The Mystery Of Banking

by Murray N. Rothbard

  Counterfeiting, and the resulting inflation, is therefore a process by which some people—the early holders of the new money—benefit at the expense of (i.e., they expropriate) the late receivers. The first, earliest and largest net gainers are, of course, the counterfeiters themselves.

  Thus, we see that when new money comes into the economy as counterfeiting, it is a method of fraudulent gain at the expense of the rest of society and especially of relatively fixed income groups. Inflation is a process of subtle expropriation, where the victims understand that prices have gone up but not why this has happened. And the inflation of counterfeiting does not even confer the benefit of adding to the nonmonetary uses of the money commodity.

  Government is supposed to apprehend counterfeiters and duly break up and punish their operations. But what if government itself turns counterfeiter? In that case, there is no hope of combating this activity by inventing superior detection devices. The difficulty is far greater than that.

  The governmental counterfeiting process did not really hit its stride until the invention of paper money.

  3. GOVERNMENT PAPER MONEY

  The inventions of paper and printing gave enterprising governments, always looking for new sources of revenue, an “open Sesame” to previously unimagined sources of wealth. The kings had long since granted to themselves the monopoly of minting coins in their kingdoms, calling such a monopoly crucial to their “sovereignty,” and then charging high seigniorage prices for coining gold or silver bullion. But this was piddling, and occasional debasements were not fast enough for the kings’ insatiable need for revenue. But if the kings could obtain a monopoly right to print paper tickets, and call them the equivalent of gold coins, then there was an unlimited potential for acquiring wealth. In short, if the king could become a legalized monopoly counterfeiter, and simply issue “gold coins” by printing paper tickets with the same names on them, the king could inflate the money supply indefinitely and pay for his unlimited needs.

  If the money unit had remained as a standard unit of weight, such as “gold ounce” or “gold grain,” then getting away with this act of legerdemain would have been far more difficult. But the public had already gotten used to pure name as the currency unit, an habituation that enabled the kings to get away with debasing the definition of the money name. The next fatal step on the road to chronic inflation was for the government to print paper tickets and, using impressive designs and royal seals, call the cheap paper the gold unit and use it as such. Thus, if the dollar is defined as 1/20 gold ounce, paper money comes into being when the government prints a paper ticket and calls it “a dollar,” treating it as the equivalent of a gold dollar or 1/20 gold ounce.

  If the public will accept the paper dollar as equivalent to gold, then the government may become a legalized counterfeiter, and the counterfeiting process comes into play. Suppose, in a certain year, the government takes in $250 billion in taxes, and spends $300 billion. It then has a budget deficit of $50 billion.

  How does it finance its deficit? Individuals, or business firms, can finance their own deficits in two ways: (a) borrowing money from people who have savings; and/or (b) drawing down their cash balances to pay for it. The government also can employ these two ways but, if people will accept the paper money, it now has a way of acquiring money not available to anyone else: It can print $50 billion and spend it!

  A crucial problem for government as legalized counterfeiter and issuer of paper money is that, at first, no one will be found to take it in exchange. If the kings want to print money in order to build pyramids, for example, there will at first be few or no pyramid contractors willing to accept these curious-looking pieces of paper. They will want the real thing: gold or silver. To this day, “primitive tribes” will not accept paper money, even with their alleged sovereign’s face printed on it with elaborate decoration. Healthily skeptical, they demand “real” money in the form of gold or silver. It takes centuries of propaganda and cultivated trust for these suspicions to fade away.

  At first, then, the government must guarantee that these paper tickets will be redeemable, on demand, in their equivalent in gold coin or bullion. In other words, if a government paper ticket says “ten dollars” on it, the government itself must pledge to redeem that sum in a “real” ten-dollar gold coin. But even then, the government must overcome the healthy suspicion: If the government has the coin to back up its paper, why does it have to issue paper in the first place? The government also generally tries to back up its paper with coercive legislation, either compelling the public to accept it at par with gold (the paper dollar equal to the gold dollar), or compelling all creditors to accept paper money as equivalent to gold (“legal tender laws”). At the very least, of course, the government must agree to accept its own paper in taxes. If it is not careful, however, the government might find its issued paper bouncing right back to it in taxes and used for little else. For coercion by itself is not going to do the trick without public trust (misguided, to be sure) to back it up.

  Once the paper money becomes generally accepted, however, the government can then inflate the money supply to finance its needs. If it prints $50 billion to spend on pyramids, then it—the government—gets the new money first and spends it. The pyramid contractors are the second to receive the new money. They will then spend the $50 billion on construction equipment and hiring new workers; these in turn will spend the money. In this way, the new $50 billion ripples out into the system, raising demand curves and individual prices, and hence the level of prices, as it goes.

  It should be clear that by printing new money to finance its deficits, the government and the early receivers of the new money benefit at the expense of those who receive the new money last or not at all: pensioners, fixed-income groups, or people who live in areas remote from pyramid construction. The expansion of the money supply has caused inflation; but, more than that, the essence of inflation is the process by which a large and hidden tax is imposed on much of society for the benefit of government and the early receivers of the new money. Inflationary increases of the money supply are pernicious forms of tax because they are covert, and few people are able to understand why prices are rising. Direct, overt taxation raises hackles and can cause revolution; inflationary increases of the money supply can fool the public— its victims—for centuries.

  Only when its paper money has been accepted for a long while is the government ready to take the final inflationary step: making it irredeemable, cutting the link with the gold. After calling its dollar bills equivalent to 1/20 gold ounce for many years, and having built up the customary usage of the paper dollar as money, the government can then boldly and brazenly sever the link with gold, and then simply start referring to the dollar bill as money itself. Gold then becomes a mere commodity, and the only money is paper tickets issued by the government. The gold standard has become an arbitrary fiat standard.7

  The government, of course, is now in seventh heaven. So long as paper money was redeemable in gold, the government had to be careful how many dollars it printed. If, for example, the government has a stock of $30 billion in gold, and keeps issuing more paper dollars redeemable in that gold, at a certain point, the public might start getting worried and call upon the government for redemption. If it wants to stay on the gold standard, the embarrassed government might have to contract the number of dollars in circulation: by spending less than it receives, and buying back and burning the paper notes. No government wants to do anything like that.

  So the threat of gold redeemability imposes a constant check and limit on inflationary issues of government paper. If the government can remove the threat, it can expand and inflate without cease. And so it begins to emit propaganda, trying to persuade the public not to use gold coins in their daily lives. Gold is “old-fashioned,” outdated, “a barbarous relic” in J.M. Keynes’s famous dictum, and something that only hicks and hillbillies would wish to use as money. Sophisticates use paper. In this way, by 1933, very few Ameri
cans were actually using gold coin in their daily lives; gold was virtually confined to Christmas presents for children. For that reason, the public was ready to accept the confiscation of their gold by the Roosevelt administration in 1933 with barely a murmur.

  4. THE ORIGINS OF GOVERNMENT PAPER MONEY

  Three times before in American history, since the end of the colonial period, Americans had suffered under an irredeemable fiat money system. Once was during the American Revolution, when, to finance the war effort, the central government issued vast quantities of paper money, or “Continentals.” So rapidly did they depreciate in value, in terms of goods and in terms of gold and silver moneys, that long before the end of the war they had become literally worthless. Hence, the well-known and lasting motto: “Not Worth a Continental.” The second brief period was during the War of 1812, when the U.S. went off the gold standard by the end of the war, and returned over two years later. The third was during the Civil War, when the North, as well as the South, printed greenbacks, irredeemable paper notes, to pay for the war effort. Greenbacks had fallen to half their value by the end of the war, and it took many struggles and 14 years for the U.S. to return to the gold standard.8

  During the Revolutionary and Civil War periods, Americans had an important option: they could still use gold and silver coins. As a result, there was not only price inflation in irredeemable paper money; there was also inflation in the price of gold and silver in relation to paper. Thus, a paper dollar might start as equivalent to a gold dollar, but, as mammoth numbers of paper dollars were printed by the government, they depreciated in value, so that one gold dollar would soon be worth two paper dollars, then three, five, and finally 100 or more paper dollars.

  Allowing gold and paper dollars to circulate side-by-side meant that people could stop using paper and shift into gold. Also, it became clear to everyone that the cause of inflation was not speculators, workers, consumer greed, “structural” features or other straw men. For how could such forces be at work only with paper, and not with gold, money? In short, if a sack of flour was originally worth $3, and is now worth the same $3 in gold, but $100 in paper, it becomes clear to the least sophisticated that something about paper is at fault, since workers, speculators, businessmen, greed, and so on, are always at work whether gold or paper is being used.

  Printing was first invented in ancient China and so it is not surprising that government paper money began there as well. It emerged from the government’s seeking a way to avoid physically transporting gold collected in taxes from the provinces to the capital at Peking. As a result, in the mid-eighth century, provincial governments began to set up offices in the capital selling paper drafts which could be collected in gold in the provincial capitals. In 811-812, the central government outlawed the private firms involved in this business and established its own system of drafts on provincial governments (called “flying money”).9

  The first government paper money in the Western world was issued in the British American province of Massachusetts in 1690.10 Massachusetts was accustomed to engaging in periodic plunder expeditions against prosperous French Quebec. The successful plunderers would then return to Boston and sell their loot, paying off the soldiers with the booty thus amassed. This time, however, the expedition was beaten back decisively, and the soldiers returned to Boston in ill humor, grumbling for their pay. Discontented soldiers are liable to become unruly, and so the Massachusetts government looked around for a way to pay them off.

  It tried to borrow 3 to 4 thousand pounds sterling from Boston merchants, but the Massachusetts credit rating was evidently not the best. Consequently, Massachusetts decided in December 1690 to print £7,000 in paper notes, and use them to pay the soldiers. The government was shrewd enough to realize that it could not simply print irredeemable paper, for no one would have accepted the money, and its value would have dropped in relation to sterling. It therefore made a twofold pledge when it issued the notes: It would redeem the notes in gold or silver out of tax revenues in a few years, and that absolutely no further paper notes would be issued. Characteristically, however, both parts of the pledge quickly went by the board: the issue limit disappeared in a few months, and the bills continued unredeemed for nearly 40 years. As early as February 1691, the Massachusetts government proclaimed that its issue had fallen “far short,” and so it proceeded to emit £40,000 more to repay all of its outstanding debt, again pledging falsely that this would be the absolutely final note issue.

  The typical cycle of broken pledges, inflationary paper issues, price increases, depreciation, and compulsory par and legal tender laws had begun—in colonial America and in the Western world.11

  So far, we have seen that M, the supply of money, consists of two elements: (a) the stock of gold bullion and coin, a supply produced on the market; and (b) government paper tickets issued in the same denominations—a supply issued and clearly determined by the government. While the production and supply of gold is therefore “endogenous to” (produced from within) the market, the supply of paper dollars—being determined by the government—is “exogenous to” (comes from outside) the market. It is an artificial intervention into the market imposed by government.

  It should be noted that, because of its great durability, it is almost impossible for the stock of gold and silver actually to decline. Government paper money, on the other hand, can decline either (a) if government retires money out of a budget surplus or (b) if inflation or loss of confidence causes it to depreciate or disappear from circulation.

  We have not yet come to banking, and how that affects the supply of money. But before we do so, let us examine the demand for money, and see how it is determined, and what affects its height and intensity.

  V.

  THE DEMAND FOR MONEY

  Let’s analyze the various elements that constitute the public’s demand for money. We have already seen that the demand curve for money will be falling in relation to the purchasing power of money; what we want to look at now is the cause of upward or downward shifts in that demand curve.

  1. THE SUPPLY OF GOODS AND SERVICES

  Before money can be held in one’s cash balance, it must be obtained in exchange. That is, we must sell goods and services we produce in order to “buy” money. However, if the supply of goods and services increases in the economy (i.e., supply curves shift to the right), the demand for money in exchange will also increase. An increased supply of goods produced will raise the demand for money and also therefore lower the overall level of prices. As we can see in Figure 3.6, as the demand for money rises, a shortage of cash balances develops at the old equilibrium price level, and prices fall until a new equilibrium, PPM, is achieved.

  Historically, the supply of goods and services has usually increased every year. To the extent it does so, this increase in the demand for money will tend to lower prices over a period of time. Indeed, so powerful has this force been for lowering prices, that they fell from the mid-eighteenth century until 1940, with the only exception being during periods of major wars: the Napoleonic Wars, War of 1812, the Civil War, and World War I. Paper money was increasing the money supply during this era, but increases in M were more than offset by the enormous increases in the supply of goods produced during the Industrial Revolution in an unprecedented period of economic growth. Only during wartime, when the governments ran the printing presses at full blast to pay for the war effort, did the money supply overcome the effects of increasing production and cause price levels to zoom upward.1

  2. FREQUENCY OF PAYMENT

  The demand for money is also affected by the frequency with which people are paid their wages or salaries. Suppose, for example, that Mr. Jones and Mr. Smith are each paid an income of $12,000 a year, or $1,000 per month. But there is a difference: Jones is paid every week, and Smith every month. Does this make any difference to their economic situation? Let us first take Smith, and find out what his cash balance is on each day. Let us assume, to keep things simple, that each man is paid
on the first day of the wage period, and then spends money at an even rate until the last day, when his money is exhausted (and we assume that each man’s income equals his expenditures for the relevant time periods).

  Smith receives $1,000 on the first of the month, and then draws down his $1,000 cash balance at an even rate until the end of the month by a bit more than $33 a day.

  FIGURE 5.1 — CASH BALANCE: MONTHLY INCOME

  What is Smith’s average cash balance for the month? We can find out by simply adding $1,000 on Day 1, and 0 on Day 30, and dividing by 2: the answer is $500.

  Let us now compare Smith to Jones, who has the same total income, but receives his paycheck once a week. Figuring four weeks to the month to simplify matters, this means that Jones gets a check of $250 at the beginning of each week and then draws it down steadily until he reaches a cash balance of zero at the end of the week. His monetary picture will be as follows:

  FIGURE 5.2 — CASH BALANCE: WEEKLY INCOME

  Jones gets a check for $250 at the beginning of each week, and then draws down his cash balance each day by approximately $35 until he reaches zero at the end of the week. His income is the same as Smith’s; but what is his average cash balance? Again, we can arrive at this figure by adding $250, at the beginning of each week, and 0 and dividing by 2: the result is $125.

  In short, even though their incomes are identical, Smith, who gets paid less frequently, has to keep an average cash balance four times that of Jones. Jones is paid four times as frequently as Smith, and hence has to keep a cash balance of only 1/4 the amount.