Inflation: An Expansion of Counterfeit Credit

The Keynesians and Monetarists have fooled people with a clever sleight of hand. They have convinced people to look at prices (especially consumer prices) to understand what’s happening in the monetary system.

Anyone who has ever been at a magic act performance is familiar with how sleight of hand often works. With a huge flourish of the cape, often accompanied by a loud sound, the right hand attracts all eyes in the audience.  The left hand of the illusionist then quickly and subtly takes a rabbit out of a hat, or a dove out of someone’s pocket.

Watching a performer is just harmless entertainment, and everyone knows that it’s just a series of clever tricks.  In contrast, the monetary illusions created by central banks, and the evil acts they conceal, can cause serious pain and suffering. This is a topic that needs more exposure.

The commonly accepted definition of inflation is “an increase in consumer prices”, and deflation is “a decrease in consumer prices.”A corollary is a myth that stubbornly persists: “today, a fine suit costs the same in gold terms as it did in 1911, about one ounce.” Why should that be? Surely it takes less land today to raise enough sheep to produce the wool for a suit, due to improvements in agricultural efficiency. I assume that sheep farmers have been breeding sheep to maximize wool production too. And doesn’t it take less labor to shear a sheep, not to mention card the wool, clean it, bleach it, spin it into yarn, weave the yarn into fabric, and cut and stitch the fabric into a suit?

Consumer prices are affected by a myriad of factors. Increasing efficiency in production is a force for lower prices.  Changing consumer demand is another force. In 1911, any man who had any money wore a suit. Today, fewer and fewer professions require one to be dressed in a suit, and so the suit has transitioned from being a mainstream product to more of a specialty market. This would tend to be a force for higher prices.

I don’t know if a decent suit cost $20 (i.e. one ounce of gold) in 1911. Today, one can certainly get a decent suit for far less than $1600 (i.e. one ounce), and one could pay 3 or 4 ounces too for a high-end suit.

My point is that consumer prices are a red herring. Increased production efficiency tends to push prices down, and monetary debasement tends to push prices up. If those forces balance in any given year, the monetary authorities claim that there is no inflation.

This is a lie.

Inflation is not rising consumer prices. One can’t understand much about the monetary system from inside this box. I offer a different definition.


Inflation is an expansion of counterfeit credit.


Most Austrian School economists realize that inflation is a monetary phenomenon. But simply plotting the money supply is not sufficient. In a gold standard, does gold mining create inflation? How about private lending? Bank lending? What about Real Bills of Exchange?

As I will show, these processes do not create inflation under a gold standard. Thus I contend the focus should be on counterfeit credit. By definition and by nature, gold production is never counterfeit. Gold is gold, it is divisible and every piece is equivalent to any other piece of the same weight.

Gold mining is arbitrage: when the cost of mining an ounce of gold is less than one ounce of gold, miners will act to profit from this opportunity. This is how the market signals that it needs more money. Gold, of course, has non-declining marginal utility, which is what makes it money in the first place, so incremental changes in its supply cause no harm to anyone.

Similarly, if Joe works hard, saves his money, and gives a loan of 100 ounces to John, this is an expansion of credit. But it is not counterfeit or illegitimate or inflation by any useable definition of the term.

By extension, it does not matter whether there are market makers or other intermediaries in between the saver and the borrower. This is because such middlemen have no power to expand credit beyond what the source—the saver—willingly provides. And thus bank lending is not inflation.

Below, I will discuss various kinds of credit in light of my definition of inflation.

In all legitimate credit, at least two factors distinguish it from counterfeit credit. First, someone has produced more than he has consumed. Second, this producer knowingly and willingly extends credit. He understands exactly when, and on what terms, with what risks he will be paid in full. He realizes that in the meantime he does not have the use of his money.

Let’s look at the case of fractional reserve banking. I have written on this topic before. To summarize: if a bank takes in a deposit and lends for a longer duration than the deposit, that is duration mismatch. This is fraud and the source of banking system instability and crashes. If a bank lends deposits only for the same or shorter duration, then the bank is perfectly stable and perfectly honest with its depositors. Such banks can expand credit by lending, (though they cannot expand money, i.e. gold), but it is real credit. It is not counterfeit.

Legitimate lending begins with someone who has worked to save money. That person goes to a bank, and based on the bank’s offer of different interest rates for different durations, chooses how long he is willing to lock up his money. He lends to the bank under a contract of that duration. The bank then lends it out for that same duration (or less).

The saver knows he must do without his money for the duration. And the borrower has the use of the money. The borrower typically spends it on a capital purchase of some sort. The seller of that good receives the money free and clear. The seller is not aware of, nor concerned with, the duration of the original saver’s deposit. He may deposit the money on demand, or on a time deposit of whatever duration. 

There is no counterfeiting here; this process is perfectly honest and fair to all parties. This is not inflation!

Now let’s look at Real Bills of Exchange, a controversial topic among members of the Austrian School. In brief, here is how Real Bills worked under the gold standard of the 19th century. A business buys merchandise from its supplier and agrees to pay on Net 90 terms. If this merchandise is in urgent consumer demand, then the signed invoice, or Bill of Exchange, can circulate as a kind of money. It is accepted by most people, at a discount from the face value based on the time to maturity and the prevailing discount rate.

This is a kind of credit that is not debt. The Real Bill and its market act as a clearing mechanism. The end consumer will buy the final goods with his gold coin. In the meantime, every business in the entire supply chain does not necessarily have the cash gold to pay at time of delivery.

This problem of having gold to pay at time of delivery would become worse as business and technology improved to allow additional specialization and thus extend the supply chain with additional value-added businesses. And it would become worse as certain goods went into high demand seasonally (e.g. at Christmas).

The Real Bill does not come about via saving and lending. It is commercial credit that is extended based on expectations of the consumer’s purchases. It is credit that arises from consumption, and it is self-liquidating. It is another kind of legitimate credit.

For more discussion of Real Bills, see the series of pieces by Professor Antal Fekete (starting with Lecture 4).

Now let’s look at counterfeit credit. By the criteria I offered above, it is counterfeit because there is no one who has produced more than he has consumed, or he does not knowingly or willing forego the use of his savings to extend credit.

First, is the example where no one has produced a surplus. A good example of this is when the Federal Reserve creates currency to buy a Treasury bond. On their books, they create a liability for the currency issued and an asset for the corresponding bond purchase. Fed monetization of bonds is counterfeit credit, by its very nature.  Every time the Fed expands its balance sheet, it is inflation.

It is no exaggeration to say that the very purpose of the Fed is to create inflation. When real capital becomes more scarce, and thus its owners become more reluctant to lend it (especially at low interest rates), the Fed’s official role is to be the “lender of last resort”. Their goal is to continue to expand credit against the ever-increasing market forces that demand credit contraction.

And of course, all counterfeit credit would go to default, unless the creditor has strong collateral or another lever to force the debtor to repay. Thus the Fed must act to continue to extend and pretend. Counterfeit credit must never end up where it’s “pay or else”. It must be “rolled”. Debtors must be able to borrow anew to repay the old debts—forever. The job of the Fed is to make this possible (for as long as possible).

Next, let’s look at duration mismatch in the financial system. It begins in the same way as the previous example of non-counterfeit credit—with a saver who has produced more than he has consumed. So far, so good. He deposits money in a bank, and this is where the counterfeiting occurs. Perhaps he deposits money on demand and the bank lends it out. Or perhaps he deposits money in a 1-year time account and the bank lends it for 5 years. Both cases are the same. The saver is not knowingly foregoing the use of his money, nor lending it out on such terms and length.

This, in a nutshell, is the common complaint that is erroneously levied against all fractionally reserved banks. The saver thinks he has his money, but yet there is another party who actually has it. The saver holds a paper credit instrument, which is redeemable on demand. The bank relies on the fact that on most days, they will not face too many withdrawal demands. However, it is a mathematical certainty that eventually the bank will default in the face a large crowd all trying to withdraw their money at once. And other banks will be in a similar position. And the collapsing banking system causes a plunge into a depression.

There are also instances where the saver is not willingly extending credit. The worker who foregoes 16% of his wage to Social Security definitely knows that he is not getting the use of his money. He is extending credit, by force—i.e. unwillingly. The government promises him that in exchange, they will pay him a monthly stipend after he reaches the age of retirement, plus most of his medical expenses. Anyone who does the math will see that this is a bad deal. The amount the government promises to pay is less than one would expect for lending money for so long, especially considering that the money is forfeit when you die.

But it’s worse than it first seems, because the amount of the monthly stipend, the age of retirement, and the amount they pay towards medical expenses are unknown and unknowable in advance, when the person is working. They are subject to a political process. Politics can shift suddenly with each new election.


Social Security is counterfeit credit.


With legitimate credit, there is a risk of not being repaid. However, one has a rational expectation of being repaid, and typically one is repaid. On the contrary, counterfeit credit is mathematically certain not to be repaid in the ordinary course. This is because the borrower is without the intent or means of ever repaying the loan. Then it is a matter of time before it defaults, or in some circumstances forces the borrower to repay under duress.

Above, I offered two factors distinguishing legitimate credit:

1.    The creditor has produced more than he has consumed

2.    He knowingly and willingly extends credit


Now, let’s complete this definition with the third factor:

3.    The borrower has the means and the intent to repay


Every instance of counterfeit credit also fails on the third factor. If the borrower had both the means and the intent to repay, he could obtain legitimate credit in the market.

A corollary to this is that the dealers in counterfeit credit, by nature and design, must work constantly to extend it, postpone it, “roll” it, and generally maintain the confidence game. Counterfeit credit cannot be liquidated the way legitimate credit can be: by paying it back normally. Sooner, or later, it inevitably becomes a crisis that either hurts the creditor by default or the debtor by threatening or seizing his collateral.

I repeat my definition of inflation and add my definition of deflation:


Inflation is an expansion of counterfeit credit.

Deflation is a forcible contraction of counterfeit credit.


Inflation is only possible by the initiation of the use of physical force or fraud by the government, the central bank, and the privileged banks they enfranchise. Deflation is only possible from, and is indeed the inevitable outcome of, inflation. Whenever credit is extended with no means or ability to repay, that credit is certain to eventually become a crisis that threatens to harm the creditor. That the creditor may have collateral or other means to force the debtor to take the pain and hold the creditor harmless does not change the nature of deflation.

Here’s to hoping that in 2012, the discussion of a more sound monetary and banking system begins in earnest.


Addendum, by Pater Tenebrarum

Our readers may remember Keith from last year's debate over fractional reserve banking in these pages. Keith writes for the Daily Capitalist and is associated with Dr. Antal Fekete's school. He has graciously allowed us to publish the above article.

We wanted to add a few comments: we agree with Keith that one could term the activity of the current banking system as creating counterfeit credit, as fractional reserve banking allows the creation of money substitutes (fiduciary media) from thin air. Given that demand deposits represent claims on money proper payable on demand, a system that creates fiduciary media is in practice no different from a medieval gold banker who issued an amount of bank notes exceeding the gold he had on deposit.

It is important to keep in mind though that this credit creation process – while generating loan assets on the asset side of a bank's balance sheet, also creates liabilities that are in fact money in the broader sense (i.e., they are  not standard money, but an immediately available and transferrable claim to standard money and can be used for final payment). In short, inflationary credit adds to the money supply.

Keith makes a very good point about the maturity mismatch issue plaguing the system: fractional reserves are a special case of this general problem.

We briefly wanted to mention on which points we disagree with Dr. Fekete. One is the viability of real bills doctrine and the other his assertion that gold's marginal utility is not diminishing. The law of marginal utility is a time- and place-invariant economic law that always holds. We would be prepared to allow that gold's marginal utility probably declines only very slowly, due to its (currently suspended) function as a medium of exchange and the functions that flow from this, such as its usefulness as a store of value. However, every additional gold ounce one holds can only be used for the satisfaction of a less urgent want than the preceding gold ounce. It is in other words the grading of want-satisfactions that is the decisive factor.





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23 Responses to “Inflation: An Expansion of Counterfeit Credit”

  • debeerr:

    Keith, i find your reply confusing at best.
    1. After page 1 of your article you discuss money under a gold standard and to my mind that is not the point you made in Page1 (which my reply addressed)
    2. My reply and your point in Page 1 discusses money only under under a fiat monetary system.
    3 My reply makes the same point Pater makes in his response to your article where he disagrees with you as follows “It is important to keep in mind though that this credit creation process – while generating loan assets on the asset side of a bank’s balance sheet, also creates liabilities that are in fact money in the broader sense (i.e., they are not standard money, but an immediately available and transferrable claim to standard money and can be used for final payment). In short, inflationary credit adds to the money supply.”
    4. A fiat system can work quite well. refer the Experience of Holland in the 17th century , i believe when the dutch banking system required 100%
    reserve of deposits. In other words there was all the money necessary had all the depositors demanded there money back at the same time. The Dutch financial system flourished and other European counties rushed to deposit funds with the Dutch banks. the Dutch economy blossomed during this period.
    5. De Soto makes the distinction between standard money earned from the production process and loans quite well – i suggest you read hid book on the subject if you have not already done so.
    6..In your reply you state “The key issue is the distinction between money (gold) and credit. Today, money has been banished from the system by legislative fiat. It’s all credit. In a gold system, the distinction is night and day.” Fractional reserve banking was practised under a gold standard and the gold standard money system did not prevent financial(credit) crisis such as those that occurred during the 19th century in the USA.The problem with our monetary system is two fold- firstly it suffers from currency debasement (printing money out of thin air) practised by Central Banks and he commercial banks and secondly from the fractional reserve banking system practised as Pater states “Given that demand deposits represent claims on money proper payable on demand, a system that creates fiduciary media is in practice no different from a medieval gold banker who issued an amount of bank notes exceeding the gold he had on deposit.” note his reference to ” money proper”.


    • debeerr:

      The following may help the debate

      For a thorough discussion see Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles – this is the book i referred to in an earlier post – it can be downloaded as a PDF file

      The following article may also be useful – note that Austrian theory does not advocate a gold standard but “Austrians therefore argue for privatizing money production, shutting down central banks, and letting the market decide what kind of money people want to use. Government wouldn’t have to play any active role in the workings of a free-market monetary system.”

      One may hold the view that precious metals — in particular gold and silver, and to some extent copper — would be the freely chosen, universally accepted means of exchange. In other words, they could become money once people have a free choice in monetary matters.”
      ( Quote from the following article )

      The Faults of Fractional-Reserve Banking
      Mises Daily: Thursday, December 23, 2010 by Thorsten Polleit

      In a November 1, 2010, blog post titled “Could the World Go Back to the Gold Standard?,” Martin Wolf, the Financial Times chief economics commentator, comes to the conclusion that “we cannot and will not go back to the gold standard.”

      Among a number of mainstream-economics arguments leveled against the desirability and feasibility of the gold standard, Mr. Wolf puts forth a line of reasoning that can serve particularly well as a starting point for debating his position. Mr. Wolf writes,

      Economists of the Austrian school wish to abolish fractional reserve banking. But we know that this is a natural consequence of market forces. It is wasteful to hold a 100 per cent reserve in a bank, if depositors do not need their money almost all of the time. Banks have a strong incentive to lend some of the money deposited with them, so expanding the aggregate supply of money and credit.
      Austrians Do Not Call for Establishing a Gold Standard by Decree

      To get the ball rolling, Austrian economists (in particular those in the Misesian-Rothbardian tradition) uncompromisingly call for replacing fiat money with free-market money — money that is produced by the free interplay of the supply of and demand for money.

      Such a recommendation has a firm economical-ethical footing: free-market money is the only monetary order that is compatible with private-property rights, the governing principle of the free-market society.

      The focus on private-property rights does not only follow from natural-rights theory (in the Lockean tradition), but it can be ultimately justified on the basis of the self-evident, irrefutable axiom of human action, as Hans-Hermann Hoppe has shown.[1]

      Austrians therefore argue for privatizing money production, shutting down central banks, and letting the market decide what kind of money people want to use. Government wouldn’t have to play any active role in the workings of a free-market monetary system.

      One may hold the view that precious metals — in particular gold and silver, and to some extent copper — would be the freely chosen, universally accepted means of exchange. In other words, they could become money once people have a free choice in monetary matters.

      However, Austrian economists wouldn’t call for establishing a gold standard, let alone a gold standard with (government-sponsored) central banking: they would argue for free-market money, under which, presumably, gold would become the freely chosen money.[2]

      Fractional-Reserve Banking Violates Property Rights

      Now let us turn to fractional-reserve banking. It means that a bank lends out money that clients have deposited with it. Fractional-reserve banking thus leads to a situation in which two individuals are made owners of the same thing.[3]

      Fractional-reserve banking thus creates a legal impossibility: through bank lending, the borrower and the depositor become owners of the same money. Fractional-reserve banking leads to contractual obligations that cannot be fulfilled from the outset.

      As Hoppe, Block, and Hülsmann note, “any contractual agreement that involves presenting two different individuals as simultaneous owners of the same thing (or alternatively, the same thing as simultaneously owned by more than one person) is objectively false and thus fraudulent.”[4] A “fractional reserve banking agreement implies no lesser an impossibility and fraud than that involved in the trade of flying elephants or squared circles.”[5]

      The truth is that fractional-reserve banking amounts to violating the nature of the law of property rights. And so the argument that fractional-reserve banking represents sensible money economizing — an argument that Mr. Wolf brings up against a gold standard — doesn’t hold water.

      “Fractional-reserve banking thus creates a legal impossibility: through bank lending, the borrower and the depositor become owners of the same money.”
      Arguing in favor of fractional-reserve banking would in fact be tantamount to saying that it is legal (or rightful or even lawful) that Mr. A does whatever he wishes with Mr. B’s property — without requiring Mr. B’s consent.

      What, however, if the bank and the depositor both agree voluntarily that money deposits should be used for credit transactions via the issuance of fiduciary media? Even such a voluntary agreement would be in violation of the law of property rights.

      While bank and depositor benefit from such a trade (or expect to), what about those who receive fiduciary media? They would be falsely lured into exchanging goods and service against an item (fiduciary media) that is already claimed as property by others — something the seller presumably wouldn’t agree to if he had only known the very nature of the trade.

      What if all market agents voluntarily agreed to engage in fractional-reserve banking? The conclusion above wouldn’t change: voluntarily accepted fractional-reserve banking would represent a monetary system that is, by its very nature, in violation of the nature of the law of private-property rights. It would produce economic chaos on the grandest scale.

      Fractional-Reserve Banking Has Not Emerged “Naturally”

      To be sure, fractional-reserve banking is not, as Mr. Wolf notes, “a natural consequence of market forces.” It is a result of, and has been upheld by, government law.

      In a free-market system, the practice of fractional-reserve banking would be illegal by its very nature. And so fractional-reserve banking would be ended (sooner rather than later) under the auspices of a functioning law of private-property rights.

      The reason that fractional-reserve banking has been around for quite some time is due to government law — which, of course, must be distinguished from the natural law of property rights. Of course, government can make fractional-reserve banking legal in a formal sense. However, even government law does not change the nature of things. As Murray N. Rothbard puts it succinctly,

      fractional reserve banks … create money out of thin air. Essentially they do it in the same way as counterfeiters. Counterfeiters, too, create money out of thin air by printing something masquerading as money or as a warehouse receipt for money. In this way, they fraudulently extract resources from the public, from the people who have genuinely earned their money. In the same way, fractional reserve banks counterfeit warehouse receipts for money, which then circulate as equivalent to money among the public. There is one exception to the equivalence: The law fails to treat the receipts as counterfeit.[6]
      Fractional-Reserve Banking under Commodity Money versus Fiat Money

      In a commodity-money regime — such as the gold standard — fractional-reserve banking is, as Austrian economists show, in effect a form of counterfeiting. However, what about fractional-reserve banking under a system of fiat money?

      Under fiat money, banks’ liabilities vis-à-vis clients (as far as demand deposits are concerned) are payable in the form of base money, or central-bank money — a type of money that can only be produced by (government-sponsored) central banks.

      Central banks hold the monopoly over the production of base money. They can increase the base-money supply at any one time at any amount deemed politically desirable. It is the central bank that eventually determines whether or not banks can meet their payment obligations.

      It may well be that the central bank decides, once a bank is called upon by its clients to pay out demand deposits in cash, to provide sufficient amounts of notes — by loaning them to the bank and/or by purchasing part of the bank’s assets.

      The essential point is, however, that banks that engage in fractional-reserve banking in a fiat-money regime create contractual obligations they cannot fulfill from the outset. Rothbard notes that

      it doesn’t make any difference what is considered money or cash in the society, whether it be gold, tobacco, or even government fiat paper money. The technique of pyramiding by the banks remains the same.[7]
      The Uncomfortable Truth about Fractional-Reserve Banking

      Austrian economists, and Ludwig von Mises in particular, have shown that fractional-reserve banking under commodity money necessarily causes economic problems on a grand scale. This is because banks then engage in circulation-credit expansion — that is, they issue money through lending that is not backed by real savings.[8]

      Circulation bank credit is inflationary, and it causes economic disequilibria and overindebtedness of the private sector — in particular on the part of governments. It is also the very cause of the “boom-and-bust” cycle.

      Print: $10 $8

      Audio: $15

      The latter, in turn, opens the door for ever-greater doses of government interventionism — regulations, nationalizations, price controls, etc. — that, over time, erodes and even destroys the very principles on which the free-market society rests.

      This conclusion doesn’t change when there is fractional-reserve banking under fiat money. Fiat money — or, to be more precise, its production — is already a violation of the free-market principle; and fractional-reserve banking amounts to leveraging the economic consequences of fiat money.

      For the sake of preserving prosperous and peaceful societal cooperation, the very opposite of Mr. Wolf’s conclusion must hold true: namely that we can and will return to sound money, and the gold standard is one particular form that is fully acceptable from an economical-ethical perspective — if and when it is freely chosen by the people.

      Thorsten Polleit is Honorary Professor at the Frankfurt School of Finance & Management. Send him mail. See Thorsten Polleit’s article archives.
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      [1] Hans-Hermann Hoppe, “On the Ultimate Justification of the Ethics of Private Property,” in The Economics and Ethics of Private Property: Studies in Political Economy and Philosophy, 2nd ed. (Auburn, Alabama: Ludwig von Mises Institute, 2006), pp. 339–45.
      [2] Murray N. Rothbard called for a return to a 100% gold dollar. However, this doesn’t contradict the statement given above, as Rothbard’s recommendation rests on the precondition that “if people love and will cling to their dollars or francs, then there is only one way to separate money from the state, to truly denationalize a nation’s money. And that is to denationalize the dollar (or the mark or franc) itself. Only privatization of the dollar can end the government’s inflationary dominance of the nation’s money supply.” See Murray N. Rothbard, “The Case for a Genuine Gold Dollar,” in The Gold Standard: Perspectives in the Austrian School, Llewellyn H. Rockwell, Jr., ed. (Auburn, Alabama: Ludwig von Mises Institute, 1992), p. 5. Rothbard’s recommendation for defining the dollar once again as a weight of a market commodity, namely gold, rests (i) on the suitability of using precious metals, especially gold, as money and, even more important, (ii) the fact that the US government confiscated gold in 1933 — so that a re-defining of the dollar in gold would be the natural choice.
      [3] For a thorough discussion see Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles (Auburn, Alabama: Ludwig von Mises Institute, 2006), esp. chapter 3, “Attempts to Legally Justify Fractional-Reserve Banking,” pp. 115–65.
      [4] Hans-Hermann Hoppe, with Jörg Guido Hülsmann and Walter Block, “Against Fiduciary Media,” in the Quarterly Journal of Austrian Economics, vol. 1, no. 1, pp. 21–22.
      [5] Ibid, p. 26.
      [6] Murray N. Rothbard, The Mystery of Banking, 2nd ed. (Auburn, Alabama: Ludwig von Mises Institute, 2008), p. 98.
      [7] Ibid, p. 100.
      [8] Circulation credit (or Zirkulationskredit) means that banks, when extending a loan to a consumer or firm, increase the money stock. In contrast, commodity credit (or Sachkredit) means that a bank extends a loan to a consumer or firm by merely transferring already existing money from the saver to the investor. For a more detailed explanation, see Ludwig von Mises, The Theory of Money and Credit (Indianapolis: Liberty Fund, 1981), pp. 296–310

  • Keith Weiner:

    Robbo: you describe what I described after page one.

    My point was that the bank does not “create money out of thin air”, but the net result of an iterative process results in the creation of credit the way you and I both described.

    The key issue is the distinction between money (gold) and credit. Today, money has been banished from the system by legislative fiat. It’s all credit. In a gold system, the distinction is night and day.

    In a gold system, what can be multiplied by fractional reserve banking is *credit*, not gold. Gold can only be increased by mining.

    By the way, the issue you described about demand depositors thinking they have their money is the issue I discuss later in my paper. It is duration mismatch. If you put money into a demand deposit, the bank has no right to lend it out. If you put your money into a 1-year time deposit, then bank has a right to lend it out–up to one year. Lending demand deposits is the same thing as lending a time deposit for longer than the time.

    And by the way, if banks respect the time limits of time deposits, their lending activities will create the same iterative process of credit expansion that you and I both described. The difference is that the structure is stable because the depositors’ money is being used in accord with their needs and expectations.

    • I should perhaps add here that I fully agree with the position outlined in de Soto’s book (I even wrote a series of articles that was largely based on it). What I think is an especially important point de Soto makes is precisely that fractional reserve banking is a violation of property rights that goes beyond just the people who deposit money with a bank. Since the creation of fiduciary media and the concomitant lowering of the interest rate below the social rate of time preference causes the boom-bust cycle and moreover leads to prices being higher than they otherwise would be, the property rights of everyone in the economy (except the small privileged groups profiting from it) are harmed by the practice.
      I also tend to agree with one of de Soto’s points that is perhaps a bit more Hayekian than Misesian (de Soto is well known for ‘re-integrating’ Hayek and Mises, similar to Roger Garrison. By contrast, Salerno once wrote an article entitled ‘Dehomogenizing Mises and Hayek’, essentially mirroring Rothbard’s critique of Hayek’s view of the socialist calculation problem). The point in question is de Soto’s somewhat broader interpretation of the socialist calculation problem. As he mentions, the modern day central bank-led banking cartel can be regarded as a special case of the theorem of the impossibility of socialist calculation. This is meant in the sense that its activities tend to falsify the calculation of others in the market economy, and hence stands in the way of the transmission of proper price information in the marketplace, which is what ultimately discoordinates the capital structure. De Soto’s view is that every coercive government intervention in the market or the granting of special privileges to certain groups (such as the banks) “results in the
      manipulation of market indicators and hence deprives economic actors from
      the unimpeded discovery and production of the information required to
      coordinate the economic system.”
      This stressing of the discovery and coordination aspect sounds more Hayekian or Kirznerian than Misesian, but if one combs through Human Action, there are many remarks that at least implicitly seem to agree with this stance. After all, malinvestment and the boom-bust cycle represent ultimately a discoordination problem, and calculation errors – in the sense of entrepreneurial, future-oriented calculation – are at its heart.

  • debeerr:

    Hello, Keith

    i refer to your article in the link provided by earlier viz.”For a more detailed discussion, I refer you to my piece on fractional reserve banking:

    In the first page of such article you say you “don’t know how you could make this ($1000) work” from the initial $100 deposit. May i suggest how it might actually work.
    We will call the bank in your article “Bank A” and the depositor “Depositor No 1”.Let us assume that the $100 deposit was surplus income earned by Depositor 1 from his hard work as an employee. This is classified as standard money.
    Now Bank A lends $90 of the $100 in its cash account to Depositor 2. In Bank A’s books Cash is credited reducing the balance to $10 and Depositor No2 account is credited with the same $90. Bank A has reduced its cash account by $90 and created an asset for the same amount by loaning to Depositor 2. Bank A’s left hand side of its balance sheet (assets) now consists of $10 cash and the loan to Depositor 2 with $90, a total of $100. Bank A’s right side of its balance sheet ( liabilities and equity) includes to liability of $100 to Depositor 1.
    Depositor 2 deposits the $90 loan funds received from Bank
    A with Bank B. In its books Bank B debits its cash account (asset) with the $90 and credits Depositor’s 2 account (liability) with $90. Now bank B lends $81 of the $90 of funds deposited by Depositor 2 to Depositor 3.
    Banks B’s balance sheet now consists of assets of $9 cash ( $90 less $81) and the loan to Depositor 3 ($81) and a liability of $90 deposited by Depositor 2.
    Depositor 3 deposits the $81 with Bank C which will lend 90% ( say $72) as the Fed requires 10% of deposits are kept in reserve. In fact there is is little, if any deposits kept in reserve especially if you include the “sweeping” mechanism applied by the commercial banks. And so the game of fractional reserve banking carries on until there is no more funds of the original $100 left to lend considering reserve requirements.

    Now let us look at the aggregate balance sheets of Banks A and B ( we could go on bur i feel this will be enough to make the point).

    Assets – Cash.. Bank A $10 and Bank B $9 , a total of $19 and Bank C $81 – total cash $100. Loans.. Bank A loan to Depositor 2.. $90 and Bank B loan to to Depositor 3 ..$81 – total loans $171. Total aggregated assets is $271.

    Liabilities – Bank A – deposit by Depositor 1 $100, Bank B – deposit by Depositor 2 $90, Bank C deposit by Depositor 3 $81 – total of $271.

    Looks like good old double entry bookkeeping to me.

    We now have standard money in the system of $100 and what Pater Tenebrarum fiduciary media of $171. Now it is almost certain that
    Depositors 1 and 2 believe their respective $100 and $90 are safe and will be available on demand. But Banks A has only $!0 and Bank B has only $9 can we say “Houston, we have a problem?”

    Hope this has helped you to better understand accounting. Nowadays it is much more difficult because of all the ‘aggressive’ financial engineering and huge load of laws and regulations which have surfaced in recent decades and looks like increasing in the future.

    I agree 100% that the issue of sound money and how we may achieve it realistically shoudd be more widely debated.

    All the best.


  • Let Us Have Peace:

    Mr. Weiner is trying to square the circle between money and credit. It cannot be done. It is as impossible as the alchemists’ dream of turning lead into gold. Money is the stuff people want when they doubt other people’s and institution’s credit. Credit is the stuff we use almost all the time because it is so much easier to use than specie. The reason money has to be specie is precisely because gold is awkward and cumbersome and cannot be reduced to paper or digital entry. The authors of our Federal Constitution understood this; that is why the Congress is authorized to borrow on the Credit of the United States but it can only coin Money.

    We cannot appeal to the judgment of the market and then attempt to use a moral standard to judge what types of credit are to be allowed. If liberty is to have any meaning, people have to be free to trade in promises no matter how absurd they may seem. Social Security may well be fraudulent but it is not more or less “counterfeit” than any other promise of the Federal government. Where the fraud and counterfeit lie in our present system is in the fact that the government still claims the monopoly on legal tender established under the Constitutional gold standard while at the same time using its own bank-created Credit to replace the Constitution’s requirement that Money have a Weight and Measure.

    Either legal tender has to be set by the market – as it was when domestic and Foreign Coin were equally accepted by the government in payment of taxes. Or, the dollar has to return to the gold standard. Since there is no foreign coin, only foreign sovereign credit, we have only one choice – returning to the Constitutional gold standard. It could be done tomorrow. Any new Specie Act would have to establish Money as a Coin of a certain Weight and Measure and then let the market for gold set a price on it in dollars. In the 19th century – both at the start of the Republic and at the resumption of the gold standard after the Civil War – the dollar had to be denominated by the Weight and Measure of Foreign Coin – the British pound. That problem no longer exists; there is no longer any Foreign Coin that the Congress is required to set a Value for under the Constitution.

    The day after the Federal government resumed the convertibility of all U.S. Bank Notes into specie, the world did not rush to the Treasury to swap its paper for coin. The day of judgment failed to appear. The very act of committing the U.S. to restoration had re-established the credit of the U.S. government so people were content to continue to deal in credit notes rather than specie. If the Congress were to enact a restoration of the Constitution Gold standard tomorrow, it is likely that the same result would occur – even though the credit of the U.S. Federal government is certainly far less than golden. A dollar whose fluctuating value would be fixed by the market’s dealings in bullion and coin and subject to redemption would not, by itself, save the credit of the United States; but it would instantly end the further abuse of that credit by the Congress and the Federal Reserve.

    The flaw of Mr. Weiner’s system is not in its intentions. It is in its failure to allow credit to be the devious, suspect instrument that it has always been in commerce. A promise to pay can, as Morgan said, only be valued by the character of the borrower. Even Constitutional Money can be cheated if Coins are allowed to be clipped; what the authors of the Constitution knew from broad experience of the world is that a scale and an assay is much easier to trust that a government promise. As long as Money itself is solid, people can accept the risks of Credit as the price of its convenience and opportunity for gain. The very argument used against the gold standard – its inflexibility – is true; when one is well established, the price of gold itself becomes monotonously steady. It is the price of Credit that fluctuates. After resumption, the Gold Room closed; and the stock and bond markets and bank clearings exploded – with a boom that was so real that is produced enough professors and well-educated (sic) students that the first thing they did was decide that so archaic a system had to be improved. We are still living with the tortures of that improvement.

    • Keith Weiner:

      Mr. Peace: Actually, I am trying to say that money is money, i.e. gold is gold, and credit is credit. I am not sure we disagree…?

      My point re: Social Security is that it (1) is credit that is not willingly extended by the creditors and (2) it is credit that is taken without means or intent to ever repay. Thus counterfeit.

      SS, of course, is not anything that emerged from any market. It came from an act of force, of fiat. The government decreed it and they use force to make it so.

      While I agree that we need to plot a path back to a gold standard, I am opposed to the idea of the government setting a fixed price of anything. If the government sets the price of gold in terms of dollars, they will get it wrong (and in reality, it would change constantly as nothing is rigid or fixated in a free market). Either the dollar or more likely gold would be undervalued, and thus hoarded. Gresham’s Law.

      I think we agree on many points. What exactly do you think is my system, and what exactly is its flaw? I could not understand from your post. Thanks.

      • debeerr:

        I would like to add something constructive towards how we might get ourselves out of this mess – there are lots of issues nad the following is just a small contribution: Author is George Reisman.. Ludwig Von Mises website

        Inflation and Deflation: Credit Expansion and Malinvestment

        The title of my talk, of course, is “A Pro-Free-Market Program for Economic Recovery.” What this entails changes as the government adds new and additional measures that create new and additional problems. If I were giving this talk a year ago, my discussion would have been weighted somewhat more heavily toward deflation and somewhat less heavily toward inflation than is the case today.

        A fundamental fact is that our present monetary system is characterized both by irredeemable paper money, i.e., fiat money, and by credit expansion. There is no limit to the quantity of fiat money that can be created. This is the foundation for potentially limitless inflation and the ultimate destruction of the paper money, when the point is reached that it loses value so fast that no one will accept it any longer.

        The fact that our monetary system is also characterized by credit expansion is what creates the potential for massive deflation — for deflation to the point of wiping out the far greater part of the money supply, which in the conditions of the last centuries has been brought into existence through the mechanism of credit expansion.

        Credit expansion is what underlay the housing bubble, and before that, the stock market bubble, and before that a long series of other booms and busts, running through the Great Depression of 1929 that followed the stock market boom of the 1920s, through the 19th and 18th Centuries all the way back to the Mississippi Bubble of 1719, and perhaps even further back.

        Credit expansion is the lending out of money created virtually out of thin air. It is money manufactured by the banking system, always with at least the implicit sanction of the government, which chooses not to outlaw the practice. Since 1913, credit expansion in this country has proceeded not only with the sanction but also with the approval, and active encouragement of the Federal Reserve System, which, as I’ve shown, is now desperately trying to reignite the process as the means of recovering from the current downturn.

        The new and additional money is created by the banking system through the lending out of funds placed on deposit with it by its customers and still held by those customers in the form of checking accounts of one kind or another. The customers can continue to spend those checking deposits themselves, simply by writing checks or using other, similar methods of transferring their balances to others.

        But now, at the same time, those to whom the banks have lent in this way also have money. To illustrate the process, imagine that Mr. X deposits $1,000 of currency in his checking account. He retains the ability to spend his $1,000 by means of writing checks. From his point of view, he has not reduced the money he owns any more than if he had exchanged $1,000 in hundred-dollar bills for $1,000 in fifty-dollar bills, or vice versa. He has merely changed the form in which he continues to hold the exact same quantity of money.

        But now imagine that Mr. X’s bank takes, say, $900 of the currency that he has deposited and lends it to Mr. Y. Mr. Y now possess $900 of spendable money in addition to the $1,000 that Mr. X continues to possess. In other words, the quantity of money in the economic system has been increased by $900. Mr. Y’s loan has been financed by the creation of new and additional money virtually out of thin air. This is the nature and meaning of credit expansion.

        Now, nothing of substance is changed, if instead of lending currency to Mr. Y, Mr. X’s bank creates a new and additional checking deposit for Mr. Y in the amount of $900. (This, in fact, is the way credit expansion usually occurs in present-day conditions.) There will once again be $900 of new and additional money. There will be altogether $1,900 of money resting on a foundation merely of the $1,000 of currency deposited by Mr. X.

        The $1,000 of currency that Mr. X’s bank holds is its reserve. If Mr. Y deposits his currency or check in another bank, it is the banking system that now has $1,000 of reserves and $1,900 of checking deposits. On the foundation of these reserves, it can create still more money and use it in the further expansion of credit. Indeed, as we have seen, the process of credit expansion is capable of creating checking deposits more than 100 times as large as the reserves that support them.

        Credit expansion makes it possible to understand what caused the housing bubble and its collapse. From January of 2001 to December of 2007, credit expansion took place in excess of $2 trillion. This new and additional money made available in the loan market drove down interest rates, including, very prominently, interest rates on home mortgages. Since the interest rate on a mortgage is a major factor determining the cost of homeownership, lower mortgage interest rates greatly encouraged buying houses.

        This artificially increased demand for houses, made possible by credit expansion, soon began to raise the prices of houses, and as the new and additional money kept pouring into the housing market, home prices continued to rise. This went on long enough to convince many people that the mere buying and selling of houses was a way to make a good living. On this basis, the demand for houses increased yet further, and finally a point was reached where the median-priced home was no longer affordable by anyone whose income was not far in excess of the median income, i.e., only by a relatively few percent of families.

        In the middle of 2004, the Federal Reserve became alarmed about the situation and its implications for rising prices in general, and over the next two years progressively increased its Federal Funds interest rate from 1 percent to 5.25 percent. This rise in the Federal Funds rate signified a reduction in the flow of new and additional excess reserves into the banking system and thus its ability to make new and additional loans. This served to prick the housing bubble.

        But before its end, perhaps as much as a trillion and a half dollars or more of credit expansion and its newly created money had been channeled into the housing market. Once the basis of high and rising home prices had been removed, home prices began to fall, leaving large numbers of borrowers with homes worth less than they had paid for them and with mortgages they could not meet.

        The investments in housing represented a classic case of what Mises calls “malinvestment,” i.e., the wasteful investment of capital in inherently uneconomic ventures. The malinvestment in housing was on a scale comparable to the credit expansion that had created it, i.e., about $2 trillion or more. That’s about how much was lost in the housing market. When the money capital created by credit expansion was wiped out, the lending, investment spending, employment, and consumer spending that depended on that capital were also wiped out.

        And, particularly important, as vast numbers of home buyers defaulted on their mortgages, the mounting losses on mortgage loans increasingly wiped out the capital of banks and other financial institutions, setting the stage for their failure.

        The current plight of the economic system is the result of credit expansion and the malinvestment it engenders. Capital in physical terms is the physical assets of business firms. It is their plant and equipment and inventories and work in progress. As Mises never tired of pointing out, capital goods cannot be created by credit expansion. All that credit expansion can do is change their employment and shift them into lines where their employment results in losses. The empty stores and idle factories around the country are very much the result of the loss of the capital squandered in malinvestment in housing.

        Other Consequences of Credit Expansion

        The plight of the economic system is also the result of other consequences of credit expansion, namely, the encouragement it gives to high debt and dangerous leverage. This is the result of the fact that while credit expansion drives down market interest rates, the spending of the new and additional funds it represents serves to drive up business sales revenues and what the old classical economists called the rate of profit. This combination makes borrowing appear highly profitable and greatly encourages it. Individuals and business firms take on more and more debt relative to their equity. They expect borrowing to multiply their gains.

        In addition, credit expansion is responsible for many business firms operating with lower cash holdings relative to the scale of their economic activity, in many cases, dangerously low cash holdings. Many businessmen develop the attitude, why hold cash when credit expansion makes it possible to borrow easily and profitably? Instead, invest the money.

        “Why hold cash when credit expansion makes it possible to borrow easily and profitably? Instead, invest the money.”
        Thus, when credit expansion finally gives way to the recognition of vast malinvestments and the accompanying loss of huge sums of capital, the economic system is also mired in debt and deficient in cash. Thus, it is poised to fall like a house of cards, in a vast cascade of failures and bankruptcies, first and foremost, bank failures.

        The Road to Recovery

        The road to recovery from our economic downturn can be understood only in the light of knowledge of credit expansion and its consequences. The nature of credit expansion and its consequences imply the nature of the cure.

        The prevailing — Keynesian — view on how to recover from our downturn totally ignores credit expansion and its effects. It believes that all that counts is “spending,” practically any kind of spending. Just get the spending going and economic activity will follow, the Keynesians believe.

        This conception of things, which underlies the support for “stimulus packages” and anything else that will increase consumer spending, is mistaken. It rests on a fundamental misconception. It ignores the fact that the fundamental problem is not insufficient spending, but insufficient capital due to the losses caused by malinvestment. It ignores the further facts that credit expansion has brought about excessive debt and, however counterintuitive this may seem, insufficient cash. Too little capital, too much debt, and not enough cash are the problems that countless business firms are facing today as a result of the credit expansion that generated the housing bubble.

        Just as a reminder: the way that credit expansion brings about a situation of too little cash while itself constituting a flood of cash is that it makes it appear profitable to invest every last dollar of cash in the expectation of being able easily and profitably to borrow whatever cash may be needed.

        What this discussion implies is that an essential requirement of economic recovery is that the widespread problems in the balance sheets of business firms must be fixed. Business firms need more capital, less debt, and more cash. When they achieve that, business confidence will be restored.

        Ironically what could achieve at least less debt and more cash in the hands of business, and thus actually do some significant good is if when people received government “stimulus” money, they did not spend very much of it, or, better still, any of it at all. To the extent that all people did with money coming from the government was pay down debt and hold more cash, they would be engaged in a process of undoing some of the major damage done by credit expansion. They would be reducing their burden of debt and increasing their liquidity, thereby increasing their security against the threat of insolvency. Such behavior, of course, would be regarded by Keynesians as constituting a failure of their policies, because in their eyes, all that counts is consumer spending.

        The 100-Percent Reserve

        The most important single step on the road to economic recovery is the establishment of a 100-percent reserve system against checking deposits. Ideally, the 100-percent reserve would be in gold. And that’s ultimately what we should aim at, for all of the reasons Rothbard explained. But even a 100-percent reserve in paper would do the job of totally preventing all future credit expansion and, equally important, all declines in the money supply.

        (Because the 100-percent gold reserve standard is the long-run ideal of advocates of sound money, I cannot help but feel a sense of great satisfaction in the fact that a major step toward its achievement is what turns out to be urgently needed as a matter of sound current economic policy.)

        In the simplest terms, to establish a 100-percent-reserve system in terms of paper, the government would simply print up enough additional paper currency so that when added to the paper currency the banks already have, every last dollar of their checking deposits would be covered by such currency. (Strictly speaking, a significant part, and for some months now the far greater part, of the reserves of the banks are not in actual currency but in checking deposits with the Federal Reserve. For the sake of simplicity, however, we can think of the checking deposits held by the banks with the Federal Reserve as a denomination of currency, since, for the banks, they are fully as interchangeable with currency as $50 bills are with $100 bills and vice versa.)

        To illustrate the process of achieving a 100-percent reserve, imagine that total checking deposits are $3 trillion. In that case, the Fed would give the banks new and additional reserves that when added to their existing reserves would bring them up to $3 trillion. Through various programs, such as purchasing bad assets, the Fed has in fact already brought the total reserves of the banks up to over a trillion dollars, but almost all of those reserves, as we’ve seen, are excess reserves, a ready foundation for a massive new credit expansion, since excess reserves can be lent out.

        What my example implies is adding to the $1.1 trillion of reserves the banking system now has, a further $1.9 trillion and making all $3 trillion of reserves required reserves. This would mean that the banks could not engage in any lending of these reserves and thus would be unable to finance credit expansion or any increase in the supply of checking deposits on the strength of them. The money supply in the hands of the public and spendable in the economic system would thus not be increased. That would happen only if and to the extent that the 100-percent reserve principle were breached.

        Under a 100-percent reserve, checking depositors could simultaneously all demand their full balances in cash and the banks would be able to pay them all. Depositors’ demand for cash would not create a problem and no amount of losses by the banks on their loans and investments would prevent them from honoring their checking deposits immediately and in full. Thus the checking deposit component of the money supply could not fall and nor, of course could its other component, which is the paper money in the hands of the public, usually described as the currency component. Thus, there could simply be no deflation of the money supply. And, as I’ve said, because all reserves would be required reserves, there would simply be no reserves whatever available for lending out, and thus no credit expansion whatever. The expression “killing two birds with one stone” could not have a better application.

        “The most important single step on the road to economic recovery is the establishment of a 100-percent reserve system against checking deposits.”
        In a addition, a significant byproduct of a 100-percent reserve system would be that the FDIC would no longer serve any purpose and thus could be abolished.

        Now an essential prerequisite of the 100-percent reserve is knowing the size of checking deposits, so that it will be known how much the 100-percent reserve needs to cover. At present, when one allows for such things as “sweep accounts,” money-market mutual funds, and money-market deposit accounts, the magnitude to which the 100-percent reserve would apply can plausibly be argued to range from about $1.5 trillion to $8 trillion. It is very solidly $1.5 trillion, but does in fact range up to $8 trillion in that checks can be written on the additional sums involved, at least from time to time and for some large minimum amount.

        To clearly establish the magnitude of checking deposits, bank depositors should be asked if their intention is to hold money in the bank, ready for their immediate use and transfer to others, or to lend money to the bank. In the first case, their funds would be in a checking account, against which the bank would have to hold a 100-percent reserve. In the second case, their funds would be in a savings account, against which the bank could hold whatever lesser reserve it considered necessary. In this case, the bank’s customers could not spend the funds they had deposited until they withdrew them from the bank.

        As I’ve said, the long-run goal in connection with the 100-percent reserve would be ultimately to convert it to a 100-percent gold reserve system. At that time, following the ideas of Rothbard further, the gold reserve of the Fed would be priced high enough to equal the currency and checking deposits of the country and be physically turned over to the individual citizens and the banks in exchange for all outstanding Federal Reserve money. The Fed would then be abolished. But this is a distinct and much later step in pro-free-market reform.

        The 100-Percent Reserve and New Bank Capital

        It should be realized that a major consequence of the establishment of a 100-percent-reserve system could be a corresponding enlargement of the capital of the banking system and thus an ability to cover even very great losses and thereby avoid such things as government bank bailouts and takeovers.

        Consider the balance sheet of an imaginary bank. It’s got checking deposit liabilities of $100. Initially, it has assets of $105, which implies that on the liabilities side of its balance sheet it has capital of $5 in addition to its checking deposit liabilities of $100.

        Now unfortunately, malinvestment has resulted in a loss of $20 in the banks’ assets, in the part of its assets consisting of loans and investments. As a result, its total assets are reduced from $105 to $85 and its capital is completely wiped out and becomes negative in the amount of $15.

        However, on its asset side the bank still has some cash reserve, say, $10. If $90 of new and additional reserves were added to these $10, to bring the bank’s reserves up to 100-percent equality with its checking deposits, the bank’s asset total would also be increased by $90. This $90 increase on the bank’s asset side would have to be matched by a $90 increase on its liabilities side, specifically by a $90 increase in its capital. Its capital would go from minus $15 to plus $75.

        Applying this to the banking system as a whole in transitioning to a 100-percent reserve, we can see that the creation of such a vast amount of new bank capital would be entailed as easily to overcome whatever losses the banks might have suffered in their loans and investments.

        As explained, if checking deposits were $3 trillion, the Fed would give the banks new and additional reserves that when added to their existing reserves would bring them up to $3 trillion. If this had been done in September of 2008, bringing reserves up to $3 trillion would have required adding $2.955 trillion of new and additional reserves to the $45 billion or so of reserves the banks already had. This vast addition on the asset side of the banks’ balance sheets would have implied an equivalent addition to the banks’ capital on the liabilities side. No matter how bad the banks’ assets were, I think it’s virtually certain that an additional sum of this size would have been far more than sufficient to cover all the losses that the banks had incurred in their bad loans and investments. Their capital would have ended up being increased to the extent that the additional reserves exceeded the losses in assets under the head of loans and investments.

        The government’s bailout program of stock purchases in the banks would have been avoided, along with all of its subsequent interference in matters of bank management.

        Now, as we’ve seen, in fact the Fed has already supplied a vast amount of reserves, about $1.1 trillion, to the banks through various programs, such as purchasing bad assets. If the 100-percent reserve principle were adopted now, many or most of those assets could be taken back, and the programs that created them cancelled.

        Thus, what I’ve shown here is how transitioning to a 100-percent reserve would guarantee the prevention both of new credit expansion and of deflation of the money supply. It could also provide additional capital to the banking system on a scale almost certainly far more than sufficient to place it on a financially sound footing. To avoid what would otherwise likely be an excessive windfall to the banks, it would be possible to match a more or less considerable part of the increase in their assets provided by the creation of additional reserves, with the creation of a liability of the banks to their depositors, perhaps in the form of some kind of mutual-fund accounts. Thus, the newly created reserves might provide a financial benefit to the banks’ depositors as well as to the banks.

        Toward Gold

        Of course, a 100-percent reserve system in which the reserves are fiat money does not address the problem of preventing inflation of the fiat money. It would still be possible for the government to inflate the fiat money without restraint. That is why it is necessary to have gold in the monetary system, serving as a restraint on the amount of currency and reserves.

        Thus, an important ancillary measure in connection with the transition to a 100-percent paper-reserve system would be for the government to demonstrate a serious intent to move to a gold standard. Obliging the Federal Reserve to carry out a program of regular and substantial gold bullion purchases might accomplish this. In any event, it would be an essential prerequisite for someday achieving gold reserves sufficient to make possible the establishment of a 100-percent-reserve gold system. Along the way, this measure should lead to the day when purchases of gold bullion were the only source of increases in the supply of currency and reserves.

        Establishing the Freedom of Wage Rates to Fall

        Along with stabilizing the financial system through the adoption of a 100-pecent reserve, it’s absolutely essential to establish the freedom of wage rates and prices to fall. This is what is required to eliminate mass unemployment. Whatever the level of spending in the economic system may be, it is sufficient to buy as much additional labor and products as is required for everyone to be employed and producing as much as he can.

        Nothing could be more obvious if one thinks about it. Assume, as is the case today, that there is 10 percent unemployment, with only 9 workers working for every 10 who are able and willing to work. The same total expenditure of money that today employs only 9 workers would be able to employ 10 workers, if the average wage per worker were 10 percent less. At nine-tenths the wage, the same total amount of wages is sufficient to employ ten-ninths the number of workers. It’s a question of simple arithmetic: 1 divided by 9/10 equals 10/9.

        (Obviously, this is an overall, average result. In reality, some wage rates would need to fall by less than 10 percent and others by more than 10 percent.)

        Of course, total wage payments are not fixed in stone. They can change. And in response to a fall in wage rates to their equilibrium level, to eliminate mass unemployment, they would increase. This is because prior to their fall, investment expenditures have been postponed, awaiting their fall. Once that fall occurs, those investment expenditures take place.

        Finally, with debt levels sufficiently reduced and cash holdings sufficiently high, and thus business confidence restored, there is no reason to believe that a fall in wage rates could abort the process of recovery as the result of already employed workers earning less and thus spending less before new and additional workers were hired. The cash reserves and financial strength of business firms would enable them easily to ride out any such situation. And thus mass unemployment would simply be eliminated.

        What stops wage rates from falling, what makes it actually illegal for them to fall, and which thus perpetuates mass unemployment, is the underlying pervasive influence of the Marxian exploitation theory. That doctrine is responsible for the existence of such things as minimum-wage laws and coercive labor unions and their above-market wage scales.

        The most important fundamental requirement for achieving a free market in labor is the total refutation of the exploitation theory and its complete discrediting in public opinion. Such a refutation will show that it is not government and labor unions that raise real wages but businessmen and capitalists, and that essentially, all that unions do is cause unemployment and a lower productivity of labor and thus prices that are higher relative to wage rates. This knowledge is what is required to make possible the repeal of minimum-wage and pro-union legislation and thus achieve the fall in wage rates that will eliminate mass unemployment


        In summation, my pro-free-market program for economic recovery is a provisional 100-percent-paper-money-reserve system applied to checking deposits, accompanied by a demonstrable commitment to ultimately achieving a 100-percent-gold reserve system. The 100-percent reserve in paper would put an end to all further credit expansion and at the same time make the money supply incapable of being deflated. Its establishment would also greatly increase the capital of the banking system. It would do so by more than enough to cover all the losses on loans and investments incurred in the aftermath of the collapse of the housing bubble and thus make possible the elimination of government ownership of common stock in banks and its interference in bank management. What it would not do is control the increase in paper currency and paper-currency reserves. That will require a 100-percent gold reserve system.

        $95 $80

        Finally, the freedom of wage rates and prices to fall must be established through the repeal of pro-union and minimum-wage legislation, and more fundamentally, the education of the public concerning the errors of the Marxian exploitation theory and their replacement with actual knowledge of what determines wages and the general standard of living. To say the least, this will certainly not be an easy agenda to follow, inasmuch as it must begin in the midst of a Marxist occupation of our nation’s capital.

        Thank you.

        Copyright © 2009 by George Reisman.
        George Reisman, Ph.D., is Pepperdine University Professor Emeritus of Economics and the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996). His web site is His blog is at Send him mail. (A PDF replica of the complete book Capitalism: A Treatise on Economics can be downloaded to the reader’s hard drive simply by clicking on the book’s title, immediately preceding, and then saving the file when it appears on the screen.) See George Reisman’s article archives.
        This talk was given at Economic Downturn: Cause and Cure (Mises Circle, Sponsored by Louis E. Carabini) Newport Beach, California, November 14, 2009.

  • LRM:

    The paper from the FED is here

    I assume they have some background in this. I am not an academic so what they say may be incorrect

  • Murray44:

    A “real bill” then is Wimpy’s promise to pay you Tuesday for a hamburger today?

    • Keith Weiner:

      Murray: Think of it this way. A miller delivers flour to a bakery and presents the baker with a bill, due NET 90. The baker endorses it. The baker (and the miller!) knows that the bread will be sold to gold- (or silver-) paying consumers. And then the baker will pay his bill. In the meantime, the bill trades as a discount to the face value that it will pay in 90 days.

      Commercial credit is hardly the same thing as borrowing to consume without intent or means of paying. Wimpy’s promise is counterfeit credit.

  • I doubt we are going back to a non-credit system, but there could be modifications that might change the landscape. This is beside the point, but I would like to add a few things.

    For one, the current credit system is fairly captive as not many people carry a significant amount of cash in relation to their balances. So, the money stays in the banks. The question is more, which banks? As this is where credit crunches arise from excessive lending of one bank, whose output ends up in another and thus must borrow to keep their balances.

    If a bank is solvent in the sense they are legitimately capitalized, I don’t consider credit as counterfeiting, as the bank possesses the resources to pay the loss on the loan or loans. The current system is all counterfeiting, because the losses in the system are greater than the capacity of the banks in general to pay. I’m not sure you can fix a system wounded as this one, unless you haircut the deposits and turn those credits to capital.

    Here is the real paradox. What people borrow from banks is their own debt. That is what is issued on check or put in your account in making a loan at a bank. There is merely a new liability from and to the bank and the bank won’t give you the credit without the debt instrument.

  • Keith Weiner:


    Thanks for posting my paper. I think it is urgently important that discussion of ideas about this topic increase by orders of magnitude. The current system is going to come off the rails at some point fairly soon, and hopefully by then there will be many people who are prepared to step up and help promote a proper, unadulterated gold standard.

    Without rehashing real bills or other disagrements, I would like to add a few quick comments:
    1) I think it is a very Austrian idea that government may pass all the laws it likes, but it cannot repeal Natural Law. The government may declare by fiat that pieces of paper are legal tender, and in so doing force the bid-ask spread to zero. But that does not make their paper “money”. When the sovereign bond goes into default, then the bid for the paper money will be withdrawn. And at that point, the distinction between paper credit and money (i.e. gold) will matter.

    2) I’d like to amend your statement of Professor Fekete’s position on the marginal utility of gold. I think (based on conversations with him) that his position can be summarized as: gold’s marginal utility either does not decline, or it declines so slowly as to not be important to monetary science.

    3) My own view of gold’s marginal utility may be more radical. Gold’s marginal utility is at least as high as that of the good of highest marginal utility extant. This is because gold can be used to buy any good. But it may be much greater than that. Gold saved or hoarded today can buy the good of highest marginal utility in the future, such as food. Or a cure for one’s terminal disease. I would go so far as to say that the more rapid the advances in invention and innovation, the higher is gold’s marginal utility. But I will allow that it may decline at a rate so slow as to be different in kind, not just degree, from all other goods (excepting maybe silver). As with Fekete, I do not think that whether it is a flatline, or a line of slope -0.000001, that this is an important distinction.

    • I would like to add something and I think Pater might have mentioned this himself. If the current system does implode and it will if the governments don’t come up with a reorganization plan that penalizes and rewards all involved equally, the only way the system will get back on the rail is with gold backing. The dollar standard after FDR was based on the fact that it stayed on a gold standard internationally and had substance to incur debt in the first place, which is all bank paper is for in the first place. Without the basis of widespread denominated debt, paper currency has no value.

      • Keith Weiner:

        mannfm: I basically agree. Though I think that FDR’s half-assed gold standard was doomed to suffer the fate which it later suffered, with the final nail in the coffin under Nixon in 1971 and the subsequent explosion of unpayable, irredeemable debts since then.

  • LRM:

    It always takes a lot of words to explain money creation. We may all rather a system where money from savers is used to lend but this is not how it works today.
    Deposits are not lent so have little to do with money creation. The way I understand it, when you go to a bank to obtain money for a purchase, the bank just creates a deposit for you by marking up digits in a newly created account. You issue your promise to pay in exchange for the purchased item but the bank pretends to be the owner of the item and expects payments and interest to come to it.
    As a borrower you think you are getting the use of someone’s money for your purchase so you believe you should rightly pay the bank but in fact, the owner of the purchased item is the actual creditor.
    I don’t know how this apparent deception was allowed to develop but not many people seem to care about how it happens because things are made to look complicated and banks do a good job of developing stellar reputations.
    However deception is taking place before our eyes. At least real Bills have something produced behind them.
    I know there needs to be an intermediary between the buyer and seller but for me, the exchange should be from real savings and not from created digits.

    • Keith Weiner:

      LRM: There are many flaws in the current monetary system, but it does not quite work like that. In brief, the bank takes in $100 of deposits, and lends out $90. It keeps $10 in reserve. The problem is that the bank presumes on behalf of the account holders how long they intended to forego the use of their money. They set a static, fixed reserve ratio (in my example, 10%). But what if 25% of the people intended to access their money?

      For a more detailed discussion, I refer you to my piece on fractional reserve banking:

      • Andrew Judd:

        Banking does not really work like that in practice. A bank does not absolutely require depositors to create a loan since capital can be increased via earnings and banks are capital constrained when they create loans rather than deposit constrained.. The bank can often create credit on its own books ownly which is denominated in national currency amounts but is a similar money to a real bill. As money flows out of the bank it can source deposits to maintain liquidity. Retail deposits are a cheap and stable source of funding however and worth keeping

        Importantly if you have 1,000,000 in cash and have 10,000,000 deposits and then get 100 deposits it is pretty safe to lend another 1000 for the same reserve you had before the 100 arrived. The 1,000,000 is your reserve rather than a figure that can never be touched. If you did not take the 100 you could have withdrawals of tens of thousands anyway. But you aim over time to keep to say an average of 10% reserve.

        Importantly also banks have accounts with each other so up to certain amounts deposits can be tranferred to another bank as book keeping entries only so that the books on each side balance with interest paid at LIBOR. Loans leads therefore to deposit creation in the wider banking system rather than deposits leading to loans.

        • Keith Weiner:

          Andrew: in today’s centrally planned manipulation-in-lieu-of-markets, you are probably right.

          I think it is important to distinguish the process of credit expansion from the end result. The process is that a bank lends less than its deposits. For example, it takes in $10,000,000 in deposits and lends $9,000,000. But then the borrowers use the money to pay people and those people deposit the $9,000,000 back into the bank. Then the bank can lend $8,100,000, and so on. It is a fractal process that tends towards a 10-fold expansion of credit (assuming a 10% reserve ratio). But that is not to say that a bank takes in 10 and lends 100.

          I emphatically disagree that this is similar to a real bill! As I commented in response to Murray, above:

          “A miller delivers flour to a bakery and presents the baker with a bill, due NET 90. The baker endorses it. The baker (and the miller!) knows that the bread will be sold to gold- (or silver-) paying consumers. And then the baker will pay his bill. In the meantime, the bill trades as a discount to the face value that it will pay in 90 days.”

          • Andrew Judd:


            Given human history it seems a fantasy notion that generations of bakers will always *know* they will be paid.

            Part of the discount is because people dont *know* they will be paid and the profits enable a person to cover losses.

      • LRM:

        I am not qualified to defend whether fractional reserve banking currently as in “In brief, the bank takes in $100 of deposits, and lends out $90. It keeps $10 in reserve.”
        From what I have read I think even the Fed has published papers debunking the fractional reserve lending theme and some CB’s such as Canada do not even have reserve requirements.

        Thanks for your response and I will check out your reference after I try to find the document from the FED
        There is sure a lot of theoties regarding something we use every day.
        Well educated people disagree on many of the actual details of how money originates . Don’t you think this confusion has a purpose?

  • Andrew Judd:

    A real bill must be a debt. The supplier is owed payment.

    The real bill circulates as money as a promise of payment by the business supplied, where payment is owed to the holder of the real bill – ie it is an iou.

    The note holder has a risk of loss.

    In a bank loan the bank guarantees the supplier will be paid and acts as middle person and gives a useable credit to the supplier who has no need to sell this IOU to get purchasing power returned. The bank has a risk of loss.

    There is no practical difference. Neither system requires sales to be funded by savers. Each requires a creditor.

    In the banking system the supplier is the creditor owed money but he is in turn gauranteed against loss by the power of the bank to remain in business.

    In either system somebody stands to lose money.

    • Keith Weiner:

      Andrew: I think the right way to look at the real bill is as a clearing mechanism. It is a way for everyone to be “netted out”, without having to possess or handle the gross amounts. Typically, each business in the supply chain makes a small margin. The real bill is a credit instrument, absolutely. And you are correct there is risk of loss to the creditor, though very small because businesses which have been in business for several years and which produce goods in urgent consumer demand seldom fail to sell those goods.

      Unlike in the case of a loan, no money is given by the creditor to the payor. This is why I say that the real bill is not funded out of savings, but out of consumption. The bill works because the creditor knows that the consumer will buy the goods with gold at the end of the day (real bills don’t work under paper money).

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