Chapter 3. Government Meddling with Money
1. The Revenue of Government
Governments, in contrast to all other organizations, do not obtain their revenue as payment for their services.
Consequently, governments face an economic problem different from that of everyone else.
Government private individuals who want to acquire more goods and services from others
must produce and sell more of what others want. Governments need only find some method
of expropriating more goods without the owner's consent. In a barter economy, government officials
can only expropriate resources in one way, by seizing goods in kind. In a monetary economy,
They will find it easier to seize monetary assets, and then use the money to acquire
goods and services for government, or else pay the money as subsidies to favored groups.
Such seizure is called taxation.
Direct seizure of goods is therefore not now as extensive as monetary expropriation.
Instances of the former still occurring are due process seizure of land under eminent
Domain, quartering of troops in an occupied country, and especially compulsory confiscation
of labor service, for example, military conscription, compulsory jury duty, and forcing business
to keep tax records and collect withholding taxes.
Taxation, however, is often unpopular, and in less temperate days, frequently precipitated
revolutions.
The emergence of money, while a boon to the human race, also opened a more subtle route
for governmental expropriation of resources.
On the free market, money can be acquired by producing and selling goods and services
that people want, or by mining, a business no more profitable in the long run than any
other.
But if government can find ways to engage in counterfeiting, the creation of new money
out of thin air, it can quickly produce its own money without taking the trouble to sell
services or mine gold.
It can then appropriate resources slyly and almost unnoticed without rousing the hostility
touched off by taxation.
In fact, counterfeiting can create in its very victims the blissful illusion of unparalleled
prosperity.
Banking is evidently but another name for inflation, both creating new money that is
not standard gold or silver and both functioning similarly.
And now we see why governments are inherently inflationary, because inflation is a powerful
and subtle means for government acquisition of the public's resources, a painless and
all the more dangerous form of taxation.
2. The Economic Effects of Inflation
To gauge the economic effects of inflation, let us see what happens when a group of counterfeiters
set about their work. Suppose the economy has a supply of 10,000 gold ounces, and counterfeiters,
so cunning that they cannot be detected, pump in 2,000 ounces more. What will be the consequences?
First there will be a clear gain to the counterfeiters.
They take the newly created money and use it to buy goods and services.
In the words of the famous New Yorker cartoon, showing a group of counterfeiters in sober
contemplation of their handiwork, retail spending is about to get a needed shot in the arm.
Precisely.
Local spending indeed does get a shot in the arm.
The new money works its way step by step throughout the economic system.
As the new money spreads, it bids prices up.
As we have seen, new money can only dilute the effectiveness of each dollar.
But this dilution takes time and is therefore uneven.
In the meantime, some people gain and other people lose.
In short, the counterfeiters and their local retailers have found their incomes increased
before any rise in the prices of the things they buy, but on the other hand, people in
remote areas of the economy who have not yet received the new money find their buying prices
rising before their incomes. Retailers at the other end of the country, for example,
will suffer losses. The first receivers of the new money gain most, and at the expense
of the Latest Receivers.
Inflation then confers no general social benefit.
Instead, it redistributes the wealth in favor of the first-comers and at the expense of
the laggards in the race.
And inflation is, in effect, a race, to see who can get the new money earliest.
The late-comers, the ones stuck with the loss, are often called the fixed-income groups.
Ministers, teachers, people on salaries lag notoriously behind other groups in acquiring the new money.
Particular sufferers will be those depending on fixed money contracts, contracts made in the days before the inflationary rise in prices.
Life insurance beneficiaries and annuitants, retired persons living off pensions, landlords with long-term leases,
It has become fashionable to scoff at the concern displayed by conservatives for the
widows and orphans hurt by inflation, and yet this is precisely one of the chief problems
that must be faced.
Is it really progressive to rob widows and orphans and to use the proceeds to subsidize
farmers and armament workers?
Inflation has other disastrous effects.
It distorts that keystone of our economy, business calculation.
Since prices do not all change uniformly and at the same speed, it becomes very difficult
for business to separate the lasting from the transitional and gauge truly the demands
of Consumers or the Cost of Their Operations.
For example, accounting practice enters the cost of an asset at the amount the business
has paid for it.
But if inflation intervenes, the cost of replacing the asset when it wears out will be far greater
than that recorded on the books.
As a result, business accounting will seriously overstate their profits during inflation,
may even consume capital while presumably increasing their investments.
This error will be greatest in those firms with the oldest equipment and in the most
heavily capitalized industries.
An undue number of firms, therefore, will pour into these industries during an inflation.
Similarly, stockholders and real estate holders will acquire capital gains during an inflation
that are not really gains at all, but they may spend part of these gains without realizing
that they are thereby consuming their original capital.
By creating illusory profits and distorting economic calculation, inflation will suspend
the free markets penalizing of inefficient and rewarding of efficient firms.
Almost all firms will seemingly prosper.
The general atmosphere of a seller's market will lead to a decline in the quality of goods
and of service to consumers, since consumers often resist price increases less when they
occur in the form of downgrading of quality.
In these days of rapt attention to cost-of-living indexes, for example escalator wage contracts,
there is strong incentive to increase prices in such a way that the change will not be
be revealed in the index.
The quality of work will decline in an inflation for a more subtle reason.
People become enamored of get-rich-quick schemes, seemingly within their grasp in an era of
ever-rising prices, and often scorn sober effort.
Inflation also penalizes thrift and encourages debt, for any sum of money loaned will be
be repaid in dollars of lower purchasing power than when originally received.
The incentive, then, is to borrow and repay later, rather than save and lend.
Inflation, therefore, lowers the general standard of living in the very course of creating a
tinsel atmosphere of prosperity.
Fortunately, inflation cannot go on forever, for eventually people wake up to this form
of Taxation.
They wake up to the continual shrinkage in the purchasing power of their dollar.
At first, when prices rise, people say, well, this is abnormal, the product of some emergency.
I will postpone my purchases and wait until prices go back down.
This is the common attitude during the first phase of an inflation.
This notion moderates the price rise itself and conceals the inflation further, since
Thus the demand for money is thereby increased.
But as inflation proceeds, people begin to realize that prices are going up perpetually
as a result of perpetual inflation.
Now people will say, I will buy now, though prices are high, because if I wait, prices
will go up still further.
As a result, the demand for money now falls, and prices go up more proportionately than
the increase in the money supply.
At this point the government is often called upon to relieve the money shortage caused by
the accelerated price rise and it inflates even faster.
Soon the country reaches the stage of the crack-up boom when people say, I must buy
anything now, anything to get rid of money which depreciates on my hands.
The supply of money skyrockets, the demand plummets and prices rise astronomically.
Inflation falls sharply as people spend more and more of their time finding ways to get
rid of their money.
The monetary system has in effect broken down completely and the economy reverts to other
monies if they are attainable, other metal, foreign currencies if this is a one country
inflation or even a return to barter conditions.
The monetary system has broken down under the impact of inflation.
This condition of hyperinflation is familiar historically in the Assignats of the French
Revolution, the Continentals of the American Revolution, and especially the German Crisis
of 1923, and the Chinese and other currencies after World War II.
A final indictment of inflation is that whenever the newly issued money is first used as loans
to business, inflation causes the dread business cycle.
This silent but deadly process, undetected for generations, works as follows.
New money is issued by the banking system, under the aegis of government, and loaned
to business.
To businessmen, the new funds seem to be genuine investments.
But these funds do not, like free market investments, arise from voluntary savings.
The new money is invested by businessmen in various projects, and paid out to workers
As the new money filters down to the whole economy, the people tend to reestablish their
old voluntary consumption-saving proportions.
In short, if people wish to save and invest about 20 percent of their incomes and consume
the rest, new bank money loaned to business at first makes the saving proportion look
higher.
When the new money seeps down to the public, it reestablishes its old 20-80 proportion,
and many investments are now revealed to be wasteful.
Liquidation of the wasteful investments of the inflationary boom constitutes the depression
phase of the business cycle.
3.
Compulsory Monopoly of the Mint
For government to use counterfeiting to add to its revenue, many lengthy steps must be
traveled down the road away from the free market.
Government could not simply invade a functioning free market and print its own paper tickets.
Done so abruptly, few people would accept the government's money.
Even in modern times, many people in backward countries have simply refused to accept paper
for Money and insist on trading only in gold. Governmental incursion, therefore, must be
far more subtle and gradual. Until a few centuries ago, there were no banks, and therefore the
government could not use the banking engine for massive inflation as it can today. What
could it do when only gold and silver circulated? The first step, taken firmly by every sizable
Government was to seize an absolute monopoly of the minting business.
That was the indispensable means of getting control of the coinage supply.
The king's or the lord's picture was stamped upon coins, and the myth was propagated that
coinage is an essential prerogative of royal or baronial sovereignty.
The mintage monopoly allowed government to supply whatever denominations of coin it,
but not the public wanted.
As a result, the variety of coins on the market was forcibly reduced.
Furthermore, the mint could now charge a high price, greater than costs, senorage, a price
just covering costs, brassage, or supply coins free of charge.
Senorage was a monopoly price, and it imposed a special burden on the conversion of bullion
to coin.
Gratuitous coinage, on the other hand, overstimulated the manufacture of coins from bullion and
forced the general taxpayer to pay for minting services utilized by others.
Having acquired the mintage monopoly, governments fostered the use of the name of the monetary
unit, doing their best to separate the name from its true base in the underlying weight
of the coin.
This, too, was a highly important step, for it liberated each government from the necessity
of abiding by the common money of the world market. Instead of using grains or grams of
gold or silver, each state fostered its own national name in the supposed interests of
monetary patriotism—dollars, marks, francs, and the like. The shift made possible the
The Preeminent Means of Governmental Counterfeiting of Coin, Debasement
4.
Debasement
Debasement was the state's method of counterfeiting the very coins it had banned private firms
from making in the name of vigorous protection of the monetary standard.
Sometimes the government committed simple fraud, secretly diluting gold with a base
In that way, government continually juggled and redefined the very standard it was pledged
to Protect. The profits of debasement were haughtily claimed as senorage by the rulers.
Rapid and severe debasement was a hallmark of the Middle Ages in almost every country
in Europe. Thus in 1200 A.D. the French livre tournoi was defined at 98 grams of fine silver.
By 1600 A.D. it signified only 11 grams. A striking case is the dinar, a coin of the
Saracens in Spain. The dinar originally consisted of 65 gold grains when first coined at the
end of the 7th century. The Saracens were notably sound in monetary matters, and by
the middle of the 12th century the dinar was still 60 grains. At that point the Christian
One king's conquered Spain, and by the early 13th century, the dinar, now called maravedi,
was reduced to 14 grains.
Soon the gold coin was too light to circulate, and it was converted into a silver coin weighing
26 grains of silver.
This too was debased, and by the mid-15th century the maravedi was only 1.5 silver grains,
and again, too small to circulate 5. Gresham's Law and Coinage
a. Bimetalism Government imposes price controls largely
in order to divert public attention from governmental inflation to the alleged evils of the free
market. As we have seen, Gresham's Law, that an artificially overvalued money tends to
To drive an artificially undervalued money out of circulation is an example of the general
consequences of price control.
Government places in effect a maximum price on one type of money in terms of the other.
Maximum price causes a shortage, disappearance into hordes or exports of the currency suffering
the maximum price, artificially undervalued, and leads it to be replaced in circulation
by the Overpriced Money.
We have seen how this works in the case of new versus worn coins, one of the earliest
examples of Gresham's Law.
Changing the meaning of money from weight to mere tolly, and standardizing denominations
for their own rather than for the public's convenience, the governments called new and
worn coins by the same name, even though they were of different weight.
As a result, people hoarded or exported the full-weight new coins and passed the worn
coins in circulation, with governments hurling maledictions at speculators, foreigners or
the free market in general for a condition brought about by the government itself.
A particularly important case of Gresham's law was the perennial problem of the standard.
We saw that the free market established parallel standards of gold and silver, each freely
would be fluctuating in relation to the other in accordance with market supplies and demands.
But governments decided they would help out the market by stepping in to simplify matters.
How much clearer things would be, they felt, if gold and silver were fixed at a definite ratio,
say 20 ounces of silver to one ounce of gold.
Then both monies could always circulate at a fixed ratio, and far more importantly,
Finally the government could finally rid itself of the burden of treating money by weight
instead of by tally.
Let us imagine a unit, the Ruhr, defined by Ruritanians as one twentieth of an ounce of
gold.
We have seen how vital it is for the government to induce the public to regard the Ruhr as
an abstract unit of its own right, only loosely connected to gold.
What better way of doing this than to fix the gold-silver ratio?
Then Ruhr becomes not only one twentieth of an ounce of gold, but also one ounce of silver.
The precise meaning of the word Ruhr, a name for gold weight, is now lost, and people begin
to think of the Ruhr as something tangible in its own right, somehow set by the government
for good and efficient purposes, as equal to certain weights of both gold and silver.
Now we see the importance of abstaining from patriotic or national names for gold ounces
or grains.
Once such a label replaces the recognized world units of weight, it becomes much easier
for governments to manipulate the money unit and give it an apparent life of its own.
The fixed gold-silver ration, known as bi-metalism, accomplished this task very neatly.
It did not, however, fulfill its other job of simplifying the nation's currency.
For once again, Gresham's Law came into prominence.
The government usually set the bi-metallic ration originally, say 20 to 1, at the going
rate on the free market.
But the market ratio, like all market prices, inevitably changes over time, as supply and
demand conditions change.
As changes occur, the fixed bimetallic ratio inevitably becomes obsolete.
Change makes either gold or silver overvalued.
Gold then disappears into cash balance, black market or exports, when silver flows in from
from abroad and comes out of cash balances to become the only circulating currency in
Ruritania.
For centuries, all countries struggled with calamitous effects of suddenly alternating
metallic currencies.
First, silver would flow in and gold disappear.
Then, as the relative market ratios changed, gold would pour in and silver disappear.
Many debasements, in fact, occurred covertly, with governments claiming that they were merely
bringing the official gold-silver ratio into closer alignment with the market.
Finally, after weary centuries of bimetallic disruption, governments picked one metal as
the standard, generally gold.
Silver was relegated to token coin status, for small denominations, but not at full weight.
The minting of token coins was also monopolized by government, and since not backed 100%
by gold, was a means of expanding the money supply.
The eradication of silver as money certainly injured many people who preferred to use silver
for various transactions.
There was truth in the war cry of the bimetallists that a crime against silver had been committed.
But the crime was really the original imposition of bimetalism in lieu of parallel standards.
Bimetalism created an impossibly difficult situation, which the government could either
meet by going back to full monetary freedom, parallel standards, or by picking one of the
two metals as money, gold or silver standard. Full monetary freedom, after all, this time,
is considered absurd and quixotic, and so the gold standard was generally adopted.
B. Legal Tender.
How was the government able to enforce its price controls on monetary exchange rates?
By a device known as legal tender laws.
Money is used for payment of past debts as well as for present cash transactions, with
With the name of the country's currency now prominent in accounting instead of its actual
weight, contracts began to pledge payment in certain amounts of money.
Legal tender laws dictated what that money could be.
When only the original gold or silver was designated legal tender, people considered
it harmless.
But they should have realized that a dangerous precedent had been set for government control
of money.
If the government sticks to the original money, its legal tender law is superfluous and unnecessary.
On the other hand, the government may declare as legal tender a lower quality currency side
by side with the original.
Thus, the government may decree worn coins as good as new ones in paying off debt, or
silver and gold equivalent to each other in the fixed ratio.
The legal tender laws then bring Gresham's law into being.
When legal tender laws enshrine an overvalued money, they have another effect.
They favor debtors at the expense of creditors.
For then, debtors are permitted to pay back their debts in a much poorer money than they
had borrowed, and creditors are swindled out of the money rightfully theirs.
This confiscation of creditors' property, however, only benefits outstanding debtors.
Future debtors will be burdened by the scarcity of credit generated by the memory of government
spoliation of creditors.
6.
Summary.
Government and Coinage.
The compulsory minting monopoly and legal tender legislation were the capstones in government's
The use of foreign coins was prevalent in the Middle Ages and in the United States down to the middle of the 19th century.
Within each country, only the coin of its own sovereign could now be used.
Between countries, unstamped gold and silver bullion was used in exchange.
The use of foreign coins was prevalent in the Middle Ages and in the United States down to the middle of the 19th century.
Between countries, unstamped gold and silver bullion was used in exchange.
This further severed the ties between the various parts of the world market,
further sundering one country from another and disrupting the international division of labor.
Yet, purely hard money did not leave too much scope for governmental inflation.
There were limits to the debasing that governments could engineer,
and the fact that all countries used gold and silver placed definite checks on the control
of each government over its own territory. The rulers were still held in check by the
discipline of an international metallic money. Governmental control of money could only become
absolute and its counterfeiting unchallenged as money substitutes came into prominence in recent
The advent of paper money and bank deposits, an economic boon when backed fully by gold or silver, provided the open sesame for government's road to power over money, and thereby over the entire economic system.
7. Permitting Banks to Refuse Payment
The modern economy, with its widespread use of banks and money substitutes, provides the golden opportunity for government to fasten its control over the money supply and permit inflation at its discretion.
We have seen that there are three great checks on the power of any bank to inflate under a free banking system.
1. The extent of the clientele of each bank.
2. The extent of the clientele of the whole banking system, that is, the extent to which
people use money substitutes, and 3. The confidence of the clients in their banks.
The narrower the clientele of each bank, of the banking system as a whole, or the shakier
the state of confidence, the stricter will be the limits on inflation in the economy.
Its privileging and controlling of the banking system has operated to suspend these limits.
All these limits, of course, rest on one fundamental obligation, the duty of the banks to redeem
their sworn liabilities on demand.
We have seen that no fractional reserve bank can redeem all of its liabilities, and we
have also seen that this is the gamble that every bank takes.
And it is, of course, essential to any system of private property that contract obligations
be fulfilled.
The bluntest way for government to foster inflation, then, is to grant the banks the
special privilege of refusing to pay their obligations, while yet continuing in their
operation.
While everyone else must pay their debts or go bankrupt, the banks are permitted to refuse
The usual name for this is a suspension of specie payments.
A more accurate name would be license for theft, for what else can we call a governmental
permission to continue in business without fulfilling one's contract?
In the United States, mass suspension of specie payment in times of bank troubles became almost
is just a tradition. It started in the War of 1812. Most of the country's banks were
located in New England, a section unsympathetic to America's entry into the war. These banks
refused to lend for war purposes, and so the government borrowed from new banks in other
states. These banks issued new paper money to make the loans. The inflation was so great
that calls for redemption flooded into the new banks, especially from the conservative,
non-expanding banks of New England, where the government spent most of its money on
war goods. As a result, there was a mass suspension in 1814, lasting for over two years, well
beyond the end of the war. During that time, banks sprouted up, issuing notes with no need
to Redeem in Gold or Silver. This suspension set a precedent for succeeding economic crises
– 1819, 1837, 1857 and so forth. As a result of this tradition, the banks realized that
they need have no fear of bankruptcy after an inflation, and this of course stimulated
inflation and wildcat banking. Those writers who point to 19th century America as a horrid
example of free banking failed to realize the importance of this clear dereliction of
duty by the states in every financial crisis.
The governments and the banks persuaded the public of the justice of their acts.
In fact, anyone trying to get his money back during a crisis was considered unpatriotic
and a despoiler of his fellow men, while banks were often commended for patriotically bailing
Many people, however, were bitter at the entire proceeding, and from this sentiment grew the
famous hard-money Jacksonian movement that flourished before the Civil War.
Despite its use in the United States, such periodic privilege to banks did not catch
hold as a general policy in the modern world.
It was a crude instrument, too sporadic.
It could not be permanent, since few people would patronize banks that never paid their
obligations.
And what's more, it provided no means of government control over the banking system.
What governments want, after all, is not simply inflation, but inflation completely controlled
and directed by themselves.
There must be no danger of the banks running the show.
And so, a far subtler, smoother, more permanent method was devised, and sold to the public
as a hallmark of civilization itself, Central Banking.
8.
Central Banking, Removing the Checks on Inflation
Central banking is now put in the same class with modern plumbing and good roads.
Any economy that doesn't have it is called backward, primitive, hopelessly out of the
and Swim. America's adoption of the Federal Reserve System, our central bank, in 1913,
was greeted as finally putting us in the ranks of the advanced nations. Central banks are
often nominally owned by private individuals, or, as in the United States, jointly by private
banks, but they are always directed by government-appointed officials and serve as arms of the government.
Where they are privately owned, as in the original Bank of England or the second Bank
of the United States, their prospective profits add to the usual governmental desire for inflation.
A central bank attains its commanding position from its governmentally granted monopoly of
the note issue.
This is often the unsung key to its power.
Invariably, private banks are prohibited from issuing notes, and the privilege is reserved
to the Central Bank. The private banks can only grant deposits. If their customers ever
wish to shift from deposits to notes, therefore, the banks must go to the Central Bank to get
them. Hence the Central Bank's lofty perch as a banker's bank. It is a banker's bank
because the bankers are forced to do business with it. As a result, bank deposits become
Some redeemable not only in gold but also in central bank notes, and these new notes
were not just plain bank notes, they were liabilities of the central bank, an institution
invested with all the majestic aura of the government itself.
Government after all appoints the bank officials and coordinates its policy with other state
policy.
It receives the notes in taxes and declares them to be legal tender.
As a result of these measures, all the banks in the country became clients of the central
bank.
In the United States, the banks were forced by law to join the Federal Reserve system
and to keep their accounts with the Federal Reserve banks.
Those state banks that are not members of the Federal Reserve system keep their reserves
with member banks.
Gold poured into the central bank from the private banks, and in exchange, the public
got central bank notes and the disuse of gold coins.
Gold coins were scoffed at by official opinion as cumbersome, old-fashioned, inefficient,
and ancient fetish, perhaps useful in children's socks at Christmas, but that's about all.
How much safer, more convenient, more efficient is the gold when resting as bullion in the
mighty vaults of the central bank?
Bathed by this propaganda, and influenced by the convenience and governmental backing
of the notes, the public more and more stopped using gold coins in its daily life.
Inexorably, the gold flowed into the central bank, where, more centralized, it permitted
a far greater degree of inflation of money substitutes.
In the United States, the Federal Reserve Act compels the banks to keep the minimum
from Ratio of Reserves to Deposits, and since 1917, these reserves could only consist of
deposits at the Federal Reserve Bank.
Gold could no longer be part of a bank's legal reserves.
It had to be deposited in the Federal Reserve Bank.
The entire process took the public off the gold habit and placed the people's gold in
and the none-too-tender care of the state, where it could be confiscated almost painlessly.
International traders still used gold bullion in their large-scale transactions, but they
were an insignificant proportion of the voting population.
One of the reasons the public could be lured from gold to banknotes was the great confidence
everyone had in the central bank.
Certainly the central bank, possessed of almost all the gold in the realm, backed by the might
and prestige of government, could not fail and go bankrupt.
And it is certainly true that no central bank in recorded history has ever failed.
But why not?
Because of the sometimes unwritten but very clear rule that it could not be permitted
to fail.
If governments sometimes allowed private banks to suspend payment, how much more readily would
Did it permit the Central Bank, its own organ, to suspend when in trouble?
The precedent was set in Central Banking history when England permitted the Bank of England
to suspend in the late 18th century and allowed this suspension for over 20 years.
The Central Bank thus became armed with the almost unlimited confidence of the public.
By this time, the public could not see that the Central Bank was being allowed to counterfeit
at will and yet remain immune from any liability if its bona fides should be questioned.
It came to see the Central Bank as simply a great national bank performing a public service
and protected from failure by being a virtual arm of the government.
The Central Bank proceeded to invest the private banks with the public's confidence.
This was a more difficult task.
The Central Bank let it be known that it would always act as a lender of last resort
to the Banks, that is, that the bank would stand ready to lend money to any bank in trouble,
especially when many banks are called upon to pay their obligations.
Governments also continued to prop up banks by discouraging bank runs, that is, cases
where many clients suspect chicanery and ask to get back their property.
Sometimes they permitted banks to suspend payment, as in the compulsory bank holidays
of 1933.
Laws were passed prohibiting public encouragement of bank runs, and as in the 1929 depression
in America, government campaigned against selfish and unpatriotic gold hoarders.
America finally solved its pesky problem of bank failures when it adopted Federal Deposit
Insurance in 1933.
The Federal Deposit Insurance Corporation has only a negligible proportion of backing for
the bank deposits it insures.
But the public has been given the impression, and one that may well be accurate, that the
federal government would stand ready to print enough new money to redeem all of the insured
deposits.
As a result, the government has managed to transfer its own command of vast public confidence
to the entire banking system, as well as to the central bank.
We have seen that by setting up a central bank, governments have greatly widened, if
not removed, two of the three main checks on bank credit inflation.
What of the third check, the problem of the narrowness of each bank's clientele?
Removal of this check is one of the main reasons for the central bank's existence.
In a free banking system, inflation by any one bank would soon lead to demands for redemption
by the other banks, since the clientele of any one bank is severely limited.
But the central bank, by pumping reserves into all the banks, can make sure that they
can all expand together and at a uniform rate.
If all banks are expanding, then there is no redemption problem of one bank upon another,
And each bank finds that its clientele is really the whole country.
In short, the limits on bank expansion are immeasurably widened, from the clientele of
each bank to that of the whole banking system.
In addition to removing the checks on inflation, the act of establishing a central bank has
a direct inflationary impact.
Before the central bank began, banks kept their reserves in gold.
Now gold flows into the central bank in exchange for deposits with the bank, which are now
reserves for the commercial banks. But the bank itself keeps only a fractional reserve
of gold to its own liabilities. Therefore, the act of establishing a central bank greatly
multiplies the inflationary potential of the country.
The establishment of the Federal Reserve in this way increased three-fold the expansive
power of the banking system of the United States.
The Federal Reserve System also reduced the average legal reserve requirements of all
banks from approximately 21 percent in 1913 to 10 percent by 1917, thus further doubling
Directing the Inflationary Potential, a Combined Potential Inflation of Sixfold.
9. Central Banking, Directing the Inflation Precisely how does the central bank go about
its task of regulating the private banks? By controlling the bank's reserves, their
deposit accounts at the central bank. Banks tend to keep a certain ratio of reserves to
to their total deposit liabilities, and in the United States, government control is made
easier by imposing a legal minimum ratio on the bank.
The central bank can stimulate inflation then by pouring reserves into the banking system,
and also by lowering the reserve ratio, thus permitting a nationwide bank credit expansion.
If the banks keep a reserve deposit ratio of 1 to 10, then excess reserves above the
required ratio of $10 million will permit and encourage a nationwide bank inflation
of 100 million.
Since banks profit by credit expansion, and since government has made it almost impossible
for them to fail, they will usually try to keep loaned up to their allowable maximum.
The Central Bank adds to the quantity of bank reserves by buying assets on the market.
What happens, for example, if the bank buys an asset, any asset, from Mr. Jones, valued
at $1,000?
The Central Bank writes out a check to Mr. Jones for $1,000 to pay for the asset.
The Central Bank does not keep individual accounts, so Mr. Jones takes the check and
deposits it in his bank.
This bank credits him with a $1,000 deposit and presents the check to the central bank,
which has to credit the bank with an added $1,000 in reserves.
This $1,000 in reserves permits a multiple bank credit expansion, particularly if added
reserves are in this way poured into many banks across the country.
If the central bank buys an asset from a bank directly, then the result is even clearer.
The bank adds to its reserves and a base for multiple credit expansion is established.
Undoubtedly the favorite asset for central bank purchase has been government securities.
In that way the government assures a market for its own securities.
Government can easily inflate the money supply by issuing new bonds and then order its central
bank to purchase them.
In addition, the central bank undertakes to support the market price of government securities
at a certain level, thereby causing a flow of securities into the bank and a consequent
perpetual inflation.
Besides buying assets, the central bank can create new bank reserves in another way, by
lending them.
The rate which the central bank charges the banks for this service is the re-discount
rate.
Clearly, borrowed reserves are not as satisfactory to the banks as reserves that are wholly theirs since there is now pressure for repayment.
Changes in the re-discount rate receive a great deal of publicity, but they are clearly of minor importance compared to the movements in the quantity of bank reserves and the reserve ratio.
When the central bank sells assets to the banks or the public, it lowers bank reserves and causes pressure for credit contraction and deflation, lowering of the money supply.
We have seen, however, that governments are inherently inflationary.
Historically, deflationary action by the government has been negligible and fleeting.
One thing is often forgotten. Deflation can only take place after a previous inflation. Only pseudo receipts, not gold coins, can be retired and liquidated.
The establishment of central banking removes the checks of bank credit expansion and puts the inflationary engine into operation.
It does not remove all restraints, however. There is still the problem of the central bank itself.
The citizens can conceivably make a run on the central bank, but this is most improbable.
A more formidable threat is the loss of gold to foreign nations.
For just as the expansion of one bank loses gold to the clients of other, non-expanding banks,
So does monetary expansion in one country cause a loss of gold to the citizens of other countries.
Countries that expand faster are in danger of gold losses and calls upon their banking system for gold redemption.
This was the classic cyclical pattern of the 19th century.
A country's central bank would generate bank credit expansion.
Prices would rise.
And as the new money spread from domestic to foreign clientele, foreigners would more and more try to redeem the currency in gold.
Finally, the central bank would have to call a halt and enforce a credit contraction in order to save the monetary standard.
There is one way that foreign redemption can be avoided, inter-central bank cooperation.
If all central banks agreed to inflate at about the same rate, then no country would lose gold to any other, and all the world together could inflate almost without limit.
With every government jealous of its own power and responsive to different pressures, however, such goose-step cooperation has so far proved almost impossible.
One of the closest approaches was the American Federal Reserve Agreement to promote domestic inflation in the 1920s,
in order to help Great Britain and prevent it from losing gold to the United States.
In the 20th century, governments, rather than deflate or limit their own inflation,
have simply gone off the gold standard when confronted with heavy demands for gold.
This, of course, ensures that the central bank cannot fail, since its notes now become the standard money.
In short, government has finally refused to pay its debts, and has virtually absolved the banking system from that onerous duty.
Pseudo receipts to gold were first issued without backing, and then, when the day of reckoning drew near,
the bankruptcy was shamelessly completed by simply eliminating gold redemption.
The severance of the various national currency names, dollar, pound, mark, from gold and silver, is now complete.
At first, governments refused to admit that this was a permanent measure.
They referred to the suspension of specie payments,
and it was always understood that eventually, after the war or other emergency had ended,
the government would again redeem its obligations.
When the Bank of England went off gold at the end of the 18th century, it continued in this state for 20 years, but always with the understanding that gold payment would be resumed after the French wars were ended.
Temporary suspensions, however, are Primrose paths to outright repudiation.
The gold standard, after all, is no spigot that can be turned on or off as government whim decrees.
Either a gold receipt is redeemable or it is not. Once redemption is suspended, the gold standard is itself a mockery.
Another step in the slow extinction of gold money was the establishment of the gold bullion standard.
Under this system, the currency is no longer redeemable in coins. It can only be redeemed in large, highly valuable gold bars.
This, in effect, limits gold redemption to a handful of specialists in foreign trade.
There is no longer a true gold standard, but governments can still proclaim their adherence to gold.
The European gold standards of the 1920s were pseudo-standards of this type.
Finally, governments went off gold officially and completely in a thunder of abuse
against foreigners and unpatriotic gold hoarders.
Government paper now becomes the fiat standard money.
Sometimes treasury rather than central bank paper has been the fiat money, especially
before the development of a central banking system.
The American Continentals, the Greenbacks and Confederate notes of the Civil War period,
the French Assignat, were all fiat currencies issued by the treasuries.
And whether treasury or central bank, the effect of fiat issue is the same. The monetary
standard is now at the mercy of the government, and bank deposits are redeemable simply in
government paper.
11. Fiat Money and the Gold Problem
When a country goes off the gold standard and on to the fiat standard, it adds to the
The number of monies in existence. In addition to the commodity monies, gold and silver,
there now flourish independent monies, directed by each government, imposing its fiat rule.
And just as gold and silver will have an exchange rate on the free market, so the market will
establish exchange rates for all the various monies. In a world of fiat monies, each currency,
If permitted, will fluctuate freely in relation to all the others.
We have seen that for any two monies, the exchange rate is set in accordance with the
proportionate purchasing power parities, and that these in turn are determined by the respective
supplies and demands for the various currencies.
When a currency changes its character from gold receipt to fiat paper, confidence in
When its stability and quality is shaken, and demand for it declines. Furthermore, now
that it is cut off from gold, its far greater quantity relative to its former gold backing
now becomes evident. With a supply greater than gold and a lower demand, its purchasing
power and, hence, its exchange rate quickly depreciate in relation to gold. And since
Since government is inherently inflationary, it will keep depreciating as time goes on.
Such depreciation is highly embarrassing to the government, and hurts citizens who try
to import goods.
The existence of gold in the economy is a constant reminder of the poor quality of the
government paper, and it always poses a threat to replace the paper as the country's money.
Along with the government giving all the backing of its prestige and its legal tender laws
to its fiat paper, gold coins in the hands of the public will always be a permanent reproach
and menace to the government's power over the country's money.
In America's first depression, 1819-1821, four western states, Tennessee, Kentucky, Illinois
Illinois and Missouri established state-owned banks issuing fiat paper.
They were backed by legal tender provisions in the states and sometimes by legal prohibition
against depreciating the notes.
And yet all these experiments, born in high hopes, came quickly to grief as the new paper
depreciated rapidly to negligible value.
The projects had to be swiftly abandoned.
Later, the greenbacks circulated as fiat paper in the North during and after the Civil War.
Yet in California, the people refused to accept the greenbacks, and continued to use gold as their money.
As a prominent economist pointed out, in California, as in other states, the paper was legal tender and was receivable for public dues,
nor was there any distrust or hostility toward the Federal Government.
But there was a strong feeling in favor of gold and against paper.
Every debtor had the legal right to pay off his debts in depreciated paper, but if he did so, he was a marked man.
The creditor was likely to post him publicly in the newspapers, and he was virtually boycotted.
Throughout this period, paper was not used in California.
The people of the state conducted their transactions in gold, while all the rest of the United States used convertible paper.
It became clear to governments that they could not afford to allow people to own and keep their gold.
Government could never cement its power over a nation's currency if the people, when in need, could repudiate the fiat paper and turn to gold for their money.
Accordingly, governments have outlawed gold holding by their citizens.
Gold, except for a negligible amount permitted for industrial and ornamental purposes, has generally been nationalized.
To ask for return of the public's confiscated property is now considered hopelessly backward and old-fashioned.
12. Fiat Money and Gresham's Law
With fiat money established and gold outlawed, the way is clear for full-scale, government-run inflation.
Only one very broad check remains, the ultimate threat of hyperinflation, the crack-up of the currency.
Hyperinflation occurs when the public realizes that the government is bent on inflation
and decides to evade the inflationary tax on its resources
by spending money as fast as possible while it still retains some value.
Until hyperinflation sets in, however, government can now manage the currency and the inflation undisturbed.
New difficulties arise, however.
As always, government intervention to cure one problem raises a host of new unexpected problems.
In a world of fiat monies, each country has its own money.
The international division of labor, based on an international currency, has been broken, and countries tend to divide into their own autarkic units.
Lack of monetary certainty disrupts trade further. The standard of living in each country thereby declines.
Each country has freely fluctuating exchange rates with all other currencies.
A country inflating beyond the others no longer fears a loss of gold but it faces other unpleasant
consequences. The exchange rate of its currency falls in relation to foreign currencies.
This is not only embarrassing but even disturbing to citizens who fear further depreciation.
It also greatly raises the costs of imported goods and this means a great deal to those
In recent years, therefore, governments have moved to abolish freely fluctuating exchange rates.
Instead, they fixed arbitrary exchange rates with other currencies.
Gresham's law tells us precisely the result of any such arbitrary price control.
Whatever rate is set will not be the free market one,
Since that can only be determined from day to day on the market.
Therefore, one currency will always be artificially overvalued and the other undervalued.
Generally, governments have deliberately overvalued their currencies for prestige reasons
and also because of the consequences that follow.
When a currency is overvalued by decree, people rush to exchange it for the undervalued currency
Foreign currency at the bargain rates. This causes a surplus of overvalued and a shortage of the undervalued currency.
The rate, in short, is prevented from moving to clear the exchange market.
In the present world, foreign currencies have generally been overvalued relative to the dollar.
The result has been the famous phenomenon of the dollar shortage, another testimony to the operation of Gresham's law.
Foreign countries clamoring about a dollar shortage thus brought it about by their own policies.
It is possible that these governments actually welcomed this state of affairs.
For A, it gave them an excuse to clamor for American dollar aid to relieve the dollar shortage in the free world.
And B, it gave them an excuse to ration imports from America.
Undervaluing dollars causes imports from America to be artificially cheap and exports to America artificially expensive.
The result? A trade deficit and worry over the dollar drain.
In the last few years the dollar has been overvalued in relation to other currencies and hence the dollar drains from the United States.
The foreign government then stepped in to tell its people, sadly, that it is unfortunately necessary for it to ration imports, to issue licenses to importers and determine what is imported according to need.
To ration imports, many governments confiscate the foreign exchange holdings of their citizens,
backing up an artificially high valuation on domestic currency by forcing these citizens to accept far less domestic money than they could have acquired on the free market.
Thus, foreign exchange, as well as gold, has been nationalized, and exporters penalized.
In countries where foreign trade is vitally important, this government exchange control imposes virtual socialization on the economy.
An artificial exchange rate thus gives countries an excuse for demanding foreign aid and for imposing socialist controls over trade.
At present, the world is enmeshed in a chaotic welter of exchange controls, currency blocks,
In some countries, a black market in foreign exchange is legally encouraged to find out the true rate, and multiple discriminatory rates are fixed for different types of transactions.
Almost all nations are on a fiat standard, but they have not had the courage to admit
this outright, and so they proclaim some such fiction as restricted gold bullion standard.
Actually gold is used not as a true definition for currencies, but as a convenience by governments,
for a, fixing a currency's rate with respect to gold makes it easy to reckon any exchange
in terms of any other currency, and gold is still used by the different governments.
Since exchange rates are fixed, some item must move to balance every country's payments,
and gold is the ideal candidate.
In short, gold is no longer the world's money, it is now the government's money, used in
payments to one another.
Clearly, the inflationist's dream is some sort of world paper money manipulated by a
world government and central bank, inflating everywhere at a common rate.
This dream still lies in the dim future, however.
We are still far from world government, and national currency problems have so far been
too diverse and conflicting to permit meshing into a single unit.
Yet the world has moved steadily in this direction.
The International Monetary Fund, for example, is basically an institution designed to bolster
national exchange control in general, and foreign undervaluation of the dollar in particular.
The fund requires each member country to fix its exchange rate and then to pool gold and
dollars to lend to governments that find themselves short of hard currency.
13.
and Money.
Many people believe that the free market, despite some admitted advantages, is a picture
of disorder and chaos.
Nothing is planned.
Everything is haphazard.
Government dictation, on the other hand, seems simple and orderly.
Decrees are handed down and they are obeyed.
In no area of the economy is this myth more prevalent than in the field of money.
Seemingly, money, at least, must come under stringent government control.
But money is the lifeblood of the economy. It is the medium for all transactions.
If government dictates over money, it has already captured a vital command post for control over the economy,
and has secured a stepping stone for full socialism.
We have seen that a free market in money, contrary to common assumption, would not be chaotic.
What then have we learned about government and money?
We have seen that over the centuries government has step by step invaded the free market and
seized complete control over the monetary system.
We have seen that each new control, sometimes seemingly innocuous, has begotten new and
further controls.
We have seen that governments are inherently inflationary, since inflation is a tempting
means of acquiring revenue for the state and its favored groups.
The slow but certain seizure of the monetary reins has thus been used to a. inflate the
economy at a pace decided by government, and b. bring about socialistic direction of the
entire economy.
Furthermore, government meddling with money has not only brought untold tyranny into the world, it has also brought chaos and not order.
It has fragmented the peaceful, productive world market and shattered it into a thousand pieces,
with trade and investment hobbled and hampered by myriad restrictions, controls, artificial rates, currency breakdowns, etc.
It has helped bring about wars by transforming a world of peaceful intercourse into a jungle
of warring currency blocks.
In short, we find that coercion in money as in other matters brings not order, but conflict
and chaos.