In another scenario the Phonees, the most powerful family in a small, isolated wilderness town, print their own paper money, as much as they like, and use that currency instead of the legal currency of the land. Rather than having pictures of George Washington and Abraham Lincoln on the bills they have pictures of the Phonee family patriarchs. Anybody who refuses to accept the Phonee money is dealt with forcibly until eventually the entire town moves to the Phonee money system. After a few years and turf wars, the Phonees are unseated by a more powerful family, the Counter-Fitters, who immediately declare the Phonee money to be of no value and the new Counter-Fitter money as the official currency of the town. Every decade or so a new family takes power and prints money at whatever intervals it desires. Sometimes, after certain exchanges of power the newly installed families simply take control of the existing printing presses and pound out whatever volume of the prevalent currency they desire for themselves.
Both of these scenarios demonstrate the flaws found in money policies of governments over the past 200 years. In the first, excessive volumes of currency without appropriate backing beget fraud and zero confidence in the distributor, this is known as fractional reserve currency. In the second, the paper money is only as good as the power behind it and can be easily undone if that power is lost, exchanged or decides to generate excessive quantities, this is known as fiat currency. There is a third system, though, that is generally ignored. Of all the known banking systems, the only sound and vital systems are those founded upon an objective commodity at full value: full reserve banking.
As with all things, the players must be known before the game can begin. For this reason, the following scorecard will prove beneficial.
Money is, by Adam Smith’s definition, “the universal instrument of commerce, by the intervention of which goods of all kinds are bought and sold, or exchanged for one another” (Smith, 2001, p. 16). Another phrase for this “instrument of commerce,” is a “medium of exchange.” Contrary to any highfalutin meaning attached by pointy-headed economic know-nothings, money is simply a means by which a trader can triangulate her purchasing power. For example:
Trader “A” wants item “C”, but trader “C” does not want any items available for trade by “A”. Trader “A” then visits trader “B” to exchange two pieces of “A” for twenty pieces of “B”, which almost everybody wants and accepts in trade. Trader “A” returns to Trader “C” where they negotiate a current exchange rate of fifteen pieces of “B” for one piece of “C”.
In the above exercise, item “B” is a money or medium of exchange. It could be gold, silver, shells, animal teeth, cigarettes and even recently paper currency, whatever is commonly accepted by those trading.
In order to trade, certain requirements must be met. To quote economist Carl Menger, for an exchange to take place a “commodity owned by somebody is of less value in use than another commodity owned by somebody else” (Menger, 1892, p.241). This is known as a “double coincidence of wants.”
According to Andrew Gause, “The reason gold and silver were chosen for the (United States’) monetary system was because of their limited supply and unique characteristics, as metals, of division and durability” (1994, p. 46). He argues that gold and silver were chosen by the US Government through some wise insight; he is unfortunately incorrect. Governments such as the United States adopted gold and silver, meaning they did not initiate their use, for their monetary systems due to the fact that they had been a market defined medium of exchange for centuries. This is an example of governments mimicking the market (often badly) and receiving accolades for brilliant insights and reasoning.
Within a fractional reserve banking system, banks act as storehouses of money, issuing paper certificates, or bank notes, for the commodities held. However, rather than simply providing bank notes matching the funds stored, the banks also act as lenders, issuing bank notes to borrowers for more than the value of commodities held in store by the borrower and eventually (and universally) exceeding the amount actually owned by the bank itself, thus distributing funds owned by other customers.
The system obviously had its legal troubles in the past because, “in the case of fractional reserve banking, bankers can infringe on property rights (of non-borrower depositors) because it is not clearly defined who owns the deposit” (Bagus, 2006). A simple fix for this would have been to write into the contract at time of deposit, as well as on the various bank notes themselves, who owned the commodity once it was deposited at the bank. This would have permitted the bank to engage non-fraudulent lending of depositor’s funds because the commodity owners would have been willingly permitting the banks to lend funds at the bank with no expectation of payment upon delivery of receipt unless it was specifically denoted in their contracts or by the bills held. This good faith could then be repaid to the depositor through payment of a portion of the interest charged by the bank.
Instead, banks continued to print an excessive volume of unsubstantiated notes and opened themselves to the prospect of immediate payouts in real commodity in exchange for representative notes exceeding the commodities held in reserve, or a “bank run.” These occurred both by natural means, when wealthy customers simply wished to transfer the entirety of their funds to another bank, and also when the bank came under rumor of insolvency.
Under a fractional reserve system bank runs and bank failures are healthy and natural. These mechanisms cull bad banks, those with poor lending and printing policies, from the strong banks with better reserves and tighter credit.
“Fiat money,” says Encarta encyclopedia, is a “type of currency issued by governments as legal tender, the value of which is based solely on decree or law rather than on actual coin” (2007). Thus, fiat currency is paper money “guaranteed” only by the word of the printer. Only governments have the power to print or guarantee a fiat currency. The paper money has no value if the printer no longer has the power to guarantee its value.
Fiat banking, therefore, is bound to nothing, so it is limitless. At will, a government body can print whatever volume of bills it desires without consequence, so long as it has the guns to back up that money.
By contrast, full reserve banking requires that banks only print currency notes to match and represent the exact stores of precious commodities held in stock. Instead of “dollars,” “marks,” or “yen,” banks would print and guarantee the value of bills in denominations of weight like “grains,” “ounces,” or “pounds” of silver or gold. Any currency printed in excess of the reserve quantity of commodities held by a given institution would be classified as fraudulent. Only private institutions could print full reserve notes and still be held accountable by both market and legal standards.
For clarification it should be noted that certain individuals confuse the “gold standard” with full reserve banking. These are not the same because a “gold standard” is also used in fractional reserve banking and typically guaranteed by a government body under that system.
Historically, governments have implemented both fiat currency and fractional reserve banking. Unfortunately, true full reserve banking has not had its day in the sun in the United States.
The United States utilized fractional reserve banking from 1815 to 1971 (Rothbard, 1990, p. 46). From 1815 to 1914 the United States existed under the “classical gold standard” where non-centralized fractional reserve banks printed currency against the gold and silver held in reserve.
The official history of the Federal Reserve Bank of San Francisco states, “In 1913 a major change in paper currency occurred with the passage of the Federal Reserve Act aimed at resolving some long-standing money and banking problems which had led to bank failures, business bankruptcies, and general economic contractions” (2006). It is amazing that the Federal Reserve’s own description of its birth demonstrates that level of candor. This established the “Federal Reserve,” the central bank of the United States.
The Federal Reserve makes it clear that by its standards a bank failure is unacceptable, even if it is the bank’s own fault. Also unacceptable is if a business declares bankruptcy (thus reducing and even eliminating the nature of risk from entrepreneurship and completely redefining entrepreneurship in the process), and economic “contraction” takes place (a fancy way of saying the paper money supply must grow indefinitely whether or not it has any value at all). The entire concept is pure rubbish as it allows (and arguably encourages) banks to lend recklessly and inflate money supplies without limit.
In 1926 Great Britain, the United States and other nations established a “gold-exchange standard” whereby, according to Rothbard, “a pyramiding of U.S. (dollars) on gold, of British pounds on dollars, and of other European currencies on pounds” created a house of cards so precarious that it only took three years to collapse. Excessive inflation followed in money markets as loose credit practices and European nations writing one another the equivalent of bad checks continued to undermine the solvency of the “lesser” global banks and eventually even the United States and Great Britain, paving the way for the Great Depression.
When the markets crashed and banks collapsed, which, contrary to common opinion is a good thing, nobody looked to blame the Federal Reserve and its bastard fractional reserve children. Instead, the “gold standard,” took the fall for its wicked doppelganger (Rothbard, 1990, p. 49). Those who wanted to own gold rather than paper were viewed as subversives and in 1931 Herbert Hoover publicly decried “gold hoarding” as unpatriotic and un-American. In 1933 and 1934 Franklin Roosevelt, Hoover’s ideological twin, signed laws banning private ownership of gold. (Rothbard, 1990, p. 49)
In 1945, at the close of World War II the United States Congress ratified the Bretton-Woods system. The standard eliminated the British “pound” and left “the dollar, valued at 1/35 of a gold ounce...to be the only key” global currency. The system proved superior to the gold-exchange standard of the 1920s and gave the illusion of being the way back to solvency. Instead, it only further severed the tie to gold and further postponed the inevitable collapse of fractional reserve banking. (Rothbard, 1990, p.50)
In 1971, after foreign banks attempted to redeem great quantities of precious metals the United States looked to reevaluate its hard currency policies and in 1973 finally and completely severed all ties with gold, allowing for a fully fiat money system. (Rothbard, 1990, p.53) It is important to describe the failures and fallout of both the historical fractional reserve system and historical fiat system and demonstrate why the system today will collapse.
The fractional reserve system under the “classical gold standard” failed because even though there were long periods of improved economic health and positive deflation the government could increase the money supply in time of war unchecked until the end of the conflict. During and following periods of war, the expanded supply of currency would cause hyperinflation and, in turn, set off a sharp and necessary contraction of the money supply. Widespread economic hardship would follow.
The fractional reserve system under the “gold exchange standard” failed because it postponed the inevitable money supply contraction and permitted expanded spending with falsely overvalued currency. When the banks finally proved insolvent and the “bank runs” occurred in 1929, rather than permitting the weak and truly insolvent banks to collapse, and even put an end to the sham of fractional reserve banking the Federal Reserve became the “lender of last resort” and developed a system to insure every deposit.
Under the new system when customers would “run” on a bank and withdraw the entirety of their funds, the Federal Reserve would provide currency for those withdrawals whether or not the paper money matched the reserve commodities.
The fiat currency system has since 1973 allowed for massive inflation as any schoolchild can tell you. The waning clout of the United States Military Industrial Congressional Complex will eventually give way to a long-overdue correction over eighty years in the making unless a remedy can be made. Evidence of hyperinflation other than the typical indices would be how a commodity of what should be decreasing value due to wear, tear, and general aging, such as a house or other structural property, continues to increase in value over time rather than decrease.
Hyperinflation thanks to fiat currency will become even more apparent in the future when it will be a money-saving venture to assume debt because inflation rates will outpace interest rates, and even the car purchased at a fixed interest rate will be worth more in 5 years than it was on the showroom floor. As Murray Rothbard states, “With a (paper money) 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” (1990, p.42).
Under full reserve banking hyperinflation ceases. Full reserve banks cannot overvalue their printed currencies. With currencies incapable of being overvalued hyperinflation cannot occur. While inflation due to diminished supply of product can occur, it will correct itself through market forces as it would with “destructive deflation.”
Under full reserve banking deposit insurance is a thing of the past. Any bank discovered practicing fractional reserve banking while promoting itself as a full reserve bank commits fraud. Fraudulent banking is a crime and customers can take comfort in their currency being redeemable in full. Customers don’t make “bank runs” on banks where they can redeem their currency in full. With no incidence of “bank runs” there is no need for a central bank to guarantee the notes.
Because governments seek only to increase their power and money is the easiest manifestation of that power. When a government controls the money supply it can increase that supply to meet its own ends without regard for actual value. Anytime it wishes to start another social program or, more likely, a war it can simply run the presses day and night to generate the necessary “capital” to fund the event without the consent of the governed and pass the inflation right along to those same people. Due to this a government managed full reserve currency quickly dissolves into a fractional reserve or even fiat currency as the government decrees its ends more vital than the value of a paper money. Additionally, everyone affected by the specified government suffers the debilitating effects of his or her money being devalued by hyperinflation. This is why full reserve banking must be exclusively private.
Because full reserve currency is based on a real commodity that is truly limited in supply, the chance for hyperinflation is eliminated; a centralized bank is rendered obsolete; and people can once again have some degree of genuine faith in the money they use and the banks where they store that money because those banks printing too many bills are criminally fraudulent organizations. As a fringe benefit of the establishment of a full reserve system, governments must truly have the consent of the governed to engage in wars and social programs because they would no longer have the power to utilize the alchemy of fractional reserve or fiat banking. All in all, to protect the economy, the citizens who hold money and the integrity of the money printed, a full reserve system is the only system that has the greatest chance to guarantee these and give everybody a chance to thrive and succeed.
References
Bagus, P. (November 12, 2003). The commons and the tragedy of banking. Retrieved February 27, 2007 from, http://www.mises.org/story/1373
Fiat Money (n.d.). Encarta Encyclopedia Online. Retrieved February 28, 2007, from Web site: http://encarta.msn.com/encyclopedia_761565134/Fiat_Money.html.
FRSB 1995 Annual Report (April 5, 2006). Federal Reserve Bank of San Francisco. Retrieved February 28, 2007 from http://www.frbsf.org/publications/federalreserve/annual/1995/history.html.
Gause, A. M. (1994). The problem with currency. Business West, 10(12), 46. Retrieved February 4, 2007 from EBSCOhost.
Menger, C. (1892). On the origins of money. Economic Journal, (2) p. 239-255. Translated by Foley, C.A.
Rothbard, M. N. (1990). What has government done to our money. Auburn, Alabama: The Ludwig von Mises Institute.
Smith, A. (2001). An Inquiry into the Nature and Causes of the Wealth of Nations (11th ed.). Retrieved February 23, 2007 from Project Gutenberg.
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