Chapter Eight: Fool’s Gold

The history of paper money without precious-metal backing forced on the public by government decree; the emergence of our present-day fractional-reserve banking system based on the issuance of a greater amount of receipts for gold than the bank has in gold to back them up.

We previously have broken down the concept of money into four categories: commodity, receipt, fiat, and fractional. In the last chapter we examined commodity and receipt money in some detail. In doing so, we also established certain monetary principles which apply regardless of their form. We shall now turn to the remaining two categories, both of which are represented by paper and which are at the root of almost all of modern man’s economic woes.

Fiat Money

The American Heritage Dictionary defines fiat money as paper money decreed legal tender, not backed by gold or silver. The two characteristics of fiat money, therefore, are (1) it does not represent anything of intrinsic value and (2) it is decreed legal tender. Legal tender simply means that there is a law requiring everyone to accept the currency in commerce. The two always go together because, since the money really is worthless, it soon would be rejected by the public in favor of a more reliable medium of exchange, such as gold or silver coin. Thus, when governments issue fiat money, they always declare it to be legal tender under pain of fine or imprisonment. The only way a government can exchange its worthless paper money for tangible goods and services is to give its citizens no choice.

The first notable use of this practice was recorded by Marco Polo during his travels to China in the thirteenth century. The famous explorer gives us this account:

The Emperor’s mint then is in this same City of Cambaluc, and the way it is wrought is such that you might say he hath the Secret of Alchemy in perfection, and you would be right!…

What they take is a certain fine white bast or skin which lies between the wood of the tree and the thick outer bark, and this they make into something resembling sheets of paper, but black. When these sheets have been prepared they are cut up into pieces of different sizes. The smallest of these sizes is worth a half tornesel … There is also a kind worth one Bezant of gold, and others of three Bezants, and so up to ten.

All these pieces of paper are issued with as much solemnity and authority as if they were of pure gold or silver; and on every piece, a variety of officials, whose duty it is, have to write their names and to put their seals. And when all is prepared duly, the chief officer deputed by the Kaan smears the Seal entrusted to him with vermilion and impresses it on the paper, so that the form of the Seal remains stamped upon it in red; the money is then authentic. Any one forging it would be punished with death. And the Kaan causes every year to be made such a vast quantity of this money, which costs him nothing, that it must equal in amount all the treasures in the world!

With these pieces of paper, made as I have described, he causes all payments on his own account to be made, and he makes them to pass current universally over all his Kingdoms … And nobody, however important he may think himself, dares to refuse them on pain of death. And indeed everybody takes them readily.

One is tempted to marvel at the Kaan’s audacious power and the subservience of his subjects who endured such an outrage; but our smugness rapidly vanishes when we consider the similarity to our own Federal Reserve Notes. They are adorned with signatures and seals; counterfeiters are severely punished; the government pays its expenses with them; the population is forced to accept them; they — and the invisible checkbook money into which they can be converted — are made in such vast quantity that it must equal in amount all the treasures of the world. And yet they cost nothing to make. In truth, our present monetary system is an almost exact replica of that which supported the warlords of seven centuries ago.

The Colonial Experience

Unfortunately, the present situation is not unique to our history. In fact, after China, the next place in the world to adopt the use of fiat money was America; specifically, the Massachusetts Bay Colony. This event has been described as not only the origin of paper money in America, but also in the British Empire, and almost in the Christian world.

In 1690, Massachusetts launched a military raid against the French colony in Quebec. She had done this before and, each time, had brought back sufficient plunder to more than pay for the expedition. This time, however, the foray was a dismal failure, and the men returned empty handed. When the soldiers demanded their pay, Massachusetts found its coffers empty. Disgruntled soldiers have a way of becoming unruly, so the officials scrambled for some way to raise the funds. Additional taxes would have been extremely unpopular, so they decided simply to print paper money. In order to convince the soldiers and the citizenry to accept it, the government made two solemn promises: (1) it would redeem the paper for gold or silver coin just as soon as there was sufficient tax revenue to do so, and (2) absolutely no additional paper notes would ever be issued. Both pledges were promptly broken. Only a few months later, it was announced that the original issue was insufficient to discharge the government’s debt, and a new issue almost six times greater was put into circulation. The currency wasn’t redeemed for nearly forty years, long after those who had made the pledge had faded from the scene.

A Classic Pattern

Most of the other colonies were quick to learn the magic of the printing press, and the history that followed is a classic example of cause and effect: Governments artificially expanded the money supply through the issuance of fiat currency. This was followed by legal tender laws to force its acceptance. Next came the disappearance of gold or silver coins which went, instead, into private hoards or to foreign traders who insisted on the real thing for their wares. Many of the colonies repudiated their previous money by issuing new bills valued at multiples of the old. Then came political discontent and civil disobedience. And at the end of each cycle there was rampant inflation and economic chaos.

In 1703, South Carolina declared that its money was a good payment and tender in law and then added that, should anyone refuse to honor it as such, they would be fined an amount equal to double the value of the bills so refused. By 1716, the penalty had been increased to treble the value.

The Printing Press and Inflation

Benjamin Franklin was an ardent proponent of fiat money during those years and used his great influence to sell the idea to the public. We can get some idea of the ferment of the times by noting that, in 1736, writing in his Pennsylvania Gazette, Franklin apologized for its irregular publication, and explained that the printer was with the Press, labouring for the publick Good, to make Money more plentiful. The printing of money was apparently a major, time-consuming operation.

In 1737, Massachusetts devalued its fiat currency by 66%, offering one dollar of new currency for three of the old. The promise was made that, after five years, the new money would be fully redeemed in silver or gold. The promise was not kept

By the late 1750s, Connecticut had price inflated by 800%. The Carolinas had inflated 900%. Massachusetts 1,000%. Rhode Island 2,300%. Naturally, these inflations all had to come to an end and, when they did, they turned into equally massive deflations and depressions. It has been shown that, even in colonial times, the classic booms and busts which modern economists are fond of blaming on an unbridled free market actually were direct manifestations of the expansion and contraction of fiat money, which no longer was governed by the laws of supply and demand.

By this time, coins had completely disappeared from the scene. Some were in private hoards, but most of them had been exported to other countries, leaving the colonies with little choice but to use fiat money or barter. Merchants from abroad were interested in neither of those, however, and international trade ground almost to a halt

A Blessing in Disguise

The experiment with fiat money was a calamity to the colonists, but it was also a thorn in the side of the Bank of England. The bank had used its influence with the Crown to forbid the colonies to mint their own coins or to establish local banks. This meant that, if the colonists wanted the convenience of paper money, they would be forced to use the notes issued by the Bank of England. No one had anticipated that the colonial governments would be so inventive as to create their own paper money. So, in 1751, Great Britain began to pressure the colonies to redeem all of their currency and withdraw it from circulation. This they eventually did, and at bargain prices. By then, their fiat money was heavily discounted in the market place and the governments were able to buy back their own currency for pennies on the dollar.

The decree from the British Parliament, although heavily resented by the colonists, turned out to be a blessing in disguise. The paper notes of the Bank of England never did become a primary medium of exchange. Probably because of their recent bad experience with paper money, the colonists merely brought what few gold and silver coins they had out of hiding and returned to a true commodity-money system. At first, the doomsdayers predicted this would spell further ruin for the colonial economy. There isn’t enough money was the all-too-familiar cry. But there was, indeed, quite enough for, as we have already seen, any amount is sufficient.

Tobacco Becomes Money

There was, in fact, a period in which other commodities became accepted as a secondary medium of exchange. Such items as nails, lumber, rice, and whisky filled the monetary void, but tobacco was the most common. Here was a commodity which was in great demand both within the colonies and for overseas commerce. It had intrinsic value; it could not be counterfeited; it could be divided into almost any denominational quantity; and its supply could not be increased except by the exertion of labor. In other words, it was regulated by the law of supply and demand, which gave it great stability in value. In many ways, it was an ideal money. It was officially adopted as such by Virginia in 1642 and a few years later by Maryland, but it was used unofficially in all the other colonies, as well. So close was the identity of tobacco with money that the previous fiat currency of New Jersey, not a tobacco growing state, displayed a picture of a tobacco leaf on its face. It also carried the inscription: To counterfeit is Death Tobacco was used in early America as a secondary medium of exchange for about two-hundred years, until the new Constitution declared that money was, henceforth, the sole prerogative of the federal government.

The primary currency at that juncture, however, was still gold and silver coin, or specie, as it is called. And the immediate result of returning to a sound monetary unit was a rapid recovery from the economic stagnation previously inflicted by the booms and busts of fiat money. Trade and production rose dramatically, and this, in turn, attracted an inflow of gold and silver coin from around the world, filling the void that had been created by years of worthless paper. The law of supply and demand was visibly at work. For a while, Massachusetts had returned to specie while Rhode Island remained on fiat money. The result was that Newport, which had been the trade center for the West Indies, lost its trade to Boston and became an empty port. After the colonies had returned to coin, prices quickly found their natural equilibrium and then stayed at that point, even during the Seven Years War and the disruption of trade that occurred immediately prior to the Revolution. There is no better example of the fact that economic systems in distress can and do recover rapidly if government does not interfere with the natural healing process.

War Brings a Return of Fiat Money

The War for Independence brought all of this to a sudden halt. Wars are seldom funded out of the existing treasury, nor are they even done so out of increased taxes. If governments were to levy taxes on their citizens fully adequate to finance the conflict, the amount would be so great that many of even its most ardent supporters would lose enthusiasm. By artificially increasing the money supply, however, the real cost is hidden from view. It is still paid, of course, but through inflation, a process that few people understand.

The American Revolution was no exception. In order to pay the bill for independence, both the Confederation and the individual states went heavily into the printing business. At the beginning of the war in 1775, the total money supply stood at $12 million. In June of that year, the Continental Congress issued another $2 million. Before the notes were even put into circulation, another $1 million was authorized. By the end of the year, another $3 million. In 1776, another $19 million. $13 million in 1777. $64 million in 1778. $125 million in 1779. And still more: the Continental Army issued its own certificates for the purchase of supplies totalling $200 million. A total of $425 million in five years on top of a base of $12 million is an increase of over 3500%. And, in addition to this massive expansion of the money supply on the part of the central government, it must be remembered that the states were doing exactly the same thing. It is estimated that, in just five years from 1775 to the end of 1779, the total money supply expanded by 5000%. By contrast, the amount raised in taxes over the five-year period was inconsequential, amounting to only a few million dollars.

And a Massive Inflation

The first exhilarating effect of this flood of new money was the flush of apparent prosperity, but that was quickly followed by inflation as the self-destruct mechanism began to operate. In 1775, paper Continentals were traded for one dollar in gold. In 1777, they were exchanged for twenty-five cents. By 1779, just four years from their issue, they were worth less than a penny. The phrase Not Worth a Continental has its origin in this dismal period. Shoes sold for $5,000 a pair. A suit of clothes cost a million.

It was in that year that George Washington wrote, A wagonload of money will scarcely purchase a wagon load of provisions.

Even Benjamin Franklin began to see the light. In a mood of sarcasm, he wrote:

This Currency, as we manage it, is a wonderful machine. It performs its Office when we issue it; it pays and clothes Troops and provides Victuals and Ammunition; and when we are obliged to issue a Quantity excessive, it pays itself off by Depreciation.

When speaking of deficit spending, it is common to hear the complaint that we are saddling future generations with the bill for what we enjoy today. Why not let those in the future help pay for what will benefit them also? Don’t be deceived. That is a misconception encouraged by politicians to calm the public. When money is fiat, as the colonists discovered, every government building, public work, and cannon of war is paid out of current labor and current wealth. These things must be built today with today’s labor, and the man who performs that labor must also be paid today. It is true that interest payments fall partly to future generations, but the initial cost is paid by those in the present. It is paid by loss of value in the monetary unit and loss of purchasing power for one’s wages.

Inflation Is a Hidden Tax

Fiat money is the means by which governments obtain instant purchasing power without taxation. But where does that purchasing power come from? Since fiat money has nothing of tangible value to offset it, government’s fiat purchasing power can be obtained only by subtracting it from somewhere else. It is, in fact, collected from us all through a decline in our purchasing power. It is, therefore, exactly the same as a tax, but one that is hidden from view, silent in operation, and little understood by the taxpayer.

In 1786, Thomas Jefferson provided a clear explanation of this process when he wrote:

Every one, through whose hands a bill passed, lost on that bill what it lost in value during the time it was in his hands. This was a real tax on him; and in this way the people of the United States actually contributed those … millions of dollars during the war, and by a mode of taxation the most oppressive of all because the most unequal of all.

Enter Price Controls and Legal Tender Laws

As prices skyrocketed, the colonies enacted wage and price controls, which was like plugging up the whistle on a tea kettle in hopes of keeping the steam from escaping. When that failed, there followed a series of harsh legal tender laws. One law even invoked the specter of treason. It said: If any person shall hereafter be so lost to all virtue and regard for his Country as to refuse to receive said bills in payment-he shall be deemed, published, and treated as an enemy in this Country and precluded from all trade or intercourse with the inhabitants of these colonies.

Rhode Island not only levied a heavy fine for non-acceptance of its notes but, upon a secmd offense, an individual was stripped of citizenship. When a court declared the act unconstitutional, the legislature called the judges before it and summarily dismissed the offenders from office.

Enter Economic Chaos and Insurrection

If the ravages of war were a harsh burden for the colonies to bear, the havoc of fiat money was equally so. After the war, inflation was followed by deflation as reality returned to the market place. Prices fell drastically, which was wonderful for those who were buying. But, for the merchants who were selling or the farmers who had borrowed heavily to acquire property at inflated wartime prices, it was a disaster. The new, lower prices were not adequate to sustain their fixed, inflated mortgages, and many hard-working families were ruined by foreclosure. Furthermore, most people still did not understand the inflation process, and there were many who continued to advocate the paper money cure. Several of the states were receptive to the pressure, and their printing presses continued to roll.

Historian Andrew McLaughlin recalls a typical scene in Rhode Island at that time as witnessed by a visiting Frenchman:

A French traveler who passed through Newport about this time gives a dismal picture of the place: idle men standing with folded arms at the corners of the streets; houses falling to ruins; miserable shops offering for sale nothing but a few coarse stuffs; … grass growing in the streets; windows stuffed with rags; everywhere announcing misery, the triumph of paper money and the influence of bad government. The merchants had closed their stores rather than take payment in paper; farmers from neighboring states did not care to bring their produce.

Idleness and economic depression also led to outbursts of rebellion and insurrection. In 1786, George Washington wrote to James Warren: The wheels of government are clogged and … we are descending into the vale of confusion and darkness, Two years later, in a letter to Henry Knox, he said: If … any person had told me that there would have been such formidable rebellion as exists, I would have thought him a bedlamite, a fit subject for a madhouse.

Fortunately, there is a happy ending to that part of the story. As we shall see in a subsequent chapter, when the state delegates assembled to draft the Constitution, the effects of fiat money were so fresh in their minds they decided to put an end to it once and for all Then, the new republic not only rapidly recovered but went on to become the economic envy of the world —for a while, at least — until the lesson had been forgotten by following generations. But that is getting ahead of our story. For now, we are dealing with the topic of fiat money; and the experience of the American colonies is a classic example of what always happens when men succumb to its siren call.

Natural Law No. 3

Let us pause at this point and observe another of those lessons derived from centuries of experience. That lesson is so clear and so universal and so widely seen throughout history that it may be stated as a natural law of human behavior:

LESSON: Fiat money is paper money without precious-metal backing and which people are required by law to accept. It allows politicians to increase spending without raising taxes. Fiat money is the cause of inflation, and the amount which people lose in purchasing power is exactly the amount which was taken from them and transferred to their government by this process. Inflation, therefore, is a hidden tax. This tax is the most unfair of all because it falls most heavily on those who are least able to pay, the small wage earner and those on fixed incomes. It also punishes the thrifty by eroding the value of their savings. This creates resentment among the people, leading always to political unrest and national disunity. Therefore,

LAW: A nation that resorts to the use of fiat money has doomed itself to economic hardship and political disunity.

Fractional Money

Let us turn, now, to the fourth and final possible form of money: a most intriguing concept called fractional money. And, to understand how this functions, we must return to Europe and the practice of the early goldsmiths who stored the precious metal coins of their customers for a fee.

In addition to the goldsmiths who stored coins, there was another class of merchants, called scriveners, who loaned coins. The goldsmiths reasoned that they, too, could act as scriveners, but do so with other people’s money. They said it was a pity for all that coin to just sit idle in their vaults. Why not lend it out and earn a profit which then could be split between themselves and their depositors? Put it to work, instead of merely gathering dust. They had learned from experience that very few of their depositors ever wanted to remove their coins at the same time. In fact, net withdrawals seldom exceeded ten or fifteen percent of their stockpile. It seemed perfectly safe to lend up to eighty or even eighty-five percent of their coins. And so the warehousemen began to act as loan brokers on behalf of their depositors, and the concept of banking, as we know it today, was born.

That’s the way many history books describe it, but there is more involved here than merely putting idle money to work. First of all, sharing the interest income with the owners of the deposits was not part of the original concept. That only became general practice many years later after the depositors became outraged and needed to be reassured that these loans were in their interest as well. In the beginning, they didn’t even know that their coins were being loaned out. They naively thought that the goldsmiths were lending their own money.

Deposits Are Not Available for Lending

In the second place, we need to consider whether the coin in the vault was even available for lending — regardless of whether or not the depositors received a part of the profit. Let us suppose that we are playing a game of poker at the home of Charlie Smith. Each of us has given $20 to Charlie who, acting as the banker, has put our money into a shoe box and given us, in return, twenty poker chips. It is the understanding that, anytime we want to go home, we can get back a dollar for each chip we have at that time. Now let us suppose that Charlie’s brother-in-law, Larry, shows up, not to play poker, but to borrow some money. Since six of us are playing and each has put in $20, there is a total of $120 in the shoe box, and that turns out to be perfect for Larry’s needs. You can imagine what would happen if Charlie decided to lend out the idle money. It is not available for lending.

Neither Charlie nor any of the players have the right to loan those dollars, because they are being held in escrow, so to speak, pending completion of the contract between Charlie and his guests. Those dollars no longer even exist as money. They have been replaced — in concept at least — by the poker chips. If any of us are so touched by Larry’s story that we decide to loan him the money ourselves, we would have to do it with other dollars or cash in our chips for the dollars in the shoe box. In that case, of course, we could no longer stay in the game. VJe cannot spend, loan, or give away the deposit and also consider the chips to be worth anything.

If you are a member of an organization and have given your proxy to a friend to vote in your absence at the annual meeting, you cannot then show up and cast your own vote in addition to your proxy. Likewise, in the beginning of banking, the certificates which were circulated as money were, in effect, proxies for the coins. Consequently, those coins were not available for lending. Their monetary value had been assigned to the certificates. If the certificate holders had wanted to lend out their coins, they should have retired the certificates first. They were not entitled to hold spendable paper money and also authorize their banker to lend that same money as coins. One cannot spend, loan, or give away the coins and also consider the certificates to be worth anything.

All of this is just common sense. But there is another dimension to the problem which has to do with honesty in business contracts.

When the bankers used those coins as the basis for loans, they were putting themselves in a position of not having enough coin in the vault to make good on their contracts when it came time for depositors to take their money home. In other words, the new contracts were made with the full knowledge that, under certain circumstances, they would have to be broken. But the bankers never bothered to explain that. The general public was led to believe that, if they approved of putting these supposedly idle funds to work, they would be helping the economy and earning a little profit besides. It was an appealing proposal, and the idea caught on like wildfire.

Fractional-Reserve Banking

Most borrowers wanted paper money, of course, not bulky coins, so, when they received their loans, they usually put the coins right back into the vault for safekeeping. They were then given receipts for these deposits which, as we have observed, were readily accepted in commerce as money. At this point, things began to get complicated. The original depositors had been given receipts for all of the bank’s coins. But the bank now issued loans in the amount of eighty-five percent of its deposits, and the borrowers were given receipts for that same amount. These were in addition to the original receipts. That made 85% more receipts than coins. Thus, the banks created 85% more money and placed it into circulation through their borrowers. In other words, by issuing phony receipts, they artificially expanded the money supply. At this point, the certificates were no longer 100% backed by gold. They now had a backing of only 54%, but they were accepted by the unsuspecting public as equal in value to the old receipts. The gold behind all of them, however, now represented only a fraction of their face value. Thus, the receipts became what may be called fractional money / and the process by which they were created is called fractional-reserve banking.

None of this shortfall unfortunately, was ever explained. The bankers decided that it would be better not to discuss reality where the public could hear. These facts became the arcane secrets of the profession. The depositors were never encouraged to question how the banks could lend out their money and still have it on hand to pay back on an instant’s notice. Instead, bankers put on great airs of respectability, stability, and accountability; dressed and acted serious if not stern; erected great edifices resembling government buildings and temples, all to bolster the false image of being able to honor their contracts to pay on demand.

It was John Maynard Keynes who observed:

A sound banker, alas! is not one who foresees danger, and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can readily blame him. It is necessarily part of the business of a banker to maintain appearances, and to confess a conventional respectability, which is more than human. Life-long practices of this kind make them the most romantic and the least realistic of men.

Creating Money out of Debt

Let us step back for a moment and analyze. In the beginning, banks served as warehouses for the safe keeping of their customers’ coins. When they issued paper receipts for those coins, they converted commodity money into receipt money. This was a great convenience, but it did not alter the money supply. People had a choice of using either coin or paper but they could not use both. If they used coin, the receipt was never issued. If they used the receipt, the coin remained in the vault and did not circulate.

When the banks abandoned this practice and began to issue receipts to borrowers, they became magicians. Some have said they created money out of nothing, but that is not quite true. What they did was even more amazing. They created money out of debt.

Obviously, it is easier for people to go into debt than to mine gold. Consequently, money no longer was limited by the natural forces of supply and demand. From that point in history forward, it was to be limited only by the degree to which bankers have been able to push down the gold-reserve fraction of their deposits.

From this perspective, we can now look back on fractional money and recognize that it really is a transitional form between receipt money and fiat money. It has some of the characteristics of both. As the fraction becomes smaller, the less it resembles receipt money and the more closely it comes to fiat money. When the fraction finally reaches zero, then it has made the complete transition and becomes pure fiat. Furthermore, there is no example in history where men, once they had accepted the concept of fractional money, didn’t reduce the fraction lower and lower until, eventually, it became zero.

No bank can stay in business for very long with a zero reserve. The only way to make people accept such a worthless currency is by government force. That’s what legal-tender laws are all about. The transition from fractional-reserve money to fiat money, therefore, requires the participation of government through a mechanism which is called a central bank. Most of the balance of this book will be devoted to a study of that Creature, but, for now, suffice it to say that the euphoria of being able to create money without human effort is so great that, once such a narcotic is taken, there is no politician or banker who can kick the habit. As William Sumner observed: A man might as well jump off a precipice intending to stop half way down.

Natural Law No. 4

And so, once again, we come to one of those natural laws that emerge from centuries of human experience. It can be stated as follows:

LESSON: Fractional money is paper money which is backed by precious metals up to only a portion of the face amount. It is a hybrid, being part receipt money and part fiat money. Generally, the public is unaware of this fact and believes that fractional money can be redeemed in full at any time. When the truth is discovered, as periodically happens, there are runs on the bank, and only the first few depositors in line can be paid. Since fractional money earns just as much interest for the bankers as does gold or silver, the temptation is great for them to create as much of it as possible. As this happens, the fraction which represents the reserve becomes smaller and smaller until, eventually, it is reduced to zero. Therefore,

LAW: Fractional money will always degenerate into fiat money. It is but fiat money in transition.

So much for the overview and generalities. In the next chapter We shall see what history has to say on this process. And what a history it is!


Fiat money is paper money without precious-metal backing which people are required by law to accept. The first recorded appearance of fiat money was in thirteenth century China, but its use on a major scale did not occur until colonial America. The experience was disastrous, leading to massive inflation, unemployment, loss of property, and political unrest. During one period when the Bank of England forced the colonies to abandon theh fiat money, general prosperity quickly returned. The Revolutionary War brought fiat money back to the colonies with a vengeance. The economic chaos that resulted led the colonial governments to impose price controls and harsh legal tender laws, neither of which were effective.

Fractional money is defined as paper money with precious-metal backing for part, not all, of its stated value. It was introduced in Europe when goldsmiths began to issue receipts for gold which they did not have, thus only a fraction of their receipts was redeemable. Fractional money always degenerates into pure fiat money.