The Mystery Of Banking

by Murray N. Rothbard

  After a few years, however, sterling balances piled up so high in the accounts of other countries that the entire jerry-built international monetary structure of the 1920s had to come tumbling down. Britain had some success with the European countries, which it could pressure or even coerce into going along with the Genoa system. But what of the United States? That country was too powerful to coerce, and the danger to Britain’s inflationary policy of the 1920s was that it would lose gold to the U.S. and thereby be forced to contract and explode the bubble it had created.

  It seemed that the only hope was to persuade the United States to inflate as well so that Britain would no longer lose much gold to the U.S. That task of persuasion was performed brilliantly by the head of the Bank of England, Montagu Norman, the architect of the Genoa system. Norman developed a close friendship with Strong and would sail periodically to the United States incognito and engage in secret conferences with Strong, where unbeknown to anyone else, Strong would agree to another jolt of inflation in the United States in order to “help England.” None of these consultations was reported to the Federal Reserve Board in Washington. In addition, Strong and Norman kept in close touch by a weekly exchange of foreign cables. Strong admitted to his assistant in 1928 that “very few people indeed realized that we were now paying the penalty for the decision which was reached early in 1924 to help the rest of the world back to a sound financial and monetary basis”—that is, to help Britain maintain a phony and inflationary form of gold standard.8

  Why did Strong do it? Why did he allow Montagu Norman to lead him around by the nose and to follow an unsound policy in order to shore up Britain’s unsound monetary structure? Some historians have speculated that Norman exerted a Svengali-like personal influence over the New Yorker. It is more plausible, however, to look at the common Morgan connection between the two central bankers. J.P. Morgan & Co., as we have seen, was the fiscal agent for the Bank of England and for the British government. Norman himself had longtime personal and family ties with New York international bankers. He had worked for several years as a young man in the New York office of Brown Brothers & Co., and he was a former partner in the associated London investment banking firm of Brown, Shipley & Co. Norman’s grandfather, in fact, had been a partner in Brown, Shipley, and in Brown Brothers. In this case, as in many others, it is likely that the ties that bound the two men were mainly financial.

  XVII.

  CONCLUSION:THE PRESENT BANKING SITUATION AND WHAT TO DO ABOUT IT

  1. THE ROAD TO THE PRESENT

  With the Federal Reserve System established and in place after 1913, the remainder of the road to the present may be quickly sketched. After Fed inflation led to the boom of the 1920s and the bust of 1929, well-founded public distrust of all the banks, including the Fed, led to widespread demands for redemption of bank deposits in cash, and even of Federal Reserve notes in gold. The Fed tried frantically to inflate after the 1929 crash, including massive open market purchases and heavy loans to banks. These attempts succeeded in driving interest rates down, but they foundered on the rock of massive distrust of the banks. Furthermore, bank fears of runs as well as bankruptcies by their borrowers led them to pile up excess reserves in a manner not seen before or since the 1930s.

  Finally, the Roosevelt administration in 1933 took America off the gold standard domestically, so that within the United States the dollar was now fiat paper printed by the Federal Reserve. The dollar was debased, its definition in terms of gold being changed from 1/20 to 1/35 gold ounce. The dollar remained on the gold standard internationally, with dollars redeemable to foreign governments and central banks at the newly debased weight. American citizens were forbidden to own gold, and private citizens' stocks of gold were confiscated by the U.S. government under cover of the depression emergency. That gold continues to lie buried at Fort Knox and in other depositories provided by the U.S. Treasury.

  Another fateful Roosevelt act of 1933 was to provide federal guarantee of bank deposits through the Federal Deposit Insurance Corporation. From that point on, bank runs, and bank fears thereof, have virtually disappeared. Only a dubious hope of Fed restraint now remains to check bank credit inflation.

  The Fed’s continuing inflation of the money supply in the 1930s only succeeded in inflating prices without getting the United States out of the Great Depression. The reason for the chronic depression was that, for the first time in American history, President Herbert Hoover, followed closely and on a larger scale by Franklin Roosevelt, intervened massively in the depression process. Before 1929, every administration had allowed the recession process to do its constructive and corrective work as quickly as possible, so that recovery generally arrived in a year or less. But now, Hoover and Roosevelt intervened heavily: to force businesses to keep up wage rates; to lend enormous amounts of federal money to try to keep unsound businesses afloat; to provide unemployment relief; to expand public works; to inflate money and credit; to support farm prices; and to engage in federal deficits. This massive government intervention prolonged the recession indefinitely, changing what would have been a short, swift recession into a chronic debilitating depression.

  Franklin Roosevelt not only brought us a chronic and massive depression; he also managed to usher in the inflationary boom of 1933–37 within a depression. This first inflationary depression in history was the forerunner of the inflationary recessions (or “stagflations”) endemic to the post-World War II period. Worried about excess reserves piling up in the banks, the Fed suddenly doubled reserve requirements in 1937, precipitating the recession-within-a-depression of 1937–38.

  Meanwhile, since only the United States remained on even a partial gold standard, while other countries moved to purely fiat standards, gold began to flow heavily into the United States, an inflow accelerated by the looming war conditions in Europe. The collapse of the shaky and inflationary British-created gold exchange standard during the depression led to a dangerous world of competing and conflicting national currencies and protectionist blocs. Each nation attempted to subsidize exports and restrict imports through competing tariffs, quotas, and currency devaluations.

  The pervasive national and regional economic warfare during the 1930s played a major though neglected role in precipitating World War II. After the war was over, Secretary of State Cordell Hull made the revealing comment that

  war did not break out between the United States and any country with which we had been able to negotiate a trade agreement. It is also a fact that, with very few exceptions, the countries with which we signed trade agreements joined together in resisting the Axis. The political lineup follows the economic lineup.1

  A primary war aim for the United States in World War II was to reconstruct the international monetary system from the conflicting currency blocs of the 1930s into a new form of international gold exchange standard. This new form of gold exchange standard, established at an international conference at Bretton Woods in 1944 by means of great American pressure, closely resembled the ill-fated British system of the 1920s. The difference is that world fiat currencies now pyramided on top of dollar reserves kept in New York instead of sterling reserves kept in London; once again, only the base country, in this case the U.S., continued to redeem its currency in gold.

  It took a great deal of American pressure, wielding the club of Lend-Lease, to persuade the reluctant British to abandon their cherished currency bloc of the 1930s. By 1942, Hull could expect confidently that “leadership toward a new system of international relationship in trade and other economic affairs will devolve very largely upon the United States because of our great economic strength. We would assume this leadership, and the responsibility that goes with it, primarily for reasons of pure national self-interest.”2

  For a while, the economic and financial leaders of the United States thought that the Bretton Woods system would provide a veritable bonanza. The Fed could inflate with impunity, for it was confident that, in contrast with the classical gold standard, dollars p
iling up abroad would stay in foreign hands, to be used as reserves for inflationary pyramiding of currencies by foreign central banks. In that way, the United States dollar could enjoy the prestige of being backed by gold while not really being redeemable. Furthermore, U.S. inflation could be lessened by being “exported” to foreign countries. Keynesian economists in the United States arrogantly declared that we need not worry about dollar balances piling up abroad, since there was no chance of foreigners cashing them in for gold; they were stuck with the resulting inflation, and the U.S. authorities could treat the international fate of the dollar with “benign neglect.”

  During the 1950s and 1960s, however, West European countries reversed their previous inflationary policies and came increasingly under the influence of free market and hard money authorities. The United States soon became the most inflationist of the major powers. Hard money countries, such as West Germany, France, and Switzerland, increasingly balked at accepting the importation of dollar inflation, and began to accelerate their demands for redemption in gold. Gold increasingly flowed out of the United States and into the coffers of foreign central banks.

  As the dollar became more and more inflated, especially relative to the newly sounder currencies of Western Europe, the free gold markets began to doubt the ability of the United States to maintain the cornerstone of the Bretton Woods system: redeemability of the dollar into gold (to foreign central banks) at $35 an ounce. To keep the gold price down to $35, the Treasury began to find it necessary in the 1960s to sell more and more gold for dollars in the free gold markets of London and Zurich. In this way, private citizens of European and other countries (U.S. citizens were not allowed to own any gold) were able to obtain a kind of redeemability for their dollars at $35 an ounce of gold. As continuing inflationary policies of the United States accelerated the hemorrhaging of gold on the London and Zurich markets, the United States began the unraveling of the Bretton Woods system by installing the two-tier gold system of 1968. The idea was that the United States was no longer committed to support the dollar in the free gold markets or to maintain the price at $35 an ounce. A bifurcated gold market was to be constructed: The free market would be left strictly alone by the central banks of the world, and the central banks pledged themselves never to have anything to do with the free gold markets and to continue to settle their mutual foreign balances at $35 an ounce.

  The two-tier system only succeeded in buying a little time for the Bretton Woods system. American inflation and gold outflow proceeded apace, despite the pleas of the U.S. that foreign central banks abstain from redeeming their dollars in gold. Pressure to redeem by European central banks led President Nixon, on August 15, 1971, to end Bretton Woods completely and to go off the gold standard internationally and adopt a pure fiat standard. The short-lived and futile Smithsonian Agreement of December 1971 tried to retain fixed exchange rates but without any gold standard—an effort doomed to inevitable failure, which came in March 1973.3

  Thus, President Nixon in effect declared national bankruptcy and completed the failure to honor commitments to redeem in gold initiated by Franklin Roosevelt in 1933. In the meanwhile, Congress had progressively removed every statutory restriction on the Fed’s expansion of reserves and printing of money. Since 1971, therefore, the U.S. government and the Fed have had unlimited and unchecked power to inflate; is it any wonder that these years have seen the greatest sustained inflationary surge in U.S. history?

  2. THE PRESENT MONEY SUPPLY

  In considering the present monetary situation, the observer is struck with a phenomenon we mentioned at the beginning of this work: the bewildering series of Ms: Which of them is the money supply? The various Ms have been changing with disconcerting rapidity, as economists and monetary authorities express their confusion over what the Fed is supposed to be controlling. In particularly shaky shape are the Friedmanite monetarists, whose entire program consists of ordering the Fed to increase the money supply at a steady, fixed rate. But which M is the Fed supposed to watch?4 The puzzle for the Friedmanites is aggravated by their having no theory of how to define the supply of money, which they define in a question-begging way by whichever of the Ms correlates most closely with Gross National Product (correlations which can and do change).5

  Everyone concedes that what we can call the old M-1 (currency or Federal Reserve Notes + demand deposits) was part of the money supply. The controversial question was and still is: Should anything else be included? One grievous problem in the Fed’s trying to regulate the banks is that they keep coming up with new monetary instruments, many of which might or might not be treated as part of the money supply. When savings banks began to offer checking services as part of their savings accounts, it became clear even to Friedmanites and other stubborn advocates of only checking accounts as part of the money supply, that these accounts—NOW and ATS—must be included as part of any intelligible definition of the money supply. Old M-1 then became M-1A, and NOW and ATS figures were included in a new M-1B. Finally, in 1982, the Fed sensibly threw in the towel by calling a new M-1 figure the previous M-1B and scrapping the M-1A estimates.6

  The inclusion of new forms of checking accounts at savings and savings and loan banks in the new M-1, however, by no means eliminates the problem of treating these thrift institutions. For regular savings accounts at these institutions, and indeed at commercial banks, while not checkable, can be easily withdrawn in the form of a cashier’s or certified check from these banks. What genuine difference, then, is there between an officially checkable account and one that can be drawn down by a simple cashier’s check? The typical answer that a savings account must be withdrawn by presenting a passbook in person hardly seems to offer any genuine obstacle to withdrawal on demand.

  No: The crucial distinction, and the crucial way to decide what is part of the money supply, must focus on whether a certain claim is withdrawable instantly on demand. The fact that any bank may be able legally to exercise a fine-print option to wait 30 days to redeem a savings deposit is meaningless, for no one takes that fine print seriously. Everyone treats a savings deposit as if it were redeemable instantly on demand, and so it should be included as part of estimates of the money supply.

  The test, then, should be whether or not a given bank claim is redeemable genuinely and in fact, on demand at par in cash. If so, it should be included in the money supply. The counter-argument is that noncheckable deposits are transferred more slowly than checking. Indeed, we saw above how commercial banks were able to engineer credit inflation in the 1920s by changing from demand to alleged time deposits, which legally required much lower reserves. We also saw how several bank runs on these savings deposits occurred during the 1930s. Everyone treated these deposits as if they were redeemable on demand, and began to redeem them en masse when the banks insisted on the fine-print wait of 30 days.

  The test, then, should be whether or not a given bank claim is redeemable, genuinely and in fact, on demand at par in cash. If so, it should be included in the money supply. The counter-argument that noncheckable deposits are transferred more slowly than checking accounts and therefore should not be “money” is an interesting but irrelevant fact. Slower-moving money balances are also part of the money supply. Suppose, for example, in the days of the pure gold coin standard, that individuals habitually had kept some coins in their house to be used for day-to-day transactions, while others were locked up in vaults and used only rarely. Weren’t both sets of gold coins part of their money stocks? And clearly, of course, the speed of spending the active balances is deeply affected by how much money people have in their slower-moving accounts. The two are closely interrelated.

  On the other hand, while savings deposits are really redeemable on demand, there now exist genuine time deposits which should not be considered as part of the money supply. One of the most heartwarming banking developments of the past two decades has been the “certificate of deposit” (CD), in which the bank flatly and frankly borrows money from the individual for
a specific term (say, six months) and then returns the money plus interest at the end of the term. No purchaser of a CD is fooled into believing—as does the savings bank depositor—that his money is really still in the bank and redeemable at par at any time on demand. He knows he must wait for the full term of the loan.

  A more accurate money supply figure, then, should include the current M-1 plus savings deposits in commercial banks, savings banks, and savings and loan associations.

  The Federal Reserve, however, has not proved very helpful in arriving at money supply figures. Its current M-2 includes M-1 plus savings deposits, but it also illegitimately includes “small” time deposits, which are presumably genuine term loans. M-2 also includes overnight bank loans; the term here is so short for all intents and purposes as to be “on demand.” That is acceptable, but the Fed takes the questionable step of including in M-2 money market mutual fund balances.

  This presents an intriguing question: Should money market funds be incorporated in the money supply? The Fed, indeed, has gone further to bring money market funds under legal reserve requirements. The short-lived attempt by the Carter administration to do so brought a storm of complaints that forced the government to suspend such requirements. And no wonder: For the money market fund has been a godsend for the small investor in an age of inflation, providing a safe method of lending out funds at market rates in contrast to the cartelized, regulated, artificially low rates offered by the thrift institutions. But are money market funds money? Those who answer Yes cite the fact that these funds are mainly checkable accounts. But is the existence of checks the only criterion? For money market funds rest on short-term credit instruments and they are not legally redeemable at par. On the other hand, they are economically redeemable at par, much like the savings deposit. The difference seems to be that the public holds the savings deposit to be legally redeemable at par, whereas it realizes that there are inevitable risks attached to the money market fund. Hence, the weight of argument is against including these goods in the supply of money.