8.
Central Banking: Removing the Checks on Inflation
Central Banking is now put in the same class with modern plumbing and good roads: any economy that doesn't have it is called “backward,” “primitive,” hopelessly out of the swim. America's adoption of the Federal Reserve System—our Central Bank—in 1913 was greeted as finally putting us in the ranks of the “advanced” nations.
Central Banks are often nominally owned by private individuals or, as in the United States, jointly by private banks; but they are always directed by government-appointed officials, and serve as arms of the government. Where they are privately owned, as in the original Bank of England or the Second Bank of the United States, their prospective profits add to the usual governmental desire for inflation.
A Central Bank attains its commanding position from its governmentally granted monopoly of the note issue. This is often the unsung key to its power. Invariably, private banks are prohibited from issuing notes, and the privilege is reserved to the Central Bank. The private banks can only grant deposits. If their customers ever wish to shift from deposits to notes, therefore, the banks must go to the Central Bank to get them. Hence the Central Bank's lofty perch as a “bankers' bank.” It is a bankers' bank because the bankers are forced to do business with it. As a result, bank deposits became redeemable not only in gold, but also in Central Bank notes. And these new notes were not just plain bank notes. They were liabilities of the Central Bank, an institution invested with all the majestic aura of the government itself. Government, after all, appoints the Bank officials and coordinates its policy with other state policy. It receives the notes in taxes, and declares them to be legal tender.
As a result of these measures, all the banks in the country became clients of the Central Bank.12 Gold poured into the Central Bank from the private banks, and, in exchange, the public got Central Bank notes and the disuse of gold coins. Gold coins were scoffed at by “official” opinion as cumbersome, old-fashioned, inefficient—an ancient “fetish,” perhaps useful in children's socks at Christmas, but that's about all. How much safer, more convenient, more efficient is the gold when resting as bullion in the mighty vaults of the Central Bank! Bathed by this propaganda, and influenced by the convenience and governmental backing of the notes, the public more and more stopped using gold coins in its daily life. Inexorably, the gold flowed into the Central Bank where, more “centralized,” it permitted a far greater degree of inflation of money-substitutes.
In the United States, the Federal Reserve Act compels the banks to keep the minimum ratio of reserves to deposits and, since 1917, these reserves could only consist of deposits at the Federal Reserve Bank. Gold could no longer be part of a bank's legal reserves; it had to be deposited in the Federal Reserve Bank.
The entire process took the public off the gold habit and placed the people's gold in the none-too-tender care of the State—where it could be confiscated almost painlessly. International traders still used gold bullion in their large-scale transactions, but they were an insignificant proportion of the voting population.
One of the reasons the public could be lured from gold to bank notes was the great confidence everyone had in the Central Bank. Surely, the Central Bank, possessed of almost all the gold in the realm, backed by the might and prestige of government, could not fail and go bankrupt! And it is certainly true that no Central Bank in recorded history has ever failed. But why not? Because of the sometimes unwritten but very clear rule that it could not be permitted to fail! If governments sometimes allowed private banks to suspend payment, how much more readily would it permit the Central Bank—its own organ—to suspend when in trouble! The precedent was set in Central Banking history when England permitted the Bank of England to suspend in the late eighteenth century, and allowed this suspension for over twenty years.
The Central Bank thus became armed with the almost unlimited confidence of the public. By this time, the public could not see that the Central Bank was being allowed to counterfeit at will, and yet remain immune from any liability if its bona fides should be questioned. It came to see the Central Bank as simply a great national bank, performing a public service, and protected from failure by being a virtual arm of the government.
The Central Bank proceeded to invest the private banks with the public's confidence. This was a more difficult task. The Central Bank let it be known that it would always act as a “lender of last resort” to the banks—i.e., that the Bank would stand ready to lend money to any bank in trouble, especially when many banks are called upon to pay their obligations.
Governments also continued to prop up banks by discouraging bank “runs” (i.e., cases where many clients suspect chicanery and ask to get back their property). Sometimes, they will permitted banks to suspend payment, as in the compulsory bank “holidays” of 1933. Laws were passed prohibiting public encouragement of bank runs, and, as in the 1929 depression in America, government campaigned against “selfish” and “unpatriotic” gold “hoarders.” America finally “solved” its pesky problem of bank failures when it adopted Federal Deposit Insurance in 1933. The Federal Deposit Insurance Corporation has only a negligible proportion of “backing” for the bank deposits it “insures.” But the public has been given the impression (and one that may well be accurate) that the federal government would stand ready to print enough new money to redeem all of the insured deposits. As a result, the government has managed to transfer its own command of vast public confidence to the entire banking system, as well as to the Central Bank.
We have seen that, by setting up a Central Bank, governments have greatly widened, if not removed, two of the three main checks on bank credit inflation. What of the third check—the problem of the narrowness of each bank's clientele? Removal of this check is one of the main reasons for the Central Bank's existence. In a free-banking system, inflation by any one bank would soon lead to demands for redemption by the other banks, since the clientele of any one bank is severely limited. But the Central Bank, by pumping reserves into all the banks, can make sure that they can all expand together, and at a uniform rate. If all banks are expanding, then there is no redemption problem of one bank upon another, and each bank finds that its clientele is really the whole country. In short, the limits on bank expansion are immeasurably widened, from the clientele of each bank to that of the whole banking system. Of course, this means that no bank can expand further than the Central Bank desires. Thus, the government has finally achieved the power to control and direct the inflation of the banking system.
In addition to removing the checks on inflation, the act of establishing a Central Bank has a direct inflationary impact. Before the Central Bank began, banks kept their reserves in gold; now gold flows into the Central Bank in exchange for deposits with the Bank, which are now reserves for the commercial banks. But the Bank itself keeps only a fractional reserve of gold to its own liabilities! Therefore, the act of establishing a Central Bank greatly multiplies the inflationary potential of the country.13
9.
Central Banking: Directing the Inflation
Precisely how does the Central Bank go about its task of regulating the private banks? By controlling the banks' “reserves”—their deposit accounts at the Central Bank. Banks tend to keep a certain ratio of reserves to their total deposit liabilities, and in the United States government control is made easier by imposing a legal minimum ratio on the bank. The Central Bank can stimulate inflation, then, by pouring reserves into the banking system, and also by lowering the reserve ratio, thus permitting a nationwide bank credit-expansion. If the banks keep a reserve/deposit ratio of 1:10, then “excess reserves” (above the required ratio) of ten million dollars will permit and encourage a nationwide bank inflation of 100 million. Since banks profit by credit expansion, and since government has made it almost impossible for them to fail, they will usually try to keep “loaned up” to their allowable maximum.
The Central Bank adds to the quantity of bank res
erves by buying assets on the market. What happens, for example, if the Bank buys an asset (any asset) from Mr. Jones, valued at $1,000? The Central Bank writes out a check to Mr. Jones for $1,000 to pay for the asset. The Central Bank does not keep individual accounts, so Mr. Jones takes the check and deposits it in his bank. Jones' bank credits him with a $1,000 deposit, and presents the check to the Central Bank, which has to credit the bank with an added $1,000 in reserves. This $1,000 in reserves permits a multiple bank credit expansion, particularly if added reserves are in this way poured into many banks across the country.
If the Central Bank buys an asset from a bank directly, then the result is even clearer; the bank adds to its reserves, and a base for multiple credit expansion is established.
Undoubtedly, the favorite asset for Central Bank purchase has been government securities. In that way, the government assures a market for its own securities. Government can easily inflate the money supply by issuing new bonds, and then order its Central Bank to purchase them. Often the Central Bank undertakes to support the market price of government securities at a certain level, thereby causing a flow of securities into the Bank, and a consequent perpetual inflation.
Besides buying assets, the Central Bank can create new bank reserves in another way: by lending them. The rate which the Central Bank charges the banks for this service is the “rediscount rate.” Clearly, borrowed reserves are not as satisfactory to the banks as reserves that are wholly theirs, since there is now pressure for repayment. Changes in the rediscount rate receive a great deal of publicity, but they are clearly of minor importance compared to the movements in the quantity of bank reserves and the reserve ratio.
When the Central Bank sells assets to the banks or the public, it lowers bank reserves, and causes pressure for credit contraction and deflation—lowering—of the money supply. We have seen, however, that governments are inherently inflationary; historically, deflationary action by the government has been negligible and fleeting. One thing is often forgotten: deflation can only take place after a previous inflation; only pseudo-receipts, not gold coins, can be retired and liquidated.
10.
Going Off the Gold Standard
The establishment of Central Banking removes the checks of bank credit expansion, and puts the inflationary engine into operation. It does not remove all restraints, however. There is still the problem of the Central Bank itself. The citizens can conceivably make a run on the Central Bank, but this is most improbable. A more formidable threat is the loss of gold to foreign nations. For just as the expansion of one bank loses gold to the clients of other, nonexpanding banks, so does monetary expansion in one country cause a loss of gold to the citizens of other countries. Countries that expand faster are in danger of gold losses and calls upon their banking system for gold redemption. This was the classic cyclical pattern of the nineteenth century; a country's Central Bank would generate bank credit expansion; prices would rise; and as the new money spread from domestic to foreign clientele, foreigners would more and more try to redeem the currency in gold. Finally, the Central Bank would have to call a halt and enforce a credit contraction in order to save the monetary standard.
There is one way that foreign redemption can be avoided: inter-Central Bank cooperation. If all Central Banks agree to inflate at about the same rate, then no country would lose gold to any other, and all the world together could inflate almost without limit. With every government jealous of its own power and responsive to different pressures, however, such goose-step cooperation has so far proved almost impossible. One of the closest approaches was the American Federal Reserve agreement to promote domestic inflation in the 1920s in order to help Great Britain and prevent it from losing gold to the United States.
In the twentieth century, governments, rather than deflate or limit their own inflation, have simply “gone off the gold standard” when confronted with heavy demands for gold. This, of course, insures that the Central Bank cannot fail, since its notes now become the standard money. In short, government has finally refused to pay its debts, and has virtually absolved the banking system from that onerous duty. Pseudo-receipts to gold were first issued without backing and then, when the day of reckoning drew near, the bankruptcy was shamelessly completed by simply eliminating gold redemption. The severance of the various national currency names (dollar, pound, mark) from gold and silver is now complete.
At first, governments refused to admit that this was a permanent measure. They referred to the “suspension of specie payments,” and it was always understood that eventually, after the war or other “emergency” had ended, the government would again redeem its obligations. When the Bank of England went off gold at the end of the eighteenth century, it continued in this state for twenty years, but always with the understanding that gold payment would be resumed after the French wars were ended.
Temporary “suspensions,” however, are primrose paths to outright repudiation. The gold standard, after all, is no spigot that can be turned on or off as government whim decrees. Either a gold-receipt is redeemable or it is not; once redemption is suspended the gold standard is itself a mockery.
Another step in the slow extinction of gold money was the establishment of the “gold bullion standard.” Under this system, the currency is no longer redeemable in coins; it can only be redeemed in large, highly valuable, gold bars. This, in effect, limits gold redemption to a handful of specialists in foreign trade. There is no longer a true gold standard, but governments can still proclaim their adherence to gold. The European “gold standards” of the 1920s were pseudo-standards of this type.14
Finally, governments went “off gold” officially and completely, in a thunder of abuse against foreigners and “unpatriotic gold hoarders.” Government paper now becomes the fiat standard money. Sometimes, Treasury rather than Central Bank paper has been the fiat money, especially before the development of a Central Banking system. The American Continentals, the Greenbacks, and Confederate notes of the Civil War period, the French assignats, were all fiat currencies issued by the Treasuries. But whether Treasury or Central Bank, the effect of fiat issue is the same: the monetary standard is now at the mercy of the government, and bank deposits are redeemable simply in government paper.
11.
Fiat Money and the Gold Problem
When a country goes off the gold standard and onto the fiat standard, it adds to the number of “moneys” in existence. In addition to the commodity moneys, gold and silver, there now flourish independent moneys directed by each government imposing its fiat rule. And just as gold and silver will have an exchange rate on the free market, so the market will establish exchange rates for all the various moneys. In a world of fiat moneys, each currency, if permitted, will fluctuate freely in relation to all the others. We have seen that for any two moneys, the exchange rate is set in accordance with the proportionate purchasing-power parities, and that these in turn are determined by the respective supplies and demands for the various currencies. When a currency changes its character from gold-receipt to fiat paper, confidence in its stability and quality is shaken, and demand for it declines. Furthermore, now that it is cut off from gold, its far greater quantity relative to its former gold backing now becomes evident. With a supply greater than gold and a lower demand, its purchasing-power, and hence its exchange rate, quickly depreciate in relation to gold. And since government is inherently inflationary, it will keep depreciating as time goes on.
Such depreciation is highly embarrassing to the government—and hurts citizens who try to import goods. The existence of gold in the economy is a constant reminder of the poor quality of the government paper, and it always poses a threat to replace the paper as the country's money. Even with the government giving all the backing of its prestige and its legal tender laws to its fiat paper, gold coins in the hands of the public will always be a permanent reproach and menace to the government's power over the country's money.
In America's first depression, 1819�
�1821, four Western states (Tennessee, Kentucky, Illinois, and Missouri) established state-owned banks, issuing fiat paper. They were backed by legal tender provisions in the states, and sometimes by legal prohibition against depreciating the notes. And yet, all these experiments, born in high hopes, came quickly to grief as the new paper depreciated rapidly to negligible value. The projects had to be swiftly abandoned. Later, the greenbacks circulated as fiat paper in the North during and after the Civil War. Yet, in California, the people refused to accept the greenbacks and continued to use gold as their money. As a prominent economist pointed out:
In California, as in other states, the paper was legal tender and was receivable for public dues; nor was there any distrust or hostility toward the federal government. But there was a strong feeling... in favor of gold and against paper.... Every debtor had the legal right to pay off his debts in depreciated paper. But if he did so, he was a marked man (the creditor was likely to post him publicly in the newspapers) and he was virtually boycotted. Throughout this period paper was not used in California. The people of the state conducted their transactions in gold, while all the rest of the United States used convertible paper.15
It became clear to governments that they could not afford to allow people to own and keep their gold. Government could never cement its power over a nation's currency, if the people, when in need, could repudiate the fiat paper and turn to gold for their money. Accordingly, governments have outlawed gold holding by their citizens. Gold, except for a negligible amount permitted for industrial and ornamental purposes, has generally been nationalized. To ask for return of the public's confiscated property is now considered hopelessly backward and old-fashioned.16
What Has Government Done to Our Money? Page 6
