The corollary to this is that the amount by which prices would otherwise have fallen in a noninflationary economy was available to be pocketed by bankers and their accomplices in a more or less undetectable theft. This proved to be an irresistible temptation that was to be gratified by the creation of monopoly central banks to constantly expand currency in partnership with commercial banks.
There is a big difference between borrowing money from a bank and borrowing money from, say, your father-in-law. If he wants to lend you $10,000, he must come up with the whole swag himself. He can only lend you money he has saved from other uses. It costs him $10,000 to lend you $10,000. But through the abracadabra of fractional reserve banking, the bank can lend you $10,000 at a negligible cost. The bankers’ only risk is that to the extent that you fail to repay the loan, with interest, they must charge the unpaid balance against their capital. The money they lend to you never existed before they wrote the check. That is what is known in technical terms as “inflation.”
There has been a lot of inflation in the United States in the past century. I write some little while after the banker’s party celebrating the one-hundredth anniversary of the founding of the Federal Reserve System. Although the Fed was allegedly created to “control inflation,” during its first century of existence, the supply of money in the United States (M2) multiplied 665 times from $15.78 billion in 1913 to $10.952 trillion in 2013.
For perspective, the M2 money supply multiplied at the slower pace of just a little over twelve times in the half-century before the Federal Reserve was instituted. It was by no means true that there was a free market in banking prior to 1913. The National Bank Act of 1864 was one among a crazy quilt of federal and state laws that regulated banks and the issuance of money prior to creation of the Federal Reserve.
Among other things, national banks were prohibited from making mortgages on real estate. This therefore limited their capacity to compete in rural areas, while intensifying banking competition in cities. As a result, the fading farm sector faced high interest rates, while intense banking competition resulted in lower interest rates in urban areas. Although the United States was ostensibly employing gold and silver money, in the half-century prior to 1913 the M2 money supply grew at an annual rate of 5.61 percent.
By contrast, M2 grew at an annual average rate of 6.76 percent—20 percent faster—after the Federal Reserve came into existence. Overall, the M2 money supply grew almost twenty-nine times more than the Consumer Price Index (CPI). According to official statistics, an item that cost $20 in 1913 would have cost $470.85 in 2013, not $13,300—a factoid that reflects two unheralded truths:
1. The government has lied about the inflation rate, especially over the last quarter of a century.
2. The greater part of inflation, rightly understood as expansion of the money supply, affected a redistribution of income and wealth rather than showing up primarily as higher consumer prices. (This is exactly what you should expect, as there is no particular advantage to anyone in adding almost $11 trillion to the money supply if the only effect of doing so were to proportionately tack zeros on the price of everything.)
During that same one-hundred-year period, real GDP per capita, calculated in 2009 dollars, multiplied just sevenfold: from $6663.85 per capita in 1913 to $49,226.16 in 2012. Notwithstanding the greatest surge of energy inputs in history, that is a compound growth rate of just a little more than 2 percent. So contrary to the pretense inherent in QE, there is no compelling evidence that monetary expansion over the long term stimulates real growth. But without a doubt, the overlay of fractional reserve banking with pure fiat money created one of the greatest realms for crony capitalist exploitation ever devised. The dilution of the dollar inherent in the 665-fold multiplication of the money supply redistributed income and wealth from the poor to the rich.
What triggered the shift away from gold and silver to a pure fiat money? Economic historians tend to blame disruptions in the wake of World War I and other unfavorable winds. But I see it in more simple terms. The shift away from gold and silver to fiat money was a follow-on consequence to the unprecedented surge in per capita energy use from about the middle of the nineteenth century forward.
Short-Term Growth Accelerated by Fiat Debt Expansion
The economy is inevitably informed by the physical resources that underlie it. When the introduction of hydrocarbon energy dramatically lifted growth rates, it also introduced an almost hydraulic pressure to restructure money. When real growth rates rose, as energy inputs expanded, this implicitly enlarged the energy economy of the future, permitting, as Tim Morgan put it, the “financial ‘shadow’ economy of money and debt” to expand. But the gold standard constricted the expansion of the financial shadow economy of money and debt, so it had to go.
Fiat money entailed temporary advantages in a rapidly growing economy. Among them were the seigniorage profits from creating money out of thin air, enjoyed by commercial banks. Another was the impact of credit inflation in temporarily lifting nominal asset prices, increasing stock prices, and enlarging tax receipts, while facilitating the illusion that the government could offer voters benefits that were worth more than they paid for them.
Put simply, the introduction of fossil fuels increased the economic growth rate, permitting the real economy to support a larger sum of claims represented by money and debt. In effect, historically unprecedented economic growth propelled by exogenous hydrocarbon energy amounted to a hidden BTU content of fiat money.
The virtual rivers of oil that the United States obtained at minimal cost precipitated a transformation of the monetary system in a direction that accorded with the interests of bankers, their best customers, and those running governments. Yale politics professor Douglas W. Rae has sought to quantify the increase in energy conversion. His A Short History of American Horsepower highlights a jump in energy production in the United States from 8,495,000 horsepower in 1850 to 34.958 billion horsepower in 1990.26
An apparent drawback of commodity-based money in a high-growth environment is the fact that supplies of gold and silver are inelastic. As Elisa Newby, head of the Market Operations Division of the Bank of Finland, spells out: “Under the gold standard the money growth rate cannot be regulated by governmental policy because the money stock can increase or decrease only if the commodity stock in monetary uses increases or decreases respectively.”27
Therefore, because governments and central banks are not alchemists capable of creating gold out of thin air, credit cannot be expanded as readily under a gold standard as under a fiat regime. As growth rates accelerated in the twentieth century, fueled by compounding use of hydrocarbon energy, authorities in one economy after another moved to replace commodity-based money that incorporated limitations on the extension of credit—which tended to limit the nominal GDP growth—in favor of a pure fiat money borrowed into existence through fractional reserve banking.
It was no drawback that fiat money facilitated the enrichment of governments, enabling them to garner more resources, fight more wars, and create the illusion of democratic consensus through deficit spending to buy votes, as they could not do so readily when hampered by the restrictions of a gold standard.
The availability of an elastic supply of credit permitted at least a temporary acceleration of growth. Part of this linkage derives from the fact that fiat money is borrowed into existence, allowing consumers, companies, and governments to spend and invest without first earning and saving the requisite amounts—as envisioned by Adam Smith. In The Wealth of Nations, he tells us that “the accumulation of stock (capital) is previously necessary.”28 The apparent ability of an elastic system of fiat money to short-circuit the need to earn profits and save them offered at least a temporary expedient for accelerating growth. A growing economy allows room for interest payments without necessarily constraining other outlays. This provides the leverage to growth through the credit system.
A rapid increase in the amount of money and debt outstandi
ng, at least in its early stages, permits consumers to make purchases beyond what their cash flow would otherwise permit and without having to save. Extra money adds to purchasing power through extra credit created out of thin air, creating demand that otherwise would not exist. The same goes for business investments in which companies can borrow money to expand. Rapid growth in the real economy is a crucial factor in the equation in that it permits the process to continue.
Falling Short of Perpetual Motion
It verges in the direction of perpetual motion, except for the fact that the amount of the mortgage on future revenues that can be supported by future sunshine falls far short of infinity. As Soddy emphasizes, debt is a purely mathematical abstraction that can follow the law of compound interest. But the real energy revenue from future sunshine cannot. As a matter of fact, it is only because the deficient energy revenues from annual sunshine can be subsidized by the consumption of energy capital, accumulated from the stored sunlight of Paleozoic summers, that the debt liens are even temporarily sustainable. In the long run, they are not. The energy capital upon which the system depends for viability is limited, and it has become more difficult to access as EROEI has plunged.
Just as fiat money can be created out of thin air through credit expansion, so it can also vanish into thin air through debt default. With fiat money in an environment of rising energy inputs, businesses and consumers could make outlays that spur growth in the current period without first restraining their budgets to accumulate savings—and not incidentally. Just as economic growth spurred the hypertrophy of predatory government, so it opened an opportunity for bankers to appropriate a hefty increment of the growth. In other words, the spur to growth, provided by the oil-powered economy, created an almost irresistible inducement to revamp the monetary system. This resulted, almost inevitably, in a debt-ridden economy.
The unprecedented surge in the amount of energy employed, and therefore the amount of work undertaken per capita, had far-reaching consequences in revolutionizing money. Rapid growth provided cover for predatory diversion of the value of money, financializing the economy while creating great profits for bankers and the government. Rapid money growth also made it easier for a majority of enterprises to profit and stock prices to rise.
Fiat Money Lifts Stock Prices
The connection between monetary expansion and higher stock prices, so clearly in evidence since 2008 due to the extreme practice of quantitative easing, has always been in play with fiat money. As Austrian economist Fritz Machlup put it in his 1940 book, The Stock Market, Credit, and Capital Formation, “In the absence of inflationary credit the funds available for lending to the public for security purchases would soon be exhausted, since even a large supply is ultimately limited . . . Only if the credit organization of the banks (by means of inflationary credit) or large-scale dishoarding by the public make the supply of loanable funds highly elastic, can a lasting boom develop . . . A rise on the securities market cannot last any length of time unless the public is both willing and able to make increased purchases.”29
Of course, if you are one of those to whom the government has directed profits by encouraging the proliferation of fiat money, and thus raising stock prices, remember that you are expected to pay for this privilege by bearing a lopsided tax burden. The way the game works is that the politicians want to make you rich so they can tax your money away and use it to provide benefits to hordes of needy voters that seem to be worth more than they paid for them. Neither the politicians nor the voters particularly care whether you like it or not.
The Transitory Advantage of Fiat Money
The introduction of hydrocarbon energy began a process that changed money and banking. But it has been little appreciated, then or now, that the system of fiat money that emerged in response to rapid growth, fueled by the surge of BTUs derived from hydrocarbon energy, could only be of transitory advantage. This is true for at least two fundamental reasons, both of which argue against an indefinite continuation of rapid growth:
1. The marginal returns from the early applications of hydrocarbon energy in the economy were bound to fall as energy inputs rose.
2. Due to the “magic” of compounding, an indefinite expansion of the economy called for prodigious increases of energy inputs to what has proven to be an unrealistic degree. As Kenneth Boulding famously quipped, “Anyone who believes that exponential growth can go on forever in a finite world is either a madman or an economist.” More on that to come.
Declining Returns from Energy Inputs
People following the normal economic imperatives tended to first invest newly available energy in areas of greatest return, generally where inadequate somatic energy capacity was a bottleneck to production. For example, the productivity gain from replacing a mule-drawn plow with a tractor was tremendous. But deploying a comparable quantity of BTUs to air condition the farmer’s house arguably contributed less dramatic gains. By the very nature of things, it tended to become harder to achieve robust productivity gains by increasing energy use as the supply of exogenous hydrocarbon energy expanded.
This is borne out by the record. If you compare economic growth through the twentieth century with the growth in energy inputs, there is clear evidence of diminishing returns. Energy analyst Gail Tverberg comments in a May 2015 article, “Why We Have an Oversupply of Almost Everything (Oil, Labor, Capital, Etc.),” that “adding one percentage point of growth in energy usage tends to add less and less GDP growth over time . . . This means that if we want to have, for example, a constant 4 percent growth in world GDP for the period 1969 to 2013, we would need to gradually increase the rate of growth in energy consumption from about 1.8 percent (= 4.0 percent—2.2 percent) growth in energy consumption in 1969 to 2.8 percent (= 4.0 percent—1.2 percent) growth in energy consumption in 2013. This need for continued growth in energy use, to produce the same amount of economic growth, is happening despite all of our efforts toward efficiency and becoming more of a ‘service’ economy.”30
Jevons and Compounding Energy Inputs
Perhaps more crucially, there is the daunting problem of compounding that so vexed Soddy, identified in a different context by William Stanley Jevons, in his classic 1865 essay, “The Coal Question: An Inquiry Concerning the Progress of the Nation, and the Probable Exhaustion of Our Coal-Mines.”
Jevons, as you may recall, was an important figure in the history of economics as one of the originators of the marginal revolution that put an end to the labor theory of value. He emphasized that “value depends entirely upon utility.”31 If no one knew the difference, a house conjured out of a top hat by a magician would be worth the same as an apparently identical house cobbled together by brigades of union carpenters, masons, and joiners. (And of course, if people did know the difference, the house created by magic would undoubtedly be worth more because of the novelty factor.)
Escaping “the Laborious Poverty of Early Times”
Writing only a few years after the launch of the petroleum industry in 1859, Jevons naturally focused his attention on coal, as it was the primary hydrocarbon fuel in use in his day. Jevons saw that energy was the “mainspring of modern material civilization . . . the source at once of mechanical motion and of chemical change.” He believed that, with it, almost any feat was possible, but without it, we would be “thrown back into the laborious poverty of early times.”32
Jevons drew on records of historical coal production to show that over the eighty years prior to 1865, production had grown at a relatively consistent rate of 3.5 percent per year, or 41 percent per decade. He also recognized the logic of this compounding: for that growth rate to continue, it meant coal production would have to climb from about 100 million tons in 1865 to more than 2.6 billion tons 100 years later. Jevons then calculated that if that were to happen, the country would produce approximately 100 billion tons within this period. Jevons recognized that known resources were insufficient for such compound growth over even 100 years. Long before the century
mark was reached, the growth rate, which was the measure of prosperity, would inevitably decline. The decline of growth associated with dwindling energy inputs is a matter I analyze further in the next chapter.
Notes
1 Morgan, Tim, Life after Growth (Hampshire: Harriman House, 2013).
2 Soddy, Frederick, The Role of Money: What It Should Be, Contrasted with What It Has Become (London: Routledge, 1934), 24.
3 Soddy, Frederick, Wealth, Virtual Wealth and Debt (London: George Allen & Unwin, 1926), 70.
4 See Daly, Herman, “The Economic Thought of Frederick Soddy,” History of Political Economy 12, no. 4 (1980), 469–88; Soddy, Frederick, The Inversion of Science (London: Henderson, 1924), 17.
5 Morgan, Life after Growth, 11.
6 Morgan, Tim, Perfect Storm: Energy, Finance and the End of Growth (London: Tylett Prebon, 2013), 60.
7 Ibid., 12.
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