The Secret Science: How the Federal Reserve Creates Money Out of Debt
G. Edward Griffin | The New American
December 19, 1988
Banks of deposit first appeared in early Greece, concurrent with the development of coinage itself. They were known in India at the time of Alexander the Great. They also operated in Egypt as part of the public granary system. They appeared in Damascus in 1200 and in Barcelona in 1401. It is the city-state of Venice, however, that is considered the cradle of banking as we know it today.
The Bank of Venice
By the year 1361, there already had been sufficient abuse in banking that the Venetian Senate passed a law forbidding bankers to engage in any other commercial pursuit, thus removing the temptation to use their depositors' funds to finance their own enterprises. They were also required to open their books for public inspection and to keep their stockpile of coins available for viewing at all reasonable times. In 1524, a board of bank examiners was created and, two years later, all bankers were required to settle accounts between themselves in coin rather than by check.
In spite of these precautions, however, the largest bank at that time, the house of Pisano and Tiepolo, had been active in lending against its reserves and, in 1584, was forced to close its doors because of inability to refund depositors. The government picked up the pieces at that point and a state bank was established, the Banco della Piazza del Rialto. Having learned from the recent experience with bankruptcy, the government prohibited the new bank from making any loans. There could be no profit from the issuance of credit. The bank was required to sustain itself solely from fees for coin storage, exchanging currencies, handling the transfer of payments between customers, and notary services.
The formula for honest banking had been found. The bank prospered and soon became the center of Venetian commerce. Its paper receipts were widely accepted far beyond the country's borders and, in fact, instead of being discounted in exchange for gold coin as was the usual practice, they actually carried a premium over coins. This was because there were so many kinds of coin in circulation and such a wide variance of quality within the same type of coin that one had to be an expert to evaluate their worth. The bank performed this service automatically when it took the coins into its vault. Each was evaluated, and the receipt given for it was an accurate reflection of its intrinsic worth. The public, therefore, was far more certain of the value of the paper receipts than of that of many of the coins and, consequently, was willing to exchange a little bit more for them.
Unfortunately, with the passage of time and the fading from memory of previous banking abuses, the Venetian Senate eventually succumbed to the temptation of credit. Strapped for funds and not willing to face the voters with a tax increase, the politicians decided they would authorize a new bank without restrictions against loans and then create the money they needed simply by "borrowing" it. So, in 1619, the Banco del Giro was formed, which, like its bankrupt predecessor, began immediately to create money out of debt. Eighteen years later, the Banco della Piazza del Rialto was absorbed into the new bank, and history's first tiny flame of sound banking sputtered and died.
Throughout the fifteenth and sixteenth centuries, banks had been springing up all over Europe. Almost without exception, however, they followed the lucrative practice of lending money which was not truly available for loan. They created excess obligations against their reserves and, as a result, every one of them failed. That is not to say that their owners and directors did not prosper. It merely means that their depositors lost all or a part of their assets entrusted for safekeeping.
The Bank of Amsterdam
It wasn't until the Bank of Amsterdam was founded in 1609 that we find a second example of sound banking practices, and the results were virtually the same as previously experienced by the Banco della Piazza del Rialto. The bank only accepted deposits and steadfastly refused to make loans. Its income was derived solely from service fees. All payments in and around Amsterdam soon came to be made in paper currency issued by the bank and, in fact, that currency carried a premium over coin itself. The burgomasters and the city council were required to take an annual oath swearing that the coin reserve of the bank was intact. In Money: Whence It Came, Where It Went, John Kenneth Galbraith reminds us:
SOME DEFINITIONS
Barter: a direct exchange of items of like value.
Commodity Money: items used as a medium of indirect exchange -- e.g. cattle, tobacco, precious metals.
Receipt Money: a note entitling bearer to a stated quantity of a specified commodity.
Fractional Money: receipt money issued in excess of commodities held by the one issuing the note.
Fiat Money: a note or bookkeeping entry with no commodity backing, used as a medium of exchange only under compulsion (e.g. legal tender laws).
The principles of honesty and restraint were not to be long-lived, however. The temptation of easy profit from money creation was simply too great. As early as 1657, individuals had been permitted to overdraw their accounts, which means, of course, that the bank created new money out of their debt. In later years enormous loans were made to the Dutch East India Company. The truth finally became known to the public in January of 1790, and demands for a return of deposits were steady from that date forward. Ten months later, the bank was declared insolvent and was taken over by the City of Amsterdam.
The Bank of Hamburg
The third and last experience with honest banking occurred in Germany with the Bank of Hamburg. For over two centuries it faithfully adhered to the principle of safe deposit. So scrupulous was its administration that, when Napoleon took possession of the bank in 1813, he found 7,506,956 marks in silver held against liabilities of 7,489,343. That was 17,613 more than was actually needed. Most of the bank's treasure that Napoleon hauled away was restored a few years later by the French government in the form of securities. It is not clear if the securities were of much value but, even if they were, they were not the same as silver. Because of foreign invasion, the bank's currency was no longer fully convertible into coin as receipt money. It was now fractional money, and the self-destruct mechanism had been set in motion. The bank lasted another 55 years until 1871 when it was ordered to liquidate all of its accounts.
That is the end of the short story of honest banking. From that point forward, fractional-reserve banking became the universal practice. But there were to be many interesting twists and turns in its development before it would be ready for something as sophisticated as the Federal Reserve System.
England's first paper money was the exchequer order of Charles II. It was pure fiat and, although it was decreed legal tender, it was not widely used. It was replaced in 1696 by the exchequer bill. The bill was redeemable in gold, and the government went to great lengths to make sure that there was enough actual coin or bullion to make good on the pledge. In other words, it was true receipt money, and it became widely accepted as the medium of exchange. Furthermore, the bills were considered as short-term loans to the government and actually paid interest to the holders.
In 1707, the recently created Bank of England was given the responsibility of managing this currency, but the bank found more profit in the circulation of its own banknotes, which were in the form of fractional money and which provided for the collection of interest, not the payment of it. Consequently, the government bills gradually passed out of use and were replaced by banknotes, which, by the middle of the 18th century, became England's only paper money.
It must be understood that, at this time, the Bank of England was not yet fully developed as a central bank. It had been given a monopoly over the issue of banknotes within London and other prime geographic areas, but they were not yet decreed as legal tender. No one was forced to use them. They were merely private fractional receipts for gold coin issued by a private bank, which the public could accept, reject, or discount at its pleasure. Legal tender status was not conferred upon the bank's money until 1833.
Meanwhile, Parliament had granted charters to numerous other banks throughout the empire and, without exception, the issuance of factional money led to their ultimate demise and the ruin of their depositors. "Disaster after disaster had to come upon the country," says W.A. Shaw, in his Theory and Principles of Central Banking, because "of the indifference of the state to these mere private paper tokens." The Bank of England, however, was favored by the government above all others and, time after time, it was saved from insolvency by Parliament. How it came to be that way is an interesting story.
The Bank of England
England was financially exhausted after half a century of war against France and numerous civil wars fought largely over excessive taxation. By the time of the War of the League of Augsberg in 1693, King William was in serious need for new revenue. Twenty years previously, King Charles II had flat out repudiated a debt of over a million pounds, which had been lent to him by scores of goldsmiths, with the result that ten thousand depositors lost their savings. This was still fresh in everyone's memory, and, needless to say, the government was no longer considered a good investment risk. Unable to increase taxes and unable to borrow, Parliament became desperate for some other way to obtain the money. The objective, says Elgin Groseclose in his Money and Man, was not to bring "the money mechanism under more intelligent control, but to provide means outside the onerous sources of taxes and public loans for the financial requirements of an impecunious government."
There were two groups of men who saw a unique opportunity arise out of this necessity. The first group consisted of the political scientists within the government. The second was comprised of the monetary scientists from the emerging business of banking. The organizer and spokesman of this group was William Paterson from Scotland. Paterson had been to America and had come back with a grandiose scheme to obtain a British charter for a commercial company to colonize the Isthmus of Panama, then known as Darien. The government was not interested in that, so Paterson turned his attention to a scheme that did interest it very much, the creation of money.
The two groups came together and formed an alliance. With much of the same secrecy and mystery that surrounded the meeting on Jekyll Island (where the Federal Reserve was conceived), the Cabal met in Mercer's Chapel in London and hammered out a seven-point plan that would serve their mutual purposes:
The circular distributed to attract subscribers to the Bank's initial stock offering explained: "Paterson hath benefit of interest on all the money which it, the Bank, creates out of nothing." The charter was issued in 1694, and a strange creature took its initial breath of life. It was the world's first central bank. In his Mystery of Banking, Murray Rothbard writes:
The Secret Science of Money
Both groups within the Cabal were handsomely rewarded for their efforts. The political scientists had been seeking about 500,000 pounds to finance the current war. The Bank promptly gave them more than twice what they had originally sought. The monetary scientists started with a capital investment of 1,200,000 pounds. Textbooks tell us that this was promptly lent to the government, but what is usually omitted is the fact that, in return for that loan, the Bank was given the privilege of printing an equal amount of banknotes which were offered to the public in the form of loans. So, after lending their capital to the government, they still had it available to loan out a second time. It is meaningless, therefore, to talk about a rate of interest. Since the new money was manufactured out of nothing, the real interest rate was not 8 percent, it was infinity.
Such is the secret science of money.
From Inflation to Bank Runs
The new money splashed through the economy like rain in April. The country banks outside of the London area were authorized to create money on their own, but they had to hold a certain percentage of either coin or Bank of England certificates in reserve. Consequently, when these plentiful banknotes landed in their hands, they quickly put them into the vaults and then issued their own certificates in even greater amounts. As a result of this pyramiding effect, prices rose 100 percent in just two years. Then, the inevitable happened: There was a run on the bank, and the Bank of England could not produce the coin.
When banks cannot honor their contracts to deliver coin in return for their receipts, they are, in fact, bankrupt. They should be allowed to go out of business and liquidate their assets to satisfy their creditors just like any other business. This, in fact, is what always had happened to banks that loaned out their deposits and created fractional money. Had this practice been allowed to continue, there is little doubt that people eventually would have understood that they simply do not want to do business with those kinds of banks. Through the painful but highly effective process of trial and error, mankind would have learned to distinguish real money from fool's gold. And the world would be a lot better because of it today.
That, of course, was not allowed to happen. When there was a run on the Bank of England, Parliament intervened. In May of 1696, just two years after the Bank was formed, a law was passed authorizing it to "suspend payment in specie." By force of law, the Bank was now exempted from having to honor its contract to return the gold.
This was a fateful event in the history of money, because the precedent has been followed ever since. In Europe and America, the banks have always operated with the assumption that their partners in government will come to their aid when they get into trouble. Politicians may speak about "protecting the public," but the underlying reality is that the government needs the fiat money produced by the banks. The banks -- at least the big ones -- must not be allowed to fail. Only a cartel with government protection can enjoy such insulation from the workings of a free market.
Once the Bank of England had been legally protected from the consequences of converting debt into money, the British economy was doomed to a nauseating roller-coaster ride of inflation, booms, and busts. The natural and immediate result was the granting of massive loans for just about any wild scheme imaginable. Why not? The money cost nothing to make, and the potential profits could be enormous. So the Bank of England, and the country banks, which pyramided their own money supply on top of the Bank's supply, pumped a steady stream of new money into the economy. Great stock companies were formed and financed by this money. One was for the purpose of draining the Red Sea to recover the gold supposedly lost by the Egyptians when pursuing the Israelites. One hundred fifty million pounds were siphoned into vague and fruitless ventures in South America and Mexico.
The result of this flood of new money was even more inflation. In 1810, the House of Commons created a special committee -- the Select Committee on the High Price of Gold Bullion -- to explore the problem and to find a solution. The verdict handed down in the final report was a model of clarity. Prices were not going up, it said. The value of the currency was going down, and that was due to the fact that it was being created at a faster rate than the creation of goods to be purchased with it. The solution? The committee recommended that the notes of the Bank of England be made fully convertible into gold coin, thus putting a brake on the supply of money that could be created.
One of the most outspoken proponents of a true gold standard was a Jewish London stockbroker by the name of David Ricardo. Ricardo argued that an ideal currency "should be absolutely invariable in value." He conceded that precious metals were not perfect in this regard because they do shift in purchasing power to a small degree. Then he said: "They are, however, the best with which we are acquainted."
Almost everyone in government agreed with Ricardo's assessment, but, as is often the case, theoretical truth was fighting a losing battle against practical necessity. Men's opinions on the best form of money were one thing. The war with Napoleon was another, and it demanded constant influx of funding. England continued to use the central-bank mechanism to extract that revenue from the populace.
Depression and Reform
By 1815, prices had doubled again then fell sharply. The Corn Act was passed that year to protect local growers from lower-priced imports. Then, when corn and wheat prices began to climb once more in spite of the fact that wages and other prices were falling, there was wide-spread discontent and rebellion. "By 1816," notes Roy Jastram in The Golden Constant, "England was in deep depression. There was stagnation of industry and trade generally; the iron and coal industries were paralyzed .... Riots occurred spasmodically from May through December."
In 1821, after the war had ended and there was no longer a need to fund military campaigns, the political pressure for a gold standard became too strong to resist, and the Bank of England returned to a convertibility of its notes into gold coin. The basic central-bank mechanism was not dismantled, however. It was merely limited by a new formula regarding the allowable fraction of reserves. The Bank continued to create money out of debt and, within a year, the flower of a new business boom unfolded. Then, in November of 1825, the flower matured into its predestined fruit. The crisis began with the collapse of Sir Peter Cole and Company and was soon followed by the failure of 63 other banks. Fortunes were wiped out and the economy plunged back into depression.
When a similar crisis with still more bank failures struck again in 1839, Parliament attempted to come to grips with the problem. After five more years of analysis and debate, Sir Robert Peel succeeded in passing a banking reform act. It squarely faced the cause of England's booms and busts: an elastic money supply. What Peel's Bank Act of 1844 attempted to do was to limit the amount of money the banks could create to roughly the same as it would be if banknotes were backed by gold or silver. It was a good try, but it ultimately failed because it fell short on three counts: (1) It was a political compromise and was not strict enough, still allowing the banks to create money out of debt to the extent of 14,000,000 pounds; in other words, a "fractional" amount thought to be safe at the time. (2) The limitation applied only to paper currency issued by the Bank. It did not apply to checkbook money, and that was then becoming the preferred form of exchange. Consequently, the so-called reform did not even apply to the area where the greatest amount of abuse was taking place. And (3) the basic concept was allowed to remain unchallenged that man, in his infinite political wisdom, can determine what the money supply should be more effectively than an unmanaged system of gold or silver responding to the natural law of supply and demand.
Within three years of the "reform," England faced another crisis, with still more bank failures and more losses to depositors. But, when the Bank of England tottered on the edge of insolvency, once again the government intervened. In 1847, the Bank was exempted from the legal reserve requirements of the Pool Act. Such is the rock-steady dependability of man-made limits to the money supply.
Groseclose continues the story:
It is an incredible fact of history that, in spite of the general and recurring failures of the Bank of England during these years, the central-bank mechanism was so attractive to the political and monetary scientists that it became the model for all of Europe. The Bank of Prussia became the Reichsbank. Napoleon established the Banque de France. A few decades later, the concept became the venerated model for the Federal Reserve System. Who cares if the scheme is destructive? Here is the perfect tool for obtaining unlimited funding for politicians and endless profits for bankers. And, best of all, the little people who pay the bills for both groups have practically no idea what is being done to them.
American money today has no gold or silver behind it whatsoever. The fraction is not 54 percent nor 15 percent. It is 0 percent. It has travelled the path of all previous fractional money in history and already has degenerated into pure fiat money. The fact that most of it is in the form of checkbook balances rather than paper currency is a mere technicality. And the fact that bankers speak about "reserve ratios" is just so much eyewash. The so-called reserves to which they refer are, in fact, Treasury bonds and other certificates of debt. Our money is pure fiat through and through.
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Consider the Poker Game
At the Friday night poker game, Charlie serves as banker. He exchanges poker chips for each player's money and puts the cash in a cigar box. The poker chips serve as a convenient form of receipt money and each person expects to cash in their chips at the end of the evening.
During the game, Charlie's brother-in-law drops in and asks for a $200 loan. Short of cash, Charlie dips into the cigar box and makes the loan. Later, as he recovers in the intensive care ward, Charlie concludes that the money was not really available for loan purposes.
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In spite of the technical jargon and seemingly complicated procedures, the actual mechanism by which the Federal Reserve creates money is quite simple. They do it exactly the same way the goldsmiths of old did except, of course, the goldsmiths were limited by the need to hold some precious metal in reserve, whereas the Fed has no such restriction.
The Federal Reserve is amazingly frank about this process. I Bet You Thought, a booklet published by the Federal Reserve Bank of New York, tells us: "Currency cannot be redeemed, or exchanged, for Treasury gold or any other asset used as backing. The question of just what assets 'back' Federal Reserve notes has little but bookkeeping significance."
Elsewhere in the same publication we are told: "Banks are creating money based on a borrower's promise to pay (the I.O.U.) .... Banks create money by 'monetizing' the private debts of businesses and individuals.
In a booklet entitled Modern Money Mechanics, the Federal Reserve Bank of Chicago says:
In the fine print of a footnote in a bulletin of the Federal Reserve Bank of St. Louis, we find this surprisingly candid explanation:
No Debt, No Money
It is difficult for Americans to come to grips with the fact that their total money supply is backed by nothing but debt, and it is even more mind boggling to visualize that, if everyone paid back all that was borrowed, there would be no money left in existence. That's right, there would be not one penny in circulation -- all coins and all paper currency would be returned to bank vaults -- and there would be not one dollar in anyone's checking account. In short, all money would disappear.
Marriner Eccles was the Governor of the Federal Reserve System in 1941. On September 30th of that year, Eccles was asked to give testimony before the House Committee on Banking and Currency. The purpose of the hearing was to obtain information regarding the role of the Federal Reserve in creating conditions that led to the depression of the 1930s. Congressman Wright Patman, who was Chairman of that committee, asked how the Feds got the money to purchase two billion dollars worth of government bonds in 1933. This is the exchange that followed.
Robert Hemphill was the Credit Manager of the Federal Reserve Bank in Atlanta. In the foreword to a book by Irving Fisher, entitled 100% Money, Hemphill said this:
With the knowledge that money in America is based on debt, it should not come as a surprise to learn that the Federal Reserve System is not the least interested in seeing a reduction in debt in this country, regardless of public utterances to the contrary. Here is the bottom line from the System's own publications. In The National Debt, the Federal Reserve Bank of Philadelphia argues: "A large and growing number of analysts, on the other hand, now regard the national debt as something useful, if not an actual blessing ... [They believe] the national debt need not be reduced at all."
In Two Faces of Debt, the Federal Reserve Bank of Chicago adds: "Debt -- public and private -- is here to stay. It plays an essential role in economic processes .... What is required is not the abolition of debt, but its prudent use and intelligent management."
What's Wrong With Debt?
There is a kind of fascinating appeal to this theory. It gives those who expound it an aura of intellectualism, the appearance of being able to grasp an economic principle that is so complex very few can understand it. And, for the less academic minded, it offers the comfort of at least sounding moderate. After all, what's wrong with a little debt, prudently used and intelligently managed? The answer is nothing, provided the debt is based on an honest transaction. There is plenty wrong with it if it is based upon fraud.
When banks place credits into your checking account, they are merely pretending to lend you money. In reality, however, they have nothing to lend. Even the money that non-indebted depositors have placed with them was originally created out of nothing in response to someone else's loan. So, what entitles the banks to collect rent on nothing? It is immaterial that men everywhere are foolish enough to accept these nothing certificates in exchange for real goods and services. We are talking here about what is logical and, more important, what is moral.
Centuries ago, usury was defined as any interest charged for a loan. Modern usage has redefined it as excessive interest. Certainly, any amount of interest charged for a pretended loan is excessive. The dictionary, therefore, needs a new definition. Usury: The charging of any interest on a loan of fiat money.
Let us, therefore, look at debt and interest in this light. Thomas Edison summed up the immorality of the system when he said:
As we have already shown, every dollar that exists today, either in the form of currency, checkbook money, or even credit card money -- in other words, our entire money supply -- exists only because it was borrowed by someone; perhaps not you, but someone. That means that every American dollar in the entire world is earning daily and compounded interest for the banks that created them. A portion of every business venture, every investment, every profit, every transaction involving money -- and that even includes losses and the payment of taxes -- a portion of all that is earmarked as payment to a bank. And what did the banks do to earn this perpetually flowing river of wealth? Did they lend out their own capital obtained through the investment of stockholders? Did they lend out the hard-earned savings of their depositors? No, neither of these was their major source of income. They simply waived the magic wand called fiat money.
That's really all one needs to know about the operation of the banking cartel under the protection of the Federal Reserve. But it would be a shame to stop here without taking a look at the actual cogs, mirrors, and pulleys that make the magical mechanism work. It is a fascinating engine of mystery and deception.
The Mandrake Mechanism
In the 1940s, there was a comic strip character called Mandrake the Magician. His specialty was creating things out of nothing and, when appropriate, to make them disappear back into that same void. It is fitting, therefore, that the process we are about to outline be named in his honor.
There are three general ways in which the Federal Reserve creates fiat money out of debt. One is by making loans to the member banks through what is called the Discount Window. The second is by purchasing Treasury bonds and other certificates of debt through what is called the Open Market Committee. The third is by changing the so-called reserve ratio that member banks are required to hold. Each method is merely a different path to the same objective: taking in I.O.U.s and converting them into spendable money.
The Discount Window is merely bankers' language for the loan window. When banks run short of money, the Federal Reserve stands ready as the "bankers' bank" to lend it. There are many reasons for them to need loans. Since they hold "reserves" of only about one or two percent of their deposits in vault cash and eight or nine percent in securities, their operating margin is extremely thin. It is common for them to experience temporary negative balances caused by unusual customer demand for cash or unusually large clusters of checks all clearing through other banks at the same time. Sometimes they make bad loans and, when these former "assets" are removed from their books, their "reserves" are also decreased and may, in fact, become negative. Finally, there is the profit motive. When banks borrow from the Federal Reserve at one interest rate and lend it out at a higher rate, there is an obvious advantage. But that is just the beginning. When a bank borrows a dollar from the Fed, it becomes a one-dollar reserve. Since the banks are required to keep reserves of only about 10 percent, they actually can loan ten dollars for each dollar borrowed. *
Let's take a look at the math. Assume the bank borrows $1 million from the Fed at a rate of 8 percent. The total annual cost for this loan, therefore, is $80,000 (.08 x $1,000,000). The bank treats the money as any other cash deposit, which means it becomes the basis for manufacturing an additional $9 million to be lent to its customers. If we assume that it lends that money at 11 percent interest, its gross return would be $990,000 (.11 x $9,000,000). Subtract from this the bank's cost of $80,000 plus an appropriate share of its overhead, and we have a net return of about. $900,000. In other words, the bank borrows a million and can almost double it in one year. That's leverage! But don't forget the source of that leverage: the manufacture of another $9 million which is added to the nation's money supply.
The most important method used by the Federal Reserve for the creation of fiat money is the operation of the Open Market Committee. The process is illustrated by the accompanying chart, "The Mandrake Open-Market Mechanism."
The figures that appear in the chart are based on a "reserve" ratio of 10 percent (a money-expansion ratio of 10 to 1). It must be remembered, however, that this is purely arbitrary. Since the money is fiat with no precious-metal backing, there is no real limitation except what the politicians and money managers decide is expedient for the moment. Altering this ratio is the third way in which the Federal Reserve can influence the nation's supply of money. The numbers, therefore, must be considered as transient. At any time there is a "need" for more money, the ratio can be increased to 20 to 1 or 50 to 1, or the charade of a reserve can be dropped altogether. There is virtually no limit to the amount of fiat money that can be manufactured under the present system.
Expansion and Contraction
The Mandrake Mechanism also works in reverse. Just as money is created when the Federal Reserve purchases bonds or other debt instruments, it is extinguished by the sale of those same items. When they are sold, the money is given back to the System and disappears into the inkwell or computer chip from which it came. Then the same secondary ripple effect that created money through the commercial banking system causes it to be withdrawn from the economy. Furthermore, even if the Federal Reserve does not deliberately contract the money supply, the same result can and often does occur when the public decides to resist the availability of credit and reduce its debt. A man can only be tempted to borrow; he cannot be forced to do so.
There are many psychological factors involved in a decision to go into debt that can offset the easy availability of money and a low interest rate: a downturn in the economy, the threat of civil disorder, the fear of pending war, the uncertainty of political climate resulting from a current election, to name just a few. Even though the Fed may try to pump money into the economy by making it abundantly available, the public can thwart that move simply by saying no, thank you. When this happens, the old debts that are being paid off are not replaced by new ones to take their place, and the entire amount of consumer and business debt will shrink. That means the money supply also will shrink, because, in modern America, debt is money. And it is this very expansion and contraction of the monetary pool -- a phenomenon that could not occur if based upon the laws of supply and demand -- that is at the very core of practically every boom and bust that has plagued mankind throughout history.
We are living in an age of fiat money. The Mandrake Mechanism was created for the express purpose of making that come to pass. It is sobering to realize that every previous nation in history that has adopted fiat money has eventually been economically destroyed by it. Furthermore, there is nothing in our present monetary structure that offers any hope that we may be exempted from that morbid roll call -- except this: It is still within the power of Congress to abolish the Federal Reserve System.
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THE MANDRAKE OPEN-MARKET MECHANISM
Start with a $1 million IOU, usually a Treasury Bond, purchased by the Federal Reserve with a check against itself -- not covered by funds in any account. Congress authorizes this practice because it is the easiest way to get the money. Otherwise, the Treasury would have to print large quantities of paper currency, which is politically controversial. This way it is mysteriously wrapped up in the banking system with the same result: the creation of fiat money.
This IOU now becomes a $1 million Securities Asset held by the Federal Reserve. The check given to the government (indirectly, through a bond dealer) is spent for whatever it wants.
The recipients of these payments now deposit them in their own banks, where they become $1 million in Deposit Assets held by commercial banks.
The commercial banks are also allowed to create money. In fact, this is where the real action is. Since banks must hold only about 10% of deposits "in reserve," they now have $900,000 "Excess Reserves," which they put into circulation in the form of loans. This is in addition to the original $1 million produced by government spending.
Recipients of the borrowers' spending deposit it in their banks, producing another $900,000 in "Deposit Assets," which yields another $810,000 in "Excess Reserves" ("Deposit Assets" minus 10%).
The process is repeated with slightly smaller numbers each cycle -- deposit assets minus 10% become excess reserves, become deposit assets, etc., until it has played itself out to the maximum effect. At that point, we have the original $1 million created by the Federal Reserve plus $9 million created by commercial banks, for a total of $10 million [*] fiat money manufactured solely out of debt.
[*] Theoretical maximum: actual numbers fall slightly short of theory
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G. Edward Griffin | The New American
December 19, 1988
Banks of deposit first appeared in early Greece, concurrent with the development of coinage itself. They were known in India at the time of Alexander the Great. They also operated in Egypt as part of the public granary system. They appeared in Damascus in 1200 and in Barcelona in 1401. It is the city-state of Venice, however, that is considered the cradle of banking as we know it today.
The Bank of Venice
By the year 1361, there already had been sufficient abuse in banking that the Venetian Senate passed a law forbidding bankers to engage in any other commercial pursuit, thus removing the temptation to use their depositors' funds to finance their own enterprises. They were also required to open their books for public inspection and to keep their stockpile of coins available for viewing at all reasonable times. In 1524, a board of bank examiners was created and, two years later, all bankers were required to settle accounts between themselves in coin rather than by check.
In spite of these precautions, however, the largest bank at that time, the house of Pisano and Tiepolo, had been active in lending against its reserves and, in 1584, was forced to close its doors because of inability to refund depositors. The government picked up the pieces at that point and a state bank was established, the Banco della Piazza del Rialto. Having learned from the recent experience with bankruptcy, the government prohibited the new bank from making any loans. There could be no profit from the issuance of credit. The bank was required to sustain itself solely from fees for coin storage, exchanging currencies, handling the transfer of payments between customers, and notary services.
The formula for honest banking had been found. The bank prospered and soon became the center of Venetian commerce. Its paper receipts were widely accepted far beyond the country's borders and, in fact, instead of being discounted in exchange for gold coin as was the usual practice, they actually carried a premium over coins. This was because there were so many kinds of coin in circulation and such a wide variance of quality within the same type of coin that one had to be an expert to evaluate their worth. The bank performed this service automatically when it took the coins into its vault. Each was evaluated, and the receipt given for it was an accurate reflection of its intrinsic worth. The public, therefore, was far more certain of the value of the paper receipts than of that of many of the coins and, consequently, was willing to exchange a little bit more for them.
Unfortunately, with the passage of time and the fading from memory of previous banking abuses, the Venetian Senate eventually succumbed to the temptation of credit. Strapped for funds and not willing to face the voters with a tax increase, the politicians decided they would authorize a new bank without restrictions against loans and then create the money they needed simply by "borrowing" it. So, in 1619, the Banco del Giro was formed, which, like its bankrupt predecessor, began immediately to create money out of debt. Eighteen years later, the Banco della Piazza del Rialto was absorbed into the new bank, and history's first tiny flame of sound banking sputtered and died.
Throughout the fifteenth and sixteenth centuries, banks had been springing up all over Europe. Almost without exception, however, they followed the lucrative practice of lending money which was not truly available for loan. They created excess obligations against their reserves and, as a result, every one of them failed. That is not to say that their owners and directors did not prosper. It merely means that their depositors lost all or a part of their assets entrusted for safekeeping.
The Bank of Amsterdam
It wasn't until the Bank of Amsterdam was founded in 1609 that we find a second example of sound banking practices, and the results were virtually the same as previously experienced by the Banco della Piazza del Rialto. The bank only accepted deposits and steadfastly refused to make loans. Its income was derived solely from service fees. All payments in and around Amsterdam soon came to be made in paper currency issued by the bank and, in fact, that currency carried a premium over coin itself. The burgomasters and the city council were required to take an annual oath swearing that the coin reserve of the bank was intact. In Money: Whence It Came, Where It Went, John Kenneth Galbraith reminds us:
For a century after its founding it functioned usefully and with notably strict rectitude. Deposits were deposits, and initially the metal remained in storage for the man who owned it until he transferred it to another. None was loaned out. In 1672, when the armies of Louis XIV approached Amsterdam, there was grave alarm. Merchants besieged the bank, some in the suspicion that their wealth might not be there. All who sought their money were paid, and when they found this to be so, they did not want payment. As was often to be observed in the future, however desperately people want their money from a bank, when they are assured they can get it, they no longer want it.
SOME DEFINITIONS
Barter: a direct exchange of items of like value.
Commodity Money: items used as a medium of indirect exchange -- e.g. cattle, tobacco, precious metals.
Receipt Money: a note entitling bearer to a stated quantity of a specified commodity.
Fractional Money: receipt money issued in excess of commodities held by the one issuing the note.
Fiat Money: a note or bookkeeping entry with no commodity backing, used as a medium of exchange only under compulsion (e.g. legal tender laws).
The principles of honesty and restraint were not to be long-lived, however. The temptation of easy profit from money creation was simply too great. As early as 1657, individuals had been permitted to overdraw their accounts, which means, of course, that the bank created new money out of their debt. In later years enormous loans were made to the Dutch East India Company. The truth finally became known to the public in January of 1790, and demands for a return of deposits were steady from that date forward. Ten months later, the bank was declared insolvent and was taken over by the City of Amsterdam.
The Bank of Hamburg
The third and last experience with honest banking occurred in Germany with the Bank of Hamburg. For over two centuries it faithfully adhered to the principle of safe deposit. So scrupulous was its administration that, when Napoleon took possession of the bank in 1813, he found 7,506,956 marks in silver held against liabilities of 7,489,343. That was 17,613 more than was actually needed. Most of the bank's treasure that Napoleon hauled away was restored a few years later by the French government in the form of securities. It is not clear if the securities were of much value but, even if they were, they were not the same as silver. Because of foreign invasion, the bank's currency was no longer fully convertible into coin as receipt money. It was now fractional money, and the self-destruct mechanism had been set in motion. The bank lasted another 55 years until 1871 when it was ordered to liquidate all of its accounts.
That is the end of the short story of honest banking. From that point forward, fractional-reserve banking became the universal practice. But there were to be many interesting twists and turns in its development before it would be ready for something as sophisticated as the Federal Reserve System.
England's first paper money was the exchequer order of Charles II. It was pure fiat and, although it was decreed legal tender, it was not widely used. It was replaced in 1696 by the exchequer bill. The bill was redeemable in gold, and the government went to great lengths to make sure that there was enough actual coin or bullion to make good on the pledge. In other words, it was true receipt money, and it became widely accepted as the medium of exchange. Furthermore, the bills were considered as short-term loans to the government and actually paid interest to the holders.
In 1707, the recently created Bank of England was given the responsibility of managing this currency, but the bank found more profit in the circulation of its own banknotes, which were in the form of fractional money and which provided for the collection of interest, not the payment of it. Consequently, the government bills gradually passed out of use and were replaced by banknotes, which, by the middle of the 18th century, became England's only paper money.
It must be understood that, at this time, the Bank of England was not yet fully developed as a central bank. It had been given a monopoly over the issue of banknotes within London and other prime geographic areas, but they were not yet decreed as legal tender. No one was forced to use them. They were merely private fractional receipts for gold coin issued by a private bank, which the public could accept, reject, or discount at its pleasure. Legal tender status was not conferred upon the bank's money until 1833.
Meanwhile, Parliament had granted charters to numerous other banks throughout the empire and, without exception, the issuance of factional money led to their ultimate demise and the ruin of their depositors. "Disaster after disaster had to come upon the country," says W.A. Shaw, in his Theory and Principles of Central Banking, because "of the indifference of the state to these mere private paper tokens." The Bank of England, however, was favored by the government above all others and, time after time, it was saved from insolvency by Parliament. How it came to be that way is an interesting story.
The Bank of England
England was financially exhausted after half a century of war against France and numerous civil wars fought largely over excessive taxation. By the time of the War of the League of Augsberg in 1693, King William was in serious need for new revenue. Twenty years previously, King Charles II had flat out repudiated a debt of over a million pounds, which had been lent to him by scores of goldsmiths, with the result that ten thousand depositors lost their savings. This was still fresh in everyone's memory, and, needless to say, the government was no longer considered a good investment risk. Unable to increase taxes and unable to borrow, Parliament became desperate for some other way to obtain the money. The objective, says Elgin Groseclose in his Money and Man, was not to bring "the money mechanism under more intelligent control, but to provide means outside the onerous sources of taxes and public loans for the financial requirements of an impecunious government."
There were two groups of men who saw a unique opportunity arise out of this necessity. The first group consisted of the political scientists within the government. The second was comprised of the monetary scientists from the emerging business of banking. The organizer and spokesman of this group was William Paterson from Scotland. Paterson had been to America and had come back with a grandiose scheme to obtain a British charter for a commercial company to colonize the Isthmus of Panama, then known as Darien. The government was not interested in that, so Paterson turned his attention to a scheme that did interest it very much, the creation of money.
The two groups came together and formed an alliance. With much of the same secrecy and mystery that surrounded the meeting on Jekyll Island (where the Federal Reserve was conceived), the Cabal met in Mercer's Chapel in London and hammered out a seven-point plan that would serve their mutual purposes:
1. The government would grant a charter to the monetary scientists to form a bank.
2. The bank would be given a monopoly to issue banknotes, which would circulate as England's paper currency.
3. The bank would create money out of debt, with only a fraction of its total currency backed by coin.
4. The monetary scientists then would loan the government all the money it needed.
5. The money created for government loans would be backed solely by government I.O.U.s.
6. Although this money was to be created out of nothing and would cost nothing to create, the government would pay "interest" on it at the rate of 8 percent.
7. Government I.O.U.s would also be considered as "reserves" for creating additional loan money for private commerce. These loans also would earn interest. Thus, the monetary scientists would collect double interest on the same nothing.
2. The bank would be given a monopoly to issue banknotes, which would circulate as England's paper currency.
3. The bank would create money out of debt, with only a fraction of its total currency backed by coin.
4. The monetary scientists then would loan the government all the money it needed.
5. The money created for government loans would be backed solely by government I.O.U.s.
6. Although this money was to be created out of nothing and would cost nothing to create, the government would pay "interest" on it at the rate of 8 percent.
7. Government I.O.U.s would also be considered as "reserves" for creating additional loan money for private commerce. These loans also would earn interest. Thus, the monetary scientists would collect double interest on the same nothing.
The circular distributed to attract subscribers to the Bank's initial stock offering explained: "Paterson hath benefit of interest on all the money which it, the Bank, creates out of nothing." The charter was issued in 1694, and a strange creature took its initial breath of life. It was the world's first central bank. In his Mystery of Banking, Murray Rothbard writes:
In short, since there were not enough private savers willing to finance the deficit, Paterson and his group were graciously willing to buy government bonds, provided they could do so with newly-created out-of-thin-air bank notes carrying a raft of special privileges with them. This was a splendid deal for Paterson and company, and the government benefited from the flimflam of a seemingly legitimate bank's financing their debts .... As soon as the Bank of England was chartered in 1694, King William himself and various members of Parliament rushed to become shareholders of the new money factory they had just created.
The Secret Science of Money
Both groups within the Cabal were handsomely rewarded for their efforts. The political scientists had been seeking about 500,000 pounds to finance the current war. The Bank promptly gave them more than twice what they had originally sought. The monetary scientists started with a capital investment of 1,200,000 pounds. Textbooks tell us that this was promptly lent to the government, but what is usually omitted is the fact that, in return for that loan, the Bank was given the privilege of printing an equal amount of banknotes which were offered to the public in the form of loans. So, after lending their capital to the government, they still had it available to loan out a second time. It is meaningless, therefore, to talk about a rate of interest. Since the new money was manufactured out of nothing, the real interest rate was not 8 percent, it was infinity.
Such is the secret science of money.
From Inflation to Bank Runs
The new money splashed through the economy like rain in April. The country banks outside of the London area were authorized to create money on their own, but they had to hold a certain percentage of either coin or Bank of England certificates in reserve. Consequently, when these plentiful banknotes landed in their hands, they quickly put them into the vaults and then issued their own certificates in even greater amounts. As a result of this pyramiding effect, prices rose 100 percent in just two years. Then, the inevitable happened: There was a run on the bank, and the Bank of England could not produce the coin.
When banks cannot honor their contracts to deliver coin in return for their receipts, they are, in fact, bankrupt. They should be allowed to go out of business and liquidate their assets to satisfy their creditors just like any other business. This, in fact, is what always had happened to banks that loaned out their deposits and created fractional money. Had this practice been allowed to continue, there is little doubt that people eventually would have understood that they simply do not want to do business with those kinds of banks. Through the painful but highly effective process of trial and error, mankind would have learned to distinguish real money from fool's gold. And the world would be a lot better because of it today.
That, of course, was not allowed to happen. When there was a run on the Bank of England, Parliament intervened. In May of 1696, just two years after the Bank was formed, a law was passed authorizing it to "suspend payment in specie." By force of law, the Bank was now exempted from having to honor its contract to return the gold.
This was a fateful event in the history of money, because the precedent has been followed ever since. In Europe and America, the banks have always operated with the assumption that their partners in government will come to their aid when they get into trouble. Politicians may speak about "protecting the public," but the underlying reality is that the government needs the fiat money produced by the banks. The banks -- at least the big ones -- must not be allowed to fail. Only a cartel with government protection can enjoy such insulation from the workings of a free market.
Once the Bank of England had been legally protected from the consequences of converting debt into money, the British economy was doomed to a nauseating roller-coaster ride of inflation, booms, and busts. The natural and immediate result was the granting of massive loans for just about any wild scheme imaginable. Why not? The money cost nothing to make, and the potential profits could be enormous. So the Bank of England, and the country banks, which pyramided their own money supply on top of the Bank's supply, pumped a steady stream of new money into the economy. Great stock companies were formed and financed by this money. One was for the purpose of draining the Red Sea to recover the gold supposedly lost by the Egyptians when pursuing the Israelites. One hundred fifty million pounds were siphoned into vague and fruitless ventures in South America and Mexico.
The result of this flood of new money was even more inflation. In 1810, the House of Commons created a special committee -- the Select Committee on the High Price of Gold Bullion -- to explore the problem and to find a solution. The verdict handed down in the final report was a model of clarity. Prices were not going up, it said. The value of the currency was going down, and that was due to the fact that it was being created at a faster rate than the creation of goods to be purchased with it. The solution? The committee recommended that the notes of the Bank of England be made fully convertible into gold coin, thus putting a brake on the supply of money that could be created.
One of the most outspoken proponents of a true gold standard was a Jewish London stockbroker by the name of David Ricardo. Ricardo argued that an ideal currency "should be absolutely invariable in value." He conceded that precious metals were not perfect in this regard because they do shift in purchasing power to a small degree. Then he said: "They are, however, the best with which we are acquainted."
Almost everyone in government agreed with Ricardo's assessment, but, as is often the case, theoretical truth was fighting a losing battle against practical necessity. Men's opinions on the best form of money were one thing. The war with Napoleon was another, and it demanded constant influx of funding. England continued to use the central-bank mechanism to extract that revenue from the populace.
Depression and Reform
By 1815, prices had doubled again then fell sharply. The Corn Act was passed that year to protect local growers from lower-priced imports. Then, when corn and wheat prices began to climb once more in spite of the fact that wages and other prices were falling, there was wide-spread discontent and rebellion. "By 1816," notes Roy Jastram in The Golden Constant, "England was in deep depression. There was stagnation of industry and trade generally; the iron and coal industries were paralyzed .... Riots occurred spasmodically from May through December."
In 1821, after the war had ended and there was no longer a need to fund military campaigns, the political pressure for a gold standard became too strong to resist, and the Bank of England returned to a convertibility of its notes into gold coin. The basic central-bank mechanism was not dismantled, however. It was merely limited by a new formula regarding the allowable fraction of reserves. The Bank continued to create money out of debt and, within a year, the flower of a new business boom unfolded. Then, in November of 1825, the flower matured into its predestined fruit. The crisis began with the collapse of Sir Peter Cole and Company and was soon followed by the failure of 63 other banks. Fortunes were wiped out and the economy plunged back into depression.
When a similar crisis with still more bank failures struck again in 1839, Parliament attempted to come to grips with the problem. After five more years of analysis and debate, Sir Robert Peel succeeded in passing a banking reform act. It squarely faced the cause of England's booms and busts: an elastic money supply. What Peel's Bank Act of 1844 attempted to do was to limit the amount of money the banks could create to roughly the same as it would be if banknotes were backed by gold or silver. It was a good try, but it ultimately failed because it fell short on three counts: (1) It was a political compromise and was not strict enough, still allowing the banks to create money out of debt to the extent of 14,000,000 pounds; in other words, a "fractional" amount thought to be safe at the time. (2) The limitation applied only to paper currency issued by the Bank. It did not apply to checkbook money, and that was then becoming the preferred form of exchange. Consequently, the so-called reform did not even apply to the area where the greatest amount of abuse was taking place. And (3) the basic concept was allowed to remain unchallenged that man, in his infinite political wisdom, can determine what the money supply should be more effectively than an unmanaged system of gold or silver responding to the natural law of supply and demand.
Within three years of the "reform," England faced another crisis, with still more bank failures and more losses to depositors. But, when the Bank of England tottered on the edge of insolvency, once again the government intervened. In 1847, the Bank was exempted from the legal reserve requirements of the Pool Act. Such is the rock-steady dependability of man-made limits to the money supply.
Groseclose continues the story:
Ten years later, in 1857, another crisis occurred, due to excessive and unwise lending as a result of over-optimism regarding foreign trade prospects. The bank found itself in the same position as in 1847, and similar measures were taken. On this occasion the bank was forced to use the authority to increase its fiduciary [debt-based money] issue beyond the limit imposed by the Bank Charter Act....
Again in 1866, the growth of banking without sufficient attention to liquidity, and the use of bank credit to support a speculative craze ... prepared the way for a crash which was finally precipitated by the failure of the famous house of Overend, Gurney and Co. The Act of 1844 was once more suspended....
In 1890, the Bank of England once again faced crisis, again the result of widespread and excessive speculation in foreign securities, particularly American and Argentine. This time it was the failure of Baring Brothers that precipitated the crash.
Again in 1866, the growth of banking without sufficient attention to liquidity, and the use of bank credit to support a speculative craze ... prepared the way for a crash which was finally precipitated by the failure of the famous house of Overend, Gurney and Co. The Act of 1844 was once more suspended....
In 1890, the Bank of England once again faced crisis, again the result of widespread and excessive speculation in foreign securities, particularly American and Argentine. This time it was the failure of Baring Brothers that precipitated the crash.
It is an incredible fact of history that, in spite of the general and recurring failures of the Bank of England during these years, the central-bank mechanism was so attractive to the political and monetary scientists that it became the model for all of Europe. The Bank of Prussia became the Reichsbank. Napoleon established the Banque de France. A few decades later, the concept became the venerated model for the Federal Reserve System. Who cares if the scheme is destructive? Here is the perfect tool for obtaining unlimited funding for politicians and endless profits for bankers. And, best of all, the little people who pay the bills for both groups have practically no idea what is being done to them.
American money today has no gold or silver behind it whatsoever. The fraction is not 54 percent nor 15 percent. It is 0 percent. It has travelled the path of all previous fractional money in history and already has degenerated into pure fiat money. The fact that most of it is in the form of checkbook balances rather than paper currency is a mere technicality. And the fact that bankers speak about "reserve ratios" is just so much eyewash. The so-called reserves to which they refer are, in fact, Treasury bonds and other certificates of debt. Our money is pure fiat through and through.
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Consider the Poker Game
At the Friday night poker game, Charlie serves as banker. He exchanges poker chips for each player's money and puts the cash in a cigar box. The poker chips serve as a convenient form of receipt money and each person expects to cash in their chips at the end of the evening.
During the game, Charlie's brother-in-law drops in and asks for a $200 loan. Short of cash, Charlie dips into the cigar box and makes the loan. Later, as he recovers in the intensive care ward, Charlie concludes that the money was not really available for loan purposes.
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In spite of the technical jargon and seemingly complicated procedures, the actual mechanism by which the Federal Reserve creates money is quite simple. They do it exactly the same way the goldsmiths of old did except, of course, the goldsmiths were limited by the need to hold some precious metal in reserve, whereas the Fed has no such restriction.
The Federal Reserve is amazingly frank about this process. I Bet You Thought, a booklet published by the Federal Reserve Bank of New York, tells us: "Currency cannot be redeemed, or exchanged, for Treasury gold or any other asset used as backing. The question of just what assets 'back' Federal Reserve notes has little but bookkeeping significance."
Elsewhere in the same publication we are told: "Banks are creating money based on a borrower's promise to pay (the I.O.U.) .... Banks create money by 'monetizing' the private debts of businesses and individuals.
In a booklet entitled Modern Money Mechanics, the Federal Reserve Bank of Chicago says:
In the United States neither paper currency nor deposits have value as commodities. Intrinsically, a dollar bill is just a piece of paper. Deposits are merely book entries. Coins do have some intrinsic value as metal, but generally far less than their face amount.
What, then, makes these instruments -- checks, paper money, and coins -- acceptable at face value in payment of all debts and for other monetary uses? Mainly, it is the confidence people have that they will be able to exchange such money for other financial assets and real goods and services whenever they choose to do so. This partly is a matter of law; currency has been designated "legal tender" by the government -- that is, it must be accepted....
What, then, makes these instruments -- checks, paper money, and coins -- acceptable at face value in payment of all debts and for other monetary uses? Mainly, it is the confidence people have that they will be able to exchange such money for other financial assets and real goods and services whenever they choose to do so. This partly is a matter of law; currency has been designated "legal tender" by the government -- that is, it must be accepted....
In the fine print of a footnote in a bulletin of the Federal Reserve Bank of St. Louis, we find this surprisingly candid explanation:
Modern monetary systems have a fiat base -- literally money by decree -- with depository institutions, acting as fiduciaries, creating obligations against themselves with the fiat base acting in part as reserves. The decree appears on the currency notes: "This note is legal tender for all debts, public and private." While no individual could refuse to accept such money for debt repayment, exchange contracts could easily be composed to thwart its use in everyday commerce. However, a forceful explanation as to why money is accepted is that the federal government requires it as payment for tax liabilities. Anticipation of the need to clear this debt creates a demand for the pure fiat dollar.
No Debt, No Money
It is difficult for Americans to come to grips with the fact that their total money supply is backed by nothing but debt, and it is even more mind boggling to visualize that, if everyone paid back all that was borrowed, there would be no money left in existence. That's right, there would be not one penny in circulation -- all coins and all paper currency would be returned to bank vaults -- and there would be not one dollar in anyone's checking account. In short, all money would disappear.
Marriner Eccles was the Governor of the Federal Reserve System in 1941. On September 30th of that year, Eccles was asked to give testimony before the House Committee on Banking and Currency. The purpose of the hearing was to obtain information regarding the role of the Federal Reserve in creating conditions that led to the depression of the 1930s. Congressman Wright Patman, who was Chairman of that committee, asked how the Feds got the money to purchase two billion dollars worth of government bonds in 1933. This is the exchange that followed.
ECCLES: We created it.
PATMAN: Out of what?
ECCLES: Out of the right to issue credit money.
PATMAN: And there is nothing behind it, is there, except our government's credit?
ECCLES: That is what our money system is. If there were no debts in our money system, there wouldn't be any money.
PATMAN: Out of what?
ECCLES: Out of the right to issue credit money.
PATMAN: And there is nothing behind it, is there, except our government's credit?
ECCLES: That is what our money system is. If there were no debts in our money system, there wouldn't be any money.
Robert Hemphill was the Credit Manager of the Federal Reserve Bank in Atlanta. In the foreword to a book by Irving Fisher, entitled 100% Money, Hemphill said this:
If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash, or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless situation is almost incredible, but there it is.
With the knowledge that money in America is based on debt, it should not come as a surprise to learn that the Federal Reserve System is not the least interested in seeing a reduction in debt in this country, regardless of public utterances to the contrary. Here is the bottom line from the System's own publications. In The National Debt, the Federal Reserve Bank of Philadelphia argues: "A large and growing number of analysts, on the other hand, now regard the national debt as something useful, if not an actual blessing ... [They believe] the national debt need not be reduced at all."
In Two Faces of Debt, the Federal Reserve Bank of Chicago adds: "Debt -- public and private -- is here to stay. It plays an essential role in economic processes .... What is required is not the abolition of debt, but its prudent use and intelligent management."
What's Wrong With Debt?
There is a kind of fascinating appeal to this theory. It gives those who expound it an aura of intellectualism, the appearance of being able to grasp an economic principle that is so complex very few can understand it. And, for the less academic minded, it offers the comfort of at least sounding moderate. After all, what's wrong with a little debt, prudently used and intelligently managed? The answer is nothing, provided the debt is based on an honest transaction. There is plenty wrong with it if it is based upon fraud.
When banks place credits into your checking account, they are merely pretending to lend you money. In reality, however, they have nothing to lend. Even the money that non-indebted depositors have placed with them was originally created out of nothing in response to someone else's loan. So, what entitles the banks to collect rent on nothing? It is immaterial that men everywhere are foolish enough to accept these nothing certificates in exchange for real goods and services. We are talking here about what is logical and, more important, what is moral.
Centuries ago, usury was defined as any interest charged for a loan. Modern usage has redefined it as excessive interest. Certainly, any amount of interest charged for a pretended loan is excessive. The dictionary, therefore, needs a new definition. Usury: The charging of any interest on a loan of fiat money.
Let us, therefore, look at debt and interest in this light. Thomas Edison summed up the immorality of the system when he said:
People who will not turn a shovel full of dirt on the project nor contribute a pound of materials will collect more money ... than will the people who will supply all the materials and do all the work.
As we have already shown, every dollar that exists today, either in the form of currency, checkbook money, or even credit card money -- in other words, our entire money supply -- exists only because it was borrowed by someone; perhaps not you, but someone. That means that every American dollar in the entire world is earning daily and compounded interest for the banks that created them. A portion of every business venture, every investment, every profit, every transaction involving money -- and that even includes losses and the payment of taxes -- a portion of all that is earmarked as payment to a bank. And what did the banks do to earn this perpetually flowing river of wealth? Did they lend out their own capital obtained through the investment of stockholders? Did they lend out the hard-earned savings of their depositors? No, neither of these was their major source of income. They simply waived the magic wand called fiat money.
That's really all one needs to know about the operation of the banking cartel under the protection of the Federal Reserve. But it would be a shame to stop here without taking a look at the actual cogs, mirrors, and pulleys that make the magical mechanism work. It is a fascinating engine of mystery and deception.
The Mandrake Mechanism
In the 1940s, there was a comic strip character called Mandrake the Magician. His specialty was creating things out of nothing and, when appropriate, to make them disappear back into that same void. It is fitting, therefore, that the process we are about to outline be named in his honor.
There are three general ways in which the Federal Reserve creates fiat money out of debt. One is by making loans to the member banks through what is called the Discount Window. The second is by purchasing Treasury bonds and other certificates of debt through what is called the Open Market Committee. The third is by changing the so-called reserve ratio that member banks are required to hold. Each method is merely a different path to the same objective: taking in I.O.U.s and converting them into spendable money.
The Discount Window is merely bankers' language for the loan window. When banks run short of money, the Federal Reserve stands ready as the "bankers' bank" to lend it. There are many reasons for them to need loans. Since they hold "reserves" of only about one or two percent of their deposits in vault cash and eight or nine percent in securities, their operating margin is extremely thin. It is common for them to experience temporary negative balances caused by unusual customer demand for cash or unusually large clusters of checks all clearing through other banks at the same time. Sometimes they make bad loans and, when these former "assets" are removed from their books, their "reserves" are also decreased and may, in fact, become negative. Finally, there is the profit motive. When banks borrow from the Federal Reserve at one interest rate and lend it out at a higher rate, there is an obvious advantage. But that is just the beginning. When a bank borrows a dollar from the Fed, it becomes a one-dollar reserve. Since the banks are required to keep reserves of only about 10 percent, they actually can loan ten dollars for each dollar borrowed. *
Let's take a look at the math. Assume the bank borrows $1 million from the Fed at a rate of 8 percent. The total annual cost for this loan, therefore, is $80,000 (.08 x $1,000,000). The bank treats the money as any other cash deposit, which means it becomes the basis for manufacturing an additional $9 million to be lent to its customers. If we assume that it lends that money at 11 percent interest, its gross return would be $990,000 (.11 x $9,000,000). Subtract from this the bank's cost of $80,000 plus an appropriate share of its overhead, and we have a net return of about. $900,000. In other words, the bank borrows a million and can almost double it in one year. That's leverage! But don't forget the source of that leverage: the manufacture of another $9 million which is added to the nation's money supply.
The most important method used by the Federal Reserve for the creation of fiat money is the operation of the Open Market Committee. The process is illustrated by the accompanying chart, "The Mandrake Open-Market Mechanism."
The figures that appear in the chart are based on a "reserve" ratio of 10 percent (a money-expansion ratio of 10 to 1). It must be remembered, however, that this is purely arbitrary. Since the money is fiat with no precious-metal backing, there is no real limitation except what the politicians and money managers decide is expedient for the moment. Altering this ratio is the third way in which the Federal Reserve can influence the nation's supply of money. The numbers, therefore, must be considered as transient. At any time there is a "need" for more money, the ratio can be increased to 20 to 1 or 50 to 1, or the charade of a reserve can be dropped altogether. There is virtually no limit to the amount of fiat money that can be manufactured under the present system.
Expansion and Contraction
The Mandrake Mechanism also works in reverse. Just as money is created when the Federal Reserve purchases bonds or other debt instruments, it is extinguished by the sale of those same items. When they are sold, the money is given back to the System and disappears into the inkwell or computer chip from which it came. Then the same secondary ripple effect that created money through the commercial banking system causes it to be withdrawn from the economy. Furthermore, even if the Federal Reserve does not deliberately contract the money supply, the same result can and often does occur when the public decides to resist the availability of credit and reduce its debt. A man can only be tempted to borrow; he cannot be forced to do so.
There are many psychological factors involved in a decision to go into debt that can offset the easy availability of money and a low interest rate: a downturn in the economy, the threat of civil disorder, the fear of pending war, the uncertainty of political climate resulting from a current election, to name just a few. Even though the Fed may try to pump money into the economy by making it abundantly available, the public can thwart that move simply by saying no, thank you. When this happens, the old debts that are being paid off are not replaced by new ones to take their place, and the entire amount of consumer and business debt will shrink. That means the money supply also will shrink, because, in modern America, debt is money. And it is this very expansion and contraction of the monetary pool -- a phenomenon that could not occur if based upon the laws of supply and demand -- that is at the very core of practically every boom and bust that has plagued mankind throughout history.
We are living in an age of fiat money. The Mandrake Mechanism was created for the express purpose of making that come to pass. It is sobering to realize that every previous nation in history that has adopted fiat money has eventually been economically destroyed by it. Furthermore, there is nothing in our present monetary structure that offers any hope that we may be exempted from that morbid roll call -- except this: It is still within the power of Congress to abolish the Federal Reserve System.
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THE MANDRAKE OPEN-MARKET MECHANISM
Start with a $1 million IOU, usually a Treasury Bond, purchased by the Federal Reserve with a check against itself -- not covered by funds in any account. Congress authorizes this practice because it is the easiest way to get the money. Otherwise, the Treasury would have to print large quantities of paper currency, which is politically controversial. This way it is mysteriously wrapped up in the banking system with the same result: the creation of fiat money.
This IOU now becomes a $1 million Securities Asset held by the Federal Reserve. The check given to the government (indirectly, through a bond dealer) is spent for whatever it wants.
The recipients of these payments now deposit them in their own banks, where they become $1 million in Deposit Assets held by commercial banks.
The commercial banks are also allowed to create money. In fact, this is where the real action is. Since banks must hold only about 10% of deposits "in reserve," they now have $900,000 "Excess Reserves," which they put into circulation in the form of loans. This is in addition to the original $1 million produced by government spending.
Recipients of the borrowers' spending deposit it in their banks, producing another $900,000 in "Deposit Assets," which yields another $810,000 in "Excess Reserves" ("Deposit Assets" minus 10%).
The process is repeated with slightly smaller numbers each cycle -- deposit assets minus 10% become excess reserves, become deposit assets, etc., until it has played itself out to the maximum effect. At that point, we have the original $1 million created by the Federal Reserve plus $9 million created by commercial banks, for a total of $10 million [*] fiat money manufactured solely out of debt.
[*] Theoretical maximum: actual numbers fall slightly short of theory
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