Greenspan and Banker Alchemy


In 1966, Alan Greenspan published an essay called 'Gold and Economic Freedom,' certain words from which have been reverberating throughout libertarian circles since he started working for the government.

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation [he wrote]. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold . . . The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves . . .

Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. [1]

How could someone of such profound insight turn his back on free markets and accept the position of Fed chairman? Was he simply a hypocrite who could write well? Or was there another element in his essay that runs counter to his defense of gold and perhaps explains his inflationist ways?

Government has always hated gold as a monetary standard because it can't create it at will, as it can bank notes and deposits. But even under a gold standard, bankers can increase the money supply through the perfectly legal operation of fractional reserve banking. Fractional reserve banking is the practice of making loans beyond what the lender has to offer in real money. Credit is usually extended as some multiple of the lender's stock of money, such as 10:1 or 20:1. This is what banking is and always has been. It is simply business as usual.

Alan Greenspan, Fractional Reserve Banker

Greenspan talked about more than gold in his 1966 essay. He also presented his views on banking, which were essentially the same then as they are now.

A free banking system based on gold is able to extend credit and thus to create bank notes (currency) and deposits, according to the production requirements of the economy. [emphasis added]

This is a clear statement of the fractional reserve lender's creed. Extend credit as business needs it. What if the bank doesn't have the money to lend out? No problem, as long as enough people 'trust' the bank.

Since it is rarely the case that all depositors want to withdraw all their gold at the same time, the banker need keep only a fraction of his total deposits in gold as reserves. This enables the banker to loan out more than the amount of his gold deposits . . .

Loan out more what? It's not gold. It's not bank notes or deposits covered by gold. What is it the banker is loaning?

On a gold standard, when banks accept deposits of gold for safekeeping, they issue receipts to the depositors. These receipts are more commonly called bank notes and serve as money substitutes. Holders of these notes can claim their gold anytime they want ' this is what is meant by the promise to pay on demand. If a bank issues more notes (or creates more deposits) than it has gold in its vaults, it cannot possibly meet its obligations. Counting on most note holders not to demand their gold at the same time is another way of saying the banks are hoping they don't get caught.

Because no one can loan something they don't have, fractional reserve banking is a gigantic fraud. But banks have done this for ages. The pseudo-receipts they issue circulate in the economy along with legitimate receipts and coin. Since the pseudo-receipts look identical to legitimate receipts, they are treated as real money substitutes. The money supply has been inflated, and all the destructive ramifications of inflation are now in play.

The Bust at the End of the Rainbow

Fractional reserve banking, which Greenspan has always supported, is a method of inflation that receives government's blessing. But the practice of extending unbacked credit leads to a bust.

Periodically, as a result of overly rapid credit expansion, banks became loaned up to the limit of their gold reserves, interest rates rose sharply, new credit was cut off, and the economy went into a sharp, but short-lived recession.

'Overly rapid credit expansion' is a euphemistic way of saying banks got carried away issuing pseudo-receipts for gold. But big bankers didn't like the penalty phase at the end of the boom, and with the help of government, decided to impose a central bank on the economy.

[T]he process of cure [i.e., the recession] was misdiagnosed as the disease: if shortage of bank reserves was causing a business decline ' argued economic interventionists ' why not find a way of supplying increased reserves to the banks so they never need be short! If banks can continue to loan money indefinitely ' it was claimed ' there need never be any slumps in business. And so the Federal Reserve System was organized in 1913.

If a recession is the cure, as Greenspan stated, what is the disease? His only answer was 'overly rapid credit expansion.' And if a recession is the cure, why is it not permanent? Why do we continually need curing? Far from criticizing fractional reserve banking as a form or fraud or embezzlement, he saw it as a legitimate and important function in promoting a robust economy ' with the only drawback being that, 'periodically,' bankers got overzealous in their efforts 'to meet the production requirements of the economy.' That's the way he saw it in 1966, and that's how he sees it now.

Fractional Reserve Banking Stays, Gold Leaves

But a system whereby reserves are supplied to banks 'so they never need be short' would eventually have to do away with gold. With the politicizing of the monetary system, it wasn't long before a Fed-induced crisis made the transition to a pure fiat money easier. After President Roosevelt severed the dollar's tie to gold domestically in 1933, money was government paper, and men in power determined its supply.

How critical was the loss of gold? Ludwig von Mises once said:

The quantity of money is the decisive problem. The quality that makes gold fit for service as money is precisely the fact that the quantity of gold cannot be manipulated by governments. [2]

Greenspan acknowledged that one of the qualities that made gold suitable for money was its 'scarcity.' But if he really believed the money commodity should be scarce, why does he support the banking system's efforts to circumvent this feature?

Inflation can be eliminated with a gold standard and 100 percent reserve banking. Greenspan advocated only one of these conditions. But as Fed chairman, he tries to assure us that central banker integrity is akin to gold in keeping inflation 'contained.' For example, in December of 2002 he told an audience:

The record of the past twenty years appears to underscore the observation that, although pressures for excess issuance of fiat money are chronic, a prudent monetary policy maintained over a protracted period can contain the forces of inflation. [3]

A prudent monetary policy means central bankers should resist the urge to create new money. But the Fed wasn't created for prudent policy. It was created for precisely what it has done, inflate the dollar, but without the retribution that gold imposes for 'overly rapid credit expansion.' If government and bankers wanted prudence, they would have stayed on the gold standard and outlawed fractional reserve banking. They did just the opposite ' they stayed with fractional reserve banking and outlawed gold.

Alan Greenspan himself is a complete stranger to prudence, given that he's added over $4.5 trillion to the money supply, as measured by M3, since taking office. [4] To most observers, keeping the money flowing has been his great virtue. Regardless of the eventual outcome of his virtue, he surrendered none of it when he took office to run a gold-less economy and stoke its credit expansion.


1 Greenspan, Alan, 'Gold and Economic Freedom'

2 von Mises, Ludwig, Economic Freedom and Interventionism, Ch. 43, 'On Current Monetary Problems'

3 Greenspan, Alan , 'Issues for Monetary Policy'

4 Bonner, William and Wiggin, Addison, Financial Reckoning Day: Surviving the Soft Depression of the 21st Century, John Wiley & Sons, Hoboken , New Jersey , 2003. p. 141.

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George F. Smith is the author of The Flight of The Barbarous Relic, a novel about a renegade Fed chairman.  Visit his website.