What gives money value, and is fractional-reserve banking fraud?

Falling 100-dollar bills

Image by Idea go

I thought I should address a couple of points that I consider to be misconceptions and that frequently come up in discussions with the audience or other speakers when I present my views on the fundamental problems with fiat money. I am not always in a position to correct these misconceptions right then. They are often woven into questions on other points and I have to leave them uncommented as not to disrupt the flow of the debate. My book is, I believe, quite clear on these points, so I could simply refer people to Paper Money Collapse. But, for whatever reason, it is still the case that many in my audience make inferences from similar arguments to my arguments, and I fear that some of the differences between these positions might get overlooked. These differences are not unimportant, and I think it is worthwhile to highlight and clarify them.

The first point is related to the question what gives money its value? The second point is, is fractional-reserve banking fraudulent and should it be banned on the basis of property rights?

Let’s first restate the central premise of Paper Money Collapse. The main message is that today’s mainstream views on money are flawed. The most important difference between commodity money, such as a proper gold standard, and ‘paper money’, such as our present fiat money system, is the elasticity of the money supply. In the former, money is essentially inelastic, in the latter it is perfectly elastic. The present consensus holds that elasticity is a big advantage. It makes fiat money, if managed properly, superior as it allows monetary authorities to stabilize the economy. This position provides the intellectual foundation for our present fiat money arrangements. My argument is that this is false, and that the opposite is true, and that this was already understood and explained some time ago by eminent economists: the elasticity of the money supply in a fiat money system, and the constant expansion of the money supply under present arrangements in particular, systematically distorts relative prices, disorients economic actors and destabilizes the economy over time. Imbalances accumulate, which obstruct further growth and which will be countered with accelerated money injections, destabilizing the economy further. Elastic money is unnecessary, suboptimal, unstable, and ultimately unsustainable.

Book cover for Paper money CollapseIt is clear that my analysis rehabilitates the gold standard. It was not only unnecessary to abandon the gold standard it was a major mistake. It is also immediately clear that I consider fractional-reserve banking an inherently destabilizing force in the economy. Even when money was essentially gold and the supply of money proper inelastic, fractional-reserve banks managed to circulate fiduciary media, that is, claims on gold that are supposed to be redeemable in gold but are not fully backed by gold. To the extent that the public used these fiduciary media the same way it used money proper (gold), the supply of what was used as money in the economy expanded and an element of elasticity was introduced into the overall money supply, even under a gold standard. Fractional-reserve banking makes money elastic, expands the money supply -within limits, so therefore only to a degree – and causes economic dislocations. Most mainstream economists today do not even consider these distortions as they work under the entirely untenable assumption that constant money injections are harmless as long as inflation stays within tolerable ranges.

Now let me address the misconceptions on these two points that often appear to enter the debate. Some critics of fiat money and advocates of the gold standard express the following sentiments, which I consider to be unfounded and which are very different from my position: “How could we even have come to accept pieces of paper that are not backed by anything of value as money? Money has always been backed by tangible assets and it should again be backed by something tangible. Gold and silver have intrinsic value but paper money has an intrinsic value of zero. The public gets fooled into accepting these pieces of paper as money. If it realized how money was created and that it was not backed by anything, the public would dump it. Only gold (or silver) can ever be money.”

Those views are not always expressed this bluntly but a trace of them is often apparent in discussions about the failure of paper money, and because they point in the same direction as my arguments – toward the abolishment of state fiat money and a return to hard money, most probably gold – they are still not my views. In fact, I consider them to be wrong. They include fundamental misconceptions about money.

Who or what bestows value on money?

Do the paper tickets in your wallet have value? Of course, they do. They are valuable.

Why are they valuable? For one reason and one reason only: Because others in society accept these paper tickets as a medium of exchange. They accept them in exchange for goods and services in the knowledge that they can trade them again for goods and services from others.

This social convention – and only this social convention – makes these paper tickets money and thus bestows value on them. That is why paper money is money and that is why you act quite rationally when you hold some of your wealth in the form of these paper tickets (how much of your wealth is a different question) and when you use them as a medium of exchange.

Most money today is not even paper money but immaterial money. It only exists as bits on a computer hard-drive. Do these bits have value? Of course, they do. As long as others in society accept them in exchange for goods and services, as long as others accept them as money, they are money. They have exchange value. They are immaterial and of no use whatsoever, other than as a medium of exchange for as long as people accept them as a medium of exchange, which – on a purely conceptual level – might be forever.

Who bestows value on these paper tickets or bits on the computer hard-drive? The trading public does. And who determines how valuable these forms of money are? The trading public does. And who can remove the value from these paper tickets or this virtual money? The trading public.

Now consider a proper gold standard. All money is gold. Who determines the exchange value of each gold coin? You got it: the trading public does. Gold also has value as an industrial commodity or as an item of jewellery (in contrast to paper tickets and binary digits) but this value – its non-monetary value – only really played a role when gold made the transition from industrial commodity to monetary commodity, when it was first used as money. At that point its previous use-value as a commodity became the reference point for its first ever use as money. Once gold had become widely used as a medium of exchange or as a monetary asset, however, it was the public’s demand for such a monetary asset – the public’s demand for money – that determined gold’s exchange value. From that moment on – and this moment occurred a few thousand years ago – it was demand for gold as a form of money that determined its price, not its residual use as an industrial commodity, which at this point only retained secondary importance.

We conclude that the only thing that makes any substance or non-substance money and that bestows an exchange value on this substance or non-substance is the use of it as a medium of exchange, a facilitator of trade, by the trading public. Once something has become money – and in order to be money it has to be widely accepted as money – its physical properties, or even the absence of any physical properties, are entirely unimportant. They are, for lack of a better word, ‘immaterial’. Money only has exchange-value and no direct use-value. For its use as money and for determining its exchange value as money (its purchasing power in trade) it does not matter one bit what other use-value, if any, the monetary asset may have. One paper dollar has the specific exchange value it has today not because of any other use-value it has – because it evidently has none other than being a medium of exchange – but simply by its exchange value in trade. The same is true of gold. An ounce of gold has the value it has today because of the specific demand for it as a monetary asset. It would retain its monetary value even if, by some act of magic, it lost overnight all its use-value as an industrial commodity or an item of jewellery. Would this affect gold’s price and lead to a one-off adjustment in the gold price? Probably. But it would not make gold worthless. I am even fairly confident, although nobody can be certain, that the drop in price would be relatively small.

Buffett & Obama

Servants of the state (Photo by Pete Souza)

The whole doltishness of Warren Buffett’s tiresome refrain that people are stupid to buy and hold gold as it doesn’t produce anything and, by the way, if you put all gold on one big heap what could you do with it, hehehe, now becomes apparent. The man may be able to read balance sheets and income statements. He evidently does not understand monetary economics. — What good would it do us if we piled all paper money in one big heap? Maybe we could have a nice fire. And all those immaterial money units that the Fed and the banks create on their computers – you cannot even put them into any pile, Mr. Buffett. Yet, all these things have value and it is quite reasonable to hold some of your wealth in the form of these ‘things’.

Mr. Buffett, statist that he is, does not object to you holding any of your wealth in state-issued paper dollars or in immaterial deposit money at Bank of America, in which he – increasingly a supporter of big business, the establishment and the status quo – has a stake. Just you holding gold, that bothers him.

Why gold is coming back

The reason why more and more people begin to prefer holding physical gold rather than paper money or electronic ledger money at shaky banks is not – at least not first and foremost – because of the physical properties of gold versus those of these other monies. The reason is that more and more people expect, correctly in my view, that the trading public, which always is the entity that bestows exchange value on or removes exchange value from any form of money, will bestow ever less value on paper money and electronic money going forward. Why? Because these forms of money are being produced in ever larger quantities for political reasons. Not their physical properties, or lack thereof, are the central problem with paper money and present forms of electronic money but the complete elasticity of their supply in present monetary arrangements. More specifically, the central problem today is that the massive over-issuance of these types of money over recent decades has created substantial imbalances that now cause considerable headaches for the banks and the various governments and that will most certainly result in ever more paper and electronic money being produced to fend off the painful dissolution of these imbalances.

1 kilo gold bar

International, inelastic, apolitical, lasting. (photo by Swiss Banker)

If the central problem with fiat money were its physical characteristics than we would not have to know anything about economics or about the specific process of paper money creation and its impact on the economy in order to pass a negative judgement on this form of money. But I do not think that this is possible. That today’s money consists of otherwise worthless pieces of paper or of immaterial electronic book entries is not the problem. What matters is the process of money creation and the impact on the economy. Once we have understood this process it is clear that the elasticity of the money supply is at the core of the problem and that we have now reached a point at which the further and accelerated production of these forms of money is almost a certainty. And that is why investing in gold makes sense, as gold is the oldest, most widely established form of money – the one with the most universal and longstanding social convention backing it – and as its supply is both inelastic and by its nature fundamentally outside the politicized process of modern fiat money creation.

Sometimes people tell me that they hesitate to buy gold as its value rests merely on others considering it valuable. What if we woke up tomorrow and people no longer considered this metal a monetary asset and thus especially valuable? This is a fair point but it applies logically to any form of money. The value of the paper money in your wallet and the electronic money in your bank account equally rests on the public continuing to accept them as money. Any form of money is only money through the acceptance of the trading public. There is no other potential source that its value could be derived from.

It is important to stress that the government does not and cannot bestow value on its paper money. This seems to be a widespread myth, as evidenced by this quote from, Philip Coggan’s recent book Paper Promises (p. 37):

“If people think that the value of something is equal to the cost of creating it, which in the case of paper and electronic money is virtually zero, then why do we accept it at all? We know there is no longer enough gold or silver to support it. The answer must be that we have faith in the government that stands behind it. The government can raise the taxes necessary to give the currency value.”

This is evidently wrong. The government does not support or back its paper money with anything. It is irredeemable money. You can take your state paper money notes to the state central bank but all you will get in exchange for them is new, freshly printed paper notes with the same numbers printed on them. The paper money in circulation does not constitute a claim on any assets that the government may possess or any reserve that the central bank may hold or any taxes that the government may collect. It is not a claim on the state at all. It is, in fact, a claim on nobody. Therefore, it is not debt. Today’s banknotes are, just like gold, assets that are nobody’s liability (in contrast to the electronic deposit money that is a liability of the specific bank that issued it and that will in fact disappear when the bank disappears). But this means the government does not guarantee money’s purchasing power. If these pieces of paper money retain any purchasing power at all it is because the trading public continues to use them as money.

In the debates on the present Greek crisis one often gets the perception that paper money would collapse if the states went bankrupt. This is completely unfounded. Sovereign default is only a threat to paper money – and a serious threat at that – because states, even when they are defaulting, retain the monopoly of paper money creation and when they are about to go bankrupt they tend to issue ever more money to sustain their spending and to appear solvent. The threat to money’s purchasing power thus comes again from the risk of over-issuance, and is again linked to the elasticity of the money supply, and not the creditworthiness of the state. If the ECB stopped printing euros, many European states would soon run out of money and default, and so would many banks, but that would not diminish the euro’s value as money, as a medium of exchange among the eurozone’s trading public, at least not that of the paper euros in circulation or the electronic euros in surviving banks. If the trading public could be confident that the market would not be swamped with paper euros in order to bail out overstretched eurozone banks and governments, there would be no reason to stop using this currency. Note that in a proper gold standard, the state would merely be a money-user, just like any household or company, and would have to manage its own finances sensibly, and if it didn’t do so, it would default on its obligations, yet nobody would stop using gold as money in response.

So, yes, the public may suddenly, one morning, decide to no longer consider gold money but I would suggest that the risk of the public no longer considering state paper money money is considerably bigger. And again, the reason is not the different physical composition but the fact that paper money is issued by the state for a reason, namely to facilitate the availability of credit beyond the availability of true, voluntary savings, and as this has now led to economic distortions of surreal magnitude, the political owners of the paper money franchise will print ever more of it. Gold is being remonetised by the public – always the ultimate arbiter of what is money and what is money’s purchasing power – because gold not only has a longer history of being money than any of the present paper monies, a history that spans all civilizations and the entire globe, it is also apolitical money, not issued by any central authority and, this is the most important aspect, with its supply essentially inelastic.

You may not wake up tomorrow to a world in which paper money is worthless but you most certainly wake up to a world in which more state paper money circulates but probably not more gold.

Elasticity and materiality

But is the elasticity of the money supply not intimately linked to the physical characteristics of the monetary substance? To say money is paper or a binary digit, is that not the same as to say money’s supply is fully elastic? Not quite, for we can imagine an immaterial form of money with a fixed supply, at least we can imagine such a thing since Satoshi Nakamoto invented Bitcoin. Bitcoin is immaterial — it only exists as virtual money on the internet. But equally it is commodity money because it is based on a cryptographic algorithm, which requires time and considerable computing energy to create Bitcoins and which is designed so that the overall supply of Bitcoin is strictly limited. Bitcoin shares with today’s electronic money that represents items on bank balance sheets the feature of immateriality. But in every other aspect it is much closer to gold: Bitcoin’s supply is strictly limited and inelastic, just as is the case with gold. Bitcoin has no issuing authority that benefits from a money-creation monopoly. Neither has gold. Bitcoin is not linked to any sovereign state. Neither is gold. Bitcoin exists outside the state-sponsored fiat-money-addicted banking sector. So does gold.

Whether Bitcoin can ever compete with gold or potentially even replace it is a hotly debated topic. We do not have to discuss it here. The point was simply to show that the key problem with today’s monetary arrangements is their politically motivated elasticity and that this feature is fundamentally different from money’s materiality.

Fractional-reserve banking and fraud

We can now address the second point that frequently comes up when discussing the unsustainability of present fiat money arrangements and that is the question whether fractional-reserve banking (FRB) is fraudulent and whether it should be banned on grounds of private property violation.

Today pretty much all banks are fractional-reserve banks. They can create money – book-entry money or deposit money – on the basis of limited reserve-money (physical cash in their vaults and deposits held at the central bank). Thus, unlike fund managers, banks not only channel savings into investment, they are also in the business of money creation. Most of the registered money stock in modern economies is simply a book-entry on bank balance sheets.

To analyze the fundamentals of FRB it is best to go back to the early days of deposit-banking when money was still essentially gold because back then the distinction between ‘original’ money (gold) and the ‘derivative’ money created by the banks (banknotes for example) was more apparent. The story goes something like this: When somebody deposited gold with a bank he received a banknote in return and was promised that he could immediately reclaim his deposited gold upon presenting the banknote. Banknotes began to be used as payment in economic transactions and to circulate in the economy as money because it was obviously more convenient to use paper tickets to pay rather than heavy gold coins, and the recipient of the banknote could always reclaim the gold. As long as all banknotes were backed by physical gold the supply of money did not expand. This was still a 100 percent gold standard, and the banknotes were simply a new form of payment technology, a means to transfer ownership in money more conveniently.

This changed when the banks began to lend the deposited gold to third parties or, to make it easier, they kept the gold but issued more banknotes than they had gold in their vaults and lent these banknotes to third parties as part of their lending activities. Of course, they still promised to repay all notes in gold when presented to them. Banknotes that are not fully backed by gold are not money proper but fiduciary media, claims on money that are not fully backed by money. Now there was money proper and fiduciary media circulating in the economy side by side. The overall supply of what was used as a medium of exchange in the economy had expanded. The supply of money was extended through FRB.

Critics of FRB argue that this process involves a property rights violation. The original depositor retains ownership in the deposited gold but the bank issues multiple claims on the same amount of gold, and whoever presents the banknote first, probably even somebody who never deposited gold in the first place but who obtained the banknote as payment in a commercial transaction, has the gold delivered to him. This appears to be a logical and convincing argument but there is one problem with it: FRB has been conducted for about 300 years. Have depositors not realized by now that they are being defrauded? If this is indeed fraud, how can the practice survive for so long?

One response is that most people do not understand how FRB works and that the banks misrepresent it. I do not think this is a valid point. To my knowledge, no bank today pretends that deposited cash is simply locked up in the vault waiting to be collected by the depositor at a later stage. Everybody knows (or should know) that banks lend deposited money to third parties. How else would they obtain the income to pay interest on the deposited money? That banks pay interest on deposits (at least in ‘normal’ times) should already give the game away. Think about it: What would you say if you valet-parked your car and the young man taking the car keys from you would offer to pay you a fee for having control of the car for a few hours? Wouldn’t you be suspicious? Would you really think he would just park the car somewhere safe and he is paying you for the privilege of doing so? –If deposit banking were indeed just about safekeeping then the depositor should pay the bank for its safekeeping services, not the bank the depositor for getting control of the money.

I believe the correct answer is that the depositor knows what is going on but that he does not care about the deposited gold as such. This follows directly from our analysis above. Remember the depositor deposits gold that he considers money. He does not care that this is a tangible asset, that it is shiny and has certain other physical properties. He does not consider this gold to be an industrial commodity or a piece of jewellery. It is money – a medium of exchange. When he deposits it with the bank he receives a banknote that is  — equally a medium of exchange. The depositor has not given up anything. As long as the fiduciary medium he now possesses has the same purchasing power as the deposited gold – and this is the precondition for FRB to work – he has not foregone any economic benefit. The gold was a medium of exchange that provided him with limitless spending flexibility. The banknote he now holds in return for the deposited gold is equally a medium of exchange that provides him with limitless spending flexibility. In fact, the assumption of the banker that most depositors may never ask for their gold back is not absurd at all. As long as not too many banknotes get circulated, thus having their purchasing power meaningfully diluted, or as long as the issuing bank does not run into trouble, the banknotes may circulate forever. These are, of course, risks that the depositor shoulders but in compensation he receives interest on his deposited gold – which in fact the early goldsmiths paid as early as the late seventeenth century! – and he has the additional benefit of the convenience of paper tickets. The bottom-line is that the willing and knowing participation of the depositor in the FRB scheme is no riddle at all but may be a fully rational subjective choice.

I believe that the analysis of the anti-FRB economists rests too much on the analogy with other safekeeping contracts. When valet-parking my car, I hand over a valuable consumption good in return for a useless and pretty much valueless piece of paper. The benefit I receive from owning a car and the benefit I receive from holding a little paper ticket (well, there is no real benefit at all in the latter) are hardly comparable. That I may never reclaim my car and be content with holding that piece of paper forever is hardly a realistic assumption. But in the case of FRB it is. Exchanging money proper for fiduciary media means exchanging one medium of exchange for another medium of exchange.

Bank run in Germany in 1930

Bank run in Germany (Photo Bundesarchiv)

I am not arguing that FRB is fine. All I am saying is that it is entirely conceivable that depositors voluntarily and knowingly participate in it. The problem with FRB is not that the depositors get defrauded but that it introduces an element of elasticity into the money supply. Thereby FRB undermines itself. When the banking sector in aggregate manages to lower reserve ratios and expands the overall money supply via FRB, they inevitably start a credit boom, and we know that this boom will end in a bust. FRB leads to business cycles, as Austrian Business Cycle Theory has explained so well. And it is in the business cycle downturn that the FRB banks run into trouble and that the public begins to distinguish again between fiduciary media, which are bank liabilities, and money proper, which is nobody’s liability. Again, we are back at the point of elasticity, which is the real Achilles heel of our system.

This is already a pretty long blog — so I stop here. I will conclude by saying briefly what I think is the one thing that needs to be done: It is to get the state out of money and banking completely. No central bank, no lender of last resort, no inflation targets, no bank regulation, no deposit insurance, no government backstops. All these modern interventions are supposed to make banking safe but what they really do is make money more elastic as they greatly incentivize banks to lower their reserve ratios and extend the money supply. This makes the economy less stable and banks ultimately less safe. Much less safe. These state interventions are nothing but gigantic state subsidies for FRB. This is what needs to stop. The state should not (and in my view cannot) ban FRB. It should simply cease to subsidize it and to socialize its costs.

In the meantime, the debasement of paper money continues.



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The deflation delusion


  1. Jamie says

    There is an argument out there that you can pay your taxes with paper money, and that is what bestows its worth, not the public. The value of the paper money is always underpinned by the government requiring you to pay your taxes. However you cannot pay your taxes with gold.

    Therefore that is presumably what underpins why Warren Buffet would feel happier holding cash than gold. Gold could be worthless if everyone decided they didn’t want it – that cannot happen to paper money unless you think the government as we know it is about to crumble completely.

    • azazel says

      Throughout human history, gold has NEVER been worthless and yet on numerous occasions paper money has become worthless. Your comment is clearly foolish. Yes gold hypothetically may be worthless if everyone decided they didnt want it. The fact is people have always valued it so your point is, well, pointless.

      • David says

        In the case you’re discussing with the government accepting dollars as payment of taxes. Right now the markets are rigged to create demand for dollars by lawful demand….or in essence by force. Once the reserve status is gone, the largest source of demand for dollars is gone. At that point, there is the government’s acceptance for taxation and public trust. Once that trust is gone…you only have government taxation as the only source of demand. But if a barter system or a commodity-based system of exchange ensues, how can the government track the flow of goods through the economy and demand a percentage of the flow they can’t track in taxation? How can they tax what they can’t track?

        At this point, you and I accept dollars as payment for our work and time. There is no tangible, physical, or rational reason why anyone would trust a piece of paper with a picture on it over a metal that lasts and does not tarnish. At the point that I decide to accept pounds of meat or gallons of water or square feet of fabric for my time and work is the point that the government’s demand for the paper it issued to become worthless.

        • Jamie says

          We are not talking about only dollars though – this (i.e. value being bestowed by taxation requirements) applies for all paper currency and they do not all have reserve status, yet the “non-reserve” currencies have not collapsed.

          Besides, if we were talking about dollars, the largest source by far of demand is US citizens and companies wishing to save money in their own currency.

          And why would a barter based system ensue if taxation is bestowing value?

          • Stephen says

            Your argument has merit: the government has its guns pointing at its population and promises to do the same to future generations. So yes, the government using force to get people to accept its crappy money has a way of influencing whether people use it.

            However, as Detlev points out, even considering the violence that governments inflict on their populations, all paper money systems in history have failed. There were 29 hyperinflations in the 20th century alone. To say that it is more likely that people will stop valuing gold than they will stop valuing a paper currency is simply ridiculous.

    • says

      Hi!, Jammie Et Al:

      A fine electrical conducting wire can be drawn from one troy oz. of eithr gold or silver which is 50 miles long. As you know both metals are used in dentistry too, along with their varied uses as coins or in jewlery. Gold becoming worthless in this modern era can only be held as an unrealistic hypothesis. Let’s all take a deep breath & life goes on.


    • Neo1 says

      Return to real money.
      The real reason you pay an income tax, is for the privilege of using a private currency.
      Also known As A: Federal Reserve Note
      Demand from your bank or brokerage, lawful money and the tax goes away, with a tax exemption on lawful money, all of your money is yours.
      Tax Exemption: http://stormthunder.com/federal-reserve-act/#ixzz1pOYzDgEm
      Web search these three different phrases:
      Redeemed in Lawful money or
      Redeemed in Lawful money Pursuant to Title 12 USC §411 or
      deposited for credit on account or exchanged for
      non-negotiable federal reserve notes of face value

    • Neo1 says

      The real reason you pay an income tax, is for the privilege of using a private currency.
      Also known As A: Federal Reserve Note
      Demand from your bank or brokerage, lawful money and the tax goes away, with a tax exemption on lawful money, all of your money is yours.
      Tax Exemption: http://stormthunder.com/federal-reserve-act/#ixzz1pOYzDgEm
      Web search these three different phrases:
      Redeemed in Lawful money or
      Redeemed in Lawful money Pursuant to Title 12 USC §411 or
      deposited for credit on account or exchanged for
      non-negotiable federal reserve notes of face value

    • Chuck Robbins says

      We have to face the fact that paper money is currently an unacceptable medium of exchange. “Why is that” you might ask? For one reason, and one reason only. The govt. is not printing the money we use. For reasons which can only be described as insanity, or just plain stupidity, out govt. pays a privately owned company to print our money and to mint our coins.

      There is interest attached to these “notes”. I laugh every time I think of this arrangement. They pay a company to provide us with a form of money, a series of “notes”, which are nothing but a “promise to pay later” in return for whatever you and I may have produced today. Plus they even have to pay interest on the stuff, the cost of which is shouldered by us, the citizens.

      This needs to stop. The govt. has to print it’s own money, which could then be provided to us, interest free, and without having to “pay back” the face value of something which has no real value.

      Imagine this, if you would, could you ever seriously consider buying or paying someone else for “money”, paying that person face value, plus interest… when you could have printed it, for yourself, for only the costs of materials?

      We have been sold down the river by our government. The vast majority of Congress is made up of lawyers. They have to be aware of the criminality of the nature of this “unenforceable contract” made between the Federal govt. and The Federal Reserve, which is not Federal anything.

      It is no wonder our economy is in shambles, because, strange as it may sound… The better our economy functions, the faster, and deeper, we get into “debt” due to that arrangement made between the Bank and the govt.

      The more “new money” that is produced, the more interest we take on.

  2. says

    Recently purchased your book Detlev via Kindle and am about 2/3rds through it, very enlightening! Another blogger has a good take on the current financial predicament, he is called Greg Pytel and has this site: http://gregpytel.blogspot.co.uk/2009/04/largest-heist-in-history.html

    His first post in 2009 contended that the banks had committed serious fraud by over extending the loan to deposit ratio above 100% your thoughts on his analysis would be well received.

  3. Luigi says

    Hi Detlev,

    great one, as usual.

    I’d like to make a question:

    What about legal tender laws? Do they affect paper money’s value, in some (positive) ways?

    In other words, paper money is valuable, in some respects, because he’s backed by state’s power, through sanctions imposed in case of infringement of legal tender laws.

    We are obliged to accept it.

    What do you think about it?



    • says

      No other century in human history has seen more currency collapses and hyperinflations than the twentieth. Not surprising as that was the century that was most hostile to gold and most in love with state power. In fact, almost all ever recorded official hyperinflations occurred between the death of the Classical Gold Standard in 1914 and today. I would argue that all these states had legal tender laws and also collected their taxes in the local paper money, yet that did not stop their currencies from collapsing. All that legal tender laws do is force creditors to accept the local paper money as repayment for outstanding debt. That does not guarantee that the public at large will patiently sit on inflating paper money balances if they do not have to repay debt with it. Once money becomes a hot potato, its value collapses. You can then easily get hold of this paper money when you repay a loan or pay your taxes as everybody else is desperately trying to get rid of it. Once the public loses confidence, it is game over, legal tender laws or no legal tender laws.

    • David Goldstone says

      The coercive significance of legal tender laws (at least in England and Wales) is vastly overstated. All that legal tender laws do is to specify how a sterling debt can be paid. But it is not a criminal offence to refuse to accept legal tender. The only consequence is that if a debtor tenders “legal tender” to pay a debt, but the creditor refuses to accept the tender and instead sues for the debt, the debtor will usually be entitled to the costs of the proceedings. As you can imagine, this is a pretty rare scenario!

      Of much more practical importance is the fact that there are certain restrictions on the issue of competing currencies and also the fact that only sterling is accepted in payment of taxes. To that extent, the value of fiat sterling is at least to some extent underpinned by coercion rather than by public preference. But that said, I suspect habit and general public acceptance are far more important. Most people use and value fiat money because they are used to do doing so, not because they are forced to do so.

      • Benjamin Booth says

        “Of much more practical importance is the fact that there are certain restrictions on the issue of competing currencies”

        This is an important point. It is constantly missed when talking about gold-backed currency, central banking, FRB, federal deposit insurance, etc. These are all symptoms of the underlying problem of currency monopoly by a central government.

        Business cycle exaggerations, central banking fraud, inflation-tax, TARP, ill advised foreign wars, etc would all but disappear if private currencies (commodity-backed bank notes) could freely compete as money.

  4. says

    For those who want to grasp most of my blog, I suggest also to read “It’s a pyramid, indeed” and follow the links in this article. Im my view the current financial system is not a fractional reserve banking anymore. It is a depleting reserve banking. It does not accumulate any reserves during deposit – loan money circulation process. Quite the contrary it depletes the already accumulated reserves with exponential and unbounded growth of money multiplier. It is a classic example (from legal and technical perspective) of a financial pyramid.

  5. Vance says

    Good article Detlev- I’ve been waiting for this FRB article!

    Do you think insurance companies, pension funds, margin traded shares & forex etc also do this FRB routine? I mean would insurance companies take in all these premiums and all is OK as long as there is not a massive amount of claims all at once no-one will know that they can’t and couldn’t ever pay? Or the super-senior risk CDO’s that Greece really really didn’t default on because it was voluntary?

    • says

      I guess if the bubonic plague came back a lot of insurance companies would run into difficulties but I don’t think that this has anything to do with FRB. We should not use that term too broadly. FRB means the issuance of fiduciary media, of monetary assets that are considered to be money or near-money by the public. I agree with you that many financial products are based on too rosy an outlook on the future and it is best to stay away from them but not every instance of leverage is FRB. Furthermore, decades of fiat money expansion and state-subsidized FRB have compressed risk premiums across the board. The financial system is massively overstretched so it is best to approach all these institutions (insurance companies, pension funds, banks) with the utmost skepticism. At this stage of the credit mega cycle you should not rely on your insurance company to be always able to meet its contractual obligations, nor should you expect your pension fund to do the same. These institutions sit on inflated paper assets and the people who run them have only ever experienced financial bull markets – until recently, and most of them expect the crisis to go away soon and the old bull market to return.

  6. daniloux libertarian says

    Hello Detlev,

    What would you think about a loan tax?
    What if a political party would support a loan tax as his first point on his political agenda; would you support it? What if the taxes collected would entirely be directed to cutting taxes?
    Could this point arrest central banking money pumping?
    My problem with gold is this:
    1 medium house is about 200.000 euros which are equal 5 kgs of gold now.
    If you would ask me what i would rather own, well, i tell you i’d rather the first one. What would you?

    • says

      I do not support any taxes, whatsoever, out of principle, so certainly not a loan tax. Also, there is nothing wrong with loans or with debt as such. Why would I want to punish everybody who takes out a loan or who gives a loan? It is part of the free market. The problem is the elasticity of money as I explained. As I said before, there is only one thing that needs to be changed: separate the state from money and banking. Completely. We don’t need any new tax or any new government intervention. — I do not get the point about the house and gold. The former is a long lasting consumption good the latter is a monetary asset. You buy them for very different purposes. If I had a pile of gold but not a place to live in I would spend some of the gold to buy a house. As it happens, I already have a house. I also have gold. Would I spend my gold to buy another house? As an investment? That would mean that I expect a house to be a better investment than 5kg of gold, right? I guess you know my view of our monetary system and the massive economic crisis we are in: I definitely keep the gold. I would certainly not sell the gold to buy real estate.

      • daniloux libertarian says

        My guess tries to imagine a democratic way to correct the imbalances of prolongued low interest rates. If a government would tax the borrower it would work as if the central bank would have highed interest rates. Infact, if there would be a tax on the borrower it would mean less loans, less fiduciary media, less money supply. Moreover if all the taxes collected would be directed to lowering taxes on production we would have what western countries need: less consumption, more production, less debt, more saving. The fallacy of my point, is that all governments do not oppose central banks policies: they just amplify central banking interventionism.
        Looking at the figures euro m1 is almost flat in the past 12 months (after it increased by 25% from 2008 to 2011)and overnights deposits are falling in Italy (where I live).Maybe in Italy there would be a bit of (not enough!) deflation in the following months. That’s why i expect some good “investment” in the housing market, expecially if banks will not reflate the bubble after Ltro2. Thank you for replying, daniloux

  7. David Goldstone says

    I think Detlev’s analysis of FRB is pretty much spot on.

    It has always been my view that FRB alone, can do only very limited mischief because in a free market, competition in the form of the threat of bank runs, personal liability and reputational losses, would impose strict limits on the extent to which any bank or group of banks could inflate their fractional reserve ratios.

    The real problems come when governments provide support to the banking sector so as to enable ratios to drop far below the levels that would prevail on a free market. That process of reducing ratios is inflationary and disruptive to a much greater extent than would ever be the case on a free market.

    As for the fraud issue, the argument is mostly nonsense. Banks do not make any representations that a depositer’s cash is held separately. They promise only to repay the same amount of cash on demand (or on notice). Whether they can actually do so is a different matter. But failing to perform a promise is not fraud.

    The only reason why I say the argument is “mostly” nonsense is because I can imagine a case where a bank takes deposits from an unsuspecting depositor, knowing that it is unlikely to be able to repay the deposit because a bank run has already started. I can see an argument that in those circumstances, there is an element of fraud. But that is a very special case.

    • Stephan Larose says

      Detlev’s analysis of fractional reserve lending entirely misses the obvious. Fractional Reserve Lending is nothing more than legal counterfeiting. Banks lend out far far more than they actually have, that’s money that does not exist. If I counterfeit some money and lend it out at interest, it’s fraud. The only reason it’s not fraud for banks is because banks wrote the rules.

      Fractional reserve lending creates untold amounts of financial irresponsibility and inflation by multiplying the money supply with legal counterfeit. Anyone who thinks that a just or sane way to set up a monetary system need only look at the global collapse of the economy to realize what utter nonsense they propose.

      A debt free, constitutional money system that set money supply growth at the rate of population growth would save the US untold piles of debt. The elimination of fractional reserve lending would cause inflation to disappear and things like “liars loans” and see the other tricks banks that collapsed the economy relegated to the dustbin of history. See MoneyMasters.

  8. Daniel says

    If a lot more gold were to suddenly enter the market, it would obviously lower the value of gold relative to everything else. But how does lending out more fractional reserve gold notes affect the value of gold? I mean the notes would still be backed by the liability of the bank that issues them, so it’s not like gold appeared from nowhere as in the first situation. Should it have any immediate effect on the value of gold?

    Secondly, how does interest tie into all of this? Inflation is tied to prime interest rates, so having a promissory note that must be repayable with interest is kind of like having money that shrinks in value over time. How does this relate to interest bearing commodities? In general, industries are always growing. So if you buy corn as an investment, and it magically doesn’t rot there will still be more corn out there next year and the year after, so your corn is dropping in value. Corn is inflationary I guess. Gold on the other hand is fixed, so it’s not changing value. So we need inflationary money to match inflating economy. Around here is where I start confusing myself. Help appreciated

  9. says

    Bitcoin is commodity money?

    I also thought that Bitcoin is a commodity money, but now I disagree. It does not fit into the definition of any money by Austrians (for example in Mises’ Theory of Money and Credit, diagram in the Appendix B, http://mises.org/books/Theory_Money_Credit/AppendixB.aspx). Commodity money is simultaneously also a consumer good (directly usable for satisfaction of needs) or a producer good (is consumed indirectly during a production process). Nor is it fiat money (money with a special legal status) or credit money (uncertain claim on commodity/fiat money). It isn’t a money substitute either, because it’s not a highly certain claim on money in the narrower sense.

    I guess if it ever evolves into money we’ll have to create a new category for it.

    George Selgin published a draft paper last month where he calls Bitcoin “Quasi-Commodity money”, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2000118. I tend to agree with this, however it’s incomplete, because Bitcoin is not only inelastic, but also provides a replacement for the banking system (payment processing, balance clearing, ledger keeping, …). From this broader point of view, I prefer to call it “money as a service”. Even though Hoppe told me that money being a service is absurd.

    I am glad you addressed the idea of some pseudo-Austrians that some money (e.g. gold) has intrinsic value. Some refer to the English translation of ToMC where Mises is saying that money cannot become from things intrinsically worthless. I believe this is an unfortunate formulation, however if you look at it more carefully, he’s only addressing something written by Locke.

    • says

      Peter, I think there is a risk here that you get all tangled up in definitions. Bitcoin is not commodity money but quasi-commodity money? C’mon. Definitions are not an end in themselves. They have to be useful. I am no expert on Bitcoin but I think it is in fact also a consumption good and thus meets the definition you use for what is commodity money, namely something that is money but also a consumption or production good. You say yourself that it also offers banking services, that it is ‘money as service’ (although I agree with Hoppe that the term is absurd). But a banking service is obviously a consumption good, so Bitcoin, using your own definitions, is commodity money. You can simply use Bitcoin as payment technology. If you want to transfer $10 dollars to a friend in Africa, you can exchange the dollars for Bitcoin and transfer the money via Bitcoin on the net, which I understand is much cheaper than doing so through established channels. Bitcoin is payment technology just as early banknotes were payment technology, i.e. a means of transferring ownership in other forms of money. Banknotes then become money in their own right as the public began to use them as money even when they were no longer a clam on gold.
      As you know, in my book I have a different definition. I focus on the elasticity of supply. This, to me, is the essential point about any monetary system. Commodity money systems are systems in which the supply of money is outside the control of any issuing authority. Commodity money cannot be created at will. Paper money systems are fiat money systems in which a central authority and those that the authority has extended the money franchise to, such as today the banks, can create money at will. It is clear to me where Bitcoin sits.

      • says

        Thank you for your reply Detlev. It is actually kind of funny, because prior to reading ToMC I argued exactly the same way, that the “service” Bitcoin provides is what makes it a commodity. I also agree that what matters from economic point of view is the elasticity rather than whether it’s a “real” commodity or not.

        I agree that the definitions need to be useful. But they also need to be consistent. If you use elasticity as the defining factor, there could be money that is simultaneously legally privileged and inelastic (see the aforementioned Selgin’s paper for examples). However, instead of creating a new type of money classification, it is also possible to redefine the types of goods. Mises defines three classes: consumer goods, producer goods, and media of exchange. Other Austrians mirror this. This threefold classification is the basis of the regression theorem: before a medium of exchange is a medium of exchange, it needs to have a market price, so it must be a good, and since there are only two other types of goods, it must be one of the other two.

        However, it is incomplete, as you yourself point out. There are other “things”. Rothbard just classifies these “other things” as “general conditions of the action”, because they aren’t means. But this is imprecise, because human action reveals that some of them nevertheless are valued. My alternative approach is then to create a new class of goods which I call information goods. This includes immaterial goods (e.g. instruction manuals), positional goods (which are interesting because they are scarce) and also media of exchange. Services are not really goods, they are the usage of goods (I forgot where I got this from, but again probably Mises or Rothbard). Information goods are neither producer goods nor consumer goods. They are not necessary to consume or produce, they just change our evaluation in interesting ways. A chemist might call them catalysts.

        If we modify the classes of goods, we can then redefine commodity money to include some information goods. This not only re-establishes consistency, it also fixes the regression theorem, or at least some of its more hardcore interpretations.

  10. John Ryan says

    “An ounce of gold has the value it has today because of the specific demand for it as a monetary asset. It would retain its monetary value even if, by some act of magic, it lost overnight all its use-value as an industrial commodity or an item of jewellery.”

    As a theoretical point doesn’t this go too far? Don’t you have to look at the reason that something becomes widely accepted as money. Gold became and continues to be widely accepted as money, because it has always been widely desired as jewelry or some other decorative prized item. This universal demand and it’s durability is what made gold (and silver) widely accepted as money. There is no way that gold’s universal acceptance as money would be maintained in the absence of any use value whatsoever.

    Paper money became widely accepted as money because it was made legal tender by the state and is accepted everywhere, or prior to that because the bank that issued it was a trusted institution and thus it was locally accepted everywhwere. It needs no inherent value because it has legal tender acceptance. It’s value comes from the fact that you can exchange it for virtually anything, anywhere at anytime.

    You could assert your confidence that gold will always maintain its desirability as jewelry and therefore always maintain its acceptance as a monetary asset. But I don’t see how you can seriously argue that it’s acceptance as a monetary asset is now permanent and independent of its use value and even more incredibly that it’s price relative to other goods and services would only change by a small amount if all of gold’s uses suddenly disappeared.

    If humankind gradually but completely grew to see no uses for gold it’s value would plummet and its acceptance as a monetary asset would vanish.

    • says

      John, no, I do not think that my argument goes too far. I think this is the only sufficient and satisfactory theory of what bestows value on money, and I simply apply it consistently to gold. Please think of the following:
      Most gold today is not jewelry but sits in vaults, most of it in central banks. Do you think that these central bankers and other investors in physical gold look at their gold holdings and think, well, if push comes to shove, this will at least make nice jewelry? Gold has been a form of money for thousands of years. Do you really think that this was only so because for the same thousands of years it also happened to be an item of jewelry? And consider this: Over the past 10 years, gold experienced a massive appreciation in price. Is this because it became more sought after as jewelry or as an industrial commodity, or is it not because in 2001 the issuing authority of the world’s leading paper money – the US dollar – had for the first time established 1 percent interest rates to reflate the economy, and since the mortgage bubble that resulted from this burst in 2007 the system has progressively moved itself into a corner where ever more currency units have to be created in order to avoid the system’s total collapse? Gold’s physical properties and its role as jewelry most certainly played an important role in establishing it as a universal monetary asset. But once it had achieved that position, its exchange value for other goods and services (its price) is driven by the demand for gold as money.
      Let’s assume that after the total collapse of our fiat money system – which I consider inevitable – we return to a proper gold standard. As in any monetary system, you, as a money user, have to decide how much of your wealth you want to hold in the form of money. The question is this: how much spending flexibility do you need? Money is always the most fungible good. It allows you to engage in transactions spontaneously at minimal transaction costs. How much gold would you hold? This depends obviously on your need for flexibility which is entirely subjective and on gold’s purchasing power, which again depends on how much gold everybody else wants to hold, in short, it depends on the public’s overall demand for the most fungible asset, for money. Do you think that in this process everybody would constantly peek over into the jewelry market or the industrial commodity market for guidance as what gold’s purchasing power as money should be? I think this would be an example of the tail wagging the dog.

      • David Goldstone says

        It is of course an entirely academic question (there is not much sign of Indians turning away from gold jewelry as a means of storing wealth), but I think there are two separate issues here.

        The first is whether gold would maintain its monetary status AT ALL if it lost its other uses (perhaps because of changing fashions?). The answer is surely yes, given the success of bitcoins which already have no use other than as money!

        The second issue is whether the monetary value of gold would fall if it lost its other uses. 60% of gold production goes into jewelry and industry so if that demand disappeared, one would expect the price of gold to fall somewhat. But that said, it has to be born in mind that much of the so-called jewelry demand is really for gold as a store of value but merely in a culturally attractive form. So in reality, most of the existing demand for gold is already for its utility as a store of value. So I would not expect the price to fall much even if jewelry were abolished!

        • John Ryan says

          Bitcoins doesn’t tell you anything about gold’s durability as money in the absence of use value, I don’t think. The two are fundamentally different, aren’t they? Bank notes, Bitcoins, US Dollars, etc. are really just payment systems, unlike gold. Each is assigned it’s value by the public market but for very different reasons. One because the public recognizes that it has a use value and predicts that it always will and thus extends to it monetary value even though many people would not accept gold as payment for their goods and services in the normal course of business. The other because sufficient people have agreed to use this defined payment system and accept the units as payment in the normal course of business, period.

          I doubt that most jewelry is bought for its store of value utility. Reminds me of the shopaholic saying that her 32nd pair of $300 shoes was a sound purchase because they were half price. If you are buying gold for store of value, it makes no sense to buy it in the form of jewelry and pay the jewelry premium that you would likely not recover when you needed to monetize it. People by gold jewelry because they like having gold jewelry and the salesman helps them rationalize the purchase by telling them it’s also a great investment.

    • Christian says

      Quote: “If humankind gradually but completely grew to see no uses for gold it’s value would plummet and its acceptance as a monetary asset would vanish.”

      But how likely is this? And why would this not happen to paper money too? Or any other form of money? Fact is that gold has been used as money for 3000+ years, and it became money in cultures around the world who had no known contact with each other. On the other hand, paper currencies have failed countless times in history, ever since the first attempts in China in the 8th century.

      As for where gold gets its monetary value from I would suggest reading up on Mises especially Theory of Money and Credit. Detlev may be able to explain this better but the way Mises explained it is that the gold’s value as money today is directly related to its value yesterday. When you follow this through the millenia you ultimately end up at a time when on the previous day gold did not have monetary value but value as jewelry for example. So yes, gold in all likelihood originally derived its value from being sought after as jewelry, but that is not the reason it has monetary value today.

  11. David Goldstone says

    I agree with Detlev that one should avoid terminological essentialism. But that said, surely one of the most interesting thing about bitcoins is that they are an empirical refutation of the proposition that on a free market, money must first begin as a commodity with use value separate from its monetary attributes? Bitcoins from the very beginning were only money. There is nothing else you can do with digits (the associated payment technology does not confer a separate “use” value any more than the fact that paper money can be transferred by posting it, confers upon it a separate use value). So in that sense they are conceptually quite distinct from commodity money because they did not originate in stuff that was used for other things first. I don’t think there is any other example of this in history.

    • says

      Some Austrians indeed claim that money must start as a commodity. Before I address that though, I’d like to advise caution against calling Bitcoin money. It is safer to say that Bitcoin is a medium of exchange, but not (yet) money.

      Now, whether Bitcoin is or is not consistent with the claim that money must begin as a commodity depends on interpretation of various aspects of economic theory. For example, Bitcoin probably would not have come to existence if we didn’t already have a monetary economy. Furthermore, it could be argued that Bitcoin is a commodity (just like Detlev pointed out). There is a precedent for this, see this article: http://mises.org/daily/4262

      Last but not least, based on empirical data, the first record of Bitcoin price I found was from October 5th 2009 with 1 USD = 1309.03 BTC. On that day there were 24418 blocks, which gives the total “Bitcoin economy” size of 932.68 USD. Now it’s about 4.8 USD = 1 BTC, i.e. over 6000 times that. This can be interpreted as the price growing from almost nothing (but nevertheless a non-zero starting price). It is unusual for goods to be completely worthless. Even paper money can be used for scribbling notes or heating (as they recently did in Hungary according to news reports).

      So I can’t definitely say if Bitcoin refutes or confirms the “hardcore” interpretations of the Mises’ regression theorem. It’s more like it makes explicit some of the assumptions of economists which have been considered implicit so far.

  12. David Goldstone says

    Coming back to the FRB fraud issue, there is one other situation in which I can see a fraud argument. That is where the institution which takes the deposits uses the money not to make commercial loans, but to speculate on its own account. This seems to me to be of very dubious legality unless it is clearly spelled out in the contract. A prime example is MF Global. Whilst it may be that clients of MFG did not expect that “their” funds would be held in separate accounts, I doubt that they expected the firm would be using client funds to engage in massively leveraged in-house trading on European sovereign debt. To me, that smacks of fraud. The issue is not FRB as such, it is what the bank or deposit institution uses the deposit funds for. It is one thing for a bank to lend out deposit money at commercial rates of interest. It is another thing for a bank to use deposit money to gamble on the horses, as it were.

    But again, this is a special case.

  13. says

    FRB is NOT understood by the public. Just because they know that the bank lends the -savings on deposit- out again; is no proof of the public agreeing to FRB. what almost nobody in the public knows is that the bank lends the same money out SEVERAL times. THAT is the whole problem and is the whole counterfeiting. By increasing the money in circulation, it pushes up prices for goods and services which in turn creates the need for paying interest for the money in a savings account. And, sadly, the compound interest on your savings account almost never keeps up not even close with the real inflation (prices always going up much faster than the official rate of inflation). In my humble opinion FRB is theft on a large scale, counterfeiting made legal with the consent of stupid and/or corrupt politicians. The heist of the millennium.

  14. htmortimer says

    This is a very good article other, perhaps, than trying to put two separate issues in one article.
    You are correct about the fraudulent nature of the banking contract – you can get your money whenever you want to except if everybody wants their money at the same time.
    That being said, the value of having banks that are able to lend money is enormous and the history of banking is an effort to address this “fraud” through the creation of lenders of last resort and the imposition of regulations, an effort which has been largely, if not always, successful. That is essentially why central banks were created.
    Without fractional banking, there can be no lending and without lending you get stunted economic growth, so let’s not do away with fractional banking until we have a system to replace it.

  15. Stephan Larose says

    Fractional Reserve is most definitely fraud. The bank lends you money it does not have, that does not exist, and expects you to pay back the principle plus interest with real value you earned through labor. It is legal counterfeit, and just because it has been made pseudo-legitimate because a) most of the public do not know how the monetary system works b) are in no position to do anything about it, does not mean that it isn’t fraud. Fraud is fraud whether it goes on for a day or an eon.

    If I just printed counterfeit money and lent it out at interest I would go to jail. If it’s fraud for me, how is it not fraud for banks? Because they wrote the laws to benefit themselves? Today, due to a private, debt-based monetary system and fractional reserve lending, and of course so-called “deregulation” the entire world economy stands on the precipice.

    No free markets exist when giant monopolies rule. Return the power to coin money to the people; watch MONEY MASTERS.

    • says

      If the bank lends me money that doesn’t exist, how come I can buy stuff with it? Do those who take that money not know it doesn’t exist? I think the fraud-argument rests on the assumption of wide-spread stupidity. The bank is not counterfeiting money, meaning the bank is not creating something that pretends to be something else. In the example that I use in the blog, counterfeiting would mean the bank issues ‘fake gold coins’. Now that would indeed be fraud but that is not what they are doing. They are issuing not money but something else. Mises called it fiduciary media, a claim on money that is not backed by money. The bank can only place these fiduciary media with the public if the public accepts them. (And yes, you can do the same if you manage to do so.) Under certain conditions the public will use these fiduciary media as if they were money. Under other conditions, they will rather not hold fiduciary media and again prefer money proper. That is the risk that everybody assumes who participates in FRB (banker, depositor, and less so the borrower). What is used as a medium of exchange in an economy is never clearly defined and never entirely fixed. But up to here, I do not see why any of this should be fraud. — However, FRB makes the supply of money more elastic (to a degree at least), that is why I consider it a mistake to systematically subsidize it, as our present system does. FRB is problematic and must always be subject to market discipline. It just isn’t fraud.

    • says

      Based on my readings of the Austrian literature, FRB is only fraud if money substitutes are a legal claim on money proper. Some Austrians claim that this is the case. However, I dissent here a bit. Mises argues that it’s the fact that people are certain that the redemption works, rather than that there is a legal obligation for it, which makes money substitutes into money substitutes (I think it’s Chapter 17 in Human Action). I argue that we cannot proceed backwards in our analysis: from the fact that money substitutes are exchangeable to money proper, we cannot conclude that there is an underlying legal claim.

      This shows what a genius Mises was, because even though he said that this wild difference in goods which act as substitutes is special to money, he admitted it’s not the legal status that causes this. In the digital age, we know that, for example, a book and an ebook act as substitutes, even though they are fundamentally physically different. Obviously, owning an ebook does not mean that one has a claim on a physical book, so analogously there should be no necessity for this to behave this way with money either.

      I’m not claiming that money substitutes are never a legal claim, merely that there is no necessity for it. And, from the point of view of property rights, if there is no legal claim, then it does not follow that FRB is illegal, similarly as copying (in Rothbard’s Title Transfer Theory of Contract) isn’t per se illegal.

      It also saddens me that some important monetary theorists (e.g. deSoto, Huelsmann, Block and I think also Hoppe) argue that FRB is illegal because it decreases the value of money, because in the praxeological framework there are no rights in values.

      To concur with Detlev, FRB does cause problems, it just isn’t necessarily fraud.

  16. joe says

    An intelligently managed fiat money system is not a problem. In fact, the fiat money system has been a big factor in the prosperity we have today and is necessary for achieving high levels of employment. The problem is having too great a portion of a nation’s work force involved in non-wealth creating activities. There are far too many people, which includes bankers, that just live off the system. Investment firms produce nothing but paper products that channel wealth to themselves at the expense of hard working people. They ensure that savings never amount to much and that costs keep rising excessively. Also, excessive unproductive government is another drain to the system. And so on. Gold though is useful as a store of wealth, for which it is proving itself very nicely right now. Unfortunately, there is a massive amount of non-existent paper gold out there courtesy of the same bankers who live off the system by taking from it. What they do is no different than a counterfeiter or someone who runs a ponzi scheme (and they do both at the same time), only they have the law on their side.

    • says

      Fiat money systems were introduced to make the supply of money more elastic and to control that elasticity for political purposes. As I show in my book, elasticity of supply is a problem, it must cause economic imbalances. If I am right – and I am convinced I am but am happy to be convinced otherwise if anybody can prove me wrong – and that elasticity is indeed the problem (in particular the constant expansion of money in our system), than no amount of intelligence on the part of the central bankers is going to make that system stable. I am happy to assume (certainly for the sake of economic analysis) that our central bankers are clever, hard-working, well-meaning and neither in the pockets of Wall Street nor in the pockets of politicians. But even under those most ideal circumstances they still couldn’t make this system work, unless they imitated a gold standard. We will never have a completely stable and unchanging money supply. Banking practices (most importantly FRB) will make sure of that. But in our fiat money system the elasticity of money is greatly enhanced in a systematic fashion.That is at the core of the problem.

  17. joe says

    I should have added that the reason Zimbabwee collapsed in a hyper inflationary spiral is because of the large portion of losers in that country who only took from the system. They produced nothing but crime. The West is a far ways from that type of environment, but the massive amount of debt the West has needs to be reduced substantially.

    • says

      Please remember that Zimbabwe is hardly an isolated case. While each case of fiat money collapse is unique, currency disasters have been widespread across all times, civilizations and cultures. In fact, all paper money systems have ultimately ended in failure. We can only figure out what causes these systems to be unstable and what ultimately leads to their demise by looking at the economic fundamentals. That is what I was trying to do with my book. My conclusion is that there is hardly reason for complacency in the West.

  18. says

    I am not sure if it has been discussed here, but I see the FRB issue divided in three camps. One that says it should be abolished completely, one that says it should be allowed completely, and one that falls somewhere in between. For example, Mish suggests that banks should only lend out at the same duration as they borrow. My opinion is that all three models could act in parallel, if necessary with competing currencies. As long as it is properly declared, and the depositor knows the risks, he has the choice where to deposit money. If he wants a short-term and safe deposit he won’t earn interest, and the banks could agree to not lend out that money and they could then have insurance such as FDIC. The role of the government could be to enforce the law, in case a bank purposely lends out, loses, or steals the money. If the depositor wants to take more risk, he can have the bank lend it out at the same duration to another borrower. The banks earns a difference, but if they make a bad decision, they lose, and ultimately the depositor could lose. No government insurance here, but there could be private insurance like CDS. If one wants even more risk, one could give the money to a FRB bank and let them lend it out at any duration they want. It’s the most risky, and akin to a hedge fund, since if everyone wants to get their money back right away, it is physically impossible for the bank to sell all their loans that quickly. But as long as people want to chose their risk level, the government could serve as reminding them constantly and making sure no banks misrepresent themselves by claiming to be in one category and then following another. So yes, there would be elasticity in the sense of FRB if many people chose to lend to risky “FRB” banks, but it might be much less. And people might switch to using the currency in which the FRB multiplier is lower. There will never be zero risk, because even without FRB, people can get caught up in a frenzy, get defrauded by counterfeiters, or sometimes even have governments rob them. So some responsibility will need to rest with the people, and then the personal choice of type of bank does make sense.

  19. says

    We seemed to have a defacto system at one time when we had true M1, M2 and M3. There were no legal raminifacitations just terminations of keeping up with 3 types of “money” as there was too much “cost” to report something that no one used according to Ben.

  20. Tom says

    If I was aware in time of your book, I would have commented on it. I think that you actually make the case well for the value of having a money supply that is elastic or able to expand in a growing economy. My answer basically in Interest Rates: The Highest Wisdom of the Market is to follow Ron Paul and most Austrians in firstly seeing the fed ended and making gold legal tender again but that without having a gold standard, but then also crucially in actually prosecuting the fraudsters. And prosecutions IMHO would be much easier if the fed is ended one day. And it is prosecutions and the threat of actually going bankrupt that should prevent the worst of the booms.

  21. Harry says

    In your analysis you assume that bankers and especially Central bankers such as Bernanke and Draghi are well meaning and creadible.

    If however i look at the history of the FED and how it APPARENTLY came into existence, i am not so sure. You don’t find that history in the Mainstream Media but many Alternative Media sources suggest that the Fed was established out of a scam purpetrated by about 4 private bankers (among those were J.P. Morgan and Rockefeller and Warburg). No need to go deep into this but seemingly J.P. Morgan deliberately caused bankruns in the early 1900′s. After which he offered to salvage the system by creating money out of nothing. He managed to stop the panic but also to consolidate the banks and was seen as a hero for doing so.

    After that the 4 men managed to convince Pres W. Wilson of the need to establish a central bank with the monopoly to print USD to prevent future problems with the financial system. Wilson aparently gave in partly because they had funded his presidential campaign and the federal reserve act was signed.

    If this is true the establishment of the FED was based on a scam, and when one sees what has happened after the FED was established,apparently FED orcestrated booms and busts which all made the bankers richer and the people poorer, and the nature of fiat money that is created out of nowhere as debt, which had made the (western) world more or less swimming in debt nowadays and which has caused massive inflation (already) for middle class savers, it looks like the current fiat money system is no more or less then a trap for the people who are ever getting poorer and poorer because of it’s nature, and a tool for the bankers to get wealthier and wealthier.

    So perhaps or probably i am wrong and maybe i see a conspiracy that is not there but one cannot help but wonder, is it all a purposely orcestrated and carefully concealed scam to rob people from their wealth and put the whole world into debt?

  22. Anthony says

    Here is another way banks turn the people into their slaves! Look how mortgage loans work! REMEMBER ONE THING! YOU ARE THE LENDER THE BANK IS THE BORROWER!

    1. Were you told that the Federal Reserve Bank Policies and Procedures as well as the Generally Accepted Accounting Principles (GAAP) requirements imposed upon all Federally-insured (FDIC) banks in Title 12 of the United States Code, Section 1831(a), prohibit banks from lending their own money from their own assets or from other depositors? Did the bank tell you where the funds for the loan were to come from?

    2. Were you told that the contract you signed, the promissory note, was going to be converted into a ‘negotiable instrument’ by the bank and become an asset on the bank’s accounting books? Did the bank tell you that your signature on that note, makes it ‘money’, according to the Uniform Commercial Code (UCC), sections 1-201(24) and 3-104?

    3. Were you told that your promissory note would be taken, recorded as an asset of the bank, and then sold by the bank for cash, without “valuable consideration” given to obtain your note? Did the bank give you a deposit slip as a receipt for the promissory note you gave them, just as the bank would normally have to provide when you make a deposit to the bank?

    4. Were you told that the bank would create a new account at the bank that would contain this money that you gave them?

    5. Were you told that a check from this new account would be issued with your signature, without your knowledge, and that this new account would be the source of the funds behind the check that was given to you as a “loan”?

  23. hotlil57 says

    You stated that ‘back when’ GOLD was deposited and a paper certificate (usable as money) was given to the depositor…The paper receipt (money) also stating claim to the (deposited) gold on demand from the depository…You stated that money was lent to 3rd parties by the bank(s), hence Fractional Reserve Banking…My question is this – What backs the federal paper notes now since Roosevelt diminished the gold standard and demanded all gold to be returned to the government (Executive Order Dated April 5th, 1933 – Order Number 6102)?…I’ve heard theories, and would appreciate your input (or anyone’s for that matter) regarding ‘what backs the US monetary system now?’…It’s surely not gold/silver, so what could it be?…If the dollar is NOT BACKED by something, it would have the worth of a piece of copy paper…So, once again my question is “what is the current (and since April, 1933) Federal Reserve Note backed by?”

    • says

      This is a system of irredeemable “paper” money – it is backed by nothing. If it were backed by anything the supply of that “something” would restrict the supply of money. But there is no limit to money production. The central bank can create as much of it as it likes. If we look at it from the perspective of an accountant we see that there are assets on the other side of the central bank’s balance sheet but these assets – mainly government debt – can be created in the process of money production: the central bank creates money and lends it to the state which spends it. The government’s IOUs are then booked on the asset side of the central bank’s balance sheet. But this is not “backing”. If money were backed by anything you could demand to exchange your money for that something with the money issuer. Again, our money is irredeemable. This is not a problem for the “value” of money. Money can have value (it evidently does) without being backed by anything else. As long as the public find the established paper money convenient and use it in exchange for goods and services, this money has value regardless of what it is backed with, if at all. The problem with paper money is not the lack of “backing” but the elasticity of its supply. – That our money is not backed by anything and can be created at will and without limit is readily admitted by all central bankers and economists. This is not even a matter of debate.

      • Dick Eastman says

        1. The money is backed — by collateral. Federal lands are collateral in international borrowing. Privatization seems to increase with indebtedness and the shrinkage of the tax base from which to service debt. Is that not the backing on all government debt. Then there is the penalty of lowering a nation’s credit
        rating — if you even look like you may default foreign money will be withdrawn requiring
        a greater flow (austerity) of wealth from tax payers who ultimately service the debt.
        Governments have nowhere else to go — but back to the lenders at higher rates.

        2. Elasticity of money is a consideration, but it is incomplete without consideration of where the new money goes and where it does not go. QE hardly touches the domestic economy loop between households and domestic consumer production. There are $13 trillion or more dollars in offshore deposits. That money could fund investment here or buy our consumer goods. It does not. In fact those holding it gain in wealth from deflation.
        The Fed was sold to Democrats — Wm Jennings Bryan included in 1912 — as a way of giving the nation an elastic money supply — and structurally it was capable of doing so. Only it did not. The reserve requirement was hardly used and open market operations, never mentioned in the original legislation, took a big roll. Money may be elastic — but we can have easy money in the international and financial loop but deflation in the lower loop.
        So we have a system that allows elasticity — but easy money in one loop and tight money in another loop. A much more institutional and sociological approach is required. I think a thin-air debt-free dividend to households as the only source of new money is the right answer. End deficit spending by government — require direct taxation of households as the only way to fund public goods and wars. Then there would be true consumer sovereignty and adequate consumer demand so that people would earn good livings without recourse to war making and war profiteering.

        • says

          The money is certainly not backed. Your dollar bills are not claims on “federal land”, and “federal land” is not collateral for the issuance of Treasury bonds either. (Check the prospectus!) If they were, the market value of that land would pose a limit on money issuance and government borrowing. Clearly, that is not the case. That excessive borrowing may damage the credit rating or even lead to the market’s refusal to accept more debt is true but that is not “backing”.
          My book is about the elasticity of money and does deal with what you call the two loops. However, these two loops cannot be separated for long. Money will not just circulate in a parallel universe of ever higher asset prices forever. Ultimately, these policies will be inflationary in a traditional sense.
          The fundamental question is, how elastic should money be, and do we need elastic money at all? My conclusion: elastic money is unnecessary, harmful, disruptive and unstable. It was a mistake to abandon the gold standard, which had given us reasonably inelastic and apolitical money.
          Under the Fed, money (and credit!) became very elastic in the late 1910s and 1920s. The Fed (directly and indirectly) financed the war effort (1917-18), the following farm boom, and provided massive credit to international buyers of US goods (the vendor finance model now copied by China). All of this led to the “roaring twenties” and caused the imbalances behind the Great Depression.
          We do not have to (and should not) devise new ways to create money but simply return to either hard and apolitical money (such as a gold standard) directly, or at any rate take the state out of the money-creation business altogether, which would most certainly lead to a system of hard money as well.
          Such a system is likely to experience moderate, secular deflation, which has many advantages and has been the norm through capitalism’s most productive phases.


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