THE MYSTERY OF BANKING
(Second Edition, 2008)
by Murray N. Rothbard
The foreword to this book, by Prof. Joseph T. Salerno, who is an associate of the Ludwig von Mises Institute (mises.org) which I proudly support, points out that an important aspect of the book, possibly the most important, is that it asks and answers the question: Just who benefits the most from the Federal Reserve? In fact, who benefits the most from all the various government regulatory agencies?
I have said often the system is set up in such a way that wealth gravitates toward establishment interests. Let's see if it does.
The first two chapters examine concepts Dr. Rothbard explained in
Man, Economy and State and other works. I wrote on this last winter in
The Works of Murray Rothbard, Part I on this blog. One of these concepts is how money originated, how a marketable commodity gradually, by custom, comes to be used in trade to alleviate the need for a “double coincidence of wants.” I illustrated by asking what would happen if my favorite rock band were headed this way and tickets had to be obtained by barter in the absence of a marketable commodity that is customarily used as money. How would I get a ticket? Somebody has a ticket he will part with but he wants a dog. I have no dog I will spare, so decide to go to the pound to get one for the ticket man. How will I pay for the dog? Well, dogs like steak and the pound has dogs to feed, so I get a few steaks out of my freezer and go to the pound. I surrender the steaks and they surrender a dog. I take him and surrender him to the ticket man, who gives me the ticket. Everyone is happier, but look at all the work that had to be done, and all the luck that was necessary. Over time, people realized some commodities were always welcome in a trade. These commodities could have been anything, but silver and gold prevailed. These became money, and that is how money originated. Government is nowhere in the picture.
The other concept is the law of supply and demand. I illustrated this with my own demand for T-shirts. I can often find nice T-shirts in a thrift store for $1. I will almost always buy one if I see one or, as an economist would say, the “quantity demanded” is high at that low price. Conversely, if the shirt is $25 I will probably take a pass. The “quantity demanded” is very low. The price on the tag depends on what the shop keeper believes he can get. If the supply in the store is too much and he wants to get rid of them, he will lower the price to attract more buyers.
The shop keeper's supply, plus the supply in other shops, constitutes the “supply.” The “demand” comes from customers who are in the market for the product in question. You can plot it on a graph to find the “equilibrium price,” or the price at which all the items are sold and all who want them can buy.
Once these concepts are reviewed, Chapter 3 goes into the demand for money itself. Right away, I see where Dr. Rothbard explodes the actions of the Obama administration, and the Bush administration before it. (There is really not that much difference between them.)
An individual's demand for money is the amount of money he wishes to hold on to (1). Obviously, everybody wants to have as much money as he can get. But he only has X amount. He spends or invests some of what he has, and keeps the rest. The part he keeps, or his cash balance, is his demand for money.
The demand for money is tied to the price level. If prices are high, one's demand for money or one's need for a cash balance is high, and vice versa.
If new money is pumped into the economy by the Federal Reserve, such as by way of bailouts or “stimulus packages,” people, particularly the “first receivers” or early receivers of the new money, will see that their cash reserves are higher than their demand for money, so they will go out and spend, bidding prices up (2). This means the purchasing power of each dollar has gone down, because of more dollars chasing the same amount of goods. Now, prices are rising and people are now finding themselves short, so they are demanding more money by trying to add to cash balances and therefore cut back on spending.
The government has been yapping because people are not spending. The myth it is trying to make us believe is that economic problems now are the result of a cutback in spending and borrowing. It is not difficult to see what hogwash this is: You do not spend yourself rich. You save yourself rich.
So, the general price level is determined by the supply of and demand for money itself. If one of these changes, the price level changes.
Let's assume the money supply in the economy increases (3). This causes the people (or some of the people) to have extra cash in their balances. What do these people do? They go right out and spend, driving prices up. After they spend for a while, they see that their extra cash is almost gone, partly because of rising prices. When they see that their cash balances do not exceed their demand for money, they slow down their spending and things return to normal (sort of). Of course, the early receivers of the new money have benefited at the expense of the later receivers, as was explained by Dr. Rothbard in
Man, Economy and State and other works, and I hope I have made it very clear in my reviews.
When the money supply falls, the opposite occurs, but how often does that happen?
That is how the money supply affects the general price level. The other factor is the demand for money (4). There might be a reason the demand for money rises, that is, a lot of people are holding on to more of their money. This means they are spending less, causing a shift in their demand schedules, which encourages a reduction in prices. A general reduction in prices means the money they have is worth more and that will reduce their demand for money. Of course, when the demand for money decreases, the opposite occurs.
My main focus here is the supply, even though Dr. Rothbard seems to be focusing on both the supply of and the demand for money in the next two chapters. The reason for my focus is that, right now, as 2009 and the new Obama administration begin, and government seems to want to bail out anything that shows signs of life, this bailout and the new “stimulus package” might total up to a trillion and a half dollars! Now, where in the heck is all this going to come from? We have to remember that this is on top of other government expenses! I needn't list these, but I cannot resist throwing some more darts at the illegal, immoral, and completely wrongheaded wars and the monstrosity unleashed here at home called “Homeland Security” which are worst than wastes of our productivity.
And, because the States are all strapped for funds (they cannot possibly consider any cutbacks now, can they?), I think the Obama administration is more than likely to bail them out too.
Naturally these bailouts will always mean more federal control over the industries and states to be bailed out and, yet again, power will gravitate to Washington.
Were I a betting person I would wager that Obama will out-Bush Bush in centralizing power into the federal government, into the Executive Branch and into the White House.
Goodbye, cruel world, I am off to Canada.
But, the money has to come from somewhere. Taxes? That would necessitate a huge tax hike. The left is screaming for more taxes on “the rich.” There are lots of issues here (the destruction of jobs is one, since the “rich” use their wealth to provide jobs), but right now the main issue is that there are not nearly enough truly rich people to be taxed enough to cover the kind of expenditures the government is considering. And, if the “rich” are taxed that way, they will not remain rich very long. This tax hike would have to be a major one on everybody. This will be a tough sell, and will take a very long time.
So, how else can they raise the money? What is almost certain is that money will simply be made (printed) out of thin air, backed up by nothing but pure faith. This means an increase in the money supply, and that is what Chapter 4 is about and is my main focus. The demand for money is important, too, but the supply of money is what I think is the most critical right now.
So, what is the optimal supply of money (5)? Isn't more money better than less? When we are talking about the supply of money in the economy, the answer is no. Unlike consumer and capital goods (which are always scarce), money is not used up. It goes from one person to another to another as it is being exchanged for what people want. Goods and services, like concert tickets, dogs and steaks, are what people want. You cannot eat, be loved by, or listen to money. Assuming the same amount of goods and services in the economy, when the money supply increases, so do prices. An increase in the money supply does not bring about any increase in goods and services. It simply dilutes the purchasing power of the dollar. Therefore, what the money supply quantitatively is doesn't matter. What does matter is the qualitative change in the money supply.
If we had a strict gold standard as Dr. Rothbard advocates (and I agree), there would be only one way to increase the money supply and that would be to dig more gold out of the ground. That is tough work, so the money supply would remain about the same. And it is really difficult to pass off something else as gold (6).
However, let's say someone could pass a cheap metal off as gold and manufactured some coins. He benefits from these, and whoever he buys from with them is next in line to benefit. If enough of these phony coins are passed off as gold, they will cause a rise in consumer demand as they flood the market. Prices will rise as a result. The “first receivers,” i.e., the counterfeiter himself and the first few who receive the fake money, will benefit. Those who are late in receiving the coins will have to pay these higher prices before the coins reach them. They lose out as the early receivers gain.
This is an important concept and I am belaboring it because it is key.
Once the printing press was invented (which is one of the best inventions ever but it can be misused) and paper money began, all bets were off. Counterfeiting became easy. And, while it is one of the most serious felonies for individuals, governments are tempted (7). Government greed goes on forever. So, if a government can print paper tickets and people believe these tickets are worth something, then governments have the means to take as much wealth as they can without people catching on.
This is how the money supply is increased. Right now, another big bailout is pending, and the first receivers of the new money are government cronies, the banks, automobile companies, and certain others. They will benefit. The rest of us are in the back of the bus. Inflation will kick in, big time, before we see a dime of it. The added cost of living can be thought of as a tax on us, paid to the government and its rich cronies. Don't think for one minute that it is accidental because it is not (8). In fact, because it is covert, it is worse because there is no protest.
Chapter 5 discusses the possible causes of a change in the demand for money other than the purchasing power of money. These are the supply of goods and services, how frequently people are paid, how fast clearing systems operate, public confidence in the money, and, most important, the expectation of inflation or deflation.
Right now I believe we can expect some major inflation because of all the money being pumped into the economy. Wise people are thinking they should buy their needed big-ticket items now or soon.
So the choice is now or soon. I was thinking of what I really needed and should get that would keep me from having to get it when prices soar. I got a car last winter. Should I have waited another year? The dealerships have more cars than they know what to do with and prices are reduced. But, last winter, I feared the old one would break down on this last summer's trip and I would have had to pay out-of-pocket for repairs. The new one did not, but a problem later on did strand me for a few days. At least this time there was a warranty. I don't know if it was the right decision. I'd have to contact the new owner of the old car to see if it in fact broke down.
That is water under the bridge. Right now, after a holiday season with deep discounts and very good prices, I went and got a few new middle-ticket items that were name brands for very reasonable prices. Because of these low prices, my demand for money decreased and I spent some that had been kept for just such a situation. I cannot say this situation is “deflation,” but when items I need are on sale at 70 percent off I think I can spend my money stash down a bit.
It would be different if lower-yet prices were expected. Then, my demand for money would be up right now, not down. But they are not; higher prices are almost inevitable. Therefore, my demand for money is down right now, and will go up as prices rise. Why hang on to money that is going to depreciate in value when, instead, one can hang on to items such as furniture, appliances, and especially gold and silver (9).
Prices have not gone up much yet. (Of course the major part of the government spending has not happened yet, but it is expected.) This actually worries me more. When the bailout and other money hits the economy, how much lag time will there be before prices start to really rise? People seem to expect the results of a monetary action within one day. Actually it may take a few months. The bailout may seem to be working. Unemployment may go down for a while and the foreclosures may drop for a while. But that is only postponing the inevitable. Later it is bound to catch up with us, just as it did in Germany in 1923 (10). What will the government do? I think there will be yet another bailout, this one bigger than ever! Inflation will accelerate, and the demand for money will actually drop as people realize that it will buy less and less.
The demand for money drops because people have to pay higher prices for necessities. When they do not have enough, they start to clamor for more money, meaning more inflation (11). This is a vicious circle where inflation is causing higher prices, higher prices cause a clamor for more money, and more money causes inflation. We will be in big, big trouble.
Where will it all end? We hope with the shutoff of the money spigot. But, barring that, it will end with barter, the use of foreign currencies and/or the use of gold (12).
The next question is, where do loans fit into the picture? I have been having a hissy-fit about how people get themselves into debt, and how government wants to re-start loans, as though borrowing made the world go around.
Chapter 6, “Loan Banking,” is about that. Normally in a free market, people keep their savings in a bank at interest, and the bank lends and invests this money at a higher interest. Dr. Rothbard gives a very simple, scaled-down summary of how the books in loan banks are kept (13), although, of course, we have to remember that the first edition of the book was written before the sophisticated computers we now have were in use. But I doubt much has really changed in this regard. What change has occurred is the whole banking system because of central banking. For one thing, Federal Reserve and government actions have changed market signals in such a way that people borrow money they believe they can pay back but later find they cannot.
After this description of loan banking, Chapter 7 is titled “Deposit Banking.” This is a different kind of banking. In fact, Dr. Rothbard regretted that both kinds of banks were called “banks” (14). Deposit banks came into being as warehouses where people kept their valuables, such as gold and silver, safe. One would leave one's valuables and receive a warehouse receipt, and when he wanted some of these valuables back he would go back to the warehouse and present the receipt.
It got so that when people left money in the warehouse, rather than take it out to pay debts, they would remit the receipt to their creditor. This way neither debtor nor creditor would have to make a trip to the warehouse (15).
The warehouse finally evolved into the deposit banks, and the warehouse receipts evolved into the checks we are so familiar with. Unlike loan banks, these banks do not borrow the money from depositors; rather they store it. (At least that was the case.) The major difference is that the loan bank borrows and must pay interest and the deposit bank stores and probably charges a fee. The loan bank borrows for a fixed period of time and the depositor makes a time deposit (such as a CD). A depositor of a deposit bank can take money out or put it in at any time (16).
Of course, as Dr. Rothbard points out and as everyone has thought, embezzlement is always a temptation. It always has been and always will be, particularly when the stored gold is something fungible like money. The warehouse, or bank, has many depositors and it is very unlikely that very many of them will withdraw their funds at the same time. It might not even be necessary for the embezzler to remove the money itself; he or she might simply write checks against it. Or, today, maybe it is only necessary to change computer records to embezzle or counterfeit money. In the old warehouse days, a dishonest warehouse keeper might have printed out fake warehouse receipts and passed them off as receipts for gold stored.
There was a court case in England in 1848 that ruled money deposited in a deposit bank belonged to the banker (as in a loan bank) rather than to the depositor, giving the banker free reign (17). This was a disaster as it went a long way toward paving the way to our present fractional reserve banking. I would also add that it is a disaster twice over, not just because of that but because a ruling by a foreign court in a foreign country was an influence here, undermining our national sovereignty. This is particularly serious these days as “transnationalism” is being advocated by the New World Order crowd, and being taken very seriously. Our side must also take this very real threat seriously.
I think most people who set up demand deposit accounts such as checking accounts believe the money in these accounts belongs to the depositor, not the bank. If your deposited money in your checking account is the bank's, then the bank can do any darn thing it wants with it. It could add your money to its balance sheets. As long as the bank keeps your (or the bank considers it its) money right there anyway, it is not going to do that much harm. But, the temptation is not to keep it there, but to lend it out. (Remember, loan banks can do this; it is on the up-and-up because depositors have loaned their money to the bank at interest, but deposit banking is different.) The deposit bank that lends money that is in your checking account is lending your money out which is at the same time also in your account. Problem is, money cannot be in two places at once any more than you and I can. You and the bank's borrower both have receipts for the very same money, and that is fishy at best (18).
This is the essence of fractional reserve banking, and this is one way the money supply is increased. To be blunt, it's inflationary and fraudulent (19).
This is the creation of money out of thin air (20) and this is probably the single most important point Dr. Rothbard is making in the book.
It is also the most important reason I am doing this particular project at this particular time. Our economy is in a state of ruin, and this increase in the money supply with money created out of thin air, backed up by nothing but faith, is the root cause.
Maybe you think I am a conspiracy theorist and this is exaggerated or completely wrong. No! This is really how it is and has been for a very long time. It caused the Great Depression, and I am about to review Dr. Rothbard's
America's Great Depression. It is about to cause another great depression.
And, of course, again as we have mentioned, the new money does not reach all parts of the economy at the same time. It is injected into the economy at some particular point, and that point is more likely to be Joe Biden than Joe Blow (21). Those at that point will benefit at the expense of the rest of us, and wealth will gravitate toward establishment interests.
Dr. Rothbard points out (22) that the expansion of bank credit (which this is) makes banks “shaky,” as he puts it, and leaves them open to a contraction of their credit. If the money supply contracts, so will prices, and people will want to withdraw money from the shaky banks. Banks will want to call in or not renew loans (23).
This is what seems to be happening now if I read it right, and government wants to get the lending and borrowing (and inflation) going again.
Bank credit expansion causes a “boom,” which is inflationary with the late receivers of the new money having to pay what amounts to a tax to the early receivers, and this is followed by a contraction where credit and investments are liquidated. This is the business cycle (24).
Because of the ability to inflate, deposit banks and loan banks started to combine, forming “commercial banks” (25).
This made it possible to inflate even more. What we need, Dr. Rothbard says, is a requirement that banks keep a 100 percent reserve (26). What happens if banking is left entirely free? Some believe inflation will go totally wild, while others believe the market would keep it in check.
Chapter 8 is about that. What if banks were given free reign and could treat demand deposits such as your checking account as though they were the bank's and not the depositor's? Those who advocate central banking say this would cause hyper-inflation. I would like to know exactly what they believe central banking causes. However, in a free market, a bank, like any other business, must earn a reputation. I can open a restaurant or health clinic without a license. But, I will not see customers arriving unless and until I can show that my food is fit to eat or that my doctors are real doctors. Chances are I will hire a reputable firm (if not five of them) to come in and carry on an inspection in hopes of earning their seal of approval, since if I do not convince people that I am legitimate, I will not make a dime in profits. And I will have to continue to toe the line. The same goes for banks. In a free market they toe the line and do not claim to have money they do not have, and withdrawal requests are promptly granted, or else it is belly-up.
Not only that, people have to be willing to use the bank's drafts. If you get a draft or counter check from the Bank of America from someone in payment for something (I paid the car dealership last year with just such a check), the recipients (once they know the check is actually a BOA check) need to have enough trust in the BofA to accept it. They “know” that when they take the check to the bank, the money will be there.
The problem is, it might not be! Under fractional reserve banking, the banks do not have enough cash on hand to cover all the deposits recorded on their books. If enough of their depositors decided to withdraw their funds at a given time, or a “run” on the bank occurred, there would be trouble (27). A few months ago, people were losing faith and a lot of withdrawals were taking place, and the banks had to get more cash (backed up by nothing) from the Federal Reserve.
I was in Canada at the time and felt some anxiety about getting back into the country to stock up on cash. By the time I crossed the border, things had cooled off a bit, but I bee-lined to my bank's ATM.
Also, a free market in banking will allow many banks to operate, limiting the clientele of each one (28). In a free market, my BofA draft to the car dealership would probably be cashed with the money ending up at a competitive bank. The BofA had better be prepared to come up with the cash. Of course, in my counter check's case it was, but not because of free banking. Actually, all the banks are tied together to the Fed, so we are all clients of the same bank. There might be an element of competition. Many years ago I was a lot sloppier and did not always balance my checkbook. One time I overdrew and had to go into overdraft protection, i.e., I had to actually borrow. When the bill came, not only did I pay it in full the same day it came, but I did it in person. Later I got a letter telling me that this payment had been late, and that in order to keep my overdraft protection I would have to fill out a form listing all my monthly payments. I adamantly refused for a number of reasons, not the very least of which was the very on-time payment. After I would not budge for a few weeks I had to threaten to close my checking and savings accounts and move them to another bank if the bank did not relent. It relented. What I did not tell it, however, was that from then on I would be more careful about balancing my books.
So, the banks at least feel competitive. Most people probably think the banks are different companies, and, on paper I think they are. However, they are all tied together by the Federal Reserve. The only exceptions I can think of might be state banks and credit unions, but I really don't know much about these.
This element of competition is a brake of sorts on inflation, as no bank wants to be the first to be hit with a bank run, but that could change at any time. Under free banking, competition is a major brake on inflation with no change in sight.
What little competition there exists is likely to end. Right now (I am writing this the night before the Obama Inauguration) there is talk of “nationalization” of the Bank of America, Citibank, and other major banks. This talk is not just libertarian and Constitutionalist hooey. The bailouts and the move toward more regulation are a very big step in that direction. Whether these bailouts are gifts or “loans” does not matter. You infuse government money into an area, more regulation follows as surely as night follows day, and whoever makes decisions over a concern might as well be the owner. So this talk of nationalization must be taken very, very seriously. That will stop competition dead in its tracks, and fuel inflation.
The only brake on inflation in that case is banks in other countries (29). If we are going to have a world central bank, that the establishment is working toward with its “New World Order,” we are done for.
In conclusion to that chapter, free market banking is the best way to curb inflation. Dr. Rothbard then turns to the real reason for central banking: to use government-granted privilege to remove the barriers to inflation (30). A central bank has the government monopoly privilege of issuing bank notes or cash. For banks to issue cash to clients, they have to obtain the cash from the central bank. So the central bank is the “bankers' bank.”
Next is a discussion of exactly how the money supply is expanded (and even contracted sometimes) (31) which I will not go into; for one thing it is like a very complicated shell game. Suffice it to say that the banks hold only a fraction of the money that is deposited in them.
The way things are now, with the Federal Reserve and totally fiat money (fiat meaning not backed up by gold or any other commodity), all money kept in banks is subject to inflation (32). What should one do? Yank your money out? Even I use a bank, because paper money kept in one's house or one's car is subject to theft. This is not to mention that, while it is technically legal to have as much cash as one wants, if one is caught with enough of it, it will be stolen (the euphemism is “forfeited”) by government officials and the owner will be labeled a “drug dealer.” Many innocent people have lost their life savings in this manner (33) to greedy government.
So the use of a bank is practical. Don't “do your part.” Rather, look out for number one.
If your bank inflates, it is not checked by competing banks. They are really all the same bank under the Federal Reserve, or at least they are cartelized. The banks welcome this as it is their road to easy wealth (34).
Banks are allowed to inflate because the reserve requirement is only a fraction of the money that is deposited. For example, if the reserve requirement is 1/10, then the banks can lend $100 for every $10 deposited. This is what the infamous money multiplier is (35). They want to lend as much as they can, too, as this is how they make their profits. They also want to minimize the reserve requirements in order to make more loans. This increases the money supply. If the reserve requirement is changed from 1/10 to 1/20, the money supply can double! (36).
How are total reserves determined? This is what Chapter 10 is about. There are two general factors, one being the marketplace and the other being the central bank.
The public's demand for cash is a big market factor. Most people feel the way I do about keeping large amounts of cash at home or in their car because they fear theft. (I am dismayed that a lot of people are oblivious to the specter of asset forfeiture of cash by police or they are foolish enough to believe that it is legitimate.) So most people keep most of their money at the bank. The more money is in the bank, the more the bank can inflate on that money. This is another reason banks dread bank runs: Money withdrawn is money that cannot be inflated upon (37).
In 1933, the federal government decided to try to end the possibility of the loss in public confidence that causes bank runs. It established the Federal Deposit Insurance Corporation (FDIC) which used the power of government to guarantee replacement of deposits that are lost up to a very high amount. This opened the door to far more inflation, as money would be manufactured out of thin air to replace the lost funds.
Under a gold standard, the public's demand for gold would similarly affect the total reserves. Of course, we are now completely off the gold standard (38).
The Federal Reserve can expand or contract the total bank reserves by increasing or decreasing its outstanding loans to banks. (It also uses this power to manipulate bank behavior) (39).
There are short term loans that are usually made to bring a bank back into line with the reserve requirement, and corrections are made so as to return the loan as soon as possible (40). More often nowadays, however, banks borrow for this reason from other banks (41).
But by far the most important method of manipulating bank reserves by the central bank is open market operations. The term “open market” does not have anything to do with any free market. What the central bank does is to buy an asset, any asset. (Usually these assets are U.S. government securities.) These assets are paid for by check, the check being backed up by nothing. The recipient of the check takes it to a local bank to cash. The local bank deposits the check at the central bank, increasing the local bank's reserves. The money supply has gone up by the amount of the check and the amount that can be inflated upon it by more bank loans. How much more depends on the reserve requirement (42).
Conversely, the reverse is true if the Fed holds an open market sale, selling off assets.
Inflation could be halted in its tracks by a law prohibiting the purchases of assets by the Fed (under the naive assumption that the law would be followed). But this will not happen; the government puts the blame for inflation everywhere but where it belongs (43).
Listen to the mainstream news these days and you will see this in action! Of course, Dr. Rothbard believes, along with Ron Paul (and I agree) that the real solution to inflation is to abolish the Fed and return to the gold standard!
Exactly how is bank credit expanded? This is what Chapter 11 explains. Now, if all the banks were the same company, i.e., the same bank with many branches, this would be no problem as all the bank would need to do for a loan client would be to simply open an account for the borrower, list the amount loaned, and allow the borrower to write checks (44). The recipients of these checks would also be clients of the same banks and would deposit the checks there.
But, the way things are now, at least here in the U.S., there are many bank companies (at least on paper) and they compete (sort of). Dr. Rothbard is reviewing what he has gone over once: What happens if the recipient of the borrower's check is a client of a different bank? That bank goes to the first bank with the check for cash. But with the reserve requirement being so low, the first bank might not have the cash. Then what? Bankruptcy?
That is why a bank cannot just lend money in such amounts as to simply comply with the minimum reserve ratio. They all expand much less, according to a formula. The expansion is such that the first bank will be able to pay the second bank, so this problem is averted (45). In the end, the aggregate expansion (on the part of all the banks) is as high as it can be.
So the Federal Reserve purchases a bond, this expands the money supply by however much it paid for the bond, and then when the check for it was deposited, the money supply was expanded more by the portion of that money that was loaned out. That money too was spent and the check taken to a third bank. And so on and so on (46). What I could see here was that the same money was added over and over, and I have to wonder how that kind of arithmetic could be used. Had I done this in third grade, I would have had to stay after school.
But this is how it is done, and this is how the “money multiplier” (inflation) comes about.
Now, the next question is, how do government deficits come into play? This is an important question because the Bush administration spent with the abandon of a drunken sailor (this is really unfair, to drunken sailors that is) and I am fearful of how the Obama administration will behave. Are government deficits really as important as free market people claim?
Actually, government deficits and inflation do not necessarily go together. Government can be in the black while the Fed is inflating and vice versa. The government bonds the Fed buys are old ones (47). Deficits can be financed by the Treasury’s selling new bonds to the public which shifts money to the Treasury but does not create any new money (48).
The problem here is that money spent on government bonds is money taken away from true private-sector production. And, when payback time comes, it will raise the tax burden. This is why free market people complain that deficit spending is a tax on future generations who will be in the work force when payback time comes (49).
(They no longer simply “print out” currency to spend, even though free market people often say the “printing presses at the mint speed up.” That is purely an expression, but it boils down to the very same thing.)
The Treasury might also sell new bonds to commercial banks. This “monetizing the debt” creates new demand deposits to cover a government deficit. Thus, future taxpayers must not only pay for this with their taxes, but they must pay interest on it as well. This is both inflationary and a future tax burden, and it lines bankers' pockets (50).
So actually there is a connection between government deficits and inflation, and inflation if left unchecked can lead to runaway inflation (51).
So much for the nuts and bolts. Not very pretty, is it?
How did the scourge of central banking come to be, anyway? Dr. Rothbard turns to that next.
It started in England in the 1600s (52) with a deal between a government nearly broke from war (chances are that war was no more legal or moral than our wars in Iraq and Afghanistan, but that is only my making a presumption) and corrupt money-changers. The Whig Party was in control and that consisted of special-privileged monopolists. The foreign policy was imperialist and mercantilist (Gads! This sounds familiar!), the very thing that our Founders were so dead set against and that spurred on our founding. It was also the very same system we have today, thanks largely to the three villains I raked over the coals in Three Enemies.
These shenanigans cost big money then just as they do now. Government bonds did not sell, and the government did not dare raise taxes, as civil wars had been fought over this issue (53).
Where would the money come from? A diabolical scheme was hatched. A “Bank of England” would be founded, which could “buy” government bonds with “money” simply printed up. This “bank” would run the presses and print out notes. If you had a copier in your basement, printed up bills, took them to the store and tried to pass them off as the real deal you would be guilty of counterfeiting.
But that is exactly what this “Bank of England” did. It printed them and took them to the treasury and “bought” bonds. Then the government was no longer broke, and could finance its deficit.
Once this “bank” was chartered, the king and some in Parliament rushed right in and bought shares of stock in it. This whole thing was shrouded in mystery (which I read as hocus-pocus) and prestige, and I can only imagine the pomp and ceremony that went with it.
Later – long story short – the government allowed the Bank of England to stop paying its obligations in gold, but allowing it to demand payments to it be made in gold. This happened on and off for quite some time. The bank nearly failed, however, when some enterprising Tories founded a competing bank. This failed, and the Bank of England got its cronies in Parliament to outlaw such competition (54). Not only that, but banks became more strictly regulated in order to empower the Bank of England more.
England was beset with boom and bust, inflation and all that goes with it thanks to the central bank. Scotland, by contrast, had free banking and none of these problems (55). Mainstream historians and economists conveniently forget this. In fact, Scottish money was so much better than English that in border counties the English were using it instead of their own.
Later, in 1844, finally a classical liberal (libertarian), Sir Robert Peel became prime minister (56). As an advocate of 100 percent reserves, he instituted a crackdown on the Bank of England to stem the tide of inflation. However, his policies were flawed. Rather than close down the central bank, he gave it monopoly power. Monopoly privilege always has a corrupting influence. He also insisted that demand deposits were not part of the money supply, and that their issue (which I believe could mean loans of demand deposits) was not inflationary. So fractional reserve banking was not ended at all (57).
Let that be a word to the wise. It is a major step forward if a libertarian is in high public office. At least we would have a fighting chance to remove many shackles, but that libertarian had better understand monetary economics backwards, forwards, and sideways or else his or her policies might backfire.
In the United States, central banking got its start in the beginning. Not all the Founders were decentralist, small-government libertarians. Robert Morris, a war contractor supplying the Revolution, drove a central bank through the Continental Congress. He also favored a mercantilist system of the English sort against which the people had rebelled (58). A central bank would be part and parcel of that. Needless to say, a lot of money flowed into Morris's pockets, just as today it lines establishment pockets as a result.
Fortunately, the public was sharp (would that it would be so sharp today) and notes from the central bank were not well received. Finally, Morris decided the bank would have to change into a commercial bank like any other, and the federal government gave up its stock in it.
That ended the central bank scourge here in the States, for the time being at least.
But, alas, self-proclaimed authority always rears its ugly head, which is why the price of freedom is eternal vigilance.
Morris's cronies, called Nationalists (they called themselves “Federalists”), were still bound and determined to foist English-style mercantilism and statism on the American people, most of whom were in the libertarian Thomas Jefferson's camp. Secretary of the Treasury Alexander Hamilton, one of the Founders who was not on the right side, was a lapdog of Morris, and led the charge. Hamilton founded the next central bank, the First Bank of the United States. Unbacked paper money paid government debts and subsidized big-business cronies of government (59).
The wholesale price index rose by 72 percent in the 1790s, which should surprise nobody, and a score of new commercial banks came into being. Ditto for state banks and they multiplied like rabbits. These banks could print their own notes. The Jeffersonians could not do much about it as moderates took the wrong side. I really understand as today's libertarians (particularly we radicals) cannot even get a platform except on the Internet. The moderates at least could stop those radicals on the other side, the radical Nationalists or Federalists (60), which slowed down the slide down to despotism, but they also thwarted the rise up to freedom.
When this bank's charter was not renewed, causing it to close, free banking was tried again, but this time it did not work very well because it was not really tried! (This is kind of like capitalism today, when so many problems are blamed on capitalism; we do not have even a speck of free-enterprise capitalism.) Under free banking, when a bank cannot pay the checks on it, it goes bankrupt and must close. But this was not allowed. Banks were allowed to not pay their debts, and they were allowed to continue to print notes. This is a free ride, not free banking, and it really opened the floodgates to inflation (61).
Something had to be done, and there were two choices. One was to go back to hard (backed-up) money, compelling the banks to redeem in gold or else liquidate. This way was not chosen by the powerful elite. Rather, a new central bank was founded, the Second Bank of the United States, which opened in 1817.
At least a few people in Congress were able to be heard advocating a gold standard. Today there is one in Congress, Ron Paul, and how often do you see him on the news? Not very, even though he has a tremendous following, including myself.
Just one year later, in 1818, inflation was so rampant that the central bank curtailed loans and credit, beginning an enormous contraction and a depression (62). This seems similar to what we are seeing today.
Finally, during the 1820s, a serious move to restore the gold standard and laissez-faire was made. President Andrew Jackson, who was by no means perfect (63), was part of this movement and in 1831 his veto prevented the renewal of the Bank's charter. That veto also got him re-elected in 1832.
Some claim there was no inflation in the 1820s because prices did not really rise (the very same thing happened a century later in the 1920s). The reason prices did not rise was gains in productivity increased the amount of goods and services in the market, and this increase pushes prices down. What is important is that prices are higher than they would have been had inflation not occurred (64).
Inflation continued even after the central bank was jettisoned, but this time it was for an unrelated reason. There was an influx of silver coins from Mexico, caused by the Mexican government’s minting copper coins and trying to pass them off as equal in value to silver ones. We still had fractional reserve, so we were not in free banking heaven, and banks inflated on top of this silver (65).
The deflation and recession that was sure to follow had a very speedy recovery (66). Of course, at that time we were not saddled with any “New Deal” as we were later in the 1930s or any “bailouts” as we are now, which really only make matters worse as those who know sound economic theory understand.
But, alas, people did still have confidence in the banks and the cycle continued until the central bank closed in 1841.
Meanwhile the states were going broke, as so many are now, and, as now, were pleading for federal help over the objections of the citizens, who at that time had the brains and the backbone to look out for #1 rather than the state and its rich cronies (67). The Whigs were in power and they issued $200 million in bonds to help. Of course at that time that was an astronomical sum, maybe even more than today's bailout.
If you read my
Three Enemies on this blog, you might remember the Whigs and Henry Clay's totally evil “American System.” I can pick up the strong, putrid stench of that here.
Dr. Rothbard points out that the recession at that time was not a hardship on the people (except for a few months), at least not compared to the Great Depression and the deep recession we are experiencing at this time, as I write this on January 28, 2009 (68). There is absolutely no comparison between the economy then and the economy now. Despite all the advanced technology today, problems of unemployment, foreclosures, etc. are rampant. The difference is, today's economy is riddled with regulation, sometimes hair-splitting rules from all levels of too-big and ever-growing government. And the rules are very strict these days with enforcers who act as if they think they are better. In the 1840s, the economy was very free, the freest on earth, allowing individuals to go as far as their ability and ambition would take them.
After these episodes, central banking was ended once and for all and a system of “free banking” was instituted. However, it was anything but free; it bore no resemblance to the free banking described by Dr. Rothbard earlier in the book. For one thing, banks were allowed to inflate on top of state government bonds they had invested in (69), meaning they could inflate on state government debt. This, along with a myriad of regulations and special privilege, did not add up to free banking, but at least it was not fiat money.
When the War Against Southern Independence began in 1861, however, money (greenbacks) was simply printed up to finance the war. The money supply almost doubled in three years (70). Later, the greenbacks were discontinued, but public debt financed the rest of the war. This public debt was bonds sold to the public, like today's savings bonds or municipal bonds, the bond issues I always vote “No” on.
Then the National Banking Acts were passed which were worse for the monetary system than anything else. (I also notice the same names coming up again and again; the same elite fatcats are always at the bottom of it.) This was not a central bank, but it was a cartelized and inflationary banking system. It paved the way to the central bank that has wreaked so much havoc on us during the twentieth and twenty-first centuries so far: the Federal Reserve. The statist mentality prevailing after the turn of the twentieth century made it inevitable that central banking was here to stay. During and after the War of Secession, inflationary policies were going gangbusters (71).
After the war, National and State banks proliferated like rabbits and all of them inflated on their deposits (72). This caused a few “panics” (recessions), the last one being in 1907, the worst one before the Federal Reserve. Bankers wanted the possibility of a government bailout were their banks to get into trouble (73). And they wanted money to be “elastic,” a fancy term meaning they wanted government to create more when “needed.” Of course, the entire establishment was on that page; there is no way they could not know that this would cause the gravitation of wealth into establishment coffers. Either they had seen it happen, they had studied it, or they had figured it out. People are not part of the establishment because they are dumb or ignorant.
People are part of the establishment because they are evil!
This statist, collectivist mentality was called progressivism and (like “progressive” education) it was modeled after Bismarck’s Germany (74). It was about as progressive as taking a wife by clobbering her over the head and dragging her off by the hair, and no more respectful of individual rights. But, alas, the term “progressive” is still used to describe this mentality, and when young people hear the term and look it up in the dictionary, they often say, “Gee! That's me!” I made that mistake myself, but fortunately got disillusioned right quick. The same applies to the term “liberal.” It is very backward and very illiberal.
The biggest shots in the establishment held the infamous Jekyll Island, Georgia, meeting in December, 1910, to hammer out the details of the even more infamous Federal Reserve Act of 1913. The year 1913 was a very dark one because of that, and also because the federal income tax was rammed through (via chicanery) in the same year.
The Federal Reserve was created for the purpose of inflation (75). For one thing, it had a legal monopoly on the legal printing of notes, so banks had to go to it for money for their customers. The Fed's “reserve banks” got to inflate on top of their deposits at the Fed, member banks could inflate on top of their deposits at reserve banks, and non-member banks could inflate on top of their deposits at member banks (76). This added up to a heck of a lot of inflation! Not only that, the reserve requirement was halved (77).
At first, gold certificates were made available. These were backed 100 percent by gold, but it was not long before these were withdrawn by the Fed and substituted for by Federal Reserve notes which were backed only 40 percent (78).
Bank deposits rose during the boom of the 1920's. Dr. Rothbard points out that the boom was largely fueled by credit expansion going into time deposits, especially in New York and Chicago where the Fed's open market operations were conducted. These time deposits “were not genuine savings but merely a convenient means by which the commercial banks expanded on top of new reserves generated by open market operations,” he wrote (79). Businesspeople and others would borrow, and any borrowed money they did not need right away would be placed in an interest-bearing time deposit.
Dr. Rothbard goes on to name names. It reads like a who's who of the establishment of the time. There were connections with munitions factories which, along with the inflation, spurred us on into unnecessary involvement with World War I (which also led to a draft and the early death of many thousands of the best and brightest).
Now, in Chapter 17, “Conclusion: The Present Banking Situation and What to Do About It,” Dr. Rothbard winds the book down. Right off, he says that, after the crash of 1929, the Fed under Hoover went right to work to inflate the currency, with open market purchases and heavy loans to banks. But the public distrusted the banks, and that stonewalled the whole thing. I guess the public was a bit more sophisticated then, at least in that regard. (People were pretty naive, however, being tricked into giving up their gold, obeying a ton of rules that only made things worse, not to mention allowing freedom's arch-enemy Franklin Delano Roosevelt to imprison 110,000 law-abiding Americans of Japanese ancestry for absolutely no reason at all. Please see my
Three Enemies essay on this blog where I am proud to have excoriated this evil-doer.)
Another evil thing the Roosevelt administration did (the list seems to go on forever; you would think they were trying to stamp out prosperity and individualism forever) was to take the country off the domestic gold standard. Internationally, we were still on the gold standard, albeit with a debased dollar. Americans' gold was taken away (“borrowed,” but of course it was never given back). The Federal Deposit Insurance Corporation guaranteed bank deposits and that calmed the fear of bank runs. It still does. If your bank goes belly-up, the FDIC will refund your money (80). That seems good, but it is only one bright spot in an otherwise dark picture. Individuals are, quite honestly, screwed by the system no matter what they do.
What galls me the most is that most people do not even know it! One of these years, I will have to write about the school system...
All of this is one thing that prolonged the Great Depression. Another equally important factor was President Herbert Hoover's economic interventions followed by President Roosevelt's, the latter magnifying the former's regimentation of the economy. The Depression went on and on. Dr. Rothbard's very brief list of what they did (81) reads like a brief rundown of what the Bush and Obama administrations are trying to do now, and the results will be no better.
After World War II – Dr. Rothbard mentions international monetary policy as a big reason for the United States to enter (82) – there was a turn of events in Europe. Some countries wised up and turned to hard money and free market principles, leaving the U.S. as the most inflationary power. Gold flowed out of the country into the hands of Europeans (83).
Of course, one of the darkest days in history, August 15, 1971, the diabolical President Richard Nixon declared a complete end to the gold standard. He also declared an across-the-board price freeze. I did not understand the part about the gold at the time, but even I knew the damage price controls would do. I thought I was having a nightmare.
Now we come to the present. Just how is the Fed to control the money supply? And just what is the money supply? With this confusing array of M1, M2, M3, etc., nobody can agree on that (84)! The lines between these Ms get fuzzier. I remember when my savings bank gave me checks to write against my money market account. I also remember when my simple checking account started to pay interest. Checking account money and money market or CD money are not the same M. Or are they? There are lots of changes like that.
The real difference between money that is part of the money supply and money that is not part of the money supply, says Dr. Rothbard, is whether it is available in cash, on demand at par (presumably this means without a penalty). If it is, it is part of the money supply. If not, it isn't (85).
In other words, your checking account that you use day in and day out is part of the money supply. It is money in, money out all the time. But your certificate of deposit (CD) is a time deposit and you must wait until the end of the term to withdraw or else pay a very large penalty. This is because the bank has loaned the money out on a time loan. That CD is not part of the money supply.
“M1” is cold cash plus demand deposits, and things like travelers' checks. “M2” is that plus short term deposits. There are a lot more Ms that I remember from economics courses (seems like they go up to 25 or so), and the higher they go, the more illiquid the money is. I think of the cash in my billfold and money in my checking account as “liquid.” And, I think of my CDs as “gelatinous” (my term, not Dr. Rothbard's) since I can get money out but it will cost me plenty. These, I think, become “liquid” during rollover time. So, what would the CDs actually be? M2 because of their smaller size? M3 because of their longer term? I am not sure and I do not think that is agreed upon (86). What about money I could get by exercising my God-given right to sell a kidney? That money is not at all liquid, but is rock solid. M100 perhaps? That particular liquidation is not on my agenda, at least not for the foreseeable future. That would be last resort, but since individuals have every right in the world to do that, it is a possibility. (A God-given right, though, is not necessarily legal, and man-denied rights include selling body parts, which is illegal. Editor)
The Ms are not easy to sort out, as Dr. Rothbard illustrates toward the end of the chapter.
Lastly, he discusses how to return to sound money. I guess first of all we have to give the entire establishment one-way tickets to a long and happy retirement some place outside the U.S. and lock the door behind them. The French Riviera perhaps? That expense would be a drop in the bucket compared to the astounding deficit the government has racked up at this time.
To abolish the Fed, return to the gold standard, and separate money from state would be necessary. A 100 percent reserve would have to be enforced (87).
The dollar must be redeemable in gold on demand, regardless. In a free country, the government has no “emergency powers.” Rights are unalienable and these include the right to own gold. This is the only way to have a true gold standard that people can trust.
However, it has to be determined some way how many dollars shall equal an ounce of gold. It was $20, then $35 decades ago, but that is certainly dated now. How about Ludwig von Mises' proposition to use the current market price? Right now I believe that would be about $1000 per ounce [which is down to below $900 toward the end of April. Editor]. This illustrates the inflation we have undergone: Today's dollar is worth about what two cents was at one time. Maybe less! My parents, when they were dating in the early 1930s, frequented restaurants where they could get a full-course dinner for a dime. After dinner, they would go to a local “speakeasy” (an illegal bar during prohibition – they made me proud!! and I wasn't even to be born for quite some time). Today a dinner like that could easily be well more than $20, which is two hundred times as much! So, today's dollar is worth about a half cent!
But, once the price of an ounce of gold is established, it must be fixed by definition. A dollar would be defined as 1/1000 of an ounce of gold, just as a yard is defined as three feet.
And, Dr. Rothbard adds, the gold that was stolen from the people in 1933 must be returned by the redemption in dollars (88). I personally think it should be returned to the heirs of those from whom it was stolen, but I don't know how or if records were kept.
He briefly outlines a step-by-step plan for the changeover (89). After the dollar is defined, all the gold should be removed from Fort Knox and other places where the Treasury has it (is there really any left?) and sent to the banks, liquidating their accounts at the Fed. Banks would have to keep a 100 percent reserve. Banks would have to keep a tight ship or else bank runs would bankrupt them. The minting of coins could be done by private companies on a competitive basis.
My only question: What would keep the gold from exiting the country? We would hope other countries would see the benefits of a gold (or some commodity) standard and follow suit with their own gold. Otherwise, that question is unanswered.
But, at the end of the day, a gold standard is by far and away better than what we have now.
(1) Rothbard, Murray N.,
The Mystery of Banking, Second Edition, Ludwig von Mises Institute, Auburn, 2008, P. 32.
(2) Ibid. P. 34.
(3) Ibid. P. 36.
(4) Ibid. P. 39.
(5) Ibid. P. 44 - 45.
(6) Ibid. P. 48.
(7) Ibid. P. 51.
(8) Ibid. P. 5.
(9) Ibid. P. 67.
(10) Ibid. P. 68 - 69.
(11) Ibid. P. 72.
(12) Ibid. P. 74.
(13) Ibid. P. 76 - 79.
(14) Ibid. P. 85.
(15) Ibid. P. 86.
(16) Ibid. P. 87.
(17) Ibid. P. 92.
(18) Ibid. P. 96.
(19) Ibid. P. 97.
(20) Ibid. P. 98.
(21) Ibid. P. 101.
(22) Ibid. P. 101.
(23) Ibid. P. 102.
(24) Ibid. P. 103.
(25) Ibid. P. 107.
(26) Ibid. P. 110.
(27) Ibid. P. 112 - 113.
(28) Ibid. P. 114.
(29) Ibid. P. 123.
(30) Ibid. P. 125.
(31) Ibid. P. 126 - 132.
(32) Ibid. P. 132.
(33) See
http://www.fear.org/(34) The Mystery of Banking P. 134.
(35) Ibid. P. 136.
(36) Ibid. P. 137 - 138.
(37) Ibid. P. 147.
(38) Ibid. P. 149.
(39) Ibid. P. 149.
(40) Ibid. P. 150.
(41) Ibid. P. 151.
(42) Ibid. P. 155 - 156.
(43) Ibid. P. 158.
(44) Ibid. P. 161.
(45) Ibid. P. 164.
(46) Ibid. 166 - 169.
(47) Ibid. P. 170.
(48) Ibid. P. 171.
(49) Ibid. P. 171.
(50) Ibid. P. 172.
(51) Ibid. P. 176.
(52) Ibid. P. 177.
(53) Ibid. P. 178.
(54) Ibid. P. 180.
(55) Ibid. P. 183.
(56) Ibid. P. 186.
(57) Ibid. P. 188.
(58) Ibid. P. 192.
(59) Ibid. P. 193 - 194.
(60) Ibid. P. 195.
(61) Ibid. P. 197.
(62) Ibid. P. 203 - 204.
(63) According to left-wing historian Howard Zinn, Pres. Jackson mistreated the Indians terribly. See Zinn, Howard,
A People's History of the United States, HarperPerennial, New York, 1990.
(64) The Mystery of Banking P. 204.
(65) Ibid. P. 210.
(66) Ibid. P. 211.
(67) Ibid. P. 212.
(68) Ibid. P. 213 - 214.
(70) Ibid. P. 219.
(71) Ibid. P. 226 - 229.
(72) Ibid. P. 229.
(73) Ibid. P. 230.
(74) Ibid. P. 232.
(75) Ibid. P. 235.
(76) Ibid. P. 236. See the reverse pyramid.
(77) Ibid. P. 238.
(78) Ibid. P. 238.
(79) Ibid. P. 240.
(80) Ibid. P. 248.
(81) Ibid. P. 248.
(82) Ibid. P. 249.
(83) Ibid. P. 251.
(84) Ibid. P. 252.
(85) Ibid. P. 254 - 255.
(86) Ibid. P. 255 - 256.
(87) Ibid. P. 261.
(88) Ibid. P. 262.
(89) Ibid. P. 263 - 264.
