As money developed and people opted to place it in secured storage, banks started issuing banknotes which represented a client’s deposit at the bank and the promise to redeem each note for the amount of gold it represented at a 100% reserve rate.
Market exchange rates of the coins were defined by their metal content. The market exchange rate of the notes was defined by the default risk of the issuer (risk-adjusted demand). These notes began to circulate more and more. They still represented the gold, and people still redeemed them for gold, but banks noticed that some gold always remained in the vaults. The bankers started loaning out some of the “dormant gold? for their own profit and at the risk of their depositors, thereby creating more claims (banknotes) than they had gold in their vaults. This meant a less than 100% reserve rate (which the State did not stop and in fact even sanctioned, encouraged and institutionalized as this meant that the State could borrow more money in the shadows of finance, beyond the comprehension of most of the citizenry).
The State constantly needs more money for wars, corruption, and vote-buying and ultimately enforces Legal Tender laws. The State takes over the reserve banks (taking control of the gold present in them and the dictating of reserve rates) and declares a single legal tender which replaces all other notes (others become forbidden), issued by the central bank. The notes still represent the fractionally reserved gold, and people can still redeem them for gold (as long as not too many people do so at once). However, as the notes themselves (as opposed to the metal coins) become legal tender and usage becomes enforced by the State, they are less often redeemed.
Fractional reserve banking becomes institutionalized at a less than 100% reserve rate. Market exchange rate of the notes no longer defined by default risk of the issuer (now the State) but by the mere dictate of the State, where every citizen is forced to accept the note, regardless of metal content underlying it (thereby negating the default risk of single banks, but also masking the systemic risk which remains the same!), at least within the same monetary union. Exchange rates still play between different LT’s but gold is indirectly “removed? from the market and the legal tender notes become the center of the monetary system.
Now, as people got used to the legal tender notes and were no longer frequently redeeming them for gold, the State – over time – started to reduce the amount of gold for which they could be traded in at the central bank. This went largely unnoticed by the general public, which came to view the notes themselves as money (secure in the belief that because it was regulated, the State was looking after their best interests). This opened the door for the State to gradually print more and more notes at lower and lower underlying gold amounts, on top of those notes that were already being created out of nothing through fractional reserve banking, as these could not be refused by citizens under legal tender law which forcefully monopolizes the issuing of currency.
Though gold and silver have been freely used as money for millennia (with the first gold coins originating around 550 BC in modern Turkey), over time States have instituted several forms of formal “gold standards? (which de jure tied the standard economic unit of account to a fixed amount of gold and / or silver).
Though similar local endeavours (with similar outcomes) had been undertaken since the introduction of gold coinage, in modern times, “England adopted a de facto gold standard in 1717 […] and formally adopted the gold standard in 1819. The United States, though formally on a bimetallic (gold and silver) standard, switched to gold de facto in 1834 and de jure in 1900 when Congress passed the Gold Standard Act. In 1834, the United States fixed the price of gold at $20.67 per ounce, where it remained until 1933. Other major countries joined the gold standard in the 1870s. The period from 1880 to 1914 is known as the classical gold standard. During that time, the majority of countries adhered (in varying degrees) to gold. It was also a period of unprecedented economic growth with relatively free trade in goods, labor, and capital? (Bordo, 2002). Deflation was rampant as economic growth outpaced gold production, and this was key to the successful economic climate.
The different currencies like the mark, pound or dollar, were at the time just different terms for certain weights of gold. Exchange rates were “fixed? as everyone was using the same money, namely gold. Consequently, international trade and cooperation increased during this period. The classical gold standard was however a fractional gold standard (i.e. allowing fractional reserve banking and masking it behind State sanctioning) and, consequently, inherently dangerously unstable.
Banks did not hold one hundred percent reserves – their deposits and notes were not 100% backed by physical gold in their vaults. They (and their depositors) were always confronted with the threat of losing reserves to bad loans and being unable to redeem deposits during bank runs.
Gold did still put a natural limit on how much money could be spent by the State (at some point the State’s gold could run out). But as war is one of the State’s most costly endeavors, “it is no coincidence that the century of total war coincided with the century of central banking? (Paul, 2009). The gold standard broke down during World War I (barring people from converting their banknotes into gold, until the gold standard was again briefly reinstated from 1925 to 1933).
“In 1933, President Franklin D. Roosevelt nationalized gold owned by private [US] citizens and abrogated contracts in which payment was specified in gold. Between 1946 and 1971, countries operated under the Bretton Woods system. Under this further modification of the gold standard, most countries settled their international balances in U.S. dollars, but the U.S. government promised to redeem other central banks’ holdings of dollars for gold at a fixed rate of thirty-five dollars per ounce. Persistent U.S. balance-of-payments deficits steadily reduced U.S. gold reserves, however, reducing confidence in the ability of the United States to redeem its currency in gold,?” in effect threatening to trigger an international bank run. “Finally, on August 15, 1971, President Richard M. Nixon announced that the United States would no longer redeem currency for gold,? thus robbing the entire world of their reserves. “This was the final step in abandoning the [modern] gold standard? (Bordo, 2002).
In other words, from the start of the gold standard, the amount of gold in which the standard unit of account represented was constantly scaled down (debased), just as it had always been in similar systems before. In 1971, the central bank notes became “unbacked? by any commodity whatsoever and now only had value because the State said so. Crucially, what actually happened was a theft of the underlying gold.
The banknotes thus became what is known as fiat money. Fiat money (all of the world’s current official currencies, including EUR, USD, GBP, CHF, JPY, CNY, BRL, RUB, INR, etc.) is not linked to commodities in any way. It is paper, base metal coins, and digital entries in a computer system. The only thing supporting it is the propaganda, the coercive apparatus of the State, and the rampant economic illiteracy of the general public.
Now, States were no longer constricted by any limitation due to an underlying backing in gold or other commodities. Gold no longer enforced discipline on politicians and States could start printing money as they saw fit, for all intents and purposes in unlimited amounts. Interest rates (the price of money) were then no longer determined by the markets, but dictated by the State as it sees fit.
In essence, the underlying “commodity? of a national fiat currency became the coercively subjugated current and future population which it supposedly represents.
So, if there is no commodity (except human slave labor and coercive State control) backing today’s fiat currencies, how do central (national) banks create them? There is much to be said for the sentiment that “it is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning?.
The mechanic is so simple that it is hard to believe, and yet, it is what it is.
As we have seen throughout this book, the State is in constant need of currency to make up for its corruption and wasteful inefficiencies. In order to cover its continuous shortfalls, the State gives out “bonds,?” financial instruments which are basically debt certificates. When you buy a bond, you pay for example 100 Units for it. In return, the bond originator promises to pay you back the 100 Units in a few years’ time, plus interest at specified intervals in between. When the State emits bonds, they get bought by the banks (who are at present all coercively tied into the national bank systems of the countries in which they operate). The bond is a liability for the State (as it represents a debt), but for the bank, it is an asset (as it represents a claim). In order to get fiat currency themselves, the banks in turn “sell,?” these bonds to the national (central) reserve banks, in return for fiat currency (in the form of cash banknotes, or today in the form of digital figures on a reserve account).
But how does the national central bank get the fiat currency to buy those bonds and bring the fiat currency into circulation? Consider the following words from an instructional booklet published by the US national bank, the Federal Reserve, aptly titled “Putting It Simply?: “when you or I write a check there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn. When the Federal Reserve writes a check, it is creating money? (FRBB, 1984).
The above paragraph is worth rereading for good measure. The central banks indeed create “money? ex nihilo.
When a central bank buys a bond, it puts the bond on its balance sheet as an asset, just like the regular banks did when they first acquired bonds from the State. On the liability side of its balance sheet, the central bank simply puts “reserves,?” of the banks from which it “purchased,?” the bonds. The banks in return get “reserves,?” (fiat currency) on their asset side, which in turn allows them to create multiple times more money through fractional reserve banking as we have seen earlier.
This has some direct implications (and many more indirect ones, as we will soon discover).
Firstly, the creation of fiat currency (i.e. without any commodity backing) is basically nothing more than an accounting entry by a central bank.
Secondly, we come to see that today, in the global system of fiat currencies, all money is debt, and debt is money – with human beings and their labor as collateral, held accountable for debts which they did not themselves agree to, to be extracted of their wealth at gunpoint through every imaginable kind of taxation guaranteed by the coercive apparatus of the State.
Thirdly, the fiat currency system is inherently unstable as more bonds will have to be created to pay the interest on the previous ones, and so on. At some point, only hyperinflation or debt default can follow, and as history shows, it is usually a combination of both. But by the time that happens, the fiat currency has been used by the parasitic classes of the State and its beneficiaries to rob others of their savings and their assets.
Which brings us to our fourth point:
When fiat currency is created, it robs every citizen (who is coercively forced to use the fiat currency in his daily transactions) of some of his or her savings and purchasing power.
Take the following example: Assume that there exists a market with only one egg which is for sale and only one unit of currency, which can be used to buy the egg (the currency would have no other uses as there are no other goods or services in this hypothetical situation). When the State (through issuing bonds – debt with the citizenry as collateral – directly or indirectly to its central bank) or the “private,?” banks of today (through fractional reserve banking) create currency out of nothing, an additional unit of currency is created and added into the system. However, this does not mean that there are now all of a sudden two eggs available for sale (compare this to a commodity-backed currency, where a banknote – or a gold or silver coin, etc. – represents a physical commodity of value). The result, in effect, is that there are now two units of fiat currency in existence, but still only one egg. In other words, all that happened is that the price of the egg simply doubled to two units of currency. This is what is called inflation.
But, and this is crucial, when we expand this situation to the whole of available goods and services, it is very hard (nigh impossible) for the population to estimate how much fiat currency is being created by central banks and by the State-sanctioned fractional reserve banking. As a result, those who are aware of the currency creation (and are the first to get their hands on it), namely the State, the banks and their accomplices, can buy goods and services at pre-inflation prices with this new fiat currency which was all of a sudden created out of nothing. Other people are not aware of the fact that the price of the egg just doubled (neither is the seller, and neither is the person who saved one unit of currency to be able to buy an egg when he pleases). As a result, all participants get tricked and robbed at the expense of the State and the banks. The sellers sell for less than the adjusted prices which will result after the sale, and the savers are robbed of their purchasing power just the same.
Through the system of buying and selling bonds, the central banks, at the direction of the State, can affect the price of these bonds (as they have unlimited funds to do so, at least as long as the public accepts the fiat currency as having value because the State says so). The price of the bond correlates with the interest it yields in comparison with the interest rates of new bonds being created. By buying and selling new and existing bonds, their interest rates (which serve as a basis for all interest rates across the system, being officially – though of course not really – “risk-free,?” due to State backing) can be manipulated by the central banks.
This brings us to the final part of this Chapter, where all of the above comes together to shed a light on one of the most destructive forces of the modern world, created by the Statist system of fiat currencies and fractional reserve banking: the “business cycle,?” (though, as we will see, actual “business,?” in a free market sense has nothing to do with it whatsoever).
What do you think about Christophe Cieters editorial called “Monopoly Money?” Let us know what you think about this subject in the comments section below.