Cave Metal
July 10, 2008

“Life, Liberty, and the Pursuit of Money?”

The business of banking has been around almost as long as money. Originally, money was entrusted to the goldsmiths. They would charge a storage fee and would safe guard a person’s money. The goldsmiths would issue notes of receipt to people that would be redeemable at a later time, for the stated amounts of gold left in their care. The goldsmiths kept sums of money on hand, usually in the form of gold or other scarce precious commodities, that represented money held for peoples’ deposits. The goldsmiths realized the potential for earning money with the money that was left in their care. Goldsmith’s started to issue these receipts for larger amounts than they actually had. Merchant bankers later adopted this practice. These were people or companies responsible for large shipments of goods and commodities. Often they would extend credit or “loans” to their customers. This credit would be paid back at a later date with interest.
These bankers knew that typically not all of the people with these receipts would ask for their money at the same time, and would often use these receipts in transactions in lieu of the gold they represented. This ability to create more receipts for gold then they actually were in possession of gave the bankers the ability to finance larger enterprises and earn ever-greater incomes. Once the “loans” were repaid, the gold stock would be unchanged and a profit was made.
This form of banking is called “fractional banking”. It is the same process used in nearly all the modern banks. The problem arises when the receipts are brought in for redemption, and the stock of gold that has been loaned out is not present for redemption. The outstanding receipts lose all value because they are not backed by anything.
In modern terms this is called a “Bank Run”. This happens when a bank (that only keeps fractional reserves of their depositors’ money) is asked to give the depositor their gold in exchange for their bank receipts. There have been many occurrences of this sort throughout the world. The banking crisis in Argentina, in 1999, being one of the most recent. Hundreds of banks have even gone under in our own countries short history, and the money of the depositors has vanished
In the U.S., systems, laws, and assurances by the government are in place to help protect peoples’ money. However, these merely cover up the innate deficiencies within this system and do not address a real solution. Although the fractional banking system our country uses seems to be effective and reliable, I maintain that it is harmful to our economy because it debases our money through inflation, it fuels the business cycle, and uses questionable monetary policies that benefit few besides the banks.
Our Nation’s central bank is called The Federal Reserve. This bank even though it contains the misnomer “Federal”, is a privately owned and governed bank. There are a few Congress appointed positions, but they, in no way constitute a majority opinion on its board. It has the duty of disbursing all the money coined by the government mints and printing presses. It also has the privilege of creating all the country’s monetary policy. The goal of which is maximum employment, stable prices, and moderate long-term interest rates. The Federal Reserve is also the “lender of last resort”, for all the banks and the government. This means the in the event of a bank run or war, the Federal Reserve is the one who creates the money to compensate for the shortage of real funds. This is called money expansion.
All banks in the U.S. are considered to be fractional reserve banks. This means that at any given time they contain only a portion, the reserve, of the actual money that is deposited. The remainder of the deposits are then loaned out, or invested, in assets that can be converted into money, i.e. real estate, stocks and government securities.
Banks, in excess of the amounts of deposited money, are also granted the ability to create loans. The created amount is based on the reserve that the bank maintains. Typically, a bank can multiply the amount of money it creates by a 10:1 ratio. For example, a deposit of $1,000 with a reserve of 10% ($100) leaves $900 that the bank can loan out 10 times. So with a deposit of $1,000 the bank can loan out $9,000 and gain interest on that amount. In effect, the bank is increasing the money supply of the country every time it creates a loan. By enabling the created money to circulate in our economy, without a direct increase in the products and services available in our economy, banks are causing the value of our money to decrease.
Paul H. Earl, an assistant professor of economics at Georgetown University, defines inflation as a sustained increase in the general level of prices, which is equivalent to a decline in the value or purchasing power of money (xvii). Some effects of inflation are: [that] people’s wages do not increase with the prices of goods and services, lenders are repaid with devalued money, savers money is worth less over time (4-10). By allowing the banks to create loans based on their reserves, we allow them to place large quantities of money into the economy that will be used to purchase goods and services.
Hixson, a well published businessman and engineer, maintains, “It seems poorly understood that the essential function of banks is not to receive and disburse parts of a money supply that remains constant but to preside over the expansion of the money supply-to create money” (63). Now this may seem like a good thing, but it in fact causes an imbalance in the quantity of products available and the money to purchase them. This imbalance causes the prices to increase. The more it happens, the higher the prices go, which essentially debases the all the moneys’ worth.
“Serious inflation has never occurred without…[an associated] increase in the money supply”(Earl 4). Simple stated, if there are no increases of money then there is no debasement of the current money supply. Hixson points out, “In their function as creators of money, banks increasingly relied on deposit creation rather than the printing of banknotes…banks as creators of money becomes less obvious”(180). Deposit creation is the banks’ way of loaning out money to people. Someone applies for a loan, and then the money is placed into his or her account at the bank. No actual currency is being created, just the availability of credit. This, however, can still be spent as actual currency within the economy. The bank has just increased the money supply.
“Continued excessive monetary expansion in time overwhelms any other forces that maybe restraining inflation”(Earl 171). This simply states that regardless of monetary policies to prevent inflation the allowance of money creation will always have the same effect.
The policy-making bodies of the Federal Reserve have specific goals; they include: maximum employment, stable prices, moderate long-term interest rates, and promotion of sustainable economic growth. These goals were established with our nations well being in mind. The Federal Open Market Committee (FOMC) is the Federal Reserves key monetary policymaking body. The most recent minutes (May 2008) from the FOMC meeting stated: “Economic growth had remained weak…Labor market conditions had deteriorated farther…overall inflation remain[s] elevated”(FOMC 20080430). We can see that we are experiencing, presently, the effects from inflation in our money supply. The realization of the goals set forth for the Federal Reserve are not being met.
J.G. Hülsmann, a senior fellow at the Ludwig von Mises Institute, states, “By the very nature of fractional-reserve banking, more IOU’s [bank money] exist in circulation than money proper”(409). As a nation, our economy has come to rely on the creation and use of bank credit in everyday commerce. This I believe takes all the power of our nations’ economy out of its peoples’ hands, and gives it to the private banks. Banks, by controlling the distribution and creation of our money, ultimately affect every aspect of our lives. This includes, but is not limited to, wages, prices of goods and services, and our quality of life. Does this give a little too much power to a non-government privately owned business?
The Federal Reserve Act of 1913 gave the Federal Reserve Bank the responsibility for setting all monetary policies. Monetary policies are considered the actions and decisions of the central bank (The Federal Reserve) that influence the availability and cost of money and credit. All of which affect the interest rates and value of monies in the U.S. economy.
With reference to the Constitution Wilson, an economist at the Federal Reserve Bank of New York, states: “the absence of outright prohibitions and the limiting word ‘expressly’ allowed room for more expansive interpretations of the monetary provisions”(8). Due to the wording of the Constitution, the actual rights and privileges of money creation and distribution have been questioned and brought for interpretation before the Supreme Court. “When the delegates…that wrote the Constitution were asked to vote on a clause that would give the federal government the specific authority to issue paper money, they voted against it”(Hixson 89). At the time when these rulings were done there was a worry that too much power would be given to the government and not the people. This ruling was eventually overturned, but the government has yet to accept the responsibility of creating its own paper money.
This in turn allowed for, “The Federal Reserve, after the Accord of 1951, [to] possess… monetary powers well beyond those contemplated in 1913, when the gold standard was still intact”(Wilson 11). The aforementioned gold standard refers to the fact that in our economy a quantity of gold needed to be held, in direct correlation to the amount of money the banks created. The repealing of the gold standard let the banks create money based on the government issued paper money instead. This meant that our money was backed not by gold, but by our own government’s promise to accept it as payment to all debts.
The Federal Reserve, to operate effectively, needs to control, or at least to have reasonable voice in all policies that affect its performance. “The congress would be well advised to exercise greater self restraint in the employment of monetary policy devices to meet it’s competing set of objectives one of which is… an ‘independent’ central bank”(Wilson 12). It is the express desire of the Federal Reserve, to be independent and have full control of monetary policy. The implementation of this would create a monopoly of a private business, the Federal Reserve, over all of the U.S.’s economy.
Contrary to Wilson’s warnings of letting the Federal Reserve establish it’s independence, Selgin, an associate professor of economics at the University of Georgia, states: “Where fractional reserve banks have operated free of both significant legal restrictions and disturbing influences of central banks…serious banking and monetary crisis have been rare or non existent”(98). The logic of this is that the central bank, being a business, would not impose hardships on its self, but would implement policies that would foster better profits and increased stability. However, the costs on the general non-banking economy would seem to be placed into a secondary position of importance.
The maintaining of the economy only becomes important if it threatens bank control. Public outcries of hardships, due to inflation and rising prices are not desirable. Bank policy is aimed to make these changes gradual. Banks know that people expect prices to rise, and create policies accordingly. The banks are then able to extract maximum profits from the economy, while keeping only tolerable conditions for the people.
“The Federal Reserve does not coin money, nor do the powers exercised by the U.S. central bank rest on some supposed claim that it, in effect, coins money”(Wilson 248). The term “coin money” is something for debate. It is true that the Federal Reserve does not mint money, that is the express function of the Federal government. However, is the act of creating credit that is as usable in the same manner as coined money, not the same thing?
“The bank, in issuing IOUs against itself, is not analogous to a counterfeiter… for the simple reason that the bank acknowledges its own debts”(Selgin 96). These debts that the bank creates against itself are repaid with real valued money from the debtor, often with “coined money” from the federal government. So the bank creates “bank money”, and then lends it out into the economy for the express reason of creating a profit. The government sanctions on this process are the only true difference between counterfeiting and monetary policy. The intangibility of bank credit does not make it less of a medium of exchange, than a physical legal tender note.
“The economy wide confusions between money titles and fractional reserve IOUs [bank money]…roduce business cycles”(Hülsman 410). Here Hülsman states that the banks’ ability to combine real money (scarce commodities such as gold) and bank money (credit) is paramount to the continuation of our fractionally backed monetary policy. “A person who deposits gold in a bank in exchange for a redeemable bank note does not retain ownership of the gold”(Selgin 96). All real moneyed assets once deposited into a fractional banking system become an asset of the bank, and then become part of its reserves that it then uses to further expand the money supply. “The view that fractional-reserve IOUs [credit] provide exactly the same services as genuine money titles distorts reality”(Hülsman 409). Once a bank claims an asset, it will succumb to the same debasement as the rest of the money supply.
One of the main ways that the Federal Reserve Bank regulates our money is through interest rates. Banks, by expanding or contracting the money supply, are creating artificially high or low interest rates that do no reflect the real supply and demand of goods and services. Due to The Federal Reserve’s constant manipulation of the money supply, a true equilibrium will not, and cannot, be reached. The constant self-correcting measures only trigger unforeseen and unpredictable fluctuations throughout the economy.
“Central banks protect the banking establishments by pumping additional… paper money into the economy whenever bank runs threaten the fractional reserve banks” (Hülsman 416). The process of saving the banks comes at the cost of inflation for the rest of the economy, and it gives the banking system an artificial appearance of stability. Banks have used this power to expand but also contract our money supply. The contraction of our money supply also has a profound effect.
The Federal Reserve will contract the money supply to compensate for the effects of inflation. What this means is they will call in outstanding loans or make loans more scarce or less desirable, i.e. higher interest rates. The goal of this is to halt price increases, and to return an equilibrium to money, and the supply and demand of goods. Again, this may seem like a sensible measure but it causes, more often than not, undue hardship on the working class. Most contractions of the money supply have been followed by increased unemployment due to businesses’ tighter budgets.
However, some feel that there is nothing wrong and that the Federal Reserve is setup to maintain its own balance. As corrective measures, The Federal Reserve will typically begin feeding money back into the economy to promote employment. “The expansion therefore serves not to trigger a boom but to avoid a bust”(Selgin 97). Here Selgin is stating that the Federal Reserve is aware of the fluctuations and faults in its system, and acts accordingly. Changes in the monetary policy ensue; the bust is avoided and everything continues as it should. The Federal Reserves’ expansion and contraction of our money supply is in constant disequilibrium. “Short-term changes in monetary policy intended to foster stability may in fact contribute to instability in view of the long and variable lags that seem to be at work”(Earl 5). The “business cycle” is an artificial balancing of our economy thru boom and bust policy.
“The aim of private bankers was not to provide the economy with a money supply that grew in step with the output of goods and services but to create a money supply they could increase or decrease in whatever way promised to optimize profits”(Hixson 92). The bank is first and foremost a business; its ability to fluctuate the economy in a way to produce the highest yields possible is key. “The tendency toward erratic monetary growth is increased by the fact that the Federal Reserve, in trying to control the money supply, focuses on the interest rate for federal funds”(Clark 104). The aforementioned federal funds are the funds lent between banks from their excess reserves held at the Federal Reserve Bank.
The imposed interest rates are in direct correlation to the interest rates made available to the general public on loans. This change can either foster or dissuade the creation of new loans. “Whether an addition to the money stock will aggravate the business cycle depends entirely on whether or not the addition is warranted by a preexisting increase in the publics demand for money balances” (Selgin 97). A thriving nation does need a certain amount of money to be injected into their economy. This money allows for the ability to purchase an ever-increasing supply of goods and services.
“Central banks routinely cause more money to be created then is needed to accommodate growth”(Selgin 98). Banks however, are not seeking to provide equilibrium but to generate optimal profits. The more loans generated based on a bank’s reserves, the closer to maximizing its earning potential it becomes.
“Modest easing in the stance of policy was appropriate to balance better the risks to achieving the committees [FOMC] dual objectives of maximum employment and price stability”(FOMC). The ‘easing of policy’ refers to the Federal Reserves ‘monetary policy’, which in turn means an increase to the money supply. This seems to be the answer to every dilemma faced by the Federal Reserve. “When in doubt increase the money supply and worry about the effects of the inflation at a later time.”
This is the most recent action of the FOMC in response to our current economic issues [March 2008].
“Uncertainty about inflation outlook [has] increased… [FOMC] actions should help promote moderate growth overtime and to mitigate the risks to economic activity… however…downside risks to economic growth remain…[the FOMC will] act in a timely manner as needed to promote sustainable economic growth and price stability” (FMOC).
The “downside risks” being referred to is inflation. Once again the Federal Reserve increases the money supply, and in doing so the debasement of the money supply is a temporary fix.
“Reduced credit availability and less-favorable lending terms had apparently weighted on activity in this [business] sector.” Businesses feeling the strain of the economy have downsized their work forces to compensate for their lessened buying power in the commodity markets. It costs more for manufacturers to repurchase the raw materials to make their products but they tend to compensate internally (downsizing) for the price difference rather than have less-then-competitive prices on the consumer market. This leads to greater unemployment.
Even as monetary policies negatively affect most of the U.S.’s economy the banking and financial market still retain positive monetary gain. “Conditions in the U.S. financial markets improved…the expected path of monetary policy over the next year... moved up significantly on the net”(FMOC).
I feel The Federal Reserve’s use of monetary policy is questionable. Opposing policy goals such as maximum employment and sustained profitability make for a very instable economy. Currently, there is little potential for bank runs due to the government policies supporting the banks. So to that point, the fractional reserve system seems to be stable enough. This is likely due to the general public’s faith that their money is available, and its security is guaranteed by the government.
However, a privately owed business such as the Federal Reserve has questionable policies that maintain it’s own viability at the cost of its customers. The misnomer, of Federal in its title, gives the public a skewed perception of the establishment controlling its money. It is my belief that the Federal Reserve’s ability to directly affect this countries monetary policy is detrimental to the economy.
In conclusion, the constant readjusting of policy to meet current needs is ill advised due to the time needed to see the effects in the economy. However, the Federal Reserve’s constant alteration in their monetary policies does not allow for these changes. They are constantly forcing the boom and bust cycles previously mentioned. Inflation, on the other hand, is innate in the Federal Reserve’s monetary policy. Its ability to create our money is its prime source of income. So the expansion is necessary for it to retain viable profits but the contraction is necessary to maintain low inflation rates.
One may ask, “Well what can I do about this?” The answer is not a simple one. Being aware of the systems in place is a good first step. Supporting laws and policies that lessen the Federal Reserve’s monopoly of our money system is another. What follows is what I believe to be an almost common sense approach to our current banking dilemma. It requires the Federal Government to exercise powers it already has, but is not using.
People have long accepted that their bank account is digital; it does not represent anything but numbers in a computer system. They can access this “money” via debit card or go to the bank and receive fiat money (money that is not backed by gold but by the word of the government “legal tender”. The change that would need to be made would be the relinquishing of physical money and the integration of a purely digital currency. This is not to say it would not be exchangeable for other countries currency or even gold if desired.
The main reason for this change is because the only way of controlling inflation trends is to know how much money is in circulation. The Federal Reserve already publishes such reports but they are not entirely accurate due to the money people keep on them or in safes. Our money supply could then be increased in step with the Gross Domestic Product or GDP. The GDP represents the goods and services part of our economy. The imbalance of the money supply and our countries GDP is the main reason for inflation. The Federal Government and not the Federal Reserve would be responsible for the policies that increase the Nation’s money. The effects of these increases would be simpler to calculate and address in a timely manner.
Next, the Federal Government would assume the responsibility of protecting its Nations money. Our money would be secure within government-protected systems and not used to artificially expand our money supply. Cards very similar to debit cards (increased security would be included) would be used to purchase goods and services. Loans will still be available, however, the interest rates would be more stable and the interest paid on them will go to benefit the country and economy instead of the banks and bankers. Loans are necessary for the growth of business, or the acquisition of costly items, or improvements Americans have come to expect.
Banks would assume a slightly different role in the handling of money. Depositors would be more aware and more involved in banks’ investment of their money. No longer will banks own the depositor’s money but become investment partners with his/her money. Banks would not be expanding our money supply because they would be working off of 100% reserves. They are able to invest only the money given to them to invest.
I do not believe the ability to create money and to create monetary policy should be the business of anyone other than the Federal Government. The desire to maximize profits will force banks to an ever-greater test of the limits. This pressing of the limits will only increase the compensating policies to be more dire. So the boom and bust cycles will be higher highs and lower lows. The lower lows will then be met by new expansive monetary policy, and the cycle continues till our money’s buying power has dramatically decreased and prices have increased.
Dramatic changes will probably never be this evident since it is more desirable to slowly force change then to make drastic policy. The nation will be less inclined to speak out against unjust ramifications if they are less evident. The banking industry relies on a complacent nation to draw its profits from. The United States, as a whole, has been this Nation; we are currently suffering from the inflation, debasement, and unemployment caused by a mismanaged economy.

“Let me issue and control a nation’s money and I care not who makes its laws.”

Mayer Amschel Rothschild


Works Cited

Clark, Lindley H. The secret tax. Princeton: Dow Jones Books, 1976.
Dwyer, Gerald P., and Margarita Samartìn. “Why do Banks Promise to Pay Par on Demand” Federal Reserve Bank of Atlanta working papers. (Nov. 2006).
Earl, Paul H. Analysis of Inflation. Lexington, MA: Lexington Books, 1975.
Hixson, William F. Triumph of the Bankers: Money and Banking in the Eighteenth and Nineteenth Centuries. Westport,CT: Praeger, 1993.
Hülsmann, J. G. “Has Fractional-Reserve Banking Passed the Market Test?” The Independent Review. 7.3 (Winter 2003): 399-422.
Madigan, Brian F. Minutes of the Federal Open Market Committee. 21 May 2008. 18 June 2008. <May[link] 20080430.htm >
Nuri, Vladimir. “Fractional Reserve Banking as Economic Parasitism.” EconWPA.15 Mar. 2002. 29 May 2008. [link]
Rothbard, Murray. ”Fractional Reserve Banking.” The Freeman. (Oct. 1995). [link]
Selgin, George. “Should We Let Banks Create Money?” The Independent Review. 5.1 (Summer 2000): 93-100.
Tobin, James. “A General Equilibrium Approach To Monetary Theory.” Journal of Money, Credit and Banking. 1.1 (Feb. 1969): 15-29.
Wilson, Thomas F. The Power “To Coin” Money: The Exercise of Monetary Powers by the Congress. Armonk, NY: M. E. Sharpe, 1992.