Back in the good ol’ days, money was something of real value that could be traded for something else of value — goods or services. A number of times over the years, this has been subverted by fiat money systems to varying degrees.
Part of the reason for the American Revolution was a desire to get free of the central bank of England. Gradually, however, bankers were able to insinuate themselves into the economy of the United States so thoroughly that eventually the independence of the people of the nation from a pervasive, inescapable system of debt-based currency was ended by the Federal Reserve Act of 1913.
The US dollar began as a defined quantity of silver (between 371 and 416 grains, depending on purity). Between 1635 and 1913, the consumer price index — an average price of consumer goods and services — remained roughly the same, thanks to the use of a stable currency. There were a couple of periods of significant drops in the buying power of the dollar, but those periods coincide with periods that the value of the paper dollar was divorced from a precious metal backing — during the War of 1812 and the Civil War. In each case, the value of the dollar was ultimately linked to precious metals again.
Note: The fiat currency created by divorcing the dollar from the value of precious metals occurred in 1862. The Secret Service was instituted, initially as an anti-counterfeiting enforcement division of the Department of the Treasury, shortly thereafter in 1865. Ironically, it is thus the Secret Service’s primary responsibility to defend the value of a “legitimate” currency, a need that arose because the role of the nation’s “legitimate” currency had essentially been replaced by Monopoly money. In short, the Secret Service was founded to investigate and end the counterfeiting of what amounted to a counterfeit currency.
The first sign something was going irreparably wrong may have been the redefinition of the dollar as 23.22 grains of gold, which was slightly below the value of the dollar over the lion’s share of its history to that point. This would have created the basis for an international inflation of the US dollar (i.e., reduction in the value of the dollar) if it were not for the fact that the world’s currencies had already entered something of a downward spiral of value. The point of no return came with the Federal Reserve Act in 1913.
This Act was intended to provide a buffer against financial panics that could provide emergency infusions of liquid assets when and where needed. Of course, the panics themselves were a problem primarily because of the fact that it was (and still is) legal for a banking institution to loan out more money than it actually owns. This was the original basis for banking as a business model; you would encourage people to deposit money in your vault, then loan it out to others in exchange for repayment plus interest. As long as you didn’t get too many people trying to withdraw their money at the same time, you’d be able to cover all needs, and profit on the interest.
Gradually, precious metals as backing for the dollar were phased out in favor of a pure fiat currency — and, predictably, the value of the dollar has plummeted. So, too, did the value of all the other major currencies in the world, though. None of them are based on anything of tangible value, either.
Thanks to the Federal Reserve Act and its many legislative children and grandchildren, our economy has “evolved” from a value-based system to a debt-based system. We have, as a nation, abandoned a currency based on real value in the form of precious metals in favor of a currency based on currency debt. It’s a devilishly circular basis for an economy, where the value of the dollar is predicated solely upon how many dollars people owe.
The problem is that money is created through debt. A bank essentially has two sets of books: the set that is used to define the money it has on-hand, and the set that tracks how much money it is owed. That money owed to it is exactly equal to how much money the bank has created. The amount of money it is allowed to loan out is (in the general case) equal to nine times what it has on-hand (thus the “money creation” aspect of this). Whenever a loan is made by a bank, it basically just adds some money to the debtor’s account without having to take it out of any other ledger column, as long as the loan amount doesn’t put the total quantity of loaned dollars over nine times the on-hand asset amount.
Note: I’m simplifying things a bit. For instance, the on-hand assets plus the assets deposited with the central bank actually form the basis of the 9:1 ratio, and for many types of loans the ratio is even higher than 9:1, et cetera. The details are generally not relevant to explaining the concepts.
Of course, when someone takes out a loan (say, to buy a house), that money is then transferred to someone else via the agency of that other person’s bank. Since the banking system is an effectively closed system, from a certain perspective banks may be regarded as creating money and sending it to each other, through the agency of debtors. Every time money is deposited in a bank, it becomes part of that bank’s assets that can be counted toward that 9:1 ratio, thus allowing the bank in question to create yet more money through another loan. The reason this isn’t all just done by a single bank (the central bank) is, of course, because at that point the shell game being played would be too simple, and too easily recognized — the complexity of a multi-bank system subordinate to the central bank is a requirement for the survival of the system.
Of course, debt is being created far more quickly than money, even though money is entirely based on debt in this system. One might imagine that all of this could be cleared up just by balancing everyone’s debts out, but that ignores the existence of interest owed on loans. It seems obvious that if everyone could pay back his or her debts and live debt-free, everything would be peachy — but, again, that ignores the problem of interest on those debts.
See, when a loan is paid back, the money that is paid back disappears other than the interest quantity — because it just translates into erasing those loan quantity tick-marks the bank uses to keep track of its total amount of loans in relation to its money on-hand. The interest, however, is profit, and the money a debtor borrowed that was created by the bank actually exists in the on-hand assets of the bank to which it was paid.
I’m sure you’ve heard about the Great Depression, and it’s possible I have readers old enough to remember it first hand. That was when the UK left the gold standard entirely, and when the United States actually outlawed the use of precious metals as currency — in fact, outlawed the private ownership of more than token quantities of gold, except under tightly controlled circumstances (such as a jeweler’s stock). The elimination of the right of the people to trade in whatever the hell they chose to value was of course a mechanism for eliminating a means by which people could avoid the economic controls being instituted at the central government level.
The cause of the depression was a reduction in money supply. In fact, whenever someone refers to inflation as the reduction in the value of the dollar and deflation as the growth of the value of the dollar, that’s an incorrect use of the term: the changing value of the dollar is a result of inflation or deflation, rather than being the inflation or deflation itself. This is why we get the counterintuitive use of “inflation” to mean “reduction in value of the dollar” — because it’s actually an inflation in the supply of money, which causes the value of the units of that money to drop thanks to the very simple economic relationship between supply and demand.
So . . . how does the money supply dry up? Another way of referring to a “reduction in the money supply” is as “money leaving circulation”. This should give you some hints to how the money supply can deflate, such as by hoarding and, more importantly under the conditions of our fiat money system, by the elimination of effective debt in the economy. That elimination of debt occurs not only by people paying back their debts, but also by people defaulting on loans, dying without repayment, and so on. As these events start happening with large numbers of debtors, fewer debts are issued because fewer people are solvent enough to be trusted with a debt by a given loaning institution (bank), and in the end the amount of new debt created dries up, thus eliminating the amount of new money created.
Unfortunately, a debt-based economy requires inflation to survive — because without inflation, there’s no way to fund all those interest payments. As a result, not only does deflation cause problems for individuals who find themselves outside the loop of people who can acquire money, but it causes further deflation, which in turn excludes even more people from that loop. The depression, from a naive perspective, seems like a wholly improbable set of circumstances; how can everyone go broke at the same time? Doesn’t the money have to go to someone? Understanding the basics of how a debt-based currency works, and an economy that trades in that currency, neatly solves that little conundrum, however, because dollars in a debt-based fiat currency economy like ours are just tick-marks on a ledger sheet, and they exist only so long as people are willing to grant each other credit. The moment too many people prove unreliable debtors, the house of cards comes crashing down.
The deflationary problems of the Great Depression would have cleared up eventually, one way or another. FDR ensured his reelection by meddling with the economy, “stimulating” it (beware any politician that talks about “stimulating” the economy) via a number of ill-conceived government programs, but with the distance granted by time economists have come to see the big picture and realize that FDR probably prolonged the depression quite a bit.
Even if you accept the notion that FDR shortened the depression, or reduced its damage during the period of the depression, his economic management plans were dependent upon the legal restriction on the populace’s right to use precious metals as legal tender, thus setting the precedent for all prohibition of competing currencies. This means that the only legal option for a capital-based system of exchange is to trade in Federal Reserve Notes, those worthless green pieces of paper we all pretend are so valuable, and in the ledger sheet tick-marks with which they’re directly exchangeable that are used to tally up debt quantities by the banks. Ultimately, this eliminates the surest protection an economy has against another Great Depression (since it ensures that only a debt-based currency that can suddenly and catastrophically suffer massive deflation, since it requires constant inflation to maintain the economy, qualifies as legal tender). That, in turn, guarantees that the federal government and the Federal Reserve system must forever after be intimately involved in economic management to hedge against such depressions.
Ron Paul has talked about replacing the current fiat money system with a precious metals based money system, going back to “the gold standard”. There are those who call this “naive”, having heard somewhere that a precious metals currency is deflation-prone and that deflation is what causes things like the Great Depression. Such people only know a small part of the story, though.
The reason deflation is so immediately dangerous is entirely based on the fact that our economy runs on a debt-based currency. An economy based on such a currency requires constant inflation to remain solvent, else it will suffer a corrective crash. Deflation is such a danger with a debt-based currency because deflation begets greater deflation, to the point that there simply isn’t enough money to go around. In other words, deflation is so immediately dangerous in our economy because the dollars of our debt-based currency basically just evaporate when the currency deflates. This is much different from what deflation means with a static currency, such as one based on precious metals.
With a precious metals based currency, on the other hand, deflation occurs simply because the overall wealth of the economy increases, and the number of people in the economy also increases. One of these is a good thing, the other not so good with regards to deflation.
As the wealth of the economy increases, specific goods and services may drop in price, thus effectively deflating a precious metals based currency in relation to those goods and services. Deflation and inflation are, after all, relative measures: the amount of money per unit deflates, as the number of available units of a good or service increases. This means that you can buy more with your dollar, but it doesn’t mean you have fewer dollars — they won’t evaporate, even when you repay a debt. The reason you can buy more with your dollar is that it is easier to make more of whatever you’re buying, thus reducing the cost of that good or service. Meanwhile, other (more “advanced”) products and services come into being that, because they are newer and less easily produced, cost more, balancing out the deflationary characteristics of the currency.
On the other hand, population growth also occurs relative to the amount of money in an economy. If that money is measured in a largely static currency, such as one based on gold (which isn’t really being created anew at the moment — we don’t have any cheap supernovae creating more gold in these parts), the currency deflates in relation to the population. This is a gradual and steady effect, however, and one to which an economy easily adjusts, within certain limits of reasonable elasticity. Eventually, there would come a time when the negative effects of a single static currency would be felt in the economy, but it would be quite a while before that happened.
Returning to a precious metals based currency would be a step in the right direction. It would eliminate much of the necessity of central management to keep the economy solvent, it would eliminate the requirement for our inflationary debt treadmill, and it would protect the economy against catastrophic deflation, at least in the short and medium term (where the short term is probably a matter of however long it takes for our economy’s population to increase fivefold, to pick a number out of thin air).
In the long term, what we really need is an open market in currencies. Eliminate the restrictions against the development and use of competing currencies. New currencies would arise as needed to fill in the gap created by the long-term deflation of a static currency. If someone doesn’t have units of the static currency available, he or she may have something else you want — and that, in turn, becomes a value of exchange, leading to the creation of a new currency.
More on that later — this marginally stream-of-consciousness essay has gone on long enough.