How You're Getting Screwed, In Plain English

This piece is about the monetary system, how it benefits the ruling class and how it adversely affects YOU.

I am deeply indebted to various popular treatments of the subject matter at hand written from the perspective of what is called the Austrian school of economics, books by such writers as Murray Rothbard, Thomas E. Woods, Peter Schiff, Henry Hazlitt, and Ron Paul. Anyone wanting deeper insight is invited to read books by these authors, and I quote directly from two such books here, Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Thomas Woods, and the classic What Has Government Done To Our Money? by Murray N. Rothbard.

MONEY

First off, what exactly is money? Money is a medium of exchange for transactions in an economy. Direct exchange is barter. The limits of barter aren’t too hard to imagine. Suppose you had eggs and wanted a set of clothes: you would have to find somebody who had a set of clothes to trade who also happened to want your eggs at the same time you wanted their clothes (if your expertise was a teacher of Spanish and you wanted some eggs…). What if you wanted to buy a loaf of bread but all you owned was a mansion? Clearly direct exchange, which is barter, has limits that make it impossible as a basis of a more complex economy.

So here we come to a money economy, an economy of indirect exchange. Someone could sell their eggs (or clothes, or Spanish lessons, etc.) for whatever is functioning as money and then exchange that money for the good or service that they desire. From the starting point in a primitive barter system, it was realized at some point in time that if someone dissatisfied with barter could trade their particular good for another that was more widely desired, they could then more likely exchange that second good for whatever others might offer to them. And the more that this more widely desired good was used for exchange, the more it was desired simply for the purpose of exchange. So we have the evolution of money. Everything from cattle to beads to tobacco has been used as money. In many societies, such as those of Europe, precious metals (gold, silver) evolved as the predominant forms of money.

The utility of money lies in its exchange value, or “purchasing power.” Even though if asked if they want more money many people will unhesitatingly answer in the affirmative, what they really want rather than more units of money is more effective units, to have their money buy more.

If there is an increase in the supply of a good other than money, the price of that good gets lower, and society as a whole benefits. An increase in the supply of money also lowers its “price” (purchasing power of the money-unit), but does not benefit society. If we assume no increase in the total goods and services of society, an increase in the supply of money just means you have more money-units chasing the same goods and services.

As can be understood from the above, government had nothing to do with the origin of money. For one thing, how would some government of the distant past have been able to determine the value of money in terms of all other goods? Yet nowadays many people might assume money came about through government decree. This is because in our present society, we have the situation where government has taken over money.

The incentives for government to be involved with the creation of money are not too difficult to see. After all, government does not gain money through selling services on the free market---it takes it from the people by threat of force, what we call taxation. With increased government spending tends to come increased government power, as well as benefits to those well-connected to government. However, there has generally been a limit on how far taxation can increase---revolutions have been precipitated when the burden is felt too heavily. The creation of money out of thin air by government therefore represents a natural development in the elite’s quest for power and wealth.

In a nutshell, our monetary system developed as follows. At some point in our history paper notes issued by banks that could be redeemed for a given weight of the commodity money (gold) began to circulate as a convenient substitute for carrying precious metal coins. In the modern era, government confiscated the commodity to which the paper notes entitled their holders, and thereby left the people with paper money that is redeemable into nothing (in America this occurred in 1933). This is called fiat money. The creation of fiat money does not have the physical limitations that would be involved in creating additional gold.

It is known that after national governments originally gained control of their nation’s commodity money currencies (for the public good, of course!), the rulers were then able to loot the population by clipping the coins and inserting some amount of non-precious metal into previously pure coins and pocketing the difference (known as debasing the currency). Economic historians can cite various examples of this happening in history.

INFLATION

Freed from the constraint of gold, our government was thus given the ability to substantially increase the money supply. Inflation is defined as an increase in the amount of money in circulation not backed by the monetary commodity, or in the case of a fiat standard as we have now, simply an increase in the amount of paper money in circulation. If done by anyone but government, this would be called counterfeiting.

But the banking system and government joined together long ago to reap the mutual benefits of inflation. The original function of a bank was simply as a warehouse for money, as it did not always seem safe or practical to carry precious metals on your person. In depositing their silver or gold, a customer would receive a warehouse receipt. If the warehouse keeper was trusted, this receipt (or bank note) could be treated as though it were itself money, making purchases more convenient. However, the warehouse keeper eventually realized that only a small fraction of the store of money in his safekeeping was ever redeemed, as people trusted his paper notes. Therefore, confident the scam will not be uncovered, he loaned out more and more of the contents of the vault as interest-earning loans. What ends up happening in such a scenario is you end up with more warehouse receipts than units of gold or silver in the vault, thus adding to the effective money supply. Banks in the U.S. have been required to keep a certain minimum ratio of reserves to their total deposit liabilities. This inflationary practice is called “fractional reserve banking” and has come to be protected by government.

If you look at the piece of paper we call a “dollar,” you will see it says at the top “Federal Reserve Note.” This means this money-unit is a note issued by our central bank, the Federal Reserve. Central banking was the latest big development in the creation of an inflationary system for the benefit of government.

America adopted its central bank---the Federal Reserve System (hereafter, called “the Fed“ for short)---in 1913. It has a governmentally-granted monopoly of the issuance of notes. Banks have to go to the Fed to get notes for their customers. A central bank like the Fed can stimulate inflation by pouring reserves into the banking system, and also by lowering the reserve ratio, thus permitting a nationwide bank credit-expansion.

Economic historian Thomas E. Woods, Jr. explains further in his book, Meltdown:

“The Federal Reserve controls the American money supply and can influence interest rates either upward or downward; it can also function as a ‘lender of last resort.’ Although people use the phrase ‘printing money’ as a kind of shorthand for what the Fed does, the Fed increases the money supply not by printing cash and putting it into circulation, but by what are called ‘open-market operations,’ which involve the purchase and sale of assets. Strictly speaking, the Fed can purchase any kind of asset it wants, but it normally purchases government bonds. If it wants to increase the money supply, it purchases, say, $1 billion in bonds from a bond dealer. It makes the purchase by writing a check on itself for $1 billion and handing it over to a firm like Goldman Sachs in exchange for the bonds. It creates this $1 billion out of thin air.

Goldman Sachs then deposits this $1 billion check from the Fed in its bank. That bank doesn’t put the $1 billion in a special vault with ‘Goldman’s Money’ on the door. Instead, the bank will lend out most of that $1 billion, since the law only requires it to keep a small percentage of its deposits on reserve. (Most of the bank’s reserves, incidentally, are kept in its own account at the Fed, with a small amount in cash in its vaults to satisfy normal day-to-day requests for cash by the bank’s depositors). When the bank, in turn, lends out the money, borrowers spend it, and it winds up in accounts in other banks, which use most of that money in still another round of expansion, and so on. With a reserve requirement of ten percent, the initial $1 billion will have supported $9 billion in additional lending by the time this process is complete. All of this $10 billion has been created out of nothing: the initial $1 billion check from the Fed, and the additional $9 billion in loans that fractional-reserve banking makes possible, were produced out of thin air. Should the Fed wish to contract credit, it follows this procedure in reverse: it sells bonds to the banks, and the money it receives for them---and the further increase in the money supply that the fractional reserve system then created on top of it---are withdrawn from the economy.” (pp.120-121)

As we explained early on, there is no social benefit resulting from an increase in the money supply. If we were to imagine inflation bringing more actual wealth to society we would be engaging in something like magical thinking. Money is not wealth, it is a medium of exchange. As we also described early on, an increase in the supply of money tends to raise prices (as measured in money-units), because the purchasing power of the money-unit lowers if we also assume no corresponding increase in the total goods and services of society.

It is not hard to see how detrimental this may be for someone on a fixed income, as prices for what they buy go up as their income stays the same. But taking a wider view, we can see that inflation acts as a kind of tax on the people. It has been called our most unfair tax. Thomas Woods explains:

“Consider this question: in what order and in what way does the new money make its way through the economy? When the government inflates the money supply, the new money does not reach everyone simultaneously and proportionately. It enters the economy at discrete points. The earliest recipients of the new money include politically favored constituencies of one kind or another: banks, for example, or firms with government contracts---in other words, wherever government spends money. These privileged parties receive the new money before inflation has pushed prices upwards. In effect the economy doesn’t yet know how much the money supply has increased, and prices have not yet adjusted accordingly. By the time the new money makes its way through the whole economy, prices will have risen throughout practically all sectors. But while this process is taking place, the privileged firms that are lucky enough to get the new money early benefit from being able to make their purchases at the previously existing price level---thereby silently looting those from whom they buy. When the average person gets his hands on this new money---through higher wages, say, or lower borrowing costs---prices have already been rising for quite a while, and he’s been paying those prices all this time on his existing income. The value of his money was diluted by the new money before it ever reached him.

Here is another way to think about it: Money in your possession is compensation for some good or service you have provided. When you buy a dozen apples, you do so with the proceeds from a good or service that you yourself provided in the past. So you are able to buy those apples because in the past you provided someone else with something he needed.

Now imagine a situation in which business firms or banks connected to the government receive a new influx of money courtesy of Fed credit expansion. That money comes out of thin air, not from the sale of some previous good or service. Thus when these favored firms spend this money, they are in effect taking goods out of the economy without providing anything themselves. Here we see very clearly how they benefit at the expense of the rest of society: they take from the stock of goods without giving anything in return. The money they pay for their goods didn’t originate in a good or service that they themselves had previously provided; it came from nowhere. The analogous case under a system of barter would be one in which, instead of trading my bread for your orange juice, I just take your orange juice.” (Meltdown, pp 122-123)

Thus the people are robbed, but it takes place invisibly. So the political function of inflation is not hard for us to see. Since the Fed began operations in 1914 following the passage of the Federal Reserve Act in December 1913, the American dollar has lost more than 95 percent of its value.

THE BOOM-BUST CYCLE

In trying to determine the cause of the economic boom-bust cycle, which is a general movement in business---in which suddenly many businesses that were doing just fine simultaneously experience losses---it makes sense to look at the common denominator of economic exchanges. That common denominator is money.

Economist Murray N. Rothbard, in his short and readable book, What Has Government Done To Our Money? brings the focus back to our enemy, inflation:

“A final indictment of inflation is that whenever the newly issued money is first used as loans to business, inflation causes the dread ‘business cycle.’ This silent but deadly process, undetected for generations, works as follows: new money is issued by the banking system, under the aegis of government, and loaned to business. To businessmen, the new funds seem to be genuine investments, but these funds do not, like free-market investments, arise from voluntary savings. The new money is invested by businessmen in various projects, and paid out to workers and other factors as higher wages and prices. As the new money filters down to the whole economy, the people tend to re-establish their old voluntary consumption/saving proportions. In short, if people want to save and invest about 20 percent of their incomes and consume the rest, new bank money loaned to business at first makes the saving proportion look higher. When the new money seeps down to the public, it re-establishes its old 20-80 proportion, and many investments are now revealed to be wasteful. Liquidation of the wasteful investments of the inflationary boom constitutes the depression phase of the business cycle.” (pp.55-56).

Rothbard elaborates this explanation more fully in his classic about the 1929 depression, “America’s Great Depression.”  In this book he shows how the Austrian cycle theory of Ludwig von Mises accounts for why there is a sudden general cluster of business errors (generated by the distortions caused by credit expansion), why capital-goods industries fluctuate in the cycle more widely than do the consumer-goods industries (the capital goods sector takes advantage of the artificially low interest rates brought about through credit expansion to fund major and long-term projects), and why with every boom there is an increase in the quantity of money in the economy (63 percent inflation of the money supply during the 1920's).

It can be plainly seen that the boom-bust cycle does not originate with the free market.