Monetary Systems and Managed Economies

by Ben Best

CONTENTS: LINKS TO SECTIONS BY TOPIC

  1. THE ORIGIN AND NATURE OF MONEY
  2. THE QUANTITY THEORY OF MONEY
  3. MONEY-CREATION BY BANKS
  4. HISTORY OF MODERN MONETARY STANDARDS
  5. A "MANAGED ECONOMY" UNDER THE FEDERAL RESERVE SYSTEM
  6. MONEY IN THE ELECTRONIC AGE
  7. CONCLUDING REMARKS
  8. SOME REFERENCES

  I. THE ORIGIN AND NATURE OF MONEY

Money has been defined as a medium of exchange, as a means of storing value, and as a standard for measuring market value. These definitions are not always equivalent. For instance, some countries have had a gold bullion standard (gold in bars or ingots) while the medium of exchange was silver coins & paper currency — valued in relation to gold. In Borneo, human skulls were the standard, but pigs & palm nuts (valued in skulls) were the medium of exchange. European financial markets denominated the value of stocks, bonds and other financial instruments in Euros prior to the introduction of the Euro currency. A mill (one-tenth of a cent) is a standard of value for taxation purposes, but is not currently part of the medium of exchange.

The essence of money is that it is a medium of exchange, whereas the storage and standard functions are derivative properties. Money as a medium of exchange solves the problem of "coincident wants". A gravestone-maker who wants to buy eggs does not need to find a poultry farmer who want a gravestone. Even if such a poultry farmer could be found, the gravestone-maker would probably prefer to purchase eggs in small quantities on a regular basis for the rest of her life. It is far more convenient for her to trade gravestones for the medium of exchange and then use the medium of exchange to buy eggs. The medium of exchange allows for a time interval between selling and buying — so each transaction can occur at more a more convenient time and place.

The first commodities used as a medium of exchange were those that were most durable and most universally valued. The Ethiopians continued to use salt as their money long after European traders had brought gold & silver coins into the economy. Some economists have speculated that the pre-eminence of gold & silver indicated a shift from useful to ornamental qualities for money (use of gold & silver for dentistry was rare before the late 19th century). But the ornamental value of gold & silver is derived from the same physical properties of metals which make them well-suited for monetary use — it is not simply a matter that luxury items are particularly well-suited to be money. And once a commodity acquires exchange-value, it will be valued above the level of its commodity-value.

Durability, divisibility, malleability, portability, recognizability, availability and a high value-to-weight ratio are important qualities which make metals useful as money. All metals are lustrous in a vacuum, but become tarnished (or ignite) when exposed to oxygen in the atmosphere. Metals resistant to oxidation are easily purified — and the value of the pure metal can be determined from a single, easily-measure quantity: weight. The metals most resistant to oxidation & acid are gold, platinum, mercury and silver, in that order — making these four the most durable of all metals. Platinum was rare in ancient times, and mercury is unsuitable for coins. For most of the history of western civilization (and from the 14th century in India), silver rather than gold has been the principal metallic monetary commodity.

Ancient Egyptians used standardized gold bars for currency. Gold rings served as both jewelry & currency throughout the ancient Near East. The world's first coins were reputedly produced in Lydia, an inland nation of what is now western Turkey, with its capital at Sardis on the Hermus (now called Gediz) river — east of Smyrna (now Izmir). The first Lydian coins were bean-shaped lumps of electrum (gold-silver alloy), stamped to certify quality rather than weight (due to their irregular shape & size). Croesus, the famously wealthy last king of Lydia from 560-546 B.C., succeeded in conquering the Greeks on the west coast of Asia Minor, but was himself ultimately defeated by the Persians from the east. During his reign, however, he was able to establish the world's first imperial currency — and the first bimetallic monetary system. Withdrawing all electrum coins from circulation, he issued coins of pure gold & silver carefully minted to be of uniform size & weight — and imprinted to indicate value. Bronze coins were introduced in Athens in the fifth century BC.

If the value of the metal in the coins exceeded the stated value of the coins they would quickly be melted-down (though no discrepancy could exist if the value were simply stated as the quantity of metal). Coins produced by honest private & government sources contained slightly less gold or silver than the stated content to cover the costs of minting. The difference between the stated value of the coin and the metal value is known as seignorage, the profit of the minter. The seignorage from minting token coins and fiat paper currency is very large.

Minted coins are an attempt to standardize & authenticate money in portable form. There has always been a temptation by governments & others to manipulate currency to extract additional, fraudulent value. Coins can be adulterated with base metals. Vertical edges were eventually added to coins to make it easier to detect coin-clipping. But gold coins could still be adulterated by "sweating" — shaking them vigorously in a pouch so as to generate gold dust from the scraping.

Governments learned early that inflation can be a tactic for expropriating wealth that is less likely to infuriate the masses than direct taxation. In the Roman Empire the gold aureus coin originally had a value equal to 25 silver denarii coins. In 64 A.D. the Roman emperor Nero reduced the silver content of the denarius coin by 15%. Other emperors followed his example, so that after 200 years the denarius contained less than 1% silver and the amount of wheat purchased by a denarius was also much less than 1% of what it had been. [Inflating government-controlled money has the added advantage for government of disproportionately benefitting the first spender (government) and the govenment's immediate payees. But if carried on long enough, money becomes valueless to everyone.] In 301 AD the miliary despot Diocletian tried to fight hyperinflation by issuing his Edict on Maximum Prices on thousands of goods & services — enforced by death penalty. Amidst much bloodshed the economy reverted to barter & black-market trade, and taxation came to be based on goods & services rather than money. (Diocletian also tried to destroy all books of alchemy, fearing that alchemists would find a way to create gold and gain power through bribery.)

The Byzantine gold solidus, introduced by Constantine the Great in 309 AD, retained its weight and purity for six centuries before beginning to be debased. The Byzantine government had a strong incentive to maintain quality in order that the golden solidus would not be displaced by other coins as a standard of international commerce.

Drachma is Greek for "handful". Originally it referred to a handful of iron nails, but it became the name of a silver coin in ancient Greece and is currently the name of the Greek monetary unit. Pound, livre, lira and ruble were originally terms for metallic weights. In the year 775 A.D., 240 silver coins known as sterlings weighed one pound — money in the Saxon kingdoms of England. The Norman conquerors later divided the pound into 20 shillings.

In the 16th century a Bohemian count who discovered silver deposits on his land began mining the metal and minting coins. He produced coins of such reputable quality — and in such quantity — that his thalers (abbreviating the name of the Joachimsthal valley) became world-renowned. Variants of the word "thaler" became the name of coins in many countries, including "dollar" in Scotland.

The silver peso was first coined by Ferdinand & Isabella of Spain. It was divided into eight reales ("pieces of eight") or eight bits — making a quarter "two bits". Because exportation of coins from Britain was forbidden by law — and because Mexico was producing half the world's silver output and operated one of the world's largest mints — Spanish pesos were the dominant currency through all the Americas. English-speaking peoples in the Americans called the coins dollars rather than pesos. Mexican silver dollars remained legal tender in the United States through most of the 19th century, despite the fact that the United States minted its own silver coins beginning in 1794. The overwriting of P (Peso) with an S (Spanish or Silver) was the probable origin of the "$" sign.

Although monies have originated from objects having commodity value, once objects are accepted as money they acquire additional exchange-value. Poker chips have little intrinsic value, but may have great exchange value as IOUs for "real money". When bank notes were issued by early reputable private bankers, they were fully backed by gold or silver and functioned as debt instruments that were more easily transported and stored than bulky gold or silver.

Modern governments have successfully separated monetary value from commodity value in the evolution of fiat currencies. (A fiat is an enforceable decree issued by a king, dictator or other government agent. Fiat money is paper or tokens made legal tender by fiat rather than by convertibility into commodity-money.) Separation of money from commodity value by governments opened the door for the inflationary practices of governments and their counterfeiting competitors.

China has had a long history of autocratic empires and emperors, so it is not surprising that money was backed by threats of violence rather than by commodity-value. Tokens made of brass or copper had square holes in the middle so they could be strung together. Printing, ink & papermaking originated in China. The world's first paper money was issued during the Tang Dynasty, reaching its peak during the Ming Dynasty. Kublai Khan issued a paper currency in 1273 backed by severe threats against any who refused to accept the bills as payment. The government confiscated gold & silver, giving paper money as replacement. Nonetheless, the abuses of fiat money finally led to it being abandoned at the end of the 14th century. Paper money was not readopted in China until the 20th century.

By 1740 twelve of the original thirteen American colonies had issued paper money (Virginia was the exception). Beginning in 1775 the Continental Congress issued Continental Currency denominated in Spanish milled silver dollars. By the late 1780s Continental notes were exchanging for as little as 250 Continental dollars per Spanish milled dollar. When the Constitution of the United States was ratified in 1787 it prohibited state governments from issuing any form of money, and it only authorized Congress to coin money. Banks, corporations, municipalities and even private individuals were not prohibited from issuing money, however. In the following years there was extensive counterfeiting as well as effort to detect and prevent counterfeiting. Some of the intricate designs and colors used in engraving at that time has not been matched to the present day. Although some questioned the constitutionality of the right of the Federal government to issue fiat paper money, this was ignored as a result of the urgency created by the Civil War. Congress authorized the issuing of notes on July 17, 1861, and private bank note companies produced the first greenbacks for the Treasury Department. The Confederate States of America also began issuing paper money in 1861. Most of the sessessionist state governments issued money during the Civil War.

At the end of the American Civil War over one third of US paper currency in circulation was counterfeit. The choice of the color green for the back of bills was due to the discovery of a chromium oxide green ink that made counterfeiting more difficult. Currently American currency notes are printed on a textile, rather than wood-based, paper — 75% cotton & 25% linen (flax), with blue & red polyester security thread. Other security features to prevent counterfeiting include designs, microprinting, watermarks, plastic strips, and special inks (including magnetic inks). (Between 0.01% to 0.02% of the U.S. notes in circulation are estimated to be counterfeit.) In 1865 the Secret Service was created as a branch of the Treasury Department charged with combating counterfeiters. (In 1906 the Secret Service was also given responsibility for protecting the President of the United States.) Most of the responsibility for issuing notes was transferred to the Federal Reserve System in 1914, but not until 1974 did the Federal Reserve assume all of the responsibility for issuance of notes from the Treasury Department.

All US paper currency has contained the words "In God We Trust" since 1963, after Congress replaced "E Pluribus Unum" as the National Motto. For a detailed explanation of the material printed on a $1 bill, click here. All bills weigh about one gram, and can be double-folded (forward then backward) about 4,000 times before tearing. The cost of producing notes varies between four to ten cents.

BillLife
(Months)
Value
($ amount)
Notes
(number)
$1221.1%34%
$5241.3%8%
$10182.1%6%
$202515.1%23%
$50558.4%5%
$1006071.7%22%

The average one-dollar bill remains in circulation 22 months before it is regarded as too worn for further use. As of June 30, 2004 the value of one-dollar bills in circulation was $7.765 billion (amounting to 1.1% of the total value of currency in circulation) and the number of one-dollar bills in circulation was 7,765 million (amounting to about 34% of the total number of bills in circulation). Denominations greater than $100 have not been issued since 1969. 95% of American paper money printed is for replacement of worn bills. A website called Where's George attempts to track the travels of US paper currency, often stamped with the URL "www.wheresgeorge.com", which purportedly does not count as defacement according to the standards established by the Bureau of Engraving and Printing.

In 2001 only 19% of transactions were done using cash — down from nearly 25% a decade earlier. Despite the fact that the average adult carries $100 in cash, per capita outstanding currency was over $2,000 — most of which was overseas. The rest was presumed to be used in cash-intense transactions, most of which may involve tax-evasion, drug-trafficking and other criminal activities. Increasingly, heavy cash use will be used by law-enforcement agencies to detect criminals & criminal activity. More than two-thirds of American currency is held outside of the United States, particularly in Latin America, Russia and the Middle East. The $100 bill is the denomination of choice. The Secret Service has offices in Moscow and Cyprus. The latter was created because of militant Islamic groups in Lebanon which have produced billions of dollars in counterfeit $100 notes.

Although American coins once had intrinsic value based on precious metal content, they have become a token-metal adjunct of paper fiat currency. The dime, quarter and half-dollar are mostly copper, with just under 10% nickel. The 5-cent piece is 25% nickel and the balance copper. Pennies are copper-plated zinc (97.5% zinc) (US Mint). The practice of milling (adding vertical edges) to coins worth more than a nickel began when the coins were still being made of precious metals — and could be clipped. All U.S. coins are dated with the year they were created, in contrast to U.S. paper money which is bears the year in which a Series (design) was introduced.

The Canadian penny & 5-cent piece have the same composition as their American counterparts, but the dime & quarter are pure nickel. The Canadian dollar coin (loonie) is aureate bronze and the two-dollar coin (twonie) is an inner ring of aureate bronze within an outer ring of nickel. The two-dollar coins last an estimated 20 times longer in circulation than the paper bills they replaced (Canadian Mint).

The cotton cloth character of paper money makes it very absorbent. Warmed by body heat, moistened by body moisture, and passed from hand to hand by a large variety and number of people, paper money can provide a good growth medium for microbes. A study of one-dollar bills in Western Ohio evaluated for bacteria found potentially pathogenic organisms in 94% of the bills [SOUTHERN MEDICAL JOURNAL; Pope,TW; 95(12):1408-1410 (2002)]. A similar study of 100 currency notes in India found one or more types of bacteria on 96 of the notes, and fungal contamination on 72 of the notes [INDIAN JOURNAL OF PATHOLOGY & MICROBIOLOGY; Basavarajappa,KG; 48(2):278-279 (2005)]. A study of coins from 17 countries concluded that the bacteria found did not constitute a health hazard provided care was taken to wash hands before handling food or dressing skin lesions after handling coins [JOURNAL OF ENVIRONMENTAL HEALTH; Xu,J; 67(7):51-55 (2005)].

Some people imagine that by writing a check they are creating their own currency. A check is simply a written order to transfer ownership of money that is being stored elsewhere (paper money with "backing" would play a similar role). The "backing" for a check is the "checkable deposit", which doesn't equate with currency. In the United States all checks have a nine digit transit/routing number which uniquely identifies the financial institution in the American Bankers Association (ABA) payment system for the clearing of checks. The first two digits identify the Federal Reserve district, the second two digits identify the Federal Reserve offices or collection information, the following four digits are the ABA Institution Identifier and the final digit is a verification digit.

Less than 10% of all the American dollars in the world are represented by coin or paper money. Money-supply is generally described in three categories: M1, M2, and M3. M1 is intended to refer only to money as a means of payment, whereas M2&M3 include M1 plus money market funds (such as treasury bills). M1 — currency, travelers' checks and checkable deposits — is intended as a definition of money devoted to spending. Before deregulation banks could not pay interest on M1, but now that many banks pay interest on checkable deposits the definitions are less distinct. M2 includes M1 plus savings accounts, small denomination time-deposits plus shares in money market mutual funds by individual investors. M3 includes M2 plus large denomination time-deposits and shares in money market mutual funds by institutional investors. A definition of money known as MZM (Money of Zero Maturity) includes M1 plus all credit instruments with zero maturity and redeemable at par. Oddly, most definitions of money exclude government deposits held in banks & central banks (such as money received from taxes).

The expanded definitions of money beyond M1 are based on the assumption that the more price-stable and easily-sold an asset is, the more it resembles money. Treasury bills are readily marketable for a pre-determined price, causing them to be viewed as a form of money. Although stocks & bonds can be as liquid as money-market funds, their asset value is less stable. If a sharp distinction is made between money claims and credit claims, then credit claims cannot be money because they cannot be used to directly purchase goods & services. Nor can credit claims count as reserves for monetary expansion.

Austrian economists distinguish between credit transactions and monetary transactions in defining money supply. Use of a credit card is actually a short-term loan to make a purchase. Similarly, traveler's checks (mistakenly included in M1), are credit claims on the portfolio of the financial institution which issued the traveler's checks. Demand deposits, by contrast (also included in M1) are true "money substitutes", treated by those engaged in transactions as if they were cash. Savings deposits are becoming increasingly equivalent to demand deposits, given the ease of transferring from one account to another. Monetarists & Keynesians abandon efforts at conceptual definitions of money in favor of econometric empirical ones (begging the question).

For more on controversies surrounding definitions of fiat money supply see "How Should We Define the Money Supply", "The 'True' Money Supply" and "The Mystery of the Money Supply".

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 II. THE QUANTITY THEORY OF MONEY

The quantity theory of money has been attributed to the philosopher David Hume. In this view the value of money is directly proportional to the amount of goods & services in an economy — and inversely proportional to the quantity of money. More simply, doubling the amount of money would double the price of goods. There is thus little advantage to be gained by increasing the money supply, since demand for goods will result in a "clearing price" for money, against the supply of money in an economy. In the words of Dr. Murray N. Rothbard, "Every supply of money is always utilized to its maximum extent, and hence no social utility can be conferred by increasing the supply of money".

To illustrate the quantity theory of money one can imagine a tiny economy on the island of Fantastica consisting of 1000 silver coins and a few items of commerce: bushels of coconuts costing 10 coins each, axes costing 30 coins and oxen costing 100 coins each. If there were suddenly 2000 silver coins in the economy, then the coconuts would become 20 coins per bushel, axes 60 coins each and oxen 200 coins each. Doubling the amount of coins doubled the price of goods (this assumes silver coins have no value but exchange-value — a simplification implying that coins would be no different from paper money). If the additional 1000 new coins had been discovered by someone in a treasure chest, that person would benefit disproportionately as the new money entered the economy. If Fantastica had used government paper money rather than silver coins, then a doubling of the supply of paper money by government printing or by counterfeiters would similarly double prices. In fact, such money supply increase would not only disproportionately benefit the government/counterfeiters (because they would begin spending the new money while the old prices still prevailed), but could more than double average prices because of the fear/expectation of future money supply increases by the same means.

Inflation is better described as an increase in quantity of money than as price increases. Price increases partially reflect future expectation of inflation. If the government begins expanding money supply following a long period of no such expansion, prices will take time to increase as the new money works its way through the unsuspecting economy. However, if the government has been expanding money supply on a regular basis, prices should continue to rise even after the government stops inflating because most people still have the expectation of future inflation. Apart from expectations, prices are also influenced by productivity. If a growing economy is increasing the total goods & services available and the government is increasing the amount of money, prices may remain unchanged — masking the inflation. Economists of the Austrian school distinguish between inflation and price inflation.

Yale economist Irving Fisher attempted to mathematicize a quantity theory of money with the equation MV=PT ("the equation of exchange"), where:

PT = total cost of what is bought
MV = total amount of monetary payments
P = average price for all transactions
T = number of transactions in a time period
M = quantity of money in the economy
V = number of times the money-supply is used in the period ("velocity" of exchange)

Simply put, for the economy as a whole, buying (MV, regarded as the "money" side of the equation) equals selling (PT, regarded as the "goods" side of the equation).

For example, if the average price P of transactions is $20 and the total number of transactions T performed in a time period is 5 billion and the total amount of money M in an economy is $10 billion, then the $10 billion has been used an average of V=(PT/M)=($100 billion/$10 billion)=10 times/period. If 10 billion transactions had been performed in the period — or the money supply had been $5 billion — the velocity would be doubled to 20. The longer the period of time between transactions (or the larger the amount of money held between transactions), the slower the velocity. In hyperinflation velocity becomes very high because people want to spend money as soon as it is acquired because it is losing value so fast.

The velocity concept can be justified by a scenario in which an employee could be paid either $1,000 every 2 weeks or $500 every week. In the former case, average cash holdings are $500, whereas in the latter case the average is $250 (assuming it is all spent, and spent at a uniform rate). The weekly payment schedule uses twice the velocity & half the quantity of money to achieve the same effect as the biweekly payment schedule.

Velocity of money in a real economy is typically calculated by equating PT (indexed prices relative to a base year) with GDP (Gross Domestic Product), and dividing by M, ie, V=(PT/M)=(GDP/M), where M could be M1 (V1), M2 (V2) or M3 (V3). Keynes said that V depends on interest rates and that M must be accounted-for by changes in V (a statement that would make V the independent variable, M=(GDP/V) ). Equating PT with GDP is questionable. The GDP is a government-compiled statistic that focuses on final goods & services (consumer), ignoring the transactions associated with production, GDP=C+Ig+G+X-M. [C=personal Consumption, Ig=gross Investment, G=Government spending, X=eXports and M=iMports.] In the Keynesian model, government deficit spending (keeping the money supply constant) will boost GDP and Velocity, by V=(GDP/M).

The Monetarist Milton Friedman claimed that because V is constant, VM=GDP shows that GDP can be increased by increasing M. In fact, these ideas, and those of Keynes, are a reductio ad absurdum of the equation of exchange — economic wealth is produced by increasing a nation's goods & services (and the capacity to produce goods & services), not by monetary manipulations that make GDP look larger. (Friedman's assumption that velocity is constant was based on data obtained before all forms of gold conversion was suspended by Richard Nixon in 1971 — claims have been made that velocity accelerated thereafter.) Similarly spurious is the claim that V is not constant, and that GDP can be increased by increasing V.

The concept of "velocity" is based on the idea that money "circulates". Critics have asserted that money does not "circulate", it changes hands — and money cannot change hands more often than goods change hands. Money & goods change hands rapidly in hyperinflation and in times of high speculative activity (items bought for the purpose of being resold rather than consumed), but this would not be a sign that the demand for money has increased.

The first century of Spain's colonization of America (1500 - 1600) was unusual insofar as the vast importation of newly discovered gold & silver from the Americas drove Spanish prices up 400%. During the 19th century, when most of the world was on a gold standard, prices typically fell by a small amount each year except in times of war when governments used inflated money to finance their military. The great durability of gold meant that the mining output of any one year had little effect on the total world supply of gold (which had accumulated for centuries). With the supply of goods increasing at a rate slightly greater than increases in the supply of gold, mild deflation boosted the real income and living standards of every worker.

In the year 1900 most goods in the United States were cheaper than they had been in the year 1800. In the 25 years following 1872 the cost of milk, rice, mutton, butter, tea and many other commodities had dropped about 50%. Contrast this gold-standard period with the era of government-controlled money: in 1997 a US dollar was worth only 14 cents (14%) of a 1947 dollar. Some people have argued that the supply of gold is inadequate to serve as a medium of exchange in the modern world. But market conditions cause supply to match demand at a clearing price for any commodity, including money. The price of gold would rise to meet the demand and/or other commodity-monies would enter the market to fulfill the demand for money.

Because price level corresponds to the relationship between the supply of goods and the supply of money, price inflation will result either from an increase in the supply of money or from a decrease in the supply of goods. Conversely, price deflation will result either from a decrease in the supply of money or an increase in the supply of goods. If the supply of money is increasing in tandem with an increase in the supply of goods, the money inflation will not correspond to a price inflation — prices will not change. The price deflation resulting from fractional-reserve monetary contraction in a recession has very different economic implications from the price deflation resulting from increased productivity.

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III. MONEY-CREATION BY BANKS

In the Middle Ages most of the banking functions were performed by Jews (who were immune from Christian prohibitions against charging interest on loans) and Knight Templars (monkish knights whose honesty & fierceness had earned them a reputation for safeguarding wealth). King Philip IV of France expelled the Jews & confiscated their property before ambushing Templar leaders, executing them and confiscating Templar property.

Banking re-emerged in the Renaissance among the merchants of Northern Italy. However the Florentine family banks were devastated in 1343 when the British monarch Edward III defaulted on his loans. Many depositors were also left destitute. Nonetheless, a century later the Medici family became the greatest of the Renaissance bankers — until Charles VIII of France invaded Italy and confiscated most of their property. Fractional reserve banking (lending money given for safekeeping was considered fraudulent when done without the consent of the depositors) had been practiced during this period — sometimes with disastrous consequences. Florence is also credited with such innovations as bills-of-exchange, double-entry bookkeeping and checks (checks) on deposits.

The Bank of Amsterdam was founded in 1609 as a "safekeeping bank" based on the principle of 100% reserves (in contrast to fractional reserves). Gold is bulky & risky for a person to hold in large quantities, so a 100% reserve bank served a valuable service by storing the gold in a safe place and issuing receipts (banknotes) for the gold. The banknotes were more convenient to trade than the heavy gold, especially for large transactions. Thus, the banknotes could serve as money.

Under the demand-deposit system, however, even banknotes become unnecessary. A depositor only needed to write a check or transfer order to the bank directing that his/her gold be transferred to another person from whom the depositor had purchased goods. A bank such as the Bank of Amsterdam that operated with 100% reserves was functioning as a money-warehouse.

For sake of example, imagine that on the island of Fantastica (as described earlier) the entire 1000 silver coin money supply was deposited in the Bank of Fantastica as demand deposits. Island inhabitants could write checks on their deposited silver coins to direct transfer of coins to another depositor when a purchase was made from that depositor. Suppose the Bank of Fantastica then issued 1000 silver coins worth of loans to other Fantastica inhabitants — also in the form of demand deposits. Now the Bank of Fantastica would have recorded on its books 2000 silver coins worth of demand deposits: 1000 from the original depositors and 1000 from those receiving loans — although there are actually only 1000 silver coins in the bank. The money supply on the Island of Fantastica has doubled, which would have the effect of doubling prices (as in the previous example). The Bank of Fantastica has engaged in fractional reserve banking using a 50% reserve — creating 100% inflation. Fractional reserve banking is fraudulent if done without knowledge & consent of the depositors.

A good case can be made for the idea that in a free economy of many competing banks (and no government central bank) that there would be little or no fractional reserve banking. If bank A received deposits of 1000 silver coins from Tom, Dick & Harry and then wrote checks for loans amounting to 1000 silver dollars to Jane, Sally & Sue, those checks would be deposited at banks B, C & D. When the other banks cleared these checks at bank A to transfer the silver to their own vaults, bank A would be left with no coins to honor checks or demands for cash from Tom, Dick & Harry. Fractional reserve banking is more easily practiced in a monopoly banking system controlled by a government central bank with the power to create fiat money at will.

Although a few economists regard fractional reserve banking to be fraudulent, the practice is not fraudulent if practiced with full disclosure. In a free society, those insisting on a 100% reserve money warehouse would expect to pay a fee for money safekeeping & services. Those willing to risk depositing at a fractional reserve bank could expect to receive interest on demand deposits in inverse proportion to the fraction of reserves held by the bank (and in direct proportion to notification time required in advance of withdrawals). In a sense, depositors at fractional reserve banks are gambling, and must be willing to accept responsibility for possible losses in exchange for receiving interest on savings. A well-managed bank that is able to minimize credit risk (risk of loan default or slow repayment), interest rate risk (risk of holding fixed-rate loans with long maturities in a market where interest rates may rise), liquidity risk (risk of not having adequate cash for demand deposits) and operating costs will be better able to carry lower fractional reserves. Other banks not practicing fractional reserve with demand deposits would only loan money from CDs and time-deposit savings accounts. Which types of banks would ultimately thrive in a free market economy is yet to be determined.

According to Austrian business cycle theory, fractional reserve banking lies behind the "boom and bust" cycles that have plagued the world since the establishment of central banks. Central banks underwrite and utilize fractional reserve banking. Central banks expand the money supply by adding to bank reserves rather than by printing money. A $1 billion addition to bank reserves by the central bank gives chartered banks $10 billion additional money to lend. Would-be borrowers with marginal credit find it easier to borrow. An artificial boom is created in which the monetary inflation begins to lead to price inflation. The central bank may try to stem the price inflation by withdrawing $1 billion of reserves, leaving chartered banks with $10 billion less money to lend. Companies with high levels of debt are most vulnerable to economic slowdowns. As businesses fail and the economy falters, borrowers struggle to manage their debts and banks become increasingly unwilling to risk making loans from their remaining reserves. Price deflation results from the contraction of reserves, from the reduction of reserves being loaned, and from the unsold goods & idle resources which resulted from malinvestments during the credit expansion.

The character of central banking was established early with the world's first central bank, the Riksbank in Sweden. Under the authority of the Parliament charter of 1668 banknotes from Riksbank were Sweden's only paper money, redeemable in precious metal. In exchange for this charter the bank agreed to loan money to the government. In 1720 when the government failed to repay a loan, panicked citizens tried to redeem their banknotes from the insufficient reserves held at Riksbank. To deal with the crisis, Parliament declared Riksbank notes to be legal tender that satisfies any claim to payment — without the requirement to redeem in precious metal.

Central banking in Britain arose from a more competitive tradition. In 1545 Henry VIII granted English citizens permission to charge interest on lent money. Since the early 17th century British goldsmiths had been issuing deposit receipts for gold held for safekeeping in their "strong rooms" — and these receipts were circulating as money. In 1694 William of Orange was desperate for money to finance his war against France so he authorized the creation of the Bank of England by a Scottish promoter. The Bank of England issued banknotes, most of which were used to buy government debt. Impressed by the royal authorization of the institution, many British citizens deposited their gold with the Bank in exchange for receipts or banknotes. But fractional reserve practices led to a disastrous bank-run within 2 years. The government defended the Bank of England by allowing the Bank to suspend all payments for 2 years. And the Bank of England continued to help the government with its need for financial assistance.

Private banks competing with the Bank of England received a boost in business in 1730 with the advent of the printed check. The Bank of England's efforts to finance the war against France and the outflow of bullion to private banks led the Bank of England to suspend its obligation to repay its notes in gold in 1797. The Bank did not reinstate a gold repayment system until 1821.

Central banking was formally instituted in Britain by the Peel Act of 1844. The Bank of England was granted a monopoly on the issuance of banknotes. Private banks could only hold demand deposits (checking accounts), redeemable in Bank of England notes. Britain was the first Western nation to adopt this central banking structure and the United States was the last.

Early in the revolutionary years, the American Continental Congress authorized paper bills ("continentals") which were supposed to be worth one Spanish dollar (peso). Despite threats of severe penalty for traitors who would not accept continentals, their value inflated by a factor of 75 within 4 years. In partial reaction against the tendency of governments to print inflated currencies, Article I Section 10 of the U.S. Constitution stated that "No State shall ... make any Thing but gold and silver Coin a Tender in Payment of Debt."

The Democratic Party of Thomas Jefferson stood as the defender of hard money for most of the 19th century. The Second Bank of the United States was a weak attempt at a central bank (it lacked a monopoly on banknotes), but its central banking powers were nullified by Democratic President Andrew Jackson in the 1830s. Hard-money Democrats were able to restore the gold standard in the United States in 1879. But the National Banking Acts enacted during the Civil War had destroyed the issuance of bank notes by state chartered banks and monopolized the issuance of bank notes for a few federally-chartered national banks. In 1913 (with strong backing from the Rockefeller & Morgan banking interests) the Federal Reserve Act brought a central banking system to the United States.

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 IV. HISTORY OF MODERN MONETARY STANDARDS

The United States adopted bimetallism beginning with the Coinage Act of 1792, which defined the "dollar" as 371.25 grains of pure silver or 24.75 grains (roughly 1/20th a troy ounce) of pure gold. (The American government had determined that the average Spanish dollar in circulation weighed 371.25 grains rather than the official weight of 377 grains claimed by Spain.) (A grain, originally defined as the weight of a plump grain of wheat, is slightly more than a 16th of a gram.)

This 371.25/24.75 exchange rate for silver/gold was the market ratio in 1792, but increased silver production soon made the legal fixed ratio deviate from the market ratio. Gresham's Law states that when two or more media of exchange are being used, one that is legally or otherwise overvalued will drive the others off the market. In this case, gold coins were driven-off the market until gold discoveries, several decades later, reversed the process and drove silver coins off the market. Most national governments began demonetizing silver in 1873 — which led to a sharp decline in the price of silver (indicating the extent to which exchange-value augmented the value of the metal above commodity-value).

In 1844 Britain adopted a gold national standard, with Bank of England notes fully backed by gold. In the 1870s virtually every country in Western Europe went onto a gold standard. A gold standard international monetary system, was most complete from the mid-1890s until 1914. This was a period of intense economic activity and international trade. The value of the use of gold as a universal currency of international trade has been compared to an idealized universal language in which "translation costs" have been eliminated, just as "transaction costs" would be eliminated in the economic sphere.

Balance of payments problems, according to an analysis originating from David Hume, are self-correcting. If one country imported more than it exported, gold would flow out of the country. With less gold competing for the same number of goods and services, price levels in the deficit country would drop, causing a higher foreign demand for exports and a lower domestic demand for imports, thereby causing gold to flow back into the country. If the deficit were due to excessive national borrowing or overspending reserves, however, the deficit country is no different from an individual who has created a "balance of payments crisis" by "living far beyond his/her currently earned means".

With the development of international trade in the 17th and 18th century, many countries developed the view that exports increased national wealth, whereas imports disrupted the national economy. This view, known as mercantilism, induced many countries to adopt protectionism and other policies designed to produce a "favorable balance of trade", meaning exports in excess of imports. Adam Smith wrote WEALTH OF NATIONS to denounce mercantilism. Smith cautioned against equating wealth with money, saying "the real wealth or poverty of a country... would depend altogether upon the abundance or scarcity of these consumable goods". The import of cheap, useful goods for consumption and productive capital assets may increase the wealth of a nation more than monetary metals. "A country that has wherewithal to buy wine will always get the wine which it has occasion for; and a country that has wherewithal to buy gold and silver will never be in want of these metals". It is possible to regard exports as a cost, draining domestically produced goods from the country, while the gain of trade stems from imports — but this view is just the converse fallacy to mercantilism.

During World War I, most belligerents went off the gold standard because of the desire to use money-creation to help finance the war effort. Although most countries were able to curtail continuing monetary expansion after the war, Germany could not — resulting in perhaps the greatest hyperinflation in history. Germany had been fined 132 billion gold Marks in war reparations by the Allies. In January 1923, France, Belgium and Italy occupied the Ruhr river valley (Germany's industrial core) to enforce compliance with reparations payments — and imposed an economic blockade. German bitterness to the Treaty of Versailles and the actions of the Allies was widespread — leading to work stoppages throughout the country, most notably in the Ruhr. Massive printing of money by the German government to meet urgent financial demands (including paying salaries to the Ruhr workers who were striking in protest) caused the value of the German Mark to drop 600-million fold in 1923 — to an exchange rate of 4.2 trillion Marks to the Dollar. Those working were paid twice daily and given a half-hour break after each paycheck so that the money could be spent before it lost too much value. Barter became widespread in Germany.

In the 1920s there was worldwide concern that there was not enough gold to meet liquidity needs. But gold was still being held at the statutory price of $20.67 per ounce. Allowing the price of gold to rise would have been equivalent to increasing its "quantity". Nonetheless, in the interest of "economizing", most Western nations in the 1920s adopted a "gold-exchange standard" based on a fractional reserve of gold for their currency. The self-correcting mechanisms of the Humean analysis were either removed or amplified to crisis proportions. A nation with a 10% gold reserve behind its currency is understandably concerned if it must redeem 5% of its currency abroad by shipping gold. It has lost half of its reserves!

Most Western countries maintained their reserves in British pounds, while Britain purported to redeem pounds for gold. Britain printed pound notes with little restraint while other countries inflated their own currencies backed by their inflated pound note reserves. Developing countries which had mainly remained on a silver standard experienced "inflation" due to reduced demand for silver. Western powers set to work using political pressure to force the "gold-exchange standard" as a replacement for silver or bimetallism throughout the world.

By the 1930s there was a widespread belief that the "gold standard" was not working. Many countries suspended gold convertibility and made gold ownership (other than some jewelry and collector's gold) illegal for their citizens. President Roosevelt made gold ownership punishable by imprisonment and he gave American citizens 3 weeks to sell their gold to the government at $20.67 per ounce — before devaluing the dollar to $35 per ounce. Governments pursued highly nationalistic policies to deal with problems of the depression, particularly unemployment. Devaluations and fixed exchange rates were the most commonly used tools. Fixed exchange rates led to shortages and surpluses of currencies, as commonly happens when prices are fixed above or below their market level.

"Competitive devaluations " between countries became known as "beggar my neighbor policies", construed as attempts to "export one's unemployment". Just as inflation causes real wages to fall (temporarily) and thereby increases demand for labor at the new lower price, reducing the gold value of one's currency reduces the price (in gold) of labor and many goods in the devaluing country, relative to its "neighbors", thus increasing the demand for exports. But the neighbor is "beggarded" in a more direct way insofar as the money of the devaluing country, held as exchange reserve abroad, immediately loses value. Economic nationalism (protectionism) stifled international trade and worsened the depression.

In an attempt to replace predatory nationalist monetary policies with deliberate international monetary cooperation, 44 nations meeting in Bretton Woods, New Hampshire in July 1944 established the International Monetary Fund (IMF). The theoretician behind the design of the Bretton Woods agreement was English economist John Maynard Keynes, who called gold a "barbarous relic" based on a superstitious "worshipping the Calf" (a Biblical reference to the story of the ten commandments).

World War II had left the United States with 75% of the world's gold, and the American economy had been relatively undamaged by the war. The Bretton Woods agreement provided for the US Dollar, convertible to gold at $35 per ounce, to be the basis of international payments. All other currencies were to have fixed exchange rates against the Dollar within a 1% range, supported by loans from the IMF. IMF member contributions to the Fund were 75% in their own currencies and 25% in gold.

The US stood a chance to gain from its role, just as someone who writes checks that others adopt as a medium-of-exchange is in the enviable position of being able to buy additional goods without losing a position of wealth. But from the 1950s to the 1970s, American gold reserves steadily dwindled. By 1972, US gold reserves were 25% of the world's monetary stock. A gold market had been established in London, but the major financial powers pooled their resources to sell gold on the London market so as to keep the price at $35 per ounce. Speculators bought gold on the London market in anticipation of eventual devaluation.

American President Lyndon Johnson's spending programs and war in Vietnam put great pressure on the US economy. The budget deficit increased from $8 billion in 1967 to $26 billion in 1968. Johnson had refused to raise taxes to finance his spending. The Federal Reserve raised interest rates to prevent inflation, contributing to recession in 1970.

In August 1971 US President Richard Nixon imposed wage & price controls while suspending gold convertibility so as "to defend the dollar against speculators". Legalization of gold ownership for American citizens was probably less motivated by a libertarian spirit, than by a desire to see the market increase the value of government gold reserves. Many Keynesians believed that the demonetization of gold had finally been completed. US Federal Reserve Notes replaced the words "Payable to the Bearer on Demand" with "In God We Trust".

The collapse of the Bretton Woods system left the world on a pure "dollar standard" which was undermined within two years following two devaluations of the dollar. Fixed exchange rates were abandoned as most nations chose to "float" their currencies. Nonetheless, these often proved to be managed floats ("dirty floats") in which central banks attempted to intervene in the foreign exchange market to influence their rates. In the 20 years following 1971 the German Mark lost 52% of its value, the US Dollar lost 70% and the British Pound lost 84%. Although Keynes was instrumental in the design of Bretton Woods system, Keynesians believe a flexible exchange rate increases the effectiveness of domestic monetary policy because the central bank has a freer hand to inflate national currency at will.

When the Special Drawing Right (SDR) was created in 1970 by the IMF, it was defined as the gold-equivalent of a US dollar. In 1981 it was redefined as a weighted average of the value of the five major currencies in international trade (currencies of Japan, Britain, France, West Germany and the US). SDRs were simply IMF bookkeeping entries added to the quotas of its members and deriving value from the obligation of its members to accept SDRs and provide national currency in exchange.

For SDRs to be a medium of exchange, they would have to be accepted in private markets, but they were only balances in central banks. If the IMF had the power to be a world central bank, it would undermine the ability of national central banks to create their own seigniorage and conduct their own monetary policy. Political pressures from those in the United States who fear that the SDR could displace the dollar as an international reserve limited SDR interest rates to 1.5%.

The central banks of many countries respond, as a matter of policy, to demands for foreign exchange (demand for exports, usually) by simply creating more money. Japan, by doing this only in moderation, was forced to deal with the consequences of an "expensive" yen: reduced demand for its exports and cheaper imports available for Japanese consumers. In a flexible economy, deflation would correct the effects of a currency grown relatively strong in world trade, but contracts for wages, materials, etc. in fixed numbers of yen makes deflation slow. The short-term consequences are unemployment and economic recession in response to the decreased foreign demand for the overpriced goods.

The inflationary practices of many governments has led to the adoption of American dollars as a de facto monetary standard in many countries. Russia has more dollars in circulation than any country outside the US. Seventy percent of the currency actually used in commerce in Peru & Bolivia is in dollars. Panama & Liberia have used dollars as the official currency for many years, and Ecuador was forced to substitute dollars for its own currency, the sucre, in early year 2000. Widespread use of the dollar as a global currency both expands the power of the Fed and allows the US government to export paper (dollars) in exchange for real goods and services from abroad.

Although the IMF failed to become the world central bank as intended by Bretton Woods, it has become a sugar daddy for foreign governments that mismanage their economies — thereby encouraging such practices. One-fifth of IMF funds used for bailout loans comes from the United States. Rather than allowing the natural discipline of economic failure to provoke reform, the IMF effectively underwrites these failures while creating indebtedness to the IMF.

As an example, in the 1990s, Thailand, Indonesia, South Korea and a number of other Asian countries rapidly expanded their money supplies while their central banks lowered interest rates. Local stock markets soared in this illusory prosperity, but in 1998 the US Dollar rose over 100% against the Thai Baht and 500% against the Indonesian ruppiah. To prevent currency collapse the local central banks tightened interest rates — precipitating the "Asian crisis", blamed on currency speculators (a favorite scapegoat of governments). Indonesia accepted money from the IMF, signing agreements which it violated, and continued its policies of crony capitalism while the IMF continued to demonstrate "considerable flexibility". Even where IMF requirements have been observed the effect is often detrimental, since the IMF so often demands tax increases. In the case of Argentina, increased taxes have actually accompanied reduced tax revenues, and have probably stifled economic growth.

In exchange for bailout funds, the IMF generally demands local central banks that can be "harmonized" with the US Fed. Cynics might argue that the IMF is acting so as to expand the global dollar-reserve system. This is not simply an issue of power-politics, however, because most people sincerely believe that government regulated money & banking is superior to a free market system — and that the US Fed "knows best".

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  V. A "MANAGED ECONOMY" UNDER THE FEDERAL RESERVE SYSTEM

The United States central bank (ie, government-controlled money & banking system) was instituted purportedly to protect the public from the "anarchy" of free banking. Money & banking were the most free from 1836 (when President Andrew Jackson ended Federal involvement in banking) to 1862 (when Congress mandated that fiat greenbacks be accepted as legal tender to finance the Civil War — but without prohibiting the use of gold or silver). The National Bank Act of 1863 required all banks to collateralize their bank notes with government securities. Private coinage was outlawed in 1864. Otherwise, from 1836 to 1913 banking remained under state jurisdiction, with over half of states allowing free banking. Prices remained stable during this period — in sharp contrast to the steep inflation produced under central banking in the period after 1913.

Apologists for the American central bank say that there were bank failures in the United States prior to the Federal Reserve System. This is true — where business is freely practiced, poorly run or poorly located businesses will fail. Free markets mean rapid progress through trial-and-error, rather than the stiflingly slow progress (or regress) of a controlled economy. But bank failures were far fewer under free (or semi-free) banking than under central banking. The ratio of capital to loans in American banks went from 40.5% in 1836 to 55.1% in 1842, falling to 41.3% in 1862, to 17% in 1913 and to 5.6% in 1989. In New York State, which had the largest, most free banking system, bank failures from 1838 to 1863 were less than one-third of 1% per year, on average (with customers receiving an average 75 cents on the dollar in the failures). By contrast, under central banking the rate of bank failures in the 1920s was in excess of 2% per year. And in the 1930-1933 period about one-third of all US banks failed. Depositors lost more money in the first 20 years of central banking than had been lost in the 75 years before central banking. Bank failure rate declined after 1934 when the institution of Federal deposit insurance effectively created a welfare system for bankers, allowing federal money to bail-out poorly managed banks — thereby underwriting inefficiency and encouraging risk-taking. The consequences of this moral hazard were amply demonstrated in the "savings & loan crisis" of the 1980s and the American housing boom and bust.

The Federal Reserve Act of 1913 established the Federal Reserve System (headed by the Federal Reserve Board) as the central bank of the United States ("the Fed"). Of course, this move was touted as the creation of high-minded oversight for money & banking that would rise above the petty interest of the market place. Conveniently, the Fed doubled the money supply during World War I to finance the war effort.

The inflation wrought by wartime government spending in Europe was far more severe than that in the United States — particularly in Germany, where a postage stamp for local delivery cost 100 billion marks in 1923. The inflationary crisis in Germany undoubtedly made people desperate for a New Deal from a "high-minded" leader like Hitler, who had no trouble rising above the petty interests of peoples who would be free. As has been mentioned, Roosevelt's New Deal made the possession of gold punishable by imprisonment for American citizens.

The Federal Reserve Act of 1913 forced all banks in the United States to become part of the Federal Reserve System. This meant that their reserves (for fractional reserve banking) had to be demand deposits at the Fed. US Dollars became Federal Reserve Notes, backed (fractionally) by gold. The fractional reserves of gold held by the Fed were "backing" for the fractional reserves of Federal Reserve notes (amount dictated by the Fed) for the member banks. The system was so "successful" that in the period from 1921 to 1933 more than half of the 30,000 US banks went of business. In 1938 the Fed doubled the reserve requirements for member banks from 10% to 20%, an economic shock treatment that led to disastrous credit liquidation.

Outlawing gold for American citizens was only half the battle for a truly fiat currency, however. As long as dollars went abroad, foreign governments could demand gold for the dollars. But central bankers in foreign countries were all engaged in the same struggle for independence from the discipline of the gold standard that the Fed was attempting (as described in the " History of Modern Monetary Standards" section of this essay). Once unencumbered by the gold standard in the 1970s, the Fed could back-up its reserves by printing as much money as it liked.

The Fed controls money supply not so much by the amount of money it prints, but by the amount of reserves created in the banking system — and the fractional reserve requirement dictated by the Fed. After 1980 the fractional reserve requirement was gradually lowered from 14% to 10%, which increased the money supply considerably. Reserve requirements for nonpersonal time deposits and CDs were eliminated entirely in 1990.

The Fed is currently not changing reserve requirements as a means to implement monetary policy. Nor do changes in the discount rate have a significant impact on money supply. Currently, the key to the Fed's control of money supply and interest rates is through its open market operations, ie, buying and selling of US government debt instruments (bonds, T-bills, etc.) through Primary Dealers. (Just over 20 Primary Dealers are authorized to buy & sell with the Fed, including Goldman Sachs and Morgan Stanley.) The buying or selling can be either permanent or temporarily through repurchase agreements (repos) or reverse repurchase agreements. For example, the Fed could increase money supply by buying $1 billion of US government bonds. The Fed writes a check to a bond dealer for $1 billion from the Federal Reserve Bank of New York and then the bond dealer deposits the check from the Fed with a commercial bank.

But a check from the Fed does not "clear" the way other checks do. The check creates a deposit at the Federal Reserve Bank, increasing the commercial bank's reserves by $1 billion. The Fed has spent no money — it has simply written a check creating $1 billion in new money. But with a fractional reserve policy of 10%, the commercial bank is now able to make $9 billion in new loans. Thus, the $1 billion purchase by the Fed has increased money supply in the economy — while helping supporting the market price of the government's bonds. Unlike the obvious inflation of printing money — which only enriches the Treasury Department — inflation through credit-expansion (lowering interest rates) enriches the Treasury from the $1 billion from the bond sale, enriches the Fed by the interest collected on the bonds, and enriches the commercial bank by the interest collected on the additional loanable funds. The purchase also ensures that the government benefits disproportionately from the new money, while others (such as pensioner's living on fixed income) are harmed disproportionately by being the last to experience the inflationary effects.

The main tools the Fed has for control of money supply & interest rates are the fed funds rate and the discount rate. In a free market, interest rates are determined by the supply & demand for savings. In contemporary regulated economies, central bankers have considerable influence on interest rate through control of money & banking. When the Fed sells government securities it decreases the supply of money (loanable reserves), which increases interest rates (the fed funds rate). When the Fed buys government securities it increases the supply of money (loanable reserves), which decreases interest rates. The Fed indirectly controls the fed funds rate by buying or selling bonds to achieve the desired rate.

Fed funds is another name for money loaned or borrowed to maintain the Fed's mandated level of bank reserves, the deposits a bank has with its regional Federal Reserve Bank plus cash in the vault. The fed funds rate is the rate at which banks make short-term (usually only overnight) loans to each other to meet reserve requirements. The loans are made on a private financial market called the federal funds market.

On any given day a bank may have more or less reserves than its required amount. Banks with excess reserves can loan to banks having a deficiency (fed funds are exempt from reserve requirements). The lending bank instructs the Federal Reserve Bank to charge its own account and credit the account of the borrowing bank — a transaction to be reversed the next day. No physical delivery occurs, the exchange is made through the Fed's electronic network, the "Fed Wire".

The fed funds rate is the shortest of short-term interest rates — and is the US short-term benchmark. The most common fed funds instrument is an overnight, unsecured loan between two financial institutions (commercial banks, savings banks, savings & loan associations or credit unions) on the basis of an oral agreement. When banks borrow heavily on the fed funds market, the fed funds rate will rise unless the Fed adds new reserves. The Fed tries to keep the fed funds rate within a narrow band (50 basis-points or less) through buying & selling of government securities. The Fed will continue buying or selling in a trial-and-error fashion until its desired fed funds rate is achieved.

The discount rate is the rate the Fed charges banks to borrow money from the Fed rather than from other banks. The Fed can directly control discount rate. When rates are changed, the fed funds rate and the discount rate are almost invariably both increased or decreased by the same amount at the same time. The Fed sets a new discount rate and targets a new fed funds rate. The Fed has historically discouraged banks from direct borrowing by imposing costly and time-consuming procedures, including scrutinization of the bank's creditworthiness — offsetting the cost advantage of direct borrowing and making the Fed the "lender of last resort". But with the worsening credit crisis from 2007 to 2008 the Fed progressively gave lower interest rates and easier terms for borrowing from the discount window.

The open market policies of the Fed are decided by the Federal Open Market Committee (FOMC), which includes all 7 members of the Board of Governors plus five of the twelve Presidents of the district Feds who serve one-year terms on a rotating basis. The Governors are appointed by the US President for a 14-year term (subject to US Senate confirmation). Because open market operations are administered through the Federal Reserve Board of New York, the President of that district bank is a permanent FOMC member, with the title of Vice-Chairman. The FOMC meets 8 times per year under Chairman Alan Greenspan to decide on interest rates. (See the FOMC "Schedule of Meetings, Statements, Minutes and Transcripts".) Banks will invariably increase or decrease their prime interest rates (ie, interest rates charged by commercial banks to their most credit-worthy customers) in lockstep with increases or decreases in fed funds rate & discount rate. Mortgage rates, bond interest and other forms of interest charge follow — although long-term interest rates tend to be more independent and subject to market forces.

The control of interest rates & money supply are powerful tools of economic regulation in a purportedly free economy. In a free economy interest rates are the "price of renting money" — and that price is determined by market forces (supply & demand). Price-fixing of interest rates by autocrats invariably results dislocation from the market price — and shocks the economy every time the change is made or anticipated. The autocrats on the FOMC undoubtedly enjoy the fawning attention of the media hanging on their every word in an attempt to second-guess the next action — but price-fixing always misallocates market resources. The FOMC meets in secret and only issues vague summaries of its meetings six weeks after they occur.

Any resemblance between the Fed Chairman and the FOMC to the Wizard of Oz is not accidental. Journalist L. Frank Baum wrote The Wonderful Wizard of Oz to satirize financial autocrats pulling levers & strings to control the economy. The players have changed since Baum wrote the book, but the game is similar. "Oz" is the abbreviation for "Gold Ounce".

The decisions of the FOMC are not only closely watched, but closely anticipated by financial markets. Interest rates are an important cost of doing business — causing the stock market to sell-off or rally on economic data which the FOMC could use in deciding whether to raise or lower interest rates.

The FOMC sees itself as responsible for engineering a "Goldilocks Economy" — not too hot, not too cold, but "just right". By the logic of the Fed, if economic growth is too great the result will be destructive inflation. Under such circumstances, interest rates must be increased to slow ("cool down") the economy. If economic growth is poor, then interest rates can be reduced as a stimulant. The Fed has been targeting an annual growth rate of just over 3%.

Economic data indicating "excessive" housing starts, consumer spending, and (especially) low unemployment are signals to the Fed to increase interest rates. Increasingly the Fed has become concerned about stock market prices, because increased capital gain from stock price appreciation reputedly is a "wealth effect" that stimulates consumer spending. But more money spent on stock means less money spent on goods. Withdrawing money for spending lowers stock prices. Also, the top 5% of wealth own 80% of all stock, and these people are the least likely to increase spending due to stock price appreciation. When demand grows faster than supply, prices rise (inflation). Nonetheless, the Fed has been willing to tolerate slightly more growth than previously on the basis of the idea that the "New Economy" is creating technological advances that are increasing worker productivity.

The Fed banking autocrats are called "inflation hawks" because of the aggressiveness with which they raise interest rates to "combat inflation". A look at M1 expansion might give some idea about how these fractional reserve bankers go about fighting inflation. Worried about a possible Y2K panic, the Federal Reserve created $194 billion in new currency during the 13 weeks preceding January, 2000.

Unemployment rate is a very important inflation indicator used by the FOMC in determining interest rates. The presumption is that low unemployment results in high labor demand which leads to pressure for higher wages, thereby causing inflation. But figures published by the Labor Department are questionable indicators of employment. Definitions of who is employable are highly politicized — many who are not classified as employable would become employable with the right incentives & circumstance. Moreover, high employment corresponds with high productivity, which counters inflation. Unemployed people consume goods & services without contributing to societal wealth — an inflationary effect. And crime rates drop when unemployment is low.

High interest rates certainly do slow the economy (increasing unemployment), but by increasing the cost of doing business, high interest rates are themselves inflationary. It is almost diabolical that the Fed has created a situation in which the stock market welcomes unemployment because the Fed will not raise interest rates. It is not difficult to find countries where unemployment & inflation are both high — and other countries where they are both low.

It is also destructive for the Fed to attack economic growth using high interest rates for the purpose of combating inflation. There should be no limit to the amount of growth which is beneficial to the economy. It is not true that high economic growth is inflationary and economically destructive. The association is based on the belief that central banks can genuinely stimulate the economy by expanding the money supply (see An Austrian Theory of Business Cycles). Even if wages did rise, the accompanying increase productivity would help to keep prices down. And higher wages create incentives for greater labor efficiency & mechanization — more productivity increases. Economic growth means greater wealth & well-being for everyone. Government agencies that attack economic growth on the basis of bizarre theories of the dangers of an "overheated economy" are a threat to progress & prosperity — to say nothing of freedom.

(For more on the subject the causes of economic growth, see my essay Say's Law and Economic Growth.)

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 VI. MONEY IN THE ELECTRONIC AGE

Some people imagine that the computer age has replaced paper money with "electronic money". But this idea usually entails a fuzzy concept of money. Before computers, banks & businesses kept track of money by journal entries and by statements that were handwritten or typed. Computers, journals and statements are means of accounting for money and money transfers, they are not money per se. Thus, computer data about deposits held in a bank are not "electronic money" any more than entries in a journal were "paper money". Smart cards contain data about money held elsewhere which is to be transferred upon each use of the smart card. A new place to record information about assets is not money, nor is a new means to direct monetary transfer a form of money. Data about money and money transfers are not money.

Increasingly, however, debit cards and smart cards are being used like money because they are backed by fiat money (not currency, necessarily) in a manner analogous to the way paper money was once backed by gold. Smart cards may replace paper money and coins altogether, thereby reducing the costs of currency management for most businesses (75% of cash transactions in 1997 were for amounts less than $20). Credit cards are also used like money, but are actually loans.

There is some truth to the claim that a credit-card user creates new money in making a purchase on credit. But this is only an example of money creation through a bank loan in a fractional reserve banking system, as has already been discussed. The bank pre-approves the credit card user for loans up to a certain maximum. Although the exact timing and amount of the particular credit card loan is at the discretion of the cardholder, banks cannot make loans in excess of what their reserve requirements will allow. Banks have always been able to make new loans on the basis of unused reserve in excess of the minimum required reserve.

Airline miles have emerged as a modern version of Green Stamps — a value given to customers to encourage patronage. Claims have been made that airline miles and smart card credits for telephone calls represent the emergence of the basis for a new commodity-based money outside of government control. Airline miles qualify as money by being an untaxed store of value, but they are not a medium of exchange, since they cannot be transferred to third parties.

Stored-value cards are a close approximation to digital money. Cash or other sources of funds are transferred to the card, and the card-issuing company is responsible for honoring the payments made by the card user. The most successful stored value card is the Hong Kong Octopus card, which can be used to pay for mass transit rides, parking meter use, and purchases from supermarkets, fast-food restaurants or vending machines.

Secure financial transactions over the Internet are greatly dependent upon cryptography. Electronic Funds Transfer (EFT) allows for direct payroll deposits to the bank accounts of employees, online bill-paying, etc. Online credit-card charges and PayPal are more sophisticated funds-transfer processes, but are not digital money.

The best examples of electronic money are digital gold currency systems that allow online payment as gold transfers. GoldMoney and e-gold are the most successful examples. Payments made by these systems are like cash transactions in that there is no time delay associated with the payment, and there can be no payment dispute or repudiation of the charge.

Mobile payment systems utilize cell phones to execute transactions. With Near Field Communication cell phones can be waived near a reader module to initiate a transfer from a bank account or pre-paid account. Such payment systems are growing faster in parts of Asia and Europe than in the United States, possibly because American authorities want to prevent money laundering and insist on mobile systems being tied to traceable bank accounts.

It is claimed that computers will reduce the transactions costs of barter, making money less necessary. Or, using government fiat currencies, encrypted digital signatures will provide the basis for an increasingly untaxed, unregulatable economy. (Even before the Internet Age, an estimated 50% of home renovations work was done by untaxed "underground economy" transactions.) Although some people may be able to subsist in cyberspace, such people are likely to remain in the minority for the near future. Companies engaged in large-scale commerce need to have a physical presence in the world which makes them vulnerable to government regulation & taxation — but also the beneficiaries of government protection of property, patents and contracts.

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 VII. CONCLUDING REMARKS

Probably the greatest step that could be taken to reform & improve world economies would be the abolition of government control of money & banking. Only then would there be no limits to economic growth free from inflation. And it would be a major step forward to freedom and away from the totalitarianism which has stifled economic progress, technical progress and civilization for most of human history.

Advocating economic liberty is not the same as advocating a gold standard. The market would decide the most efficient media of exchange, standards of value and means to preserve value. However, it does seem likely that a gold standard (or multi-metallic standard) would be the starting point, at least.

It is claimed that the mining of gold only to store it away again in underground vaults is a waste of scarce resources. But the expense is justified, considering the inflationary tendencies of governments — just as locks, safes and burglar alarms are justified. Gold has the advantage of already commanding more universal "support and reverence" as money than any other commodity.

A laissez-faire attitude toward money has been criticized on the grounds that "the money supply is too important an element in economic growth and stability of nations to be uncontrolled by man". The production of food is also important, but little evidence is available that it is best done by governments — quite the opposite. Government control of money has been called "leaving the fox in charge of the proverbial henhouse" by economist Dr. Murray N. Rothbard.

Implementation poses serious problems insofar as radical actions by governments could cause great damage. Governments should repeal any restrictions between private parties or businesses contracting between themselves for monetary usage. Restrictions on banks or others to produce money should be eliminated. Ideally, competing moneys would emerge as government money recedes. But governments could not agree to accept any currency for payment of taxes without inviting the creation of worthless moneys.

The fact that most people seek the most universally accepted money militates against rapid change. Few people would care to be among the first to have a FAX machine or to speak a new language. Bad money does not drive out the good except where there are laws or costs causing both moneys to be accepted at par. Otherwise, good money would predominate. Government agents may not be very intelligent, but they should be shrewd enough to demand good money for taxes — so there should be no worry about what money governments would receive for taxes if money was not produced & controlled by government.

As long as government money is not subsidized, the market should eventually produce a superior product through free competition of media of exchange. Privatization of money & banking would be one of the greatest steps forward for freedom, progress & prosperity in the history of mankind.

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 VIII. SOME REFERENCES (by publication date)

BOOKS:

David Friedman's Policy Analysis on money

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