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Source link: http://archive.mises.org/8381/getting-closer-to-debasing-the-currency/

Getting Closer to Debasing the Currency

August 7, 2008 by

Whatever the technicalities for propping up the government-sponsored paper-money systems may be, the decade-long debt binge will most likely end in inflation. This is because the “crisis” is widely perceived as a calamity — rather than the necessary economic correction of malinvestment brought about by central banks’ manipulation of market interest rates through credit and money expansion. On top of that, people fear deflation much more than inflation. Lower interest rates and more credit and money are seen as a remedy of the disease brought about by central banks’ artificial lowering of the interest rate through credit expansion. FULL ARTICLE

{ 58 comments }

Paul August 7, 2008 at 8:15 am

“…the decade-long debt binge will most likely end in inflation”. I don’t see how that can happen. And I don’t anything in his article that supports the argument that credit binges ends in inflation. The author even contradicts himself in saying that the drop in money stock is deflationary. So how can we have both inflation and deflation at the same time? The government fears deflation more than inflation and for good reason. However, the naive public is still led by the media into believing that inflation is the biggest threat right now. There are articles everywhere comparing the current situation to the 70s, which is absolute nonsense.

The fed’s main job is to facilitate credit and make borrowing more accomodative. That can only go on for so long. Once the people are to the knees in debt, there is no where to go but down. Asset bubble always pops and that’s almost always deflationary. (Try to envision a balloon and the impossibilities of making it larger to no end.) If people start curbing their borrowing, start defaulting on their loans, and banks stop lending, that’s deflationary. That may be what’s happending right now with the decline in real estate prices and banks suddenly becoming scared to lend. M2 has actually contracted last quarter by the largest amount in 60 years.

Stanley Pinchak August 7, 2008 at 10:55 am

The Fed’s most recent policies have tended to be contractionary, but recent actions from the treasury have extended the outstanding obligations with the bail outs of the GSEs and staunch advocacy of the moral hazard of the policy of the “lender of last resort.” The policy makers are getting stuck between the rock of an insolvent banking industry and a nation of taxpayers who can be tapped no further, and the hard place that the Asian central banks increasing reservation to purchase debt obligations represents.

What is a poor Fed to do? If they let the banks contract the monetary supply, they will placate the the foreign banks with a strong dollar, but make payment on the debt relatively more difficult, at the same time, the general public is ignorant of economics and would likely call for Paulson and Bernakie’s heads. As for the low yield bond swap deal, who wants to hold long term bonds at say a conservative 4% when inflation is running at 12% and increasing even by the government’s doctored measurements?

The Fed can’t ask congress to increase taxes, because the economy is already sliding into a recession and further governmental interference will only deepen it. With approval ratings for the federal government at historic lows, does congress dare make any moves that could undermine people’s shaky faith in the legitimacy of the state?

Seems like the only valid option is to try to reinflate the bubble and monetize the debt. The question is how much more insolvent will this make the banking sector? When will foreign central banks begin to protect what is left of their assets?

Jake August 7, 2008 at 1:25 pm

Great article Thorsten,

Thank you very much. I prescribe to the theory that countries across the globe are experiencing debt deflation because of all the write-offs, resulting in financial asset prices dropping.

The Fed is currently not inflating and neither are the asset swops with the banks inflationary. Once the Fed’s balance sheet starts drying up, (Freddie and Fannie’s bailout could be the culprit) then we’re in for some serious inflation.

The dollar appears to be correcting against the euro, which is not supposed to happen because of the interest spread. This could be the result of dollars being sucked out of the market because of all the credit destruction.

Based on the fractional reserve system that would make sense. Any destruction of the reserves at the bottom of the inverted pyramid would cause a contraction.

I wouldn’t be surprised to see the Fed cutting rates further in the next 12-18 months. We might even see simultanious cutting of rates by both the ECB and the Fed. The eurozone economy’s wheels are coming of fast.

Hell, we might even see all the Central Banks cutting and re-inflating at the same time to start the mother of all booms!!!

David Hilllary August 7, 2008 at 2:45 pm

Talk about assuming what you’re trying to prove! Thorsten Polleit just assumes that converting one type of liability for another (bank demand or time deposits to bank shares) will be deflationary as it reduces the stock of issued money. As intuitive as it may seem, this point does NOT follow. What happened in his first example is that the bank’s assets went down in value, reducing the wealth of the bank’s share holders, who were wiped out, with the bank being re-structured by converting some debt liabilities to equity. The wealth loss happened on the asset side of the balance sheet, and the accounting identity allocates that loss first to equity investors, then to creditors.

Fractional reserve banking is not a government invention or a government intervention, it is merely a banking practice for liquidity and balance sheet management.

Dick Fox August 7, 2008 at 3:17 pm

Fractional reserve banking is not a government invention or a government intervention, it is merely a banking practice for liquidity and balance sheet management.

David, I would like to followup on your comment. Using the government to remove the right of the people to invest in fractional banking is just as Fascist as most policies of our central planning government. As long as people are informed they should be allowed to invest in anything they want.

There are a lot of “Austrians” who would do well to take Henry Hazlitt’s Economics In One Lesson to heart because they do not think through their criticisms of fractional banking considering that most businesses use the same concept.

Consider health insurance, if every person who bought insurance from a particular company lived to be 125 the company would go out of business, just as if everyone pulled money out of a fracitonal reserve bank the bank would go out of business. But it does not stop there. Airlines regularly over book because they know there will be no shows, as do hotels, concerts, and many other businesses. “Playing the float” is an accepted method of doing business. So why do these modern Austrians only pick on fractional reserve banks?

Similarly there is a misunderstanding of the increase in credit increasing the money supply. This only happens if the monetary authority supplies this credit out of fiat. Credit alone does not cause inflation. If there were no money could I extend credit? Of course, that once again is a normal way of doing business. I give you my product and you promise to give me your product in the future when it is complete or vice versa. This is not inflation.

The premise of the article is good, governments always debase a currency if they can get away with it, but as they say the Devil is in the details.

Mike Sproul August 7, 2008 at 4:25 pm

Dick Fox:

“Similarly there is a misunderstanding of the increase in credit increasing the money supply. This only happens if the monetary authority supplies this credit out of fiat.”

You and David are right about fractional reserve banking not being inflationary, but if you follow the quantity theory to its logical conclusion, you’d have to say that privately-created money reduces the demand for so-called ‘fiat money’, and thereby reduces its value. This would be like saying that the issue of call options on GM stock reduces the demand for GM stock and thereby reduces GM’s stock price. After all, a checking account dollar is nothing but a call option of green paper dollars.

The resolution is that green paper dollars are NOT fiat money. They are backed by the assets of the fed, just as GM stock is backed by GM’s assets. Once this is realized, we no longer have to accept the quantity theory’s strange proposition that the issue of private ‘derivative’ moneys reduces the value of the government-issued money.

Jacob Steelman August 7, 2008 at 4:39 pm

While it is true airlines over book as do hotels and motels fractional reserve banking is different because of the legal relationship. When banks act in their role as warehouse for deposit, storage and safekeeping of your money from a legal and accounting standpoint that should be treated as continuing to be your money not the banks money. Modern day banking laws and accounting have distorted the banking relationship. Banking is similar to storage of grain or storage of goods in a warehouse which is called a bailment in common law. Upon presentment of your receipt any and all depositors are entitled to the money, grain or goods on deposit. There is no such thing as fractional reserve warehousing or grain storage. Were you to go to a warehouse where you had goods in storage and told “sorry you will have to wait for return of your goods as I leased them out to someone else (without your knowledge)” or told “sorry I pledged your goods as security for my loans and my creditors re-possessed the goods” would you be upset? This is fractional reserve banking – your assets become the bank’s assets. Fractional reserve banking could not exist without the government mandating such a fraud on depositors. This is not the case when you loan money to the bank – time deposits in which you are paid interest are in fact unsecured loans to the bank. You become a creditor and take your chances as any other unsecured creditor. In his treatise on the subject entitled Money, Bank Credit and Economic Cycles, Jesus Huerta De Soto describes in detail the history of banking from ancient Greece to modern day bankers

JIMB August 7, 2008 at 5:01 pm

“What about the option of the government setting up special funds, which would take over banks’ distressed loan and security portfolios? Here, banks would receive (interest bearing) claims against the government-sponsored special funds, while the latter would be refinanced by issuing government-guaranteed bonds.

However, such a transaction would reduce the economy’s money stock: the government’s special fund would pay for banks’ assets with commercial-bank money (which was acquired through the issue of bonds). As a result, the banking sector’s balance-sheet volume would shrink, and so would the money stock.”

Such an arrangement would validate the prior monetary excess by swapping US Treasury debt for bad paper and would slow the purging process. Whether it leads to inflation or deflation depends how the losses from the bad debt are financed. If they are financed by taxation, it reduces productivity and “supply” and would be price inflationary (although not inflationary by the strictly Austrian definition of an expansion of money supply). If the losses are financed by selling government bonds to the central bank, it would be price inflation and monetary inflation.

JIMB August 7, 2008 at 5:01 pm

“What about the option of the government setting up special funds, which would take over banks’ distressed loan and security portfolios? Here, banks would receive (interest bearing) claims against the government-sponsored special funds, while the latter would be refinanced by issuing government-guaranteed bonds.

However, such a transaction would reduce the economy’s money stock: the government’s special fund would pay for banks’ assets with commercial-bank money (which was acquired through the issue of bonds). As a result, the banking sector’s balance-sheet volume would shrink, and so would the money stock.”

Such an arrangement would validate the prior monetary excess by swapping US Treasury debt for bad paper and would slow the purging process. Whether it leads to inflation or deflation depends how the losses from the bad debt are financed. If they are financed by taxation, it reduces productivity and “supply” and would be price inflationary (although not monetary inflation by the strictly Austrian definition of an expansion of money supply). If the losses are financed by selling government bonds to the central bank, it would be price inflation and monetary inflation.

JIMB August 7, 2008 at 5:38 pm

BTW, monetary and price deflation occurs if the swapping of the government debt does not slow or stop the purging process … and the central bank is “forced” by market participants not to finance the government deficit. In that case, the collapse of credit as a money-substitute makes monetary and price deflation occur.

It depends how the deficit is financed ….

David Hillary August 7, 2008 at 6:31 pm

Dick Fox

There is a difference between a promise to pay money and a promise to do another act such as delivery of passengers. The common law provides for money damages as the normal remedy for breach of contract. In other words the law treats failure to perform an obligation as basically convertible into an obligation to pay money damages. However an obligation to pay money, if defaulted on, requires a different remedy, one that converts the right to be paid money into the right to take assets of the debtor, or a share of the proceeds thereof.

However the real issues here are:
1. what are the legal obligations of a debtor who owes money ‘on demand’, correctly understood, and
2. what are the economic consequences for the issue and redemption of demand debt in the form of bank notes and current account balances with banks.

the first point is a matter of settled law under the common law as understood and practiced today: the obligation of the debtor to seek out and pay the creditor does not apply, the debtor is not liable to pay the debt until the note is presented for payment or the current account balance is demanded or a cheque drawn on the account is presented for payment. Thus the bank can and does meet all its obligations unless it actually fails to meet a payment demand, and the bank can be said to be able to meet its obligations in the ordinary course of business so long as it has some reserves left.

The second point is more contentious but also more about assuming what you’re trying to prove, going by most writers on the subject. Specifically many writers state that bank issued money causes a proportionate decline in the value of money, without any analysis or argument to back it up – it is just sort of churned out as if repetition makes it true.

Free Market Phooey August 7, 2008 at 6:46 pm

Interesting article and a good quote from Mises. A few aggressive comments there by readers about the fractional reserve banking system. Aggressive comments are always a clue that the debate is based on religion instead of logic.

David Hillary August 7, 2008 at 6:49 pm

Jacob Steelman

The law of contract enables contractors to make their own bargains, and this includes the right to make bargains to hold money as a bailment rather than on current account.

The allegation that current account banking and bank note issue arose from breach of a bailee’s obligations are poorly substantiated and even if true, does not stop the parties choosing the type of relationship they want more explicitly, to clear up any fuzziness.

Promissory notes have never been and can never plausibly be confused with bailments. By definition, promissory notes are promises to pay money, and not promises to store goods.

The fact is that most people most of the time want to hold their most liquid wealth in the form of current account balances with creditable parties (i.e. banks) and not in the form of metal, and this is why banks and bank customers and creditors do not seek out bailments when creditor claims on banks better meet their needs and wants.

Clay Baldwin August 7, 2008 at 8:23 pm

“The resolution is that green paper dollars are NOT fiat money. They are backed by the assets of the fed, just as GM stock is backed by GM’s assets.”
-Mike Sproul

Mr. Sproul:
GM can go bankrupt and their company will be liquidated and shareholders will be compensated to the best of GM’s ability with the remaining assets, but will everyone be compensated? No. The answer is that stockholder’s equity won’t even come close to being fully compensated. This is the natural way of competition and if GM goes bankrupt and I lose my shirt, well too bad, I should have been more vigilant and watched the company.
Now we come to the Federal Reserve. If the Federal Reserve decides to inflate the currency to the point that my dollar (fed stock right?) is worth nearly nothing; what could I have done? Nothing, I have no choice but to sit by and watch my fortune deplete because the government has made it, through legal tender laws, that the dollar is the only currency I can hold. The only safety net one has against this debasing of one’s wealth is through buying gold, which at more than one point in our history was made illegal. That is how holding a dollar is nothing like holding stock in GM; You do not voluntarily purchase and hold dollars, it is mandated by law.
Now to your statement that the dollar is NOT a fiat money because it is backed by the assets of the fed. The whole reason our dollar is called a fiat money is simply because the Federal Reserve has NO assets backing up the dollar. The Federal Reserve will tell you themselves that there are no assets backing up the dollar except for the “full faith and credit of the American government”. Which I personally don’t feel too confident about considering that the Federal Reserve is one of, if not the largest, holder of federal debt. The only reason confidence in the dollar remains is because the government has mandated that this is the only currency the American people can use. If the dollar had to compete on the open market it would be wiped out in short time, as would any fiat money when commodity based money is once again allowed to be issued in the market place. Same with fractional reserve banking; No one would take their notes if we had a free market for money because there would be no way to tell the value of their currency. If the dollar were actually backed by the assets of the Federal Reserve, why does the value of our dollar fall every year? Is the fed losing assets, or are their assets just staying the same and they are printing (in conjunction with the treasury) more money? I think many people here know the answer to this question which is: Neither. We completely left the gold standard in 1971. The dollar is a purely fiat money, forced upon us by gun and gavel, that could only survive in a market through government intervention. A fiat currency, completely detached from any commodity is just paper unless there are laws forcing its use. You really need to read Murray Rothbard’s History of Money and Banking in the United States. The only asset the Federal Reserve has to back up the dollar with is a big fat printing press.
“Fractional reserve banking is not a government invention or a government intervention, it is merely a banking practice for liquidity and balance sheet management.”- David Hillary
Fractional reserve banking is a way for banks to make a LOT more money through fraudulent lending. As I stated above, on a free market fractional reserve notes could not exist for long because they would have to compete with commodity backed currencies and would be less preferred simply because their value cannot be guaranteed. So, fractional reserve banking may not be a government intervention per se, but it wholly requires government intervention to remain in the market. For more on fractional reserve banking read Rothbard’s The Case Against the Fed.

Bruce Koerber August 7, 2008 at 8:32 pm

What I like most about this article is tying the analysis to property rights. There are always multitudinous economic movements and it is very difficult to pinpoint cause and effect, at least in a way that is clear to most people. Examining what is happening to property rights makes it clear that there is a deliberate shifting of property rights during the ‘boom’ and since it is done with counterfeit money we can quickly identify the origin of the theft.

The ‘bust’ period is a partial return of property rights with much of it squandered and lost during the ‘boom.’

Again, when people start thinking in terms of property rights they will be better able to see what is happening and then stop the ego-driven interventionists.

David Hillary August 7, 2008 at 9:00 pm

Clay Baldwin wrote:
‘Fractional reserve banking is a way for banks to make a LOT more money through fraudulent lending. As I stated above, on a free market fractional reserve notes could not exist for long because they would have to compete with commodity backed currencies and would be less preferred simply because their value cannot be guaranteed. So, fractional reserve banking may not be a government intervention per se, but it wholly requires government intervention to remain in the market. For more on fractional reserve banking read Rothbard’s The Case Against the Fed.’

Competition between metal and paper under free banking resulted in increasing use of paper and reduced use of metal.

Competition among papers resulted in higher and higher quality issuers, i.e. more secure and credit worthy issuers displacing weaker and more risky issuers.

Thus, consumers appear to be wanting high quality paper as their holdings for conducting their transactions.

The same results apply to book-entry money — current accounts with banks, with cheque book access.

The value of paper is the amount of metal that is payable under the terms of the note, i.e. the sum payable, and the date of payment, i.e. future dated or on demand, and the credit quality of the issuer. Demand claims on credit worthy issuers are valued at par, because if their value was less they would have been redeemed.

Mike Sproul August 7, 2008 at 11:07 pm

Clay Baldwin:

“The whole reason our dollar is called a fiat money is simply because the Federal Reserve has NO assets backing up the dollar. The Federal Reserve will tell you themselves that there are no assets backing up the dollar except for the “full faith and credit of the American government”. ”

The fed’s balance sheet identifies its gold holdings and its bond holdings as “collateral held against federal reserve notes”, and the fed stands ready to use the bonds (not the gold) to buy back the dollars it has issued. Economists who call the dollar fiat money observe that the dollar is physically inconvertible into gold, and conclude that it is unbacked. The most remarkable thing about this simple non sequitur is that it has survived virtually unquestioned for centuries.

You and I are free to keep our bank balances in euros, pesos, gold, etc. I keep my bank balance in dollars because the bank pays me enough interest to offset inflation. I would guess that you do the same. Also, since I keep about $75 in paper dollars in my pocket at any given time, I figure that a 5% annual inflation rate only robs me of about $4 per year.

Clay Baldwin August 8, 2008 at 1:42 am

David Hillary:
“Competition between metal and paper under free banking resulted in increasing use of paper and reduced use of metal.”

When has there been true free market banking in a country not run by a government? That is not a rhetorical question, I’ve just only studied United States banking and I know that we never really had free market banking in America. The U.S. government has always intervened in banking through such actions as issuing money during war, setting the value of metals in ever changing markets, or in the case of such privately owned commercial banks as The Bank of North America, granting them monopoly privilege over other banks. The United States government has regulated banking since 1780 and even before that England regulated colonial banking. I don’t consider privately owned central banks that are granted privileges by the government to be examples of free market banking.

This does not mean there were not examples of private banks that were left pretty much alone during colonial days. One example that Murray Rothbard refers to in his A History of Money and Banking in the U.S. that is relevant to this conversation is The Massachusetts Land Bank of 1740. The Land Bank issued inflationary paper money, not redeemable in specie. As soon as they issued these notes, another bank propped up and issued silver-redeemable notes. Within six months time the Land Bank’s notes were nearly worthless. This is how the free market takes care of the fractional reserve system. With the fractional reserve system we have now there is hardly any check on inflationary tendencies because the dollar is the only currency you can legally use inside this country for transactions, so it doesn’t have to worry nearly as much about being defeated by competing currencies. The dollar only has to worry about international markets: although, it’s trying to solve that slight barrier to outright and total fraud through such international banking schemes as the IMF and the World Bank.

There is no competition in banking because under competition, banks would have to hold 100% reserves to keep a run from happening and therefore the venture would be much less profitable for bankers. On a free market a bank could hold say, 80% reserves and provide interest that a 100% reserve bank could not, but they would have to indicate on their notes that they had an 80% reserve ratio. Who would want to be that 20% to get screwed if everyone were to draw out their money, so I think that people wouldn’t want to hold their money in anything on a free market except for a 100% reserve account. Before anyone starts yelling FDIC FDIC!!, let me say that the FDIC is a big fraud; they hold less than one half of one percent of all the accounts they supposedly “insure”. On a free market there could be the possibility for private bank insurance companies. The federal reserve acts as a cushion for irresponsible banks so that they don’t feel the consequences of loaning out too much money (moral hazard what?) and are actually encouraged to do this in order to provide “liquidity” for the markets. I do not understand how self-proclaimed free marketers such as Chicago School monetarists advocate free market principles throughout the economy and then at the same time advocate such egregious violations of these same principles within the banking world.

The law only requires a 10% reserve ratio, from which all banks are practically encouraged to inflate the currency. If you do not have to worry about a run on your bank because you have a lender of last resort, what are you going to do? You are going to loan out as much credit as possible in order to make the most profit. These examples where private banks were debasing the metals and inflating the paper without the customer knowing were acts of fraud. On the free market today we would have efficient ways of verifying the value of currency and anyone caught fraudulently debasing a currency could be tried for contract violation. I think banks should be allowed to practice fractional reserve banking on the free market so long as they disclose to their customer and anyone accepting their notes what the value of their currency is (1/20th of an oz Silver; 1/30th oz Gold; “This is adjustable rate fiat money”; etc.) along with their reserve ratio.

David Hillary:
“Thus, consumers appear to be wanting high quality paper as their holdings for conducting their transactions.”

I am not arguing that we necessarily use commodity coins; I was speaking of commodity backed currency which of course would include paper money. Anyway, there is really no way to test what consumers “want” in monetary banking today because as far as the United States goes you really do not have a choice because we have legal tender laws forbidding a great number of choices.

Mike Sproul:
“The fed’s balance sheet identifies its gold holdings and its bond holdings as “collateral held against federal reserve notes”, and the fed stands ready to use the bonds (not the gold) to buy back the dollars it has issued.”

The Federal Reserve has about $1.075 trillion in assets; I don’t think they could “buy back” all the dollars they have issued with this…even if they were willing…

Mike Sproul:
“Economists who call the dollar fiat money observe that the dollar is physically inconvertible into gold, and conclude that it is unbacked. The most remarkable thing about this simple non sequitur is that it has survived virtually unquestioned for centuries.”

Non sequitur? unquestioned for centuries? Actually Mike, we did not go off the gold standard officially until 1971. Our dollar was tied to gold, albeit a weak connection, until Nixon closed the gold window in 1971 because everyone in the Bretton Woods agreement started to realize that these dollars we just kept spending were NOT backed by gold. When they found this out the French came first for their money and then Nixon permanently detached the dollar from gold and basically forced the world to use the dollar as their reserve currency in the Smithsonian agreement. Now we are on floating exchange rates, but until 2005, the Chinese Yuan was still pegged against the dollar in value. The dollar hasn’t even been unquestioned for the 37 years its been off the gold standard; people are having serious confidence issues with the dollar. The Euro and the pound are stronger currencies and soon the Chinese yuan will be a stronger currency than the U.S. dollar. A 100% gold standard is the only thing that can keep the government from debasing the currency. So, no, I wouldn’t call the fact that the United States dollar is no longer backed by gold a non sequitur.

David Hilllary August 8, 2008 at 4:17 am

In response to Clay Baldwin:
Free banking is a question of degree, and while banking has never been entirely free, it has been a lot more free than it is now in particular times and places, and indeed many historical banking regulations have now been removed. For example in New Zealand now there is freedom to form banks (no licence required), and banks can freely branch and decide their own reserve and capital ratios, asset and investment policies and so on, and there is no deposit insurance or government guarantee of bank deposits either. A lot of degrees of freedom there. On the other hand some restrictions remain concerning bank notes (restricted to the government’s central bank), and the government has some involvement in banking, owning a central bank and since about 2001 a retail bank. The central bank also regulates banks that elect and qualify to be ‘registered’ as banks (only registered banks can use the word ‘bank’ in their name or title, but unregistered banks can still offer banking services and use the word bank in their advertising (provided they also state that they are not registered)).

Free banking examples historically have been those that had both free banking and a metallic monetary standard, i.e. a good degree of freedom to form and operate banks that issue bank notes and offer cheque accounts, with gold and/or silver coin as the monetary standard, without central banking. The most well known historical example is Scotland from the late 18th century to 1844, however Australia, Switzerland, Sweden and some US States/regions are also relevant or significant cases.

Historically under metallic coin monetary standards and competitive issue of bank notes and cheque account services competition between rival banks the points of competition have been
a) ease of redemption (availability of branch banking to pay notes on demand, quality and ease of service),
b) ease of redemption via payment (i.e. cheque access and inter-bank clearing etc.)
c) security against counterfeiting, and convenient denominations and forms of payment media
d) financial strength (size, number of partners/shareholders, capital ratio, asset quality), and
e) in the case of book-entry money, payment of interest, or the interest rate offered.

Competition concerning reserve ratios does not seem to have featured, as far as I know — banks and customers appear to be more concerned about other aspects of the service mentioned above.

The 10% reserve ratio requirement is particular to US banks (and as far as I know not even all banks or all types of demand deposit). For example New Zealand has no minimum reserve ratio for banks (registered or unregistered). Banking regulation these days is focused on capital adequacy, and not reserve ratios, the theory being if a bank has an adequate capital ratio, it can maintain its desired liquidity ratios through borrowing on the market.

Promissory notes are not supposed to be for adjustable amounts, in fact an essential component of a promissory note is ‘a sum certain in money’: ‘A promissory note is an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay on demand, or at a fixed or determinable future time, a sum certain in money to or to the order of a specified person or to bearer.’ (Bills of Exchange Act 1908 (NZ), section 84 (1)). Bank notes are promissory notes issued by a bank, payable to bearer on demand. Thus the bank, like any other maker of a promissory note, must pay the note in full upon presentation of the note for payment. The maker of the note either pays or defaults, there is no middle ground. The maker’s financial affairs do not affect his liability for payment on presentation.

You wrote: ‘With the fractional reserve system we have now there is hardly any check on inflationary tendencies because the dollar is the only currency you can legally use inside this country for transactions, so it doesn’t have to worry nearly as much about being defeated by competing currencies.’

This is a very confused statement. The system we have today is a) central banks with monopoly or near monopoly on the business of issuing bank notes, b) irredeemable paper money standard without any anchor to metal and c) prudentially regulated private commercial banking, and d) in some countries deposit insurance systems. Restrictions on the ownership or use of foreign currencies or gold is not a significant feature of today’s banking and money system, however coining money is still a feature of government monopoly. Fractional reserve banking predates the present system by a long time and also existed during metallic coined money standard and free banking times and places.

Bank notes issued by commercial banks that are payable in coin are not backed by metal, they are backed by all the assets and financial capacity of the issuer. The issuers hold primarily a portfolio of loans and advances, but also marketable debt securities and metallic reserves. The correct term could be ‘secured’ however, unless some assets are specifically charged or provided as security for the notes, bank notes are unsecured claims on the issuing bank. Take a look at the full definition of a promissory note from the Bills of Exchange Act 1908 (NZ) section 84:
Promissory note defined
(1) A promissory note is an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay on demand, or at a fixed or determinable future time, a sum certain in money to or to the order of a specified person or to bearer.
(2) An instrument in the form of a note payable to maker’s order is not a note within the meaning of this section unless and until it is indorsed by the maker.
(3) A note is not invalid by reason only that it contains also a pledge of collateral security, with authority to sell or dispose thereof.
(4) A note that is, or on the face of it purports to be, both made and payable in New Zealand is an inland note; any other note is a foreign note.

Dick Fox August 8, 2008 at 8:56 am

“The resolution is that green paper dollars are NOT fiat money. They are backed by the assets of the fed…”

Mike Sproul,

At least you are consistent. You have taken this position before but it is a foolish statement. What FED assets are you talking about? Treasury bonds? Or are you talking about the assets that are delivered to the FED for use of dollars? Mike, the FED injects money into the economy by exchanging dollars for FED bonds and pulls money out of the economy by selling bonds. Are these the assets that back the money? Hmmmmmmm!

jp August 8, 2008 at 10:00 am

The Fed injecting and pulling money into and out of the economy is colourful word use, but doesn’t capture the process properly. In open market operations the Fed passively sets up an auction, the primary dealers bidding for new cash (ie open market purchases), or bidding for bonds (open market sales). It is the dealers, not the Fed, “pulling” money into the economy or “injecting” it back into the Fed.

The Fed can influence the dealer’s “injecting” and “pulling” by offering a wider range of acceptable securities, accepting more bids/offers, allowing a wider range of parties to use open market ops (or the discount window), accepting lower/higher prices, or reducing the possibilities of convertability (say by never announcing open market sale auctions). But to say that the Fed single handedly sets money supply through “injecting” ignores the entire demand side’s influence.

As for assets, the Fed has assets just like a 100% gold bank does, they’re just not gold. Note holders “pull” cash out of the bank by depositing gold, and they “inject” cash into the bank via the opposite.

I don’t like that government bonds are the main asset backing notes either. But that’s not fractional reserve banking’s fault, that just one of the peculiarities of governments taking over control of the note issue. Unfortunately they get to determine the backing asset. If I had to pick notes to hold they’d be backed by a bit of gold, sound mortgages, short term commercial debt, and investments in strong companies, and they’d be convertible into gold.

Mike Sproul August 8, 2008 at 1:21 pm

Clay Baldwin:

“The Federal Reserve has about $1.075 trillion in assets; I don’t think they could “buy back” all the dollars they have issued with this…even if they were willing..”

The fed has issued $831 billion in currency, so obviously 1.075 trillion is enough to buy it back. Of course that 1.075T figure counts the fed’s gold stock as being worth $11.041B, when its market value is closer to $230B. This also assumes that none of the $831B in paper dollars has been lost or destroyed by accident.

Inconvertible currencies have been around for centuries. On feb 26, 1797, the bank of england suspended convertibility, and convertibility was restored 24 years later. It was during this time that the idea of fiat money took hold. People seemed to think that the pound was backed on feb 25, and suddenly became ‘fiat’ on feb 26, only to become backed again 24 years later. Of course, the bank’s gold and bonds were there in the vault the whole time, backing the currency in spite of what economists thought.

Mike Sproul August 8, 2008 at 1:34 pm

Dick Fox:
“What FED assets are you talking about? Treasury bonds? Or are you talking about the assets that are delivered to the FED for use of dollars? Mike, the FED injects money into the economy by exchanging dollars for FED bonds and pulls money out of the economy by selling bonds. Are these the assets that back the money? ”

I’m talking about the gold and bonds and miscellaneous assets that are listed on the fed’s balance sheet. You seem to believe the “money out of thin air” claim that is circulated by Ron Paul and others. Paper dollars are not created out of thin air. The fed only issues dollars to someone who offers a dollar’s worth of assets in exchange. Normally the assets are US bonds held by private citizens, but the fed could just as well issue a new dollar for a dollar’s worth of farm land. That might make it a little easier to see that as new dollars are issued, the fed’s assets rise in step, and the value of the dollar is therefore unaffected.

Alex M August 8, 2008 at 1:53 pm

There are a number of arbitrary assumptions in Polleit’s examples that lead to some of his conclusions.

1. Just above Fig. 3, he assumes the banking sector sells $1051 bn of new bank stock and then concludes that there would be a reduction in the money supply. However, supposing the bank sold $1170 bn of new bank stock, the equilibrium money supply would be the same after the loan losses as before the loan losses.

2. In Fig. 4, the asset side of the central bank should read $744 bn bank equity, not $744 risky bank loans.

3. In Fig. 5, the central bank’s equity would not be wiped out by transferring $1051 bn of government bonds from the central bank’s balance sheet to the banking sector, since the central bank would receive bank stock as an asset in return. And, if the government transfers a new $1051 bn of government bonds to the central bank, the new liability on the central bank’s balance sheet would be (“government deposits” or some other such liability to the government.)

Despite these accounting problems, however, Polleit’s main point is well taken. That is, the banking sector’s shareholders can take the loss or taxpayers can absorb a fraction or all the loss by various central bank and government manoeuvres.

However, whether or not taxpayers or bank shareholders absorb bank losses has nothing to do with the money supply, since the money supply can be increased or decreased independently of that issue.

newson August 8, 2008 at 10:36 pm

paul says:
“If people start curbing their borrowing, start defaulting on their loans, and banks stop lending, that’s deflationary.”

loan defaults are not necessarily deflationary. the money supply contracts when loans are repaid, but in the case of default it’s owners equity that is reduced, not the money supply. now it may be the case that massive losses of owners’ equity results in the banks’ changing their credit policies, but it’s not a given.

newson August 8, 2008 at 10:48 pm

jp says:
“But to say that the Fed single handedly sets money supply through “injecting” ignores the entire demand side’s influence.”

but look at the skewed nature of the fed intervention through its open market operations. purchases of treasuries far exceed sales; the fed’s balance sheet grows every year.

where would treasuries be were the fed not such a big player on the buy side?

newson August 8, 2008 at 11:19 pm

dick fox says:
“David, I would like to followup on your comment. Using the government to remove the right of the people to invest in fractional banking is just as Fascist as most policies of our central planning government. As long as people are informed they should be allowed to invest in anything they want.”

both you and hillary fall in the same trap. contracts over illegal acts are null and void. the fact that frb is a fraud is covered at great length by jesus huerta de soto (cited by steelman, above). in chapters 1,2 & 3 of “money, bank credit and economic cycles”, he traces how tortured the law has become (roman and english codes) to accommodate this deception.

i don’t think the airline seat analogy is particularly helpful – i don’t own the airline seat, nor do i have any guarantees of arriving at my destination on schedule. people buy travel insurance to guard against that very disappointment, though often airlines can arrange compensatory deals to placate angry customers. (it’s obviously embarassing to the carrier when reality trumps modelling).

now if i actually purchased outright a seat on a particular route, i want to be assured that seat is always vacant unless i’m in it. i don’t want any probabilistic games played by the operator to maximize his yield. i want it empty, because it’s mine!

Mz Sexy Legz August 8, 2008 at 11:29 pm

I read all of this and the analysis to the article – I like knowing the reasons behind what is happening as much as all the other posters – But I also ask – The point is?

To rehash the ‘why’ this has happened does not get anyone any closer to the ‘fix’ for the situation. No offense but pissing and moaning over what the Fed has done to this point will not provide a solution – Get over the mess and let’s find the solution! Or is Mises just for discussing the history of the mess?

So will the economic logic of what Mises represents prevail – or do you want to continue to pout? Funny that a woman would be asking this ~

Mz Sexy Legz August 8, 2008 at 11:30 pm

I read all of this and the analysis to the article – I like knowing the reasons behind what is happening as much as all the other posters – But I also ask – The point is?

To rehash the ‘why’ this has happened does not get anyone any closer to the ‘fix’ for the situation. No offense but pissing and moaning over what the Fed has done to this point will not provide a solution – Get over the mess and let’s find the solution! Or is Mises just for discussing the history of the mess?

So will the economic logic of what Mises represents prevail – or do you want to continue to pout? Funny that a woman would be asking this ~

Mz Sexy Legz August 8, 2008 at 11:31 pm

I read all of this and the analysis to the article – I like knowing the reasons behind what is happening as much as all the other posters – But I also ask – The point is?

To rehash the ‘why’ this has happened does not get anyone any closer to the ‘fix’ for the situation. No offense but pissing and moaning over what the Fed has done to this point will not provide a solution – Get over the mess and let’s find the solution! Or is Mises just for discussing the history of the mess?

So will the economic logic of what Mises represents prevail – or do you want to continue to pout? Funny that a woman would be asking this ~

newson August 8, 2008 at 11:43 pm

to sexy legz:
the “solution” is not going to be one coming from the mises camp.

analyzing the causes of the present mess, and understanding the motives of the real players (banks and their political allies) will help you, the investor, navigate the turbulent waters that lie ahead.

newson August 9, 2008 at 12:17 am

to mike sproul:
in citing the 1797 episode, you neglect to mention that coincident with the suspension of convertibility, the english government it made obligatory to satisfy debts and taxes in bank of england notes.
hello “fiat”, yet again!

(fiat: “”a short order or warrant of a Judge or magistrate directing some act to be done; an authority issuing from some competent source for the doing of some legal act”, blacks law dictionary).

newson August 9, 2008 at 12:38 am

to thorsten polleit:

i’m curious about what you think the fed will do when its emergency short-term facility reaches its term (september?).

if the banks’ garbage paper goes back on their balance sheets at market value their shareholders are going to take a massive haircut.

do you think the fed is going to extend these facilities’ expiry date, and do you think this paper will ever be bought outright by the fed?

David Hillary August 9, 2008 at 12:42 am

newson claims that the law is ‘tortured’ to fit with bank current accounts and bank notes as unsecured claims on the bank. However this is incorrect: as I mentioned earlier, promissory notes are impossible to confuse with bailments — a promissory note is an engagement to pay money on presentation not an engagement to hold money in reserve.

The most appropriate term for demand deposits is ‘current account’ or ‘cheque account’. A current account is a record of money owing. For example if a person has an account with a telephone company or a power company, that account records the charges and payments between the parties, and the balance of the account is the financial position between the parties, a debtor-creditor relationship as a result of their commerce. This is under the legal principle that debts can be offset (a principle that does not apply to promissory notes and bills of exchange). A cheque account is a current account with a bank, where the customer can draw on the account by drawing cheques. To see that the account represents a simple debtor-creditor relationship at law, consider the case of an overdraft: the bank is lending money to the customer, and the customer has no obligation to hold the bank’s money in storage, instead the customer can use it for his own purposes, so long as he repays the bank should the bank demand repayment. The business of the bank is borrowing money on current account, repayable to the customer’s order. The bank’s business is also lending money, whether by way of advances on current account, or term loans or investments in debt securities.

newson August 9, 2008 at 1:27 am

to david hillary:

if you read de soto, you’ll see how the law on warehousing fungible goods took two different routes for grain warehousing versus current accounts. (a function of the weakness of the warehousemen’s lobby, compared to the bankers’ lobby?).

the current legal code does indeed treat current-account holders as bank creditors, but you’ll see that wasn’t always the case.

under frb, the current account becomes an aleatory contract, as de soto says.

David Hilllary August 9, 2008 at 3:58 am

There is no ‘legal code’ under common law, this is a civil law concept. For example under New Zealand law there is no ‘Banking Act’ or other legislation setting out the bank-customer contract, instead the courts and judges figure out what are the rights and obligations on the banker and customer concerning an account. Of course they will use the bank’s written terns and conditions, and consider what is settled law based on previous decisions, including decisions in English courts and other foreign common law courts. Under common law, therefore, the banker-customer, is a matter of contract, not of some code.

It appears you accept that bank notes are promissory notes and cannot be confused with bailments, and your contention is limited to cheque account balances.

Considering cheque accounts with a bank, note that:
1. Cheques are a species of bill of exchange, and bills of exchange may be drawn on non-bank, e.g. financiers.
2. Cheque accounts are a species of current account, and non-banks can conduct current accounts for their customers too, most commonly for accounts payable for goods or services provided on credit terms.

Bills of exchange are financial instruments, contracts for the payment of money, debt securities.

Current accounts are financial accounts, tracking the financial position between two parties, as a result of their dealings. The device of the current account is based on the legal principle that debts between the parties can be offset, i.e. the law cares about the net position between two parties, with any credit standing to a person’s account being carried forward to offset any later debts, or otherwise being entitled to be paid as a debt owing.

The law is not static, and its development is not a bad thing. In a free market people can use institutions as a tool, they can structure their transactions to take advantage of its features and pitfalls. Under today’s law, people can use established and settled law concerning security interests in property, supervisory debt security trusts and trustees with financial and other covenants to provide for 100% metallic reserve banking, if they so desire. On the other hand, the law is there to serve man, not the other way around: so the law should try to support and accommodate unsecured banking too.

P.M.Lawrence August 9, 2008 at 4:47 am

Newson wrote “the current legal code does indeed treat current-account holders as bank creditors, but you’ll see that wasn’t always the case”.

Actually, for as long as bank statements have been prepared showing your current account in credit when you have funds at the bank, current account holders have been treated as creditors. Your own account with the bank would show you in debit, if you kept one; the statement is a description of the bank’s account with you.

newson August 9, 2008 at 6:49 am

to pm lawrence:
the operative word is “current”.

de soto cites abbot payson usher’s “the early history of deposit banking in mediterranean europe”. usher indicates that in 12th century genoa, banks made a clear difference in their books between demand deposits and “time” deposits, the latter being recorded in their books as loans or mutuum contracts.

newson August 9, 2008 at 6:56 am

to david hillary:

the federal reserve system is legal, and being legal it therefore serves the population well, is that the gist of your argument?

you still haven’t addressed the primary issue, how can two or more people make valid, competing claims for one asset?

Mike Sproul August 9, 2008 at 10:18 am

Newson:

“coincident with the suspension of convertibility, the english government it made obligatory to satisfy debts and taxes in bank of england notes.
hello “fiat”, yet again! ”

Such a declaration can only impart value to B of E notes if the entity making the declaration has the power to enforce it. In effect, the notes become backed by the government’s ability to take away your gold, rather than the bank’s ability to pay out gold. A ‘fiat’ forcing an insolvent bank to pay out 1 ounce of gold for each of its notes will not give value to those notes, any more than a ‘fiat’ declaring that a powerless government will accept notes instead of 1 ounce in payment of taxes. Money can be backed by gold, by bonds, by ‘taxes receivable’, etc. But the mainstream meaning of ‘fiat money’ is that it is not backed by anything. It only has value because it is limited in supply and useful for making trades. Unfortunately, that insipid theory is virtually the only theory ever discussed in economics textbooks.

David Hilllary August 9, 2008 at 3:56 pm

Newson:
‘legal’ in what sense? In the sense of being an enterprise designed and sponsored by the government, with special rights and powers other concerns do not have? Kinda like socialism or fascism if you ask me.

The kind of legality I’m talking about is recognised and settled law as between contracting parties, i.e. common law and the principles of equity, not fiat or regulatory law.

Creditors have claims on debtors, and not debtor’s property. Creditors only have recourse to the debtor’s property in the event of default by the the debtor, either through security agreements that charge assets or groups of assets, or through insolvency or debt enforcement proceedings that convert general claims on a debtor into rights over specific assets of the debtor, or to a share of the proceeds of the liquidation of the debtor’s estate.

Ireland August 9, 2008 at 5:29 pm

Does someone else find constructions as “is backed by” and “has value” inappropriate when they’re used in reference to money?

The term “money” describes those goods and services, that have the special quality that they are accepted in exchange for other goods and services. This quality is usually the main property which makes money species valued by people. (If there are other uses, as with gold, these contribute to the overall valuation relatively little.)

It’s people who ascribe monetary value to whatever is accepted as money – and it works as long as those who receive it can then exchange it further for goods and services of their own choosing. That’s about the only “backing” any money ever has or needs: a common understanding of what it can buy you, daily confirmed by purchases.

Value of money comes from the same source as value of all other things: people’s desire to posses them. As all other things also money is valued, which is a wee bit different from “it having some value”.

john taylor south australia August 9, 2008 at 5:52 pm

I’m sick of these Real Bills doctrine guys like Mike Sproul. Sean Corrigan and others have made mince meat out of their arguments here at mises.org – but they fail to accept them – your exactly like Lord Keynes – stodgy.
I really don’t think it’s hard to see why the Real Bills Doctrine is wrong – quite simply it’s business man and banks together getting the right to determine the value of their transactions in terms of money which the general population is forced to accept. The same flaw as the current fiat system just in a different package.

I can see that and I’m not an economist – no where near it just an interested layperson.

By the way you have said in one of your previous blog posts that Mises and the other Austrian economists were just less wrong than other Economists about these matters. Get of your high horse – I don’t idolise anyone but in my search for truth and understanding of economics over the last 22 of my 37 years of life I have taken into consideration many ideas (yes, i was once a socialist) but have come to the conclusion Mises and the Austrians are right. However I have like reading your contributions and will still listen to criticisms of them but have yet to find anything convincing.

john taylor south australia August 9, 2008 at 5:56 pm

I’m sick of these Real Bills doctrine guys like Mike Sproul. Sean Corrigan and others have made mince meat out of their arguments here at mises.org – but they fail to accept them – your exactly like Lord Keynes – stodgy.
I really don’t think it’s hard to see why the Real Bills Doctrine is wrong – quite simply it’s business man and banks together getting the right to determine the value of their transactions in terms of money which the general population is forced to accept. The same flaw as the current fiat system just in a different package.

I can see that and I’m not an economist – no where near it just an interested layperson.

By the way you have said in one of your previous blog posts that Mises and the other Austrian economists were just less wrong than other Economists about these matters. Get of your high horse – I don’t idolise anyone but in my search for truth and understanding of economics over the last 22 of my 37 years of life I have taken into consideration many ideas (yes, i was once a socialist) but have come to the conclusion Mises and the Austrians are right. However I have and will still listen to criticisms of the Austrians but have yet to find anything convincing but found like your criticisms most are unwilling to change their view when they are wrong – plain and simple.

newson August 9, 2008 at 10:15 pm

to mike sproul:

the problem of arguing about the 1797 suspension of convertibility by dint of government fiat, is that the data is so very patchy. two major european nations are at war with their respective currencies rendered unconvertible by government fiat.

i’d imagine that currencies of those countries not party to the napoleonic wars would have benefited from capital flight, but i haven’t got the forex data.

it may well be that the inflationary expectations were tempered by the populace’s firm belief that the suspension would be revoked on the cessation of hostilities (naturally victorious).

rothbard notes that bank stocks fell on average by 16% on the resumption of convertibility, so clearly fiat was good for some parties, as is the case today.

newson August 9, 2008 at 10:27 pm

that is: rothbard’s “mystery of banking” p.112

Mike Sproul August 9, 2008 at 11:25 pm

John Taylor:

“I’m sick of these Real Bills doctrine guys like Mike Sproul. Sean Corrigan and others have made mince meat out of their arguments here at mises.org – but they fail to accept them – your exactly like Lord Keynes – stodgy.”

Sean Corrigan has never responded to a word I’ve said. (Neither did Robert Blumen, for that matter.) A few years ago, they attacked the view that money should only be issued in exchange for productive assets–an old and incorrect view of what the real bills doctrine says. They never addressed the view that all money is backed by the assets of the entity that issued it.

Anyone who says I’m exactly like Keynes has obviously been handling too many poisonous snakes.

newson August 10, 2008 at 2:35 am

to david hillary:
the common law judgements which allowed current account depositors to be classified as bank creditors rather than bailors have been cited and discussed by rothbard. these judgements are a couple of centuries old (from memory). in roman law courts upheld the obligations of banks to maintain 100% reserves against current accounts, up to the early 20th century.

it’s entirely possible that legal judgement
via the common law erred in understanding banking in economic terms.

if you accept that common law is derived in an evolutionary process, only dr pangloss could conclude that the the law is constantly moving towards perfection.

newson August 10, 2008 at 3:18 am

to david hillary(cont.):
carr v. carr, devaynes v. noble, foley v. hill et al – early nineteenth century.

David Hilllary August 10, 2008 at 4:06 am

So if the common law erred, it erred in interpretation, while still allowing contracting parties to avoid the error by making it explicit in their written terms that the depositor was bailor and the bank bailee, rather than creditor and debtor. The fact that this has not happened is evidence that either the common law did not err and/or that this type of commercial arrangement is not in demand.

As I have also said before, even keeping with debtor-creditor analysis of the bank-customer contract, 100% metallic reserve banking can be arranged via a security interest over the bank’s metallic reserves in favour of depositors, and a financial covenant to maintain a 100% reserve ratio in a security trust deed monitored by a security trustee, as commonly occurs with debt securities offered for subscription by the public. (It is not the 100% reserve ratio financial covenant that is common, but the making of financial covenants and provision of security and trust deed and trustee arrangement described above.)

200 years is a long time for commerce and law to evolve and develop and sort our errors, too.

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