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How Central Banks Create Inflation (Intellectual Capitalism Part 4)

This article continues from where my article Money and Banking ended.

Central Banks like the Federal Reserve in the United States are different than commercial fractional reserve banks.   As explained in the article A Brief History of Central Banks on the Federal Reserve Bank of Cleveland’s website,

A central bank is the term used to describe the authority responsible for policies that affect a country’s supply of money and credit. More specifically, a central bank uses its tools of monetary policy—open market operations, discount window lending, changes in reserve requirements—to affect short-term interest rates and the monetary base (currency held by the public plus bank reserves) and to achieve important policy goals.[1]

Unfortunately, this definition misses that fact that central banks are monopolies and therefore not part of capitalism (free market).

A central bank, or monetary authority, is a monopolized and often nationalized institution given privileged control over the production and distribution of money and credit. In modern economies, the central bank is responsible for the formulation of monetary policy and the regulation of member banks.[2]

According to this definition a central bank has control over “printing” the national currency, which in the modern world can be done by just a computer entry.  If you look into the Federal Reserve of the United States you will find that they have control over printing paper money, while the Treasury has control over minting coins.  However most currency today is just a computer entry and here the answers get even more obscure.  The best answer is that direct money creation is a dance between Congress, the Treasury, and the Federal Reserve.  Everything becomes convoluted when a central bank is added into the equation and so far we have only discussed direct creation of currency not open market operations, discount window lending, and changes in reserve requirements.  I think politicians and central banks, not to mention the largest banks and brokerages, like this obscurity.

In order to make this less obscure I will analyze each “tool” of a central bank separately.  In addition, we are going to analyze the direct money creation issue through the lens of Modern Monetary Theory (MMT).  One reason to look at MMT it is how most central bankers see the world, which is illuminating.  It also points out some uncomfortable truths and exposes some of the Keynesian nonsense.  Wikipedia explains MMT as:

Modern Monetary Theory (MMT or Modern Money Theory, also known as Neo-Chartalism) is a macroeconomic theory which describes and analyses modern economies in which the national currency is fiat money, established and created by the government. The key insight of MMT is that “monetarily sovereign government is the monopoly supplier of its currency and can issue currency of any denomination in physical or non-physical forms. As such the government has an unlimited capacity to pay for the things it wishes to purchase and to fulfill promised future payments, and has an unlimited ability to provide funds to the other sectors. Thus, insolvency and bankruptcy of this government is not possible. It can always pay”.[3]

This quote is very revealing, especially the idea that “the government has an unlimited capacity to pay for the things it wishes to purchase and to fulfill promised future payments, and has an unlimited ability to provide funds to the other sectors.”  At the beginning of this series I pointed out that when money enters the equation in economics, people think magic happens and logic disappears.  The MMT people think they can create wealth by manipulating money.  The MMT advocates believe money and banking allow for good magic and Austrian Economics argues that money and banking are bad magic (meaning it destroys wealth). econgrowth.small

This is why I wrote my book on The Source of Economic Growth, which shows that increases in real per capita wealth are created by applying our reason to the objective problems of life – in other words by inventing and increasing our level of technology.  Money is not wealth, as I showed earlier in this series.  Money and banking are mainly a lubricant for the economy.  Of course real inventions in money and banking do increase our per capita wealth, such as cryptocurrencies might do if the governments (central banks) of the world would get out the way.  Cryptocurrencies hold the promise of significantly reducing the cost of transferring money around the world.

Modern Monetary Theory is correct that the government cannot run out of money if has legal tender laws, but that does not mean that “the government has an unlimited capacity to pay for the things it wishes.”  The Gross Domestic Product (GDP) of the United States in 2016 was around $17 trillion.[4]  If the government decides to spend $20 trillion of wealth and continues to spend more than the total output of wealth of the United States, then the Unites States will go bankrupt.  The ability to print (create) more money will not matter.  Venezuela has a central bank, but it has not saved Venezuela or allowed its government “to pay for the things it wishes.”  The expected inflation rate in 2017 for Venezuela is 1,660% according to the IMF (International Monetary Fund) and its GDP fell 15% in 2016.  It also did not save the Weimar Republic which had a central bank, and it did not provide the government an unlimited capacity to pay for the things it wishes.  The MMT’s answer to the Weimar Republic is that they were forced to repay their war debts in gold.  According to MMT governments with a central bank and legal tender can be infinitely wealthy, which is clearly absurd.

The problem with MMT is it confuses money with wealth.  This is similar to how Keynesians reverse cause and effect, by arguing wealth is created by spending (consumption).  The ideas underlying MMT were proposed by John Law, who created the Mississippi Company in France in the early 1700s and almost bankrupt the whole country.[5]  It is a fascinating story, but beyond the scope of this article.

According to MMT the government creates money by spending.  As this article, Why a Central Bank Can Never Run Out of Money, explains:

The U.S. government spends it currency into existence. This is important, too. The government spends first and then collects taxes. (Logically, this is how it began, or else how would people get the money to pay taxes?) Taxes are what give the dollar value. As Alfred Mitchell-Innes, a diplomat and credit theorist, once put it: “A dollar of money is a dollar, not because of the material of which it is made, but because of the dollar of tax which is imposed to redeem it.”

According to this statement then increasing spending causes inflation, while increases in taxes cause deflation.  In the United States the Democrats (socialists) always want to increase spending and taxes, which cancel each other out according to MMT.  Republicans (conservatives) want to reduce spending and taxes which would also cancel each other out by this theory.  This analysis again confuses money with wealth and it ignores debt financing.

Another amazing thing about this statement is that if you or I “spent money into existence” it would be called counterfeiting and would be considered theft.  Somehow when the government does this, it is okay and according to MMT stimulates the economy (creates wealth).

The parenthetical comment “else how would people get the money to pay taxes?” is easily refuted by history.  People in the United States paid taxes, before the United States government had any legal tender.  As a result, there was no way for the government to spend before it collected taxes.  Even a cursory review of history provides numerous other examples, including early man in which there was no formal government.  In addition, my earlier article on Banking shows that banks create money when they create loans, which any MMT advocate should know.

I cannot make any sense of the final statement that the value of a dollar is created because of the tax necessary to redeem it.  This statement could only make sense to a totalitarian.  Totalitarians believe that when the government spends money it gives up some of its power and when it taxes and redeems the money it redeems this power.

This article explains the mechanism by which money is created as:

The Treasury spends dollars into existence through the central bank. The central bank credits the accounts of banks, and banks credit whoever is getting paid. Taxes reverse the process. Banks then debit accounts, and the central bank debits the banks. The government cannot run out of credits.

Note that no liability is created by the government in this direct money creation and no one is paying interest on this money, just like no one pays interest when money is printed.  There is a myth that all money in the United States (most modern countries) is created by a loan and that we have to pay the banks interest on all money created.  This is incorrect, the money created by this direct money creation process is not a loan and no one pays interest to have this money.

This process of money creation is only possible because the government has legal tender laws.  In my earlier article on Banking, I pointed out that legal tender laws were necessary for the government counterfeit money.  Since a central bank is tasked with controlling the money supply they require legal tender laws.  One of the fastest ways to undermine (eliminate) the Federal Reserve is to eliminate legal tender laws.

In theory Congress has to first authorize spending first.  However, in the United States we are not allowed to audit the Federal Reserve.  Thus it is possible even likely that the Federal Reserve creates money (direct money creation as opposed to a loan) and no one knows about it.  For instance, the Federal Reserve admitted that it could not account for $9 trillion of off-balance sheet transactions.[6]  While these may have been loans (we don’t know because we cannot audit the Federal Reserve), it shows how easy it would be for the Federal Reserve (or Treasury) to just credit someone’s bank account without anyone knowing.  Of course, I have no evidence of this, because we cannot audit the Fed, but human history would be on my side.


“Simple Inflation” under a Central Bank

In my earlier article on Banking and Inflation I defined simple inflation as that which occurs because of printing money or debasing the currency.  This direct creation of money function the same as these processes.  The amount of direct money created is equal to the total amount of money spent by the government, less the amount of taxes received, and less the amount of money borrowed by the government.  When a government resorts to direct money creation to pay for a large part of their operations, it results in rapidly increasing inflation rates.  Venezuela is the most blatant example today.


What we have learned:

  *Central banks do not arise in a free market (capitalism) they are a distortion of the free market.

            *Central banks require legal tender laws in order to fulfill their mission of controlling the money supply.

            *The amount the government spends less the amount it taxes and borrows is the amount of money created by the government (government counterfeiting), which results in simple inflation.

            *Modern Monetary Theory confuses money with wealth.

            *The fastest way to undermine (eliminate) the Federal Reserve is to eliminate legal tender laws.


Discount Window Lending

When most people think about the Federal Reserve (the central bank in United States) they immediately think about interest rates.  The Federal Reserve mainly affects interest rates in the United States by it setting of the Federal Funds Rate and by the Discount Rate.  The Federal Funds Rate is set by the Federal Reserve and is the interest rate at which banks lend reserve balances to each other.  The Discount Rate is the interest rate that the Federal Reserve charges banks to borrow from the Federal Reserve.  Both of these are related to the Federal Reserve’s function as a lender of last resort and are intended to prevent a “run on a bank.”

A run on bank is when a bank does not have enough cash (species) on hand to meet its customers demand.  This can occur to a sound bank and just represents a cash flow issue or it can be the result of a legitimate lack of solvency and confidence in the bank.  One of the main justifications for creating the Federal Reserve was to reduce the frequency of this occurring.  The empirical evidence is a mixed on this issue.  The Federal Reserve was created before the Great Depression and there were huge numbers of bank failures then.  However, the number of runs on banks and the number of bank failures where depositors lost money have probably decreased in frequency since the Great Depression.

When the Federal Reserve changes the Federal Funds Rate or the Discount Rate, which they usually change at the same time, it affects the interest rates that banks charge.  If the Federal Reserve increases either or both of these interest rates it usually causes banks to increase the interest rates they charge customers.  Generally the goal of raising interest rates is to reduce the number of loans banks are making and thereby decrease the money supply or slow its growth.  The opposite is true when the Federal Reserve lowers interest rates.  Thus it is normally considered inflationary when interest rates are lowered and deflationary when interest rates are raised.  Unfortunately, the empirical evidence is a bit murky on this issue.  For instance, interest rates were very low during the Great Depression in the United States and the money supply was shrinking.[7]  Milton Friedman and Anna Jacobson Schwartz argued that the Federal Reserve failed to fulfill their responsibility of lender of last resort.[8]

Since there appears to be some contradiction between the empirical data and the theory let’s examine this issue more closely.  When the Federal Reserve increases interest rates above the free market rate the result is that some projects that would have made economic sense to fund with a loan no longer are.  As a result fewer loans will be imitated by banks than would have been the case if interest rates were at the free market rate (the free market rate is the interest rate that banks would charge if there was no central bank).  This will reduce the money supply.  However this is a transient effect.  Once the economy has adjusted to the new interest rates loans will be created at this new lower rate.  At this point it is likely the money supply will grow (shrink) roughly at the same rate as the economy, as I explained in my earlier article on Banking.  If the Federal Reserve raises interest rates too far above the free market rate it can cause a nationwide liquidity crises, which will destroy some wealth that was or would have been created.  The government can destroy wealth, but it cannot create wealth only redistribute it.

If the Federal Reserve sets the interest rate lower than the free market rate but not too low, then more projects that would have not made economic sense to fund with a loan now are.  This results in a one-time increase the money supply and after that it the money supply should grow at about the same rate as the economy.  As a result, lowering the interest rate below the free market rate, but not too low, will result in a one-time increase in the money supply.

If a central bank lowers the interest rates too low, banks will refuse to initiate loans.  How low?  Well if the interest rate that banks can charge to commercial customers is the same as they can get on Treasuries, then the banks are not compensated for the risk and expense of initiating a commercial loan.  Banks need to be able to charge interest rates to their commercial customers that compensates for the extra risk and expense involve over supposedly safe investments like Treasuries (government bonds).  As a result, when interest rates are set too low by the central bank it results in a contraction of the money supply.

This shows that low interest rates (lower than free market rates) are not the cause of long term inflation and if the interest rate is too low it can be deflationary.  This is likely what has been happening in Japan since the 1990s and happened in United States during the Great Depression.  Other government policies can also effect how the economy behaves, which makes it hard to nail down the exact effect of the central banks policies.  For instance, Friedman and Schwartz seemed to blame the Federal Reserve for everything that happened in the Great Depression, however it is clear that other anti-free market policies by Roosevelt and Hoover before him also contributed significantly to the Great Depression.

Central banks can also change the number of loans that are initiated by changing the reserve ratio requirement.

The commercial bank’s reserves normally consist of cash owned by the bank and stored physically in the bank vault (vault cash), plus the amount of the commercial bank’s balance in that bank’s account with the central bank.[9]

However, this also should have a one-time effect on the money supply.  The result is that long term inflation is not caused by a central bank’s interest rate policy.  A central bank’s failure to act as a lender of last resort may cause an extended period of deflation however.


Open Market Operations

Another tool of central banks is open market operations where the bank goes into the market and sells or buys securities, usually bonds.  When a central bank buys securities it increases the money supply.  This operation involves the central bank creating money (a computer entry without any associated liability) and then buying the securities, which puts money into the economy.  As those bonds (normally the central bank buys bonds) are paid off it decreases the money supply.  As a result, buying securities results in a one-time increase in inflation that is removed as the bond is paid back.  Of course the central bank can continue to buy bonds if it wants to continue to inflate.

Alternatively, the central bank can sell securities, which results in a decrease in the money supply as private parties trade cash for the security.  As the private parties receive payments from the securities (if they are bonds) the money is reintroduced into the economy.  Each purchase by the central bank is a one-time decrease in the money supply (assuming the security is a bond) that is removed over time as the bond is paid back.

Both of the scenarios above assume that the central bank is buying or selling bonds (or other securities) at their free market rate.  If the central bank over pays for a bond the amount that it overpays for the bond is a direct creation of money and is not redeemed as the bond is paid off.

When the bond is a government bond (national) and the central bank agrees to purchase the bond at a lower interest rate than the free market rate, then this results in the direct creation of money equal to the difference in the required payments in a free market verses what the government actually pays.  This is clearly inflationary and very subtle.

When a central bank starts buying a significant percentage of the government bonds when issued, the most likely reason is that private buyers are not willing to purchase the bonds at the price (interest rate) the government wants to sell them at.  This is one of the surest signs that the central bank is creating large amounts of money to finance the government.  However, it is very subtle.  It is very hard to calculate how much money has been directly created.  If the central bank buys the government bonds near their real cost and requires payments based on tax receipts, then the amount of inflation is very small or not at all.  The central bank can just quietly retire these bonds and then the inflation is huge.  Since in the United States we cannot audit the Federal Reserve we have very little idea of what is really happening.  Inflation caused by open market operations and interest rate targeting are subtle and hard to detect and I call the inflation caused by these operations “complex inflation.”  Central banks and the legal tender laws they depend are designed to obscure what the government and central bank are doing.  This allows for all sorts of mischief and inside deals.

Attempts to measure money creation, M0-M4, do not differentiate between these mechanisms and therefore are poor at predicting inflation.

How many companies did the Federal Reserve bail out in 2008?  Did these companies really pay back these loans?  We know for sure that banks were allowed to “borrow” huge sums money from the Federal Reserve at near zero interest rates and then “invest” this money in Treasuries.  This was just a complex way of hiding the fact that the Federal Reserve created (printed) money and gave it to these banks.  The procedure was obscure enough that most Americans would either not understand what was happening or would get bored when someone explained it to them.  However, the money created was paid for by (really stolen from) all those Americans (and people forced to use US dollars around the world) who hold or work for US dollars.  The bankers then paid themselves huge bonuses for their brilliant investment strategies.


Here is what we have learned:

          *Central banks create money directly, although in theory in the United States with the direction of Congress and the Treasury.
            *When central banks change the interest rates it causes a one-time increase in inflation (deflation).  Low interest rates do not

            *Open market operations provide numerous ways to increase inflation that are subtle and hard to detect. 



History of Central Banks in the United States

Many people label the First National Bank of the United States as a central bank.  A central bank is different from a national bank, such as the First National Bank (FNB) of the United States setup during Washington’s presidency.  The FNB was a private bank in which the federal government had a twenty percent equity interest.  It was forbidden from buying government bonds, had a mandatory rotation of directors, it could not issue notes or incur debt beyond its capitalization, and the federal government could withdraw its money from the FNB and place it with another bank.[10]  The FNB of the United States was a truly a private bank not a central bank.  It did not set the policies that “affect a county’s supply of money and credit.”  It also did not issue legal tender.

Hamilton and Washington pushed for a national bank because the national government had to be able to pay bills through-out the nation and a national bank made this easier than working with multiple different banks.  Depending on a person’s view of central banking they either vilify Hamilton or think he was a genius.  Both sides seem to confuse the national bank issue with the Hamilton’s efforts to put the newly formed United States government on sound footing.  Hamilton’ s first report on public credit did not mention a national bank, it only dealt with the state and foreign bonds left over from the revolutionary war.  The report called for:

1) Assumption of the state and foreign bonds that were trading around 20-25% of their face value.

2) Paying off these state and foreign bonds at their face value by issuing new federal bonds.

3) Tariffs and tonnage duties would back these new federal bonds.

The result of this legislation, according to Wikipedia was:

The adoption of Hamilton’s Report had the immediate effect of converting what had been virtually worthless federal and state certificates of indebtedness into $60 million of funded government securities. Fully funded, the central government regained the ability to borrow, attracting foreign investment as social unrest destabilized Europe. In addition, the newly issued bonds provided a circulating currency, stimulating business investment.[11]

Hamilton’s plan worked brilliantly and it had nothing to do with a National Bank.

            The national bank was proposed in a separate report.  Hamilton would not have been in favor of a central bank.  Hamilton believed that a bank run by the government would be tempted print too much money.[12]  The First National Bank was not a central bank, however it was a government chartered and supported enterprise sort of like Fannie Mae and not strictly a free market enterprise either.  Such enterprises are prone to inside deals.

Most people point to the Second National Bank of the United States created in the Madison administration as a central bank.  The Second National Bank was modeled after the First National Bank, except it had some regulatory authority over other banks.  This made it closer to a central bank, however it did not have the power of legal tender or a monopoly on the issuance of money.  Apparently, the Second National Bank was poorly run and became involved in politics.  Andrew Jackson refused to renew its charter so its operations ended in 1836.  The information I could find on the Second National Bank was sparse compared to the First National Bank.

The first real central bank in the United States is the Federal Reserve, which was created in 1913.  The Federal Reserve is a private entity of sorts.  It is more like Fannie Mae than a true private bank however.  It has the power to create legal tender, it is tasked with setting interest rates to achieve policy goals, and it has regulatory control over the whole banking system in the United States.

There were two main justifications for the Federal Reserve: 1) the United States needed a lender of last resort to avoid banking panics, and 2) the idea that the United States government almost went bankrupt a couple of times, but JP Morgan saved the day.[13]

The United States did suffer from a number of bank panics, but these were due to over-regulation, not the free market.  Oddly, finance (stocks and bonds) was not regulated at all in the United States until the Kansas’ Blue Sky Law in 1911, which was the blue print for the Securities Act of 1933.  Banks on the other hand were highly regulated, the most obvious of these regulations were unit banking laws.  Unit banking laws required that banks could have only one location and these laws existed in a number of states and was applied to federal banks.  These resulted in a lack of diversification in banks’ portfolios, which increased their risk of failure.[14]  Canada did not have these restrictions.  Canada had many nationwide banks and as a result did not have a single bank fail during the Great Depression.[15]

Private banks had already created clearing houses that acted as a lender of last resort, before the Federal Reserve.

Friedman understood . . . that before the Federal Reserve Act financial panics in the US were mitigated by the actions of private commercial bank clearinghouses. Friedman and Schwartz’s view of the 1930′s was that the Fed, having nationalized the roles of the clearinghouse associations [CHAs], particularly the lender-of-last-resort role, did less to mitigate the panic than the CHAs had done in earlier panics like 1907 and 1893. In that sense, the economy would have been better off if the Fed had not been created. This position is perfectly consistent with the position that, provided we take the Fed’s nationalization of the clearinghouse roles for granted, the Fed was guilty of not doing its job.[16]

The idea that the United States needed a central bank, is not justified by the banking failures before the Federal Reserve and the Federal Reserve failed in this function during the Great Depression.

The other justification for the creation of the Federal Reserve was the supposed bailouts of the United States federal government in 1893 and 1907 by JP Morgan.  The United States was on a gold standard and the governments gold reserves were being depleted rapidly in both cases.  In both cases Morgan guaranteed to buy bonds issued to purchase gold for the United States Treasury.  These bonds were sold on the strength and credit of the United States and Morgan profited by both of these so-called bailouts.  If the Treasury had been doing its job correctly it would have cultivated a market for these bonds long before this crisis.  In addition, the federal government could also have slashed spending.  Not surprisingly the bailout of 1907 happened under the bad economic policies of Teddy Roosevelt.  In addition, the United States had the power to issue legal tender, which it could have done to conserve its gold.  The history surrounding these events is confused and has not been fully explored.  This paper is not full exploration of this topic, however it raises serious doubts that the narrative of these panics was a legitimate justification for the creation of the Federal Reserve.

Another narrative pushed by the banking interests is that somehow banks are different than other businesses.  Banks always argue that if one bank (large politically connected bank) fails then the whole banking system will collapse.  This narrative is trotted out every time banks demand a bailout, the most recent being the bailouts in 2008.  When a bank fails it goes through bankruptcy, which acts as a circuit breaker from a cascading series of failures.  This is exactly what happens in other areas of the economy.  Another solution that I do not endorse, but is better than bailouts, was the Resolution Trust Corporation that was created to liquidate the savings and loan failures of the late 1980s.  The Resolution Trust Corporation was essentially a massive bankruptcy proceeding and importantly its existence was limited.  It had to liquidate all its assets by 1992 (five year life).

The justifications of for the Federal Reserve are weak at best and considering the damage the Federal Reserve has done to the economy and its potential for abuse it should be ended.  The origins of the Federal Reserve are based on government failure, specifically interference in a free market.


What we have learned:

        *Central banks do not arise naturally in a free market and are not part of a free market.

            *Central banks and legal tender laws are the source of inflation, not private fractional reserve banks.

            *Central banks provide an easy way to obscure that the central bank and the government are creating inflation.

            *Lowering interest rates causes a one-time increase in the money supply over the trend line.

            *The fastest way to undermine (eliminate) the Federal Reserve is to eliminate legal tender laws.



[1] Bordo, Michael D., A Brief History of Central Banks, Federal Reserve Bank of Cleveland,, A Brief History of Central Banks, December 1, 2007.

[2] Investopedia, Central Bank, accessed January 7, 2017.

[3], accessed January 13, 2017.

[4] We can debate the accuracy of the actual number, however the point is the same.

[5], accessed January 13, 2017.


[1] Lawrence Hunter, Forbes, OCT 29, 2012,  Is The Federal Reserve Using Money-Laundering Techniques To Cleanse Banks’ Balance Sheets?, accessed February 7, 2017.

[7] Ivan Pongracic Jr., The Great Depression According to Milton Friedman, FEE, Saturday, September 01, 2007, ., accessed January 14, 2017.

[8] [8] Ivan Pongracic Jr., The Great Depression According to Milton Friedman, FEE, Saturday, September 01, 2007, ., accessed January 14, 2017.

[9] Wikipedia, , accessed January 14, 2017.

[10] The book, Hamilton’s Blessing, is a great reference for this but I do not have a copy anymore.

[11] , accessed January 15, 2017.

[12] Gordon, John Steele, Hamilton’s Blessing: The Extraordinary Life and Time of Our National Debt, Penguin Books, 1997, p. 34.


[13], accessed January 15, 2017.

[15] CARPE DIEM, , accessed January 15, 2017.

[16] .,  The Great Depression According to Milton Friedman, Ivan Pongracic Jr., Saturday, September 01, 2007, accessed January 15, 2017.

January 16, 2017 Posted by | Intellectual Capitalism | , , , , | Leave a comment

Understanding the Coming Financial Collapse: Central Banking, Fraction Reserve Banking, and Legal Tender Laws

The Federal Reserve caused the financial crisis of 2008, according to many of its critics.  On the other hand, many people have credited the Fed with avoiding another great depression.  This debate often becomes confused because people intermingle the concepts of a central bank, fractional reserve banking and legal tender laws.  For instance, Ron Paul has argued that fractional reserve banking creates money out of thin air and intersperses this with his arguments to end the Federal Reserve.  A commonly proposed solution is a return to the gold standard.  Proponents of the Federal Reserve also seem to believe that these concepts are a package deal.

The idea of a modern central bank that controls the money supply, sets interest rates separate from market forces, and is allowed to create money to buy government bonds, is relatively new.  In the case of the US this dates from the creation of the Federal Reserve in 1913.  As explained in the article A Brief History of Central Banks on the Federal Reserve Bank of Cleveland’s website,

 A central bank is the term used to describe the authority responsible for policies that affect a country’s supply of money and credit. More specifically, a central bank uses its tools of monetary policy—open market operations, discount window lending, changes in reserve requirements—to affect short-term interest rates and the monetary base (currency held by the public plus bank reserves) and to achieve important policy goals.[1]

When you read this explanation of the functions of a central bank in black and white it is clear that it is a central planning system for a country’s money and credit.[2]  Central planning of economic activity has always resulted in market distortions and the Federal Reserve is no different.

A central bank is different from a national bank, such as the First National Bank (FNB) of the United States setup during Washington’s presidency.  The FNB was a private bank in which the federal government had a twenty percent equity interest.  It was forbidden from buying government bonds, had a mandatory rotation of directors, it could not issued notes or incur debt beyond its capitalization, and the federal government could withdraw its money from the FNB and place it with another bank.[3]  The FNB of the United States was a truly a private bank not a central bank.  It did not set the policies that “affect a county’s supply of money and credit.”

The First National Bank of the United States was a fractional reserve bank however.  A fractional reserve bank is a bank in which a fraction of the bank deposits are kept in reserve.  Or stated another way the bank’s loans exceed its capital.  The Riksbank, founded in Sweden in 1656, is commonly accepted to be the first fractional reserve bank.  Murry N. Rothbard has argued that fractional reserve banks are counterfeiting money.[4]  This is incorrect.  Unfortunately, in order to explain it is wrong it is necessary to delve deeper into the history of banking.  Originally, bank notes were issued by a bank to indicate that a depositor had so much gold or silver on deposit.  When the depositor wanted to retrieve their gold, they would present the bank note to the issuing bank.  Since bank notes were bearer notes, meaning the bank paid whoever presented the note, holders of the notes started exchanging these notes instead of going to the bank and pulling out coins.  The cost and risk of transporting large sums gold made bank notes a much more practical currency.  Think about a merchant living in England that needed to purchase large sums of tobacco in the colonies or spices from the Far East or lumber to repair his ship.

What the banks had done with bank notes is securitize the gold they had on deposit.  However, gold and silver are not the only things of value.  Banks realized that they could securitize other property.  For instance, quality farm land had significant value.  There was a difference of course.  You cannot put your land on deposit with a bank.  However, the bank could have a contingent legal title to the land.  The bank did not need land, so it would provide you with a loan against this contingent title, known a mortgage or deed trust.  The borrower would pay the bank back in bank notes or species that he earned from his farm.  If the farmer defaulted, then the bank would take legal title to the land and sell it.  A bank could only loan money from its capital reserve making it a 100% reserve ratio bank.  But there is no logically reason that bank notes should only be backed (secured) by gold.  If I want to buy some land adjacent to my farm, but I do not have the funds it makes economic sense to take out a loan.  I could pledge to pay the widow who owns the farm over time.  This might work, but she may have pressing financial needs and a payment plan is not a good solution for her.  This problem is compounded if the farmer/borrower needs to buy extra seed corn, build a barn on the property, and pay extra laborers to realize the full economic potential of the farm he is buying.  He cannot promise to pay all these people on time.  The bank steps in and issues bank notes that are recognized as currency secured by the land owned by the farmer.  If the farmer dies, becomes disabled, or is just not able to pay back the loan, the bank takes over the farmer’s loan and sells it for currency, which could be bank notes or gold coins.  This ensures that they have enough gold on hand to pay off any holder of their bank notes.  In a fractional reserve bank, the bank has not created money out of thin air they have backed their bank notes by both gold deposits, their capital reserve, and the farmers land or whatever other collateral they have for the loans they have made.

It may be legitimate to require a bank to disclose that they are a fractional reserve bank to their depositors.  I asked a former president of a bank if they ever did disclose this to customers when they setup an account.  The answer was no.  As a lawyer, it seems that banks should have to disclose that they are a fractional reserve bank.  However, in discussions with mid-level bank employees, most of them do not know they work at a fraction reserve bank.

Bank securitization of farms is no different than a company selling bonds against its assets and future earnings.  The bonds it issues are not backed by gold, they are backed by the assets of the company.  You might argue that the purchasers of the bond have given gold to the company.  This may be true, but a company does not hold the gold in reserve.  It spends the gold for plant and equipment or expansion.  You may argue that a bond is not money.  That is true in this day and age of legal tender laws, but before legal tender laws there was very little difference.  Even today if you owe someone $10,000 you might sign over some bonds to that person to pay them.  Clearly, those bonds are acting like money.  Money is anything that functions as a medium of exchange and a store of value.  Rocks, tobacco leafs, paper, bonds, stock options, gold, silver, computer entries and bonds, are just a few of the ‘things’ that have functioned as money in history.  An interesting experiment in money is being conducted by the company Bitcoin.  Bitcoins have appreciated significantly against other currencies in the last couple of years and they are just computer entries.

Legal tenders laws mandate that certain state approved money can be used to satisfy debts within the country.  The first legal tender law in the United States was passed by the North during the Civil War.  Eventually this law was declared unconstitutional in Hepburn v. Griswold, 75 U.S. 603 (1870).  The Court reasoned that the Constitution allowed the federal government to coin money, but not the power to make paper legal tender.  The government argued that since it had the power to carry out war and the issuance of the legal tender was necessary for carrying on the war, then legal tender laws fell under the “necessary and proper’ clause of the Constitution.  The Court rejected this argument and also pointed to the fact that the Constitution prohibited the states from interfering with contracts.  The Constitution did not specifically, prohibit the federal government from interfering with private contracts, but it would be against the spirit of the Constitution to allow the federal government to do so.  Unfortunately, this case was quickly overruled by the Knox v. Lee, 79 U.S. 457 (1871) Supreme Court decision.  Multiple competing bank notes were the norm at that time.  According to the Cato Institute, “the government did not entirely monopolize issuance of notes until 1935, but the laws that made the monopoly possible date from the Civil War.”[5]  Today the legal tender law in the US is 31 USC § 5103 which states:

United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues. Foreign gold or silver coins are not legal tender for debts.

Legal Tender laws are necessary for government counterfeiting[6] to be successful.  Without legal tender laws, people would quit accepting the money government printed.  A central bank is not necessary for the government to counterfeit money.  The Union was able to print $450,000,000 of counterfeit money without a central bank.

The Federal Reserve uses a more sophisticated method of printing money.  The Federal Reserve can affect the money supply by either changing the interest rates or by buying and selling bonds.  However, the money supply in a free market also varies.  A fractional reserve bank is not a government creation and neither are bonds.  When a bond is issued or a bank funds a loan, they both increase the supply of money.  However, the amount of money that can be created in this manner is limited by the size of the economy, since bonds and loans have to be backed by productive assets.  If too many loans are funded, then the bank goes out of business, which shrinks the supply of money.  If too many bonds are floated, then they are not repaid and become worthless shrinking the supply of money.  The Federal Reserve can use its interest rate setting mechanism to encourage too many bad loans, but eventually this short term increase in the money supply will evaporate.  If the Federal Reserve wants to permanently increase the money supply, then it needs to use its open market operations to buy Treasury Bills or more recently to buy bad mortgages from private banks.  It is these open market operations that are used to create money out of thin air and why the Federal Reserve’s balance sheet is the best way to determine how much money the Federal Reserve has counterfeited.

The most effective way to stop the damage caused by government manipulation of the money supply and interest rates is to repeal the legal tender laws.  The North was able to print money without a central bank, but not without legal tender laws.  If the Federal Reserve attempted to flood the market with counterfeit money and there were no legal tender laws, the market would quickly discount the value of government issued currency and individuals would price their contracts in other more stable currencies.  This is why FDR outlawed the ownership of gold and gold clauses in contracts.  From a political point of view it will be easier to repeal the legal tender laws than to eliminate the Federal Reserve.

Presently, the Federal Reserve and other central banks are convinced that by counterfeiting money as fast as they can, they can create wealth.  Ben Bernanke believes that wealth can be created by the government dropping money out of a helicopter.[7]  If this were true, we could be really rich if every citizen were given the power to print money or just go online and change the amount of money in their bank accounts.  This insanity ensures that we are headed for a huge financial crisis that will make the 2008 recession seem trivial.  This financial crisis will be caused by both central banks and legal tender laws, but it will not be caused by fractional reserve banking.

[1] Bordo, Michael D., A Brief History of Central Banks, Federal Reserve Bank of Cleveland,, A Brief History of Central Banks, December 1, 2007.

[2] I think there is a quote on this from the book Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse Unfortunately, I do not have a copy of this book anymore.

[3] The book, Hamilton’s Blessing, is a great reference for this but I do not have a copy anymore.

[4] Rothbard, Murray N., Taking Money Back, Ludwig Von Mises Institute website, June 14, 2008,, This article originally appeared in The Freeman, September and October 1995.

[5] Schuel, Kurt, Cato Journal, Vol. 20, No. 3 (Winter 2001) p 454.

[6] Counterfeiting in an economic sense is any currency that is not backed by productive or creative effort that someone willing exchanged their creative effort for.  Gold is clearly not counterfeit money, since it requires productive effort to mine gold.  Buy paper money presents a problem.  It takes productive effort to make and print paper, but no one would trade twenty dollars of their effort for someone who printed a twenty dollar bill.  Economic counterfeiting is really a fraud where someone believes the other person has provided value that they did not provide and purposely withheld this fact from the other party.

November 13, 2012 Posted by | -Economics, -History | , , , , , , | 1 Comment

Were the Recessions of 2000 and 2008 Both Caused by Easy Money?

It is common for pundits to declare that the last two recessions were due to easy money on the part of the Federal Reserve.  Both free market proponents, such as Austrian economists, and Keynesians agree on this point.  David Faber even did a one hour show called the “Bubble Decade.”  First, let’s distinguish between easy credit bubbles and investment manias.  The recession of 2008 was clearly the result of excessive debt and is therefore a credit bubble.  Not only did the Federal Reserve hold interest rates low, but more importantly the federal government pursued a number of policies to encourage overinvestment (borrowing) in the housing sector.  Among these policies were the creation of Fannie and Freddie Mac and their investment in subprime mortgages and debt rating agencies, sanction by the SEC, that rated securities based on these mortgages as AAA.  Both of these contributed to a false sense of security on the part of investors.  It was believed that even if these securities (CMOs) failed the government would stand behind any mortgages backed by Fannie and Freddie.

Now compare this to the recession of 2000.  There were no policies encouraging debt (or equity) investments in technology start-up companies.  Banks do not loan money to even highly successful technology start-up companies.  Even very accommodative money policies by the Federal Reserve do not result in direct loans to these companies.  The Fed has small indirect effects.  For instance, easy money by the Fed makes it easier for founders to mortgage their house (or other property) and invest in their start-up.  Another indirect effect is that lower interest rates make it more attractive to invest in technology start-ups than debt instruments.  A third indirect effect is low interest rates encourage margin accounts for stock investors.  As a result, it is unlikely that the investment mania of the late 90s was the result of easy money policies on the part of the Fed.

Some people seem to believe that manias and bubbles can only occur because of easy money policies on the part of the Federal Reserve (Central Bank).  This cannot be right, because the tulip mania of Holland reach its peak in 1623.  This was before fractional reserve banking.  The first fractional reserve bank was the Swedish Riksbank established in 1656.  The first central bank was not established until the next century.  Clearly, investment manias can occur without central bank.

Gold is one of the most sensitive barometers of inflation due to excessive money creation.  The price of gold fell from about $400.00 an ounce in 1996 to below $300.00 per ounce in 1999 and most of 2000.  This is not the sort of response we would expect in gold prices, if the Federal Reserve was inflating the money supply.  The Discount Rate was 4 ½% in November 1998 and was increased to 6% by May 2000.  Again this is not one would call an easy money policy.  The investment mania in technology companies in the late 90s was not the result of over inflating the money supply.  Part of the deflation of the late 90s was due to a rapid increase in the amount of goods and services being produced, due to the new technologies being developed.  This may be one of the cases where the GDP measurement actually understated the actual growth.

The recession of the 90s was not caused by too easy money, but imprudent tightening of the money supply.  Alan Greenspan was determined to cool the stock market.  As a result, the Fed increased interest rates until they caused a recession.  The yield curve turned negative 1999 or early 2000.  A negative yield curve would never occur in a free market economy – that is without a central reserve bank.  No one would ever loan out money for a longer term at a lower interest rate in than a shorter term loan.  An inverted yield curve is the product of a central bank.

The economic growth of the 90s was built on companies developing new technologies, which is the only way to increase real per capita income.  As a result, the recession of 2000 was relatively mild.  Alternatively, the housing bubble was built on easy credit and did not result in new technologies.  The recession of 2008 was the deepest since the recession of 1980.

September 22, 2010 Posted by | -Economics, Innovation | , , , , , , , , | Leave a comment

Phoenix: Mythical Fed Chairman Muses on the Economic Growth of the 90s

Phoenix: Mythical Fed Chairman Muses on the Economic Growth of the 90s

The Federal Reserve Chairman was sitting in his office contemplating the fantastic problem that he and the other fed governors were trying to solve.  The Federal Reserve, since its inception in 1913, had never faced such a dilemma.  Huge federal budget surpluses were likely to wipe out the federal debt in the next couple of years and the fed chairman was concerned how the Federal Reserve was going to control the money supply.  Buying and selling treasury notes was one of the major methods the Federal Reserve used to control the money supply.  Controlling the money supply was necessary to control inflation, ease recessions and deal with banking crises, such as 1930’s style runs on banks.  The Federal Reserve buys treasury bills when they want to increase the money supply and sells treasury bills when they want to decrease the money supply.  If the federal deficit was paid off, then the Federal Reserve would have difficulty using open market operations to control the money supply.  The Federal Reserve could still alter the discount rate or the required reserve ratio of banks to alter the money supply, but open market operations have a more immediate. Continue reading

June 15, 2009 Posted by | -Economics, -History, Innovation, Uncategorized | , , , , , , , , , , | Leave a comment