slim that any one bank will experience an embarrassing currency drain and be forced to close its doors.  Of course, by insulating bankers from market discipline, the boom period can last much longer than it would without central bank protection.  A lengthy boom instills confidence in the claim that this time we’ve entered a new era of permanent prosperity.  Debt is our friend, risk is passé, and saving is the enemy.  All we have to do is believe, borrow, and spend to keep the good times alive.  When the bust comes and the formerly attractive risks suddenly become a weight to bear, the big bank can team with government to intervene massively, as we’ve seen - and are paying for.  Together, the team will prop up the biggest losers and start the process all over again.  The little guys who saw their 401Ks shrink now see them come alive again.  They feel thankful.  Their attention turns to more pressing problems than the existence of the banking cartel.  They come to accept things they feel powerless to change.

In 2006 Ron Paul told the House: “Everything possible is done to prevent the fraud of the monetary system from being exposed to the masses who suffer from it.“  The fraudulent system benefits the power-holders at the expense of everyone else.  Those others will never get it until they learn to challenge the Establishment’s propaganda.