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More Criticism of Banks

Interestingly, money is managed in largely the same way in every corner of the world. How is it we have come to rely on central banking so much, in spite of its potential problems? Is this really the best we can come up with?

The primary reasons most often cited for creating the Federal Reserve in the first place are:

  • Maintaining a stable currency, and
  • Preventing financial crises.

Yet, since the Fed was created in 1913, the US dollar has lost approximately 95% of its value. In other words, a dollar today is worth about what a nickel could buy a century ago. By contrast, in the 100 years prior to 1913, the purchasing power of the dollar remained more or less constant.

It does not seem like the Fed has been able to prevent financial crises either. Soon after its implementation, the country still suffered a decade of poverty during the Great Depression. The century was filled with various other financial instabilities. And most recently we have experienced the Great Recession in the years following 2008. Federal Reserve policy has been stretched beyond its normal limits in attempting to regulate the money supply. And it still has not been enough. So what has it really done for us?

Another criticism has to do with the way our money is backed, or secured. In the narrative of the goldsmith, we discussed how paper money was first created as certificates that could be exchanged for gold. Without going into too much detail about the history of the gold standard in America, it is sufficient to say that prior to 1971, US dollars worked in a similar way. They represented, and were theoretically redeemable, for a standardized amount of gold or silver.

After leaving the gold standard, Federal Reserve notes were no longer backed by precious metals. Instead, they were simply payable in dollars.

Due to this strange, self-referencing twist, many have concluded the US dollar is now a “fiat currency.” Essentially, this means a currency that has no inherent value, but derives its value by the declaration of a government or some other authority. It is only valuable because people think it is valuable.

Fiat money has no particular commodity of known value to back it up. And in many respects, it is true—US Dollars now are partially a fiat currency, but not entirely. Even after 1971, our money was still backed collectively by our homes, our cars and our willingness to go to work each day and earn enough money to pay our income taxes.

But the notion that each dollar had a value tied somehow to the value of gold was gone, and with it, the stability of the currency suffered dramatically as well. Indeed, after going off the gold standard, the rate at which dollars could be exchanged for gold dropped precipitously and has never recovered since.

One of the most important purposes of money is to store value for future use. When we accept money in exchange for something else of value, we hope its value will last a long time. When we want to turn the money back into something else we need, it is important for that value to still be available. Can we count on our saved money to hold its value, even for a very long time?

For example, we might save up money while we are younger and more productive. This way, we can still maintain our lives when we are older and can no longer engage in productive work. If the money is not dependable to maintain its value, it is not very useful for this purpose. So people might have to consider storing value in some other kind of commodity instead.

Origins

A discussion of the Federal Reserve would not be complete without considering the circumstances in which it was created. For the full-blown, conspiracy theorist viewpoint, it is instructive to read The Creature From Jekyll Island, by G. Edward Griffin. Some of the narrative in the book could be exaggeration or even conjecture. But there is also much to learn from.

The reader can also get a variety of other viewpoints by spending a couple of hours searching the web for information regarding the creation of the Federal Reserve. You can visit the Federal Reserve’s own website and get its point of view. You will not suffer from a shortage of opinions, both for and against.

It does seem evident that, like much large federal legislation, the Federal Reserve Act of 1913 required the concerted efforts of a few very powerful special interests, working largely without the full knowledge or consent of the public. Most people had no idea what was really being proposed or how it would affect the country. The bill was passed just before Christmas at a time when people were less apt to pay attention and it was a vote very polarized along strict political party lines.

Like many other federal regulatory measures, it clearly empowered big business to operate in a monopolistic way with the blessing and consent of big government. It would prevent smaller, private operators from freely competing in the banking industry. In order to be a bank, one would have to become a part of the larger cartel. And the cartel would be managed and controlled centrally—and not fully subject to our elected representatives or the people.

Interest

As we consider the way most money is created, through either voluntary or forced borrowing by the public, it is instructive to consider the problem of paying interest. Remember, when you borrow money on your home or car, you have to pay that money back. But you also have to pay other money in addition to the principal you borrowed. This is called interest, and it is the fee the bank earns for the service of lending you the money in the first place.

A problem arises, however with these interest payments when all money is essentially lent into circulation through a central bank. To better understand it, let us return to our 5 castaways and imagine they want to start their own paper money system.

In this scenario, there is no pirate’s chests full of gold. But fortunately, one of the group used to work for a bank, so the others rely on him to come up with a system they can all use and trust.

So he prepares special strips of leather from the skins of the wild boar they have been eating to survive. And he burns an official looking insignia into the leather by heating up his secret Rothschilds signet ring. Each of these new tokens, he affectionately refers to as a “pig note”. And viola! Money is born.

Since our banker understands the difference between fiat money and backed money, he is not willing to just hand out the newly created bills for free. Rather, he will only exchange them for notes of similar value pledged by each of the other islanders. In other words, everyone will have to borrow the pig notes from the bank.

As people work and exchange food and other value with each other, they will also be able to earn pig notes. So they can use this income, as well as the proceeds from their initial loan to begin to pay back their pig loans.

Our banker will be working hard managing the money supply so he won’t have as much time to provide for his own food and shelter. So the group agrees to pay him 10% interest over a year’s time as they pay back their loans.

So they get started and each of the other four receives an initial loan from the banker of 100 pig notes. In exchange, each performs a witnessed pledge to pay all the money back, and with interest. Each pledge is accompanied by an additional promise: if he does not complete the agreed payments, he will forfeit any personal property he may possess, such as his hut, his food and extra clothing. This property will form the collateral for the loan.

But there is a problem. The initial money supply consists of only 400 pig notes. But by the time the year is up, the total due back to the banker will be 440 pig notes. Where will the additional 40 pig notes come from?

The obvious answer is, the banker is going to have to create some more money. The slightly less obvious result is, someone is going to have to borrow it, again at interest.

The hope with this kind of system is, one or more of the islanders will have been busy during the year. Hopefully they will have built better shelters or developed areas of ground for growing their food. These new improvements, called “economic growth,” will constitute new potential collateral that have not yet been exploited for the purpose of borrowing.

As mentioned, the inherent demand in the economy is for 440 units of money but there are only 400 units in existence. As you might expect, this would have a deflationary effect. In other words, money would become more valuable because it is becoming more scarce, or harder to come by.

In fact, someone might eventually become too short on cash to make his monthly interest payment to the banker. When that happens, he will either need to put up some additional collateral and borrow more money, or he will have to forfeit his property to the banker.

This problem may not occur right away but it is bound to happen eventually—at least if people continue to make payments on their loans. True, the act of borrowing created new money. But conversely, the act of making payments back to the bank destroys money already in existence.

Paying the loans back literally reduces the size of the money supply. And eventually it may become too small to pay back all the outstanding obligations. When that happens, the negative consequences are most likely to hit the poorest, or least productive of the islanders. Unless the total amount of borrowing is increased each year, someone is going to lose his collateral to the banker.

We see this same phenomenon in our modern banking system. Virtually all money is lent into existence and it must be repaid with interest. That interest is measured in the same units as the original loan—dollars. So there will never be enough to go around unless we continually create more.

The Federal Reserve touts its ability to change the size of the money supply as being a dynamic way to control an “elastic currency.” Something elastic should grow when it needs to, but then snap right back to its smaller size again later. In reality, our money supply has only had to get larger and larger over time.

This is in large part, because of the need for constant interest to be paid back into the system. The money supply can never really get smaller or people will run out of the money needed to service their debts. When that happens, poor people will lose what little they have. In other words, value, in the form of commodities, will be transferred from the poor to the wealthy.

The only other alternative is to use artificial means to increase the money supply. Another way of saying this is: force people to borrow money they otherwise would not choose to borrow. But the result of such policy is an ever-increasing degree of involuntary servitude forced upon anyone still willing to work in a productive job.

In our current political debate, we have developed a culture of perpetual growth and expansion. The economy always has to be growing in order for us to think things are going well. If we have economic growth, things must be good. If the economy is flat or decreasing, then things must be bad—and the politicians had better do something in order to keep things growing.

Why have we come to accept this premise? Surely if a population is growing, we would expect the total size of the economy to also grow in proportion to the increased number of people. But should people have to continually take on more and more debt in order for us to enjoy good living conditions?

Or is there a more sustainable way to enjoy happy and comfortable lives?
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