DESCENT FROM GOLD TO FIAT

[FoundingFathers]

DESCENT FROM GOLD TO FIAT
Copyright 2004 J. N. Tlaga

By placing our example in 1900 AD when gold coins constituted the ultimate legal tender for all debts, we were able to debunk the persistent myth that fractional reserve banking provides a mechanism for bankers to create credit money out of thin air.

The myth maintains that when Corn Farmer deposits $100,000 in Corn Bank, and Corn Bank then lends $83,000 to Alcohol Distiller, the $83,000 is not taken out of Corn Farmer's account, no Sir! Rather it is simply created out of thin air, yes Sir, created out of thin air!

The "smoke and mirror" for this mystification was provided by the fact that the loan was made by way of issuing $83,000 in Corn Bank's notes, and Alcohol Distiller used those banknotes to purchase a trainload of potatoes.

But Potato Bank knew better, and promptly presented those banknotes to Corn Bank for redemption in gold coins, the real money. Then everyone could see that Corn Bank had nowhere to turn for gold coins except to the Corn Farmer's deposit.

That's how we proved to everyone's satisfaction that fractional reserve loans were never created out of thin air but were always pilfered out of demand deposits, obviously without telling depositors about it, for open pilfering is called plundering.

It is our thesis that only a central bank can create new money out of thin air by printing it or by making a computer ledger entry to that effect. It is this central bank's counterfeiting that is the cancer that is causing inflation and boom-and-bust cycles; fractional reserve banking is not the source.

Accordingly, to stop inflation and economic cycles it is the central banking that needs to be excised, not the fractional reserve banking.

Making a false culprit out of the fractional reserve banking is providing cover for the central bank's counterfeiting. By maintaining the myth that fractional reserve banking was creating new money out of thin air, the Fed in effect has been saying to the whole world during the entire 80 years of its existence that it was the fractional reserve banking that was causing the never ending inflation and the boom-and-bust cycles, not the Fed's counterfeiting racket.

And this is the reason why our effort to separate central banking from fractional reserve banking, in order to abolish the central banking and to keep the fractional reserve banking, will be met with heavy resistance, persistent disinformation and heckling.

This is the reason why the doctoral thesis of Harald Haas at Bremen University attempts to convey incorrect conclusion that "Tlaga's proposal asks for the abolishment of the central bank(s) and the abolishment of fiat paper money and thereby fractional reserve banking." See: http://www.gold-eagle.com/editorials...aga010504.html

Now, beginning our discourse once again from AD 1900, when gold was the ultimate form of money, will help us to explain the meaning of the term "cash" which is essential for understanding the changes injected into fractional reserve banking by the central bank's counterfeiting.

In fact we have already defined the meaning of "cash". Cash is simply the ultimate form of money; a form of money into which other forms of money can be exchanged, but which itself cannot be exchanged into any other money under the existing legal order.

When Gold Standard Act became law in 1900, the amount of currency in circulation had just passed the two billion dollar mark. Rounded off by category to the nearest half a million dollars, it consisted of the following:

$715.5 million in gold coins.

$210.5 million in gold certificates, redeemable into $210.5 million worth of gold coins kept in US Treasury's vaults, and earmarked for this purpose.

$410.5 million in silver certificates, redeemable into $410.5 million worth of silver dollars or in gold coins at US Treasury option. If you showed up at US Treasury service window in downtown Manhattan and requested redemption of silver certificates in the amount so large that they would have to bring more silver dollars say from West Point, and that would take an extra day or so, they would give you gold coins right away, and you had to take gold for silver. They could not give you silver for gold, but they could give you gold for silver, and you had to take it. The rationale for this rule was that the very fact of waiting for your silver to be brought to you from remote storage vault would make silver certificates not truly redeemable on demand. So you had to take gold right away.

$84.0 million in Treasury notes, representing unminted silver, which upon redemption were being replaced in circulation with silver certificates, representing already minted silver dollars.

$322.5 million in US notes (Abe Lincoln's "greenbacks"), secured by the redemption fund of $150 million in gold at US Treasury, which were being gradually replaced in circulation by gold coins.

$257.0 million in national banknotes, secured by a deposit of $219 million in US bonds and $38 million in lawful money.

The last category, always added to the list by the bankers, was not considered a money by US Treasury. If you paid your taxes in national banknotes, Treasury would discount your banknotes, for under their own terms they were promises to pay, not the actual payments. The other forms of money, also known as "lawful money", were being accepted for taxes at face value, without a discount.

But even though all the forms of "lawful money" were being accepted for taxes at face value, they were all convertible into gold coins. Only gold coins could not be exchanged into something else, and for this reason only gold coins were considered to be the real "cash" which could validly settle legal obligations.

Even gold certificates, which dollar-for-dollar represented gold coins in US Treasury, were not considered a legal tender by the courts of law. After all, a payment could be made in counterfeited gold certificates, which would then reopen already settled transaction for further proceedings. To settle obligations irreversibly, with finality, gold coins had to be used in payment.

Under fully developed central banking, the ultimate form of money, into which all other forms of money can be exchanged, but which itself cannot be exchanged into other form of money under the existing order, is the banknote of the central bank. To convert your money to cash in America right now means to convert it into Federal Reserve notes.

Transition from gold to fiat was of course gradual.

In the green salad days of my awakening into economic reality (it is possible to go through one's life without paying discernible attention to economics until something odd catches one's eye) I simplified description ofcentral banking by resorting to the following parable of fiction:

One day in 1913, Congressional leaders in Washington met five gentlemen from New York, whose spokesman proceeded to announce: "We have an offer for you, you cannot refuse."

"The other autumn, it dawned upon us that our banks, First Gambino City Bank, Bonano Guaranty, Luchese Manhattan Bank, Colombo Bank of Commerce, and Genovese Trust should form a syndicate under the name and title of La Cosa Nostra Reserve Bank for the purpose of printing and circulating counterfeited dollar bills.

"Later on, we decided that the Federal Reserve Bank would be a better name, and you, that is, Bureau of Engraving and Printing of the United States Treasury could do the printing for us, at a cost, naturally.

"You will print our Federal Reserve notes and we will circulate them to our friends and associates, who in turn will pass them on the unsuspecting public at the face value of gold and silver coins now in circulation. If anyone will question the value of our notes, you, that is, the Treasury of the United States will exchange these notes for gold coins at face value on demand. That way, people will get used to the idea that our counterfeited dollars are as good as gold."

Did US Congress accept this "offer"?

Yes it did. Only not the fictitious mafia banks but the real life Anglo-American banks were on the receiving end of that giveaway of the century.

Initially, the status of the Federal Reserve notes was very much the same as the status of the national banknotes they replaced. All the national banks were required by the Federal Reserve Act to join the Federal Reserve System or to surrender their charter.

I have in front of me a specimen of a 20 dollars Federal Reserve note issued by the Federal Reserve Bank of Cleveland, Ohio, and this is what it says on its face:

NATIONAL CURRENCY

SECURED BY THE UNITED STATES BONDS

DEPOSITED WITH THE TREASURER OF

THE UNITED STATES OF AMERICA

OR BY LIKE DEPOSIT OF OTHER SECURITIES

THE FEDERAL RESERVE BANK OF CLEVELAND OHIO

WILL PAY TO THE BEARER ON DEMAND

TWENTY DOLLARS

REDEEMABLE IN LAWFUL MONEY

OF THE UNITED STATES

AT UNITED STATES TREASURY

OR AT THE BANK OF ISSUE

In form, the Federal Reserve notes were not any different than national banknotes, they circulated in lieu of "lawful money of the United States", as promises to pay in "lawful money of the United States", but in reality it was a fiat cancer programmed to grow on top of "the lawful money of the United States" into a plain fiat money, expanding the nation's money supply at will of its creators.

The bill of goods sold to US Congress was that the sole purpose of the Federal Reserve notes was only to serve as a temporary currency, a script money so to speak, to alleviate the pressure on the banks during the time of money panics, to prevent economic recessions caused by temporary unavailability of "lawful money" for financing commercial paper. Once the panic subsides -- the bankers siren song went -- the Federal Reserve notes will of course be displaced by the returning lawful money, but will always be ready to stand in for the lawful money again whenever the new panic arises.

Whenever something is offered as a temporary remedy it should not be taken lightly, for nothing on this planet is more eternal than temporary remedies.

The ostensible rationale for the Federal Reserve notes was to provide means for financing commercial paper, and thus keeping economy alive, during the time of money panics when the credit was scarce because gold deposits were being withdrawn from the banks. Translated into our example, this is how the theory went:

Corn Farmer deposits $100,000 in gold at his bank, and Corn Bank lends $83,000 to Alcohol Distiller, then comes money panic, and Corn Farmer wants his $100,000 back. Ordinarily, this would bring Corn Bank down because it could not refund Corn Farmer's deposit until Alcohol Distiller repaid his loan. But the Federal Reserve System offered the following way out:

Corn Bank presents Alcohol Distiller's commercial paper for re-discount at the nearest Federal Reserve Bank and receives for it Federal Reserve notes, like the ones I just described. Corn Farmer is paid in Federal Reserve notes, which are redeemable in "lawful money of the United States" at US Treasury or at Federal Reserve bank which issued the notes. Corn Farmer gets gold or other lawful money of his choice from the Federal Reserve bank and Federal Reserve bank gets back its gold or other lawful money from Alcohol Distiller when his commercial paper becomes due.

On its face, it was seemingly honest and elegant system, where central bank's reserves of gold and other lawful money of the United States were used to stand in for temporary deficiency of gold or other lawful money in commercial banks during the money panics in order to avoid disruption of nation's economy. US Treasury was brought in to use its current balances on hand as the additional means of reassurance for the public confidence in the system. But reality always takes exceptions to declared intentions.

Federal Reserve Act was signed by President Wilson in great haste on December 23, 1913, and it took until November 16, 1914 to organize the whole system. By that time the Great War, later known as the First World War, was raging in Europe. The great wave of gold that came to US shores with immense orders for war supplies made re-discounting of commercial paper by the Federal Reserve banks by and large unnecessary.

All the war orders were being paid in cash in advance. The supply of eligible commercial paper was so limited, that Federal Reserve banks were recycling it in order to exchange as much of incoming gold into Federal Reserve notes as possible.

Under initial Federal Reserve Act, Federal Reserve notes were only allowed to be issued by US Treasury agents delegated to each Federal Reserve bank in exchange for collateral consisting of 40% gold and 60% commercial paper. That was so because the very argument for the Federal Reserve System was that it was needed to finance commercial paper. "So, give us that commercial paper" - the US Government said - "and US Treasury will give you Federal Reserve notes." But now it turned out there was not enough commercial paper around to exchange all the gold coming from Europe into Federal Reserve notes at the prescribed 40:60 ratio. So, Federal Reserve banks resorted to the following scheme:

First they presented all the commercial paper they could gather (by way of re-discounting or direct buying on the market) to the Treasury agents with the corresponding 40% in gold to obtain Federal Reserve notes, and then...

...they turned around and redeemed that commercial paper in gold, as if the issuers of that paper have just repaid their underlying debt, and then...

...they resubmitted the same commercial paper with new 40% in gold to their Treasury agents in order to obtain new load of the Federal Reserve notes, and then...

...they turned around and redeemed that commercial paper in gold again, only to have it resubmitted with the new 40% in gold for yet another load of the Federal Reserve notes, again, again and again.

Why would Federal Reserve banks waste so much gold by obtaining their notes against gold in effect at 100% rather than required 40%?

The idea was to replace as much gold as possible with Federal Reserve notes in daily commerce to teach the public to accept them as real money that were "as good as gold". People are creatures of habit. They will do today what they were doing yesterday without asking why. Once you teach them new habit which seems to have no adverse effects whatsoever, they will stick to it forever.

With economy booming, with markets flooded with Federal Reserve notes, and with gold more plentiful than it ever was, it was not long for the people to learn to accept Federal Reserve notes as cash. The line between money and a mere promise to pay money has been blurred during the First World War. It would take another generation to substitute "THE FEDERAL RESERVE BANK WILL PAY TO THE BEARER ON DEMAND" with "THIS NOTE IS LEGAL TENDER FOR ALL DEBTS PUBLIC AND PRIVATE" on Federal Reserve notes, and yet another generation to eliminate the last remnants of convertible currencies after JFK assassination.

Under plain fiat system, when Corn Farmer deposits $100,000 in Federal Reserve notes in Corn Bank, and Corn Bank then lends $83,000 in Federal Reserve notes to Alcohol Distiller, and Corn Farmer then withdraws his $100,000 in Federal Reserve notes while the loan to Alcohol Distiller is outstanding, even the intellects of Austrian caliber can be overwhelmed by central bankers sophistry and embrace openly irrational conclusion that Corn Bank must have created $83,000 out of thin air.

In the real world, when Corn Bank lends some cash to Alcohol Distiller, whether in the form of gold coins or inthe form of fiat banknotes, that cash must come from somewhere:

(1) under free banking system, the lent cash can come only from other people's deposits;

(2) under central banking system, the lent cash can come either from other people's deposits, or is acquired from the central bank under various programs and pretenses.

Only the central bank can create new fiat money by printing it or by writing in new deposits. Regular banks and depositary institutions do not have such powers. When commercial bank lends more cash than it has on hand and then covers for that loan by borrowing money from the central bank, it does not mean that it has created new money out of thin air.

Likewise, when we write a check, and then we transfer funds from another account to cover it, this is known as robbing Peter to pay Paul, but it is not creating money out of thin air.

By the time President Wilson decided to "make the world safe for democracy", enough Federal Reserve notes were in circulation to drop the pretense that they were needed as temporary substitute for gold during the money panics, and to use them openly for their truly intended purpose, i.e., for financing the war expenses of the United States and the European borrowing by directly expanding US money supply.

It was done by:

(1) allowing new Federal Reserve notes to be issued directly against gold;

(2) reducing fractional reserve requirements of the member banks to 13% on demand deposits in New York and Chicago, 10% in other reserve cities, 7% in country banks, and 3% on time deposits in all banks;

(3) requiring member banks to transfer their reserves to Federal Reserve banks, to be able to count them toward the required reserves, in exchange for Federal Reserve notes or deposit credits (depending on whether their customers primarily used cash or checks);

(4) coercing large state chartered banks to join Federal Reserve System ostensibly as war related measure.

Fractional reserve deposits at Federal Reserve banks are used for clearing checks written on member banks. Statistically, daily totals of debits do not exceed the fractional reserve. If they occasionally do, overnight credit from the Fed covers deficiency. The remainder is lent out as if it was a time deposit.

The biggest nonsense in the fractional reserve mythology is that with fractional reserve at 10%, a bank can lend ten times the amount of deposits on hand.

Nothing could be more wrong!

Under free banking system and under central banking system, with fractional reserve at 10%, a bank must keep 10% in reserve, and can lend the remaining 90%. For example, if someone deposits $1000, bank must keep $100 in reserve and can lend $900. The persistent notion that the bank can lend $10,000 and keep $1000 as a reserve is downright idiotic. The check written against non-existent deposit would not clear. Under free banking system, the bank engaging in such lending practices would have to close down, and under central banking the check would be covered by Federal Reserve credit, but a banker engaging in such practices would ultimately be disciplined.

Even when Federal Reserve distributes newly created fiat money, also known as "high powered money", say by way of buying Treasury securities, a bank receiving such money can only lend 90% of it and must keep 10% in reserve. It may NOT lend out ten times more than it has received.

As we can see, fractional reserve banking operates on similar principles under both the free banking and the central banking if only because under both system arithmetic principles are still the same. The only difference is that under central banking a counterfeiter who never runs out of money serves as the lender of last resort.

In the final analysis, it is the central bank's counterfeiting that is responsible for inflation and boom-and-bust cycles. Fractional reserve banking can only utilize the existing money, it cannot create new money out of thin air. The confusion about creating new money out of thin air results from inability to distinguish between lending new money that was just printed, and lending old money that was sitting unutilized in somebody's bank account or under somebody's mattress. Fractional reserve banking can only utilize the existing cash sitting in people's bank accounts. It cannot pull the existing cash from under people's mattresses, and most of all it cannot create new cash out of thin air and add it to the nation's money supply, only the central bank can do it.

The central banking system inherited fractional reserve banking from the free banking system, and is utilizing it as an instrument of control, because it is a superb instrument of control, after all, it was capable to enforce gold discipline entirely on its own. When central bank will be erased overnight, as proposed in http://www.gold-eagle.com/editorials...aga112801.html no attempt should be made to erase fractional reserve banking.

Again, again and again, fractional reserve banking per se cannot add new money to the existing money supply on its own, only the central bank can do it. For background explanation how the expansion of credit from 1922 on led to the crash of 1929, see: http://www.gold-eagle.com/editorials...aga081202.html



1 February 2004

J. N. Tlaga

jtlaga@bellsouth.net

PS: "Why The Austrian School Needs To Purge Its Flaws" generated very interesting responses. They will be all addressed in due time, with proper respect and necessary attention. We have waited 80 years for this fractional reserve myth to fall. What's the rush now?

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