Season's Greetings from the Fed

by George F. Smith

In 1903, a lawyer in Germany took out an insurance policy and made payments on it faithfully.  When the policy came due in 20 years, he cashed it in and bought a single loaf of bread with the proceeds. [1] He was fortunate.  If he had waited a few days longer, the money he received would have bought no more than a few crumbs.

Germany had been on the usual fractional reserve gold standard prior to World War I, with the Reichsbank, its central bank, expanding the money supply at a “mild” 1-2 percent inflation rate. When war broke out in 1914, government followed the standard policy of deficit spending rather than attempting to raise taxes.  The Reichsbank’s role was to monetize the government debt – that is, pay for new treasury obligations by printing more money.

At the war’s end, the number of German marks in circulation had quadrupled and prices had gone up 140 percent.  [2]  But the mark was no worse off than the currencies of other belligerents.  It was weaker than the American dollar but stronger than the French franc, and about the same as the British pound.

Yet five years later, by December 1923, Germans were paying trillions of marks for ordinary goods, an almost inconceivable situation in a country with a long tradition of education and scholarship, where Americans had once gone to study for advanced degrees.  What happened?

In addition to carrying the economic burdens of the Armistice, the socialist German government had pushed ahead with state funding of health, education, and welfare.  It also had to deal with astronomical deficits from its nationalized industries and demobilization expenses from the war.  From 1914 to 1923, its tax revenues paid for only 15 percent of its expenses; by October 1923, tax receipts covered only 0.8 percent of government expenditures.

Government’s choices throughout were either to cut spending, borrow from the public, raise taxes, or print more money.  It pursued the latter policy, while vehemently denying it was inflating the money supply.  To the government and its supporters, its paper inflation was a consequence, not a cause.  The real culprit in Germany’s monetary meltdown were the impossible reparation payments and other burdens imposed by the Treaty of Versailles.  Eventually, currency speculators shared the blame, but the official press never placed responsibility for the inflation on the institution actually printing the money.

In a fitting twist of justice, the government’s inflationary policies, in destroying taxable wealth, reduced its revenue.  With the mark collapsing, mortgages, bonds, annuities, pensions and the like were virtually worthless, and tax authorities had almost nothing to tax. Savers, especially rich ones, had moved their savings to foreign bank accounts and foreign currencies in a massive “flight of capital” to escape the plunder.  With inflation increasing hourly, overall tax revenue fell simply due to the time lapse between taxable transactions and tax payments.  Meanwhile, government expenditures accelerated, pushing deficits higher.  Government printed ever greater quantities of money to meet its liabilities, which created even higher deficits. Like a man caught in quicksand, each frantic struggle only moved it closer to the end.

As the hyperinflation accelerated, people spent money as fast as they got it, on the most durable goods they could afford.  The “flight of capital” was augmented and replaced by the “flight from currency.” Factory workers were paid twice daily in large bundles of cash, which their spouses or relatives took and rushed off to spend.  People began by buying diamonds, gold, pianos, antique furniture, land and later bought just about anything to get rid of the currency.  They gradually switched from money transactions to barter.  Desperate people began to steal what they couldn’t obtain in trade.  Gasoline was siphoned from cars.  Prostitutes of both sexes walked the streets of Berlin.  But some of the young people found the atmosphere exhilarating.  Their parents had taught them to work hard and save, but clearly this was a time to spend and pay close attention to politics.


The Yugoslavia Meltdown

The German hyperinflation was one of many runaway inflations of the last century.  Hungary, China, Bolivia, Argentina, Peru, Brazil, Russia, Austria, Poland, Greece, and the Ukraine, among others, all experienced hyperinflations in varying degrees.  But the worst case of monetary destruction happened in Yugoslavia from 1993-1994. [3]

The Communist Party running the country had been financing government projects with printing press money, a tradition it inherited from the Tito regime but which it carried to a far greater degree.  The government ran a network of stores that were supposed to sell goods below market prices, but the stores rarely had anything to sell.  The government’s gasoline stations eventually closed, leaving people dealing with roadside vendors who sold gas at $8 a gallon from plastic cans sitting on the hoods of their cars.  Car owners turned to public transportation, but the Belgrade transit authority only had the funds to run 500 of its 1,200 buses.  The buses were so overcrowded the ticket collectors couldn’t get aboard to collect fares.

The entire infrastructure was in shambles.  Streets were full of potholes, elevators stopped working, construction projects shut down. Unemployment rose to over 30 percent.   The government tried to halt rising prices with price controls, but food producers refused to sell their products to the government at its artificially low prices. 

The government modified its edict by requiring merchants to file paperwork every time they wanted to raise prices.  But inflation got worse.  Merchants increased their prices in bigger increments so they wouldn’t have to file forms again so soon.  In October, 1993, in an effort to halt soaring prices, the government issued a new currency unit, the dinar, worth one million of the old dinars.  By early 1995, prices had increased by five quadrillion (5,000,000,000,000,000) percent.

As in other super-inflated economies, people adopted new methods of survival. Thieves robbed hospitals and clinics of needed medicines, then sold them in front of the places they robbed.  People postponed paying their bills as long as possible so they could pay them in near-worthless currency.  Postmen were responsible for collecting telephone bills, but one postman found it cheaper to pay the bills of 780 customers himself rather than try to collect payment. 


Fractional Reserve Banking

Hidden in all this gruesome detail is a quiet concept mentioned at the beginning, fractional reserve banking.  Fractional reserve banking is the practice of creating money out of thin air, by expanding credit beyond what a bank has in cash holdings.  It is the modern method of inflation.

It has its roots in the West in mid-17th century England, where merchants began storing their gold with private goldsmiths, who would give them receipts in exchange.  The receipts began to function as money substitutes, being used in daily transactions as if they were gold.  People accepted the receipts because they had unfailing trust that the goldsmiths could redeem them on demand for the gold they represented.

Because of the convenience paper offered, people got into the habit of not redeeming the receipts.  The goldsmiths noticed this.  They always had gold on deposit that no one was claiming.  Eventually they decided to lend out fake receipts for which no gold had been deposited.  As long as they didn’t get too grabby and issue too many counterfeit receipts, they could usually meet the occasional demands for redemption.

The fake receipts circulated side-by-side with legitimate deposit receipts and gold coins.  Not only was the issue of counterfeit receipts fraudulent, it also inflated the money supply.

Yet there were almost no laws to incriminate the goldsmiths – and the deposit banks that followed – for the practice of printing fake deposit receipts.  The first test cases didn’t come until the early 19th century in England, which ruled in favor of the banks.  Though one of the counsel argued that “a banker is rather a bailee of his customer’s funds than his debtor,” the presiding judge (“Master of the Rolls”), Sir William Grant, ruled that no, that wasn’t true; money deposited with a banker becomes “immediately part of his general assets; and he is merely a debtor for the amount.” [4]

In 1848, in Foley v. Hill and Others, the English judge Lord Cottenham went further, saying that “the money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases . . . he is not bound to keep it or deal with it as the property of his principal.”  Thus, if banks are unable to meet their obligation to redeem on demand, they become merely a “legitimate insolvent instead of an embezzler,” as Murray Rothbard observes. [5]

American banking law has followed Foley faithfully in most key respects.  Rothbard concludes: “To Foley and the previous decisions must be ascribed the major share of the blame for our fraudulent system of fractional reserve banking and for the disastrous inflations of the past two centuries.” [6]

Banks, of course, can pyramid fake receipts or credit on top of any kind of money – whether it’s gold, government fiat paper, or something more exotic.  But their practice is perpetually shaky because they always have more liabilities than assets, more notes or deposits outstanding than they can redeem in cash.  They are subject not only to depositor bank runs, but to daily demands for redemption from other banks.

The free market is very unforgiving of fractional reserve banking.


Central Banking Institutionalizes the Fraud

The ability to create money out of thin air is very heady – and enticing, if you’re the government in need of revenue.  With banks periodically facing insolvency from their inflationary practices, they were in need of government-backed assistance. It is not surprising, then, that banks and government worked out a deal.  Government gave banks the laws they needed in exchange for which banks would buy government debt – with money created from nothing.

The institution that made everything tidy and discreet for both parties was the central bank, which in the U.S. is called the Federal Reserve System.

A major function of the Fed is to monetize government deficits, thus avoiding the risky business of raising taxes or reducing spending. The Federal Reserve Act, passed by a short-handed Congress on December 23, 1913, endowed the Fed with a deeply inflationary structure so it could expand the money supply at a controlled, even pace at whatever level it wished.

Because of the Fed, the U.S. had the funds to send our boys into the slaughterhouse known as World War I.  A little later it sponsored the boom that led to the Crash.  Since it began operations in 1914, it has ripped away 95 percent of the value of the dollar.

Most people view the Fed as our tireless public servant promoting a stable economy and fighting the curse of inflation.  The truth is the exact opposite.  The Fed is solely responsible for inflation and has caused economic havoc since its inception.  It has created what Rothbard describes as a “chronic, permanent inflation problem, a problem which, if unchecked, is bound to accelerate eventually into the fearful destruction of the currency known as runaway inflation.”  [7]

References

1 The German Hyperinflation, 1923, excerpt from Paper Money by "Adam Smith," (George J.W. Goodman), pp. 57-62

2 Hyperinflation in Germany, Hans Sennholz

3 Episodes of Hyperinflation, Thayer Watkins

4 Rothbard, Murray N., The Mystery of Banking, p. 61

5 Ibid., p. 61

6  Ibid., p. 62

7 Ibid., p. 108