Fractional money is born

Receipt money made trading with others easier than ever. It was light, easily divisible, didn't need food or water, never went bad, and was backed 100% by a commodity preferred by all. As a result of its use, communities flourished and individuals prospered. But just as so many before them, the goldsmiths could not resist their temptation to corrupt the money supply in pursuit of illegitimate profits.

As noted, it was very rare for individuals to cash in their receipts and withdraw actual coins. The goldsmiths realized at any given time 90% or more of all coin deposits were left untouched. This sparked an idea. Why leave all that gold gathering dust in the vault when instead it could be loaned out (at interest) to earn a profit?

Where once the goldsmith was limited to loaning out what belonged to him (a tiny amount of what was held in the vault), he now could earn 10 times as much, or more, loaning out what belonged to others. It would be a profitable little secret known only to him and others in his trade.

This of course was pure fraud. Every coin in the vault had an equivalent receipt, which was held by the coin's rightful owner.

Those who had accepted these receipts in exchange for their coin deposits and those in the community who accepted these receipts as payment for their products and services believed them to be no different than receiving the actual coins themselves.

Instead, unbeknownst to the receipt holders, the receipts they held were now only backed by a fraction of the value stamped on their face. What began as receipt money had now evolved into a new form; it was now "fractional money."

To easily understand the problem, imagine I ask you to sell me a one-ounce gold coin. To purchase the coin, I pay you with receipt money equal in value to the coin itself. (The receipt represents one ounce of gold sitting safely in the goldsmith's vault — or so you think.)

In reality, what I've given you is a receipt that is only partially backed by gold, no different than if I traded you half of a coin for a whole coin. Would you knowingly agree to such a "deal"? Would you ever trade half a coin for a whole coin? Of course not.

But you would agree to the deal if you didn't know any better, and that was the problem. Nobody knew the coins (supposedly backing each receipt 100%) were being loaned to others. And when the people finally did discover their coins were being loaned (without their permission), they still didn't comprehend the seriousness of the problem. Sure, they were outraged, but not because they understood the dangers or inherent fraud of fractional money; no, they were upset because the goldsmiths were getting rich loaning out their coins!

Well, making tons of money had never been so easy for the goldsmiths; the last thing they wanted was to see it end. So, to calm their depositors (and continue earning big bucks loaning coins that didn't belong to them), they made the following offer:

Depositors could now store all their coins in the vault free of charge, and (as if that generous offer weren't enough) depositors would also be paid a percentage of the value of the coins they kept in storage! (Let's say 5%.)

This was a very clever solution. Not only would tons of gold start flowing into the goldsmith's vault; but it was even less likely that depositors would ever withdraw any of their coins because to do so would only reduce their own earnings.

The average citizen's view was a little less sophisticated than that of the goldsmith. They were certain they'd hammered out a great deal. (1) They'd get to continue using their convenient paper/ receipt money; (2) they'd no longer have to pay a storage fee for their coins; and (3) they'd earn some extra money on the side. The goldsmith, all of a sudden, wasn't such a bad guy after all.

While it's true the people had solved the problem of the goldsmith earning all of the money on their coin deposits, two bigger problems had not been solved: the inflation of the money supply and the threat that posed to their wealth. Nor were either of these two problems understood by the general public. Let's briefly cover them both.

Inflation

Assume a depositor places $1,000 worth of gold coins in the goldsmith's vault and, in exchange, receives $1,000 worth of paper receipts. The community's money supply will not change as a result of this transaction. ($1,000 in gold coins are removed from the economy, and $1,000 in paper receipts are added. And if the receipt holder returns to withdraw his gold coins, he must surrender $1,000 worth of paper receipts in exchange for the gold. Any way you slice it, there will be either $1,000 in gold coins circulating or $1,000 in receipts, not both.)

However, under the fractional money system, something different happens. Our depositor still comes in with $1,000 in gold coins, and he still receives $1,000 in receipts. No problem there. But an hour later, another man comes in. He doesn't want to make a deposit; he wants to borrow $1,000.

The goldsmith agrees to the loan and issues the borrower $1,000 worth of new receipts. In our first example, the money supply did not change, but in this example, the money supply has doubled. (There is now $2,000 worth of receipts circulating in the economy, backed by only $1,000 worth of gold coins in the vault.)

Threat to depositor's wealth

Aside from the inflation, there is also another big problem. Say the borrower takes his newly printed $1,000 worth of receipts and spends them at a local store. And say the store owner decides he'd rather have the actual gold coins instead of the paper. No problem there. The store owner can take the receipts to the goldsmith, cash them in for $1,000 worth of gold coins, and be on his way.

But what happens if an hour later the man who made the original gold deposit shows up to withdraw his coins? Let's say he decided he'd rather just store his gold himself. Too bad for him; his gold walked out the door an hour earlier.

This is a highly simplified example, but it illustrates what happens when a banker/goldsmith makes more promises to pay on demand than he can honor. The banker/goldsmith cannot produce the coins, he is bankrupt, and he takes the depositor down with him.

Now in the simplified example above, the goldsmith got into trouble by pushing his reserves down to 50%. (The goldsmith held $1,000 in coins to "back" the $2,000 in receipts he issued. That puts the fraction of reserves at 50 %.) However, it's very unlikely he'd ever get into trouble at that level.

In reality, there are hundreds or thousands of depositors and the vast majority of them are happy to leave their coins in the vault earning interest. Additionally, those who receive the receipts in commerce aren't likely to come in and request coins because the paper receipts are much more convenient to carry and use.

The goldsmith knows this. He's seen firsthand that customer demand for actual coins is very low. So, the goldsmith/banker inevitably pushes the reserves down more and more, always walking closer to the edge of insolvency. Why? Because every time he "creates more receipts" and loans them out, he earns more interest.

Returning to our simplified example, consider the following: A man deposits $1,000 in coins with the goldsmith and receives $1,000 in receipts. In addition, the goldsmith has agreed to pay the man a percentage of the value of his deposit. We'll assume that percentage is 5% per year.

To earn the money to pay this 5%, the goldsmith prints up an extra $1,000 in receipts and loans them out at, say, 8% interest. That leaves the goldsmith a profit of 3% on money he created out of nothing. (The goldsmith earns 8% on the newly created receipts; he pays the original depositor 5%, and that leaves a 3% profit.)

But in this example, the goldsmith has only doubled the money supply. He still has 50% reserves, and that is far more than he needs, so the game continues. What if he quadruples the money supply? Instead of earning just 3% per year on the original $1,000 deposit, the goldsmith's profits soar to 19%! That is over six times as much profit as he earned originally, and he is still only down to a 25% reserve ratio.

Here is the math: Instead of creating a single $1,000 loan, this time the goldsmith creates a total of three $1,000 loans. Add the original $1,000 worth of receipts (issued to the depositor) to the $3,000 worth of receipts loaned to borrowers, and you get $4,000 in total receipts backed by only $1,000 worth of coins. (That puts the reserve ratio at 25%.)

As in our first example, the first $1,000 loan only produces a profit of 3% for the goldsmith (8% minus 5% paid to the depositor.) However, each of the next two loans generates a full 8% for the goldsmith. So, 3% profit on the first loan, plus 16% total on the next two loans means the goldsmith earns 19% on money he created out of nothing.

But the goldsmith still has far more reserves than he feels he needs. From what he can tell, he thinks he can push his reserves down to 10% and still be OK. So, he decides to expand the money supply some more, a lot more.

If he multiplies the money supply by eight times, he still will have reserves of 12.5%, and his profits will soar to 51%![1] Sure, the money supply is being diluted, inflation is wreaking its havoc, and the depositors are blissfully unaware how close they are to losing everything, but the goldsmith is literally making money by simply creating it out of thin air! Who would want to interrupt something as marvelous as that?

If the goldsmith charges more for his loans, things get even more exciting. Even a small increase in the loan rate increases profits significantly. For instance, with his reserves at 12.5% and loaning at 8%, he earns more than a 50% annual profit on every $1,000 of his depositor's money. But if he loans at an interest rate of 10%, he earns more than 60%! And at 15%, he earns nearly 100%! At that rate, for every $1 million he attracts in deposits, he can earn nearly $1 million for himself!

But wait, maybe he can inflate the money supply even more. Maybe he can get by with driving reserves down to only 6.25%, more than doubling his profits yet again. ... Maybe 3%; maybe even 1%!

The game is intoxicating, and it always leads to disaster for depositors. Inevitably, the scam collapses when people realize the receipts they're holding are only worth a small fraction of what is printed on them. A one-ounce gold receipt might only be backed by a tenth of an ounce of gold (or less). When the truth is discovered, a run on the bank ensues, and only the first few in line are able to withdraw gold. All the rest, the vast majority, are left holding worthless paper.

One would think, after witnessing the aforementioned disaster unfold repeatedly, that bankers would realize the error of their inflationary ways. One would think they'd devise an honest monetary system, a system that permits them to earn legitimate profits without exploiting (if not completely ruining) the people who depend on it. One would think.

Instead, they set out to devise a sort of "banker's utopia," where they could expand their fraud, operate with zero reserves of gold and silver, and shift any losses they might incur on to others. And that brings us to the final form of money we'll be discussing in this chapter: fiat money.

Once the idea of fractional money is accepted, the fraction is inevitably pushed down to zero, at which point the money becomes nothing more than pure fiat. Fiat money is money backed by absolutely nothing. It's the equivalent of the wooden coins mentioned earlier -- centralized, easily created, inherently worthless. And because fiat money is inherently worthless, the people must be forced to accept it via legal tender laws.

Fiat money

The American Heritage Dictionary defines fiat money as "paper money decreed legal tender, not backed by gold or silver." The two characteristics of fiat money, therefore, are (1) it does not represent anything of intrinsic value and (2) it is decreed legal tender. Legal tender simply means that there is a law requiring everyone to accept the currency in commerce. ... [W]hen governments issue fiat money, they always declare it to be legal tender under pain of fine or imprisonment. The only way a government can exchange its worthless paper money for tangible goods and services is to give its citizens no choice.[2]

The first recorded appearance of fiat money was in thirteenth century China, but its use on a major scale did not occur until colonial America. The experience was disastrous, leading to massive inflation, unemployment, loss of property, and political unrest.[3]

The first paragraph above provides a good definition of fiat money: not backed by gold or silver, issued by (or for the benefit of) a centralized government, and decreed legal tender. That's pretty easy to understand, so let's expand on the second paragraph: the track record of fiat money in colonial America.

Fiat money first appeared in Massachusetts following a failed military campaign against Quebec in 1690. Previous expeditions had been successful, but this time Massachusetts had seized nothing of value and, as such, could not pay her troops.

Raising taxes would have been very unpopular, a risky proposition. However, ignoring the obligation to pay her troops what they'd been promised was even riskier.

Desperate to discharge her debt, the government of Massachusetts decided to simply print the money. Other colonies watched in amazement, and before long, they too were enjoying the magic of printing their own cash (and the citizens enjoyed the consequences).

As the printing presses inflated the money supply, legal tender laws were instituted to ensure that citizens accepted the worthless paper. Predictably, gold and silver coins disappeared from circulation in the colonies. (Why pay with real money when all you could expect was fiat paper in return?)

The only time gold and silver coins were spent was with foreigners who demanded real money as payment for their products and services. This steadily drained the colonies' total supply of gold and silver. As the supply of gold and silver dwindled, international trade nearly ceased. (Foreigners had no interest in trading their products for fiat paper; who could blame them?)

As the inevitable problems of an inflationary fiat money system began to surface, the colonial governments took steps to "fix" the problems. In 1703, South Carolina threatened citizens who refused its paper with fines "double the value of the bills so refused." That didn't work, so in 1716, it increased fines to "treble the value."

Some colonies began printing new money to soak up some of the old. For instance, in 1737, Massachusetts traded its citizens $1 of new fiat money for $3 worth of their old money, with the added promise the new money would be fully redeemable in gold or silver in five years. (A promise that wasn't kept.)

By the late 1750s, Connecticut had prices inflated by 800%. The Carolinas had inflated 900%. Massachusetts 1000%. Rhode Island 2300%. Naturally, these inflations all had to come to an end, and when they did, they turned into equally massive deflations and depressions. It has been shown that, even in colonial times, the classic booms and busts which modern economists are fond of blaming on an "unbridled free market" actually were direct manifestations of the expansion and contraction of fiat money which no longer was governed by the laws of supply and demand.[4]

This downward spiral was temporarily brought to a halt by, of all things, British intervention. The Bank of England, using its influence with the Crown, sought to force the American Colonies to use its paper money.

The Bank got its way in 1751 when the British Parliament began putting heavy pressure on the colonies to withdraw their currency from circulation. The pressure was increased until, in 1764, the British Parliament passed the Currency Act, which made it illegal for the colonies to issue paper currency in any form.

Despite major opposition, the Currency Act actually ended up working to the benefit of the colonies. Rather than accept Bank of England money as a primary medium of exchange, the colonists simply returned to a true commodity-based monetary system. The remaining gold and silver coins began to circulate again, and other commodities, like tobacco, also served as money. Returning to an honest money system produced immediate results.

Trade and production rose dramatically, and this, in turn, attracted an inflow of gold and silver coin from around the world, filling the void that had been created by years of worthless paper. ... After the colonies had returned to coin, prices quickly found their natural equilibrium and then stayed at that point[.][5]

Unfortunately, the recovery was short-lived.

The colonies declare their independence -- fiat money returns

Wars are very expensive and it's rare for them to be fought using existing government funds. The American War for Independence was no exception. Faced with a shortage of money, the leaders of the revolution had the usual options available to finance the war:

• They could look to borrow the funds, but that would put them at the mercy of their lenders. Even if the colonies were heavily favored to win their battle against Great Britain, there would be limits to how much lenders could produce or would be willing to risk. And, up against the most dominant military in the world, the colonies were anything but "heavily favored to win."
• They could try to raise the money via taxation, but (as is often the case) taxes sufficient to fully fund the war would have been severe. Support for this approach would have been very difficult to sustain.
• Finally, there was the path of least resistance, the printing press. Arguably, this approach ends up costing the most, but as G. Edward Griffin explains:

By artificially increasing the money supply ... the real cost is hidden from view. It is still paid, of course, but through inflation, a process that few people understand.[6]

Between 1775 and 1779, the central government expanded the total money supply from just $12 million to a whopping $425 million. That's an increase of more than 3,500%. In addition, the individual states were busy doing the same thing. It's been estimated, in just five years, the total expansion reached 5,000%.

The first exhilarating effect of this flood of new money was the flush of apparent prosperity, but that was quickly followed by inflation as the self-destruct mechanism began to operate. In 1775, paper Continentals were traded for one dollar in gold. In 1777, they were exchanged for twenty-five cents. By 1779, just four years from their issue, they were worth less than a penny. ... It was in that year George Washington wrote, "A wagon load of money will scarcely purchase a wagon load of provisions."[7]

Fiat money might provide instant purchasing power for those who create it, but it does so at the expense of those who are forced to use it. Every dollar worth of products and services it buys is extracted from the citizens via the hidden tax of inflation. As stated in Chapter 1, it makes little difference whether the government takes $3,000 worth of your purchasing power by direct taxation or takes $3,000 of your purchasing power through an inflationary policy; the effect on your wealth is the same. You're $3,000 weaker in either case.

That said, there are many aspects that make inflation a far more insidious tax:

• Those on fixed incomes or who have actually saved their money are hit the hardest.
• Whereas normal taxation cannot be hidden from the people (placing firm limits on its use), inflation allows purchasing power to be confiscated secretly. Like theft, there isn't even the illusion of an agreement between those who are taking the money and those who are surrendering it. Purchasing power taken from citizens in this fashion is abusive in and of itself. That so few understand the process only makes it easier for the abusers.
• So long as the citizens are forced to use the fiat currency, there is nothing they can do to stop the confiscation of their money. Ten thousand dollars under the mattress today might only retain $5,000 in actual purchasing power next month. (Consider the case of the Continentals. At the end of four years, what began as $10,000 worth of purchasing power deteriorated to only $100! That's like looking under your mattress to discover somebody took $9,900 of what you had saved.)

The massive inflation caused economic chaos, and that was soon followed by attempts to fix the problems. (Sound familiar?) As prices went through the roof ($5,000 for a pair of shoes, $1 million for a suit of clothes, etc.), the colonies instituted wage and price controls. When that wasn't enough, severe legal tender laws were enacted to further encourage people to be good patriots. According to this law, refusing the worthless currency was tantamount to treason:

If any person shall hereafter be so lost to all virtue and regard for his Country as to refuse to receive said bills in payment...he shall be deemed, published, and treated as an enemy in this Country and precluded from all trade or intercourse with the inhabitants of these colonies.[8]

And as night follows day, the chaos of inflation was followed by the chaos of deflation. As the bubble burst, unemployment, bankruptcies, foreclosures, even riots and insurrection, appeared in its wake. The full costs would finally be counted.

Prices fell drastically, which was wonderful for those who were buying. But, for the merchants who were selling or the farmers who had borrowed heavily to acquire property at inflated wartime prices, it was a disaster.

The new, lower prices were not adequate to sustain their fixed, inflated mortgages, and many hard-working families were ruined[.] ... Idleness and economic depression also led to outbursts of rebellion and insurrection. George Washington wrote: "If ... any person had told me that there would have been such formidable rebellion as exists, I would have thought him... a fit subject for a madhouse."[9]

When our founding fathers drafted our Constitution, the pain and suffering of fiat money was still fresh in their minds. They firmly resolved to rid our nation of it once and for all.

As a result, the United States of America became the most powerful economic force the world had ever seen.

But the wisdom of our nation's founders was lost with the passage of time, allowing those who benefit from fractional reserve and/ or purely fiat money systems to steal their way back into power. In the next chapter, we'll delve deeper into the "unbroken record of fraud, booms, busts, and economic chaos"[10] of their dishonest money.