CHAPTER III: A Little Bit About Our Money System

Today our money system is a sophisticated confidence game which has been operated successfully for over 300 years. It is complex, and its oracles pose as experts in economics. To understand it more easily, let us go back to the days when this system was new and in a simpler form.

How Paper Money Started

Prior to the English Civil War (1642), the money of England was precious metal coin issued by the king and bearing the impress of sovereign authority. This was not honest money, whose value comes basically from its metallic content. The king was cheating the people by putting less metal in the coin than its face value. This system was justified by the doctrine of fiat money, which states that value comes from the declaration (fiat) of the king. If you objected to the doctrine of fiat money, the king would throw you in the dungeon.

But as kings began to lose their overall power, they also lost power over money, a fact dramatized by a series of events beginning in the reign of Charles I. At that time wealthy people would deposit their money with the king for safekeeping. But in the 1630s a massive tax revolt swept England. Charles was desperate for money, and he tried to seize some of the coins which had been deposited with him. After this, Englishmen with extra money to store no longer deposited it with the king. Soon the practice sprang up of taking one's coins to the local goldsmith, depositing them and receiving slips of paper promising that the gold or silver was on deposit and could be redeemed on demand.

These slips of paper became very important for the future of our economic system. A slip payable only to the person named constituted what we today call a check. A slip payable to anyone carrying it came to be known as a bearer note; and these bearer notes began to be used, in place of the coins, as money themselves.

Pay to J. Jones

5 lbs. sterling

check

Pay to bearer

5 lbs. sterling

bearer note1

The way this happened was as follows: a man would go to buy some meat from the butcher; not having gold or silver coin, he would pull out one of his bearer notes nd persuade the butcher to accept it. After all, the butcher could take it to the goldsmith and exchange it for gold if he so desired. But instead of doing so, it often happened that the butcher would pass the note along to the shoemaker by the same argument, etc. Soon the goldsmith's note was circulating as money.2

The problem began when one of these goldsmiths noticed that his clients were using his bearer notes as money and leaving the gold on deposit with him. Since most people never bothered to redeem their gold coins, paying for goods with the notes, the goldsmith figured that he could issue additional notes in excess of his gold. If depositors had left 1,000 pounds3 in coin and received 1,000 pounds in promissory notes (which they used as money), then the goldsmith would print up an additional 1,000 pounds of notes, or even 2,000 or 3,000, having no gold at all with which to redeem them.

The reason this action was not regarded as counterfeiting was that the goldsmith did not keep the extra money for himself; he lent it out at interest. The time was only 1660-1670, hardly removed from the Middle Ages, and there was widespread belief in the Church's position that all interest was usury and hence a sin. That age had no understanding of the role of interest in rewarding the saver and providing a motive for the exchange of capital.

The people of the late 17th century had begun to realize on a practical level that interest was a good thing. But they did not know why this was so, and their theories on the subject were dominated by medieval thinking. Their attitude was, 'Well, it may be immoral, but I'm going to do it anyway.' They were not able to distinguish between the legitimate, productive role of interest and the scheme devised by this unknown goldsmith. In fact, the free charging and paying of interest was not fully legalized until the 19th century, so that the early goldsmith-bankers probably performed a useful function in helping to start the capitalist system. In any case, the opponents of the bankers' privilege to create money were monarchists, who defended the king's privilege to create money; and the idea that no one should have the privilege to create money did not receive a fair hearing.

By lending his newly created notes, the goldsmith became a banker (displacing the old money lender). Soon there was a vigorous competition as bankers arose all over the country trying to attract cash from depositors and issuing their bank notes. The undoubted winner of this competition and the most famous banker of the day was William Paterson, who found a way to become banker to the king and in so doing founded the Bank of England. Paterson put together a consortium of some of London's wealthy citizens and raised 72,000 pounds in gold and silver coin. Then he issued (Bank of England) notes for 1,200,000 pounds (almost 17 times as much). This he lent to the King (who needed the money to finance a war) at 8 1/3% interest. This was 8 1/3% of 1,200,000 pounds, not 8 1/3% of 72,000 pounds. The King paid Paterson and his consortium 100,000 pounds per year in interest -- more than they had had in original capital.

Two years after it set up in business, note bearers came to the Bank of England asking for their gold, and the bank could not pay. Since it was in default of contract, it should have been declared bankrupt and its directors put in jail. This is what would happen if non-bankers tried to practice the same principle.

But the Bank of England notes were essential for the war; so the Government did not arrest the bankers for their breach of contract. This was the genius of being the banker to the king. The Government solemnly declared that the pieces of paper on which the Bank of England had written its promises to pay gold had the same value as the gold itself and that therefore the holders of those promises had not been cheated by the default. This was done by a legal tender law which made paper Bank of England notes legal to give (tender) at the same value as the gold they had promised.4 In essence, the doctrine of fiat money was applied to the notes of private bankers.

Perhaps we can appreciate what those early bankers were able to pull off if we consider a similar situation today. Suppose you give your baggage to the airline and receive a baggage receipt (i.e., a promise, written on paper, to redeem your baggage); then when you get to your destination and present your receipt, the airline tells you that you cannot have your baggage back; and when you take the airline to court, the judge rules that the baggage receipt has the same value as the baggage, and therefore you have not been cheated.

Airlines can't get away with such a thing in our society. But the tragedy is that this basic fraud has never been overturned, and bankers can. In this series of events, the sovereign authority to create money passed from the monarch to the banker,5 and it has remained there to this day. Central banks, modeled on the Bank of England, are set up in almost every country in the world. As we shall see, the bankers use this system to make unearned profits at the people's expense.

Paper Money Today

The past 300 years can best be thought of as a struggle between the bankers and the people, with the former always trying to extend their privilege and the latter failing for the most part to understand what was going on. In the early history of America, Thomas Jefferson emerged as the great champion of the people and fought the bankers' attempts to establish a central bank modeled on the Bank of England. Jefferson's supporters, led by Andrew Jackson and Martin van Buren, finally killed this central bank (the Bank of the United States) in 1836, and America moved into a period of unparalleled prosperity over the next century. Democrats still celebrate Jefferson-Jackson days in memory of this victory.

Unfortunately, such celebrations are only the reenactment of a ritual. Modern Democrats do not understand the meaning of their celebrations because their party later betrayed its heritage. It reinstituted a central bank (in 1913) called the Federal Reserve System6 and gave the notes of this bank legal tender status (in 1933). Claiming to represent the people, the modern Democratic Party gave the country away to the bankers. It set up a money system even worse than that of the old English goldsmiths.

The goldsmith's system was fraudulent, but it was, at least, based on gold.

ILLUSTRATION I

promises to pay cash

written on paper

(bank notes)

gold

(cash in 17th century)

17TH CENTURY GOLDSMITH

To explain our modern money system, without going through all the steps between: what happened was that central bank notes took the place of gold and became the normal cash in the society. Upon a base of bank notes, there was erected a pyramid of checkbook money. That is, entries are made in checkbooks all around the country wherein the bankers promise us cash. Yet there is not enough cash to keep all these promises.

promises to pay cash

in checking accounts

(demand deposits)

bank notes

of the Federal Reserve

(cash in 20th century)

20TH CENTURY COMMERCIAL BANK

You see, if you and all your friends went to the bank tomorrow and asked to withdraw your cash from your checking account, and so did all the other people in the country, there would not be enough cash in the banks. There would not be anywhere near enough. Your modern commercial bank is deceiving you, just as the 17th century goldsmith deceived his customers.

Indeed, your modern bank is a lot worse. The goldsmith made more promises than he had cash, but the cash, being gold, was a given and out of his control. Today's banker expands his promises beyond his cash; but for him cash is notes of the Federal Reserve, and these can be increased at the will of the central bank. Therefore controlling the Federal Reserve and getting it to issue more notes has been an important objective of the commercial bankers. Since the plans for the Federal Reserve were drawn up by a group of bankers and since the general public does not understand the system, this objective was achieved right from the beginning, and the most important commercial bankers control the Fed up to this day.

How Money is Created

We are now ready to put everything together to understand how money is created today.

ILLUSTRATION II

U.S. Government or Government agency

spent in the normal course of business

defense contractors, government employees, consultants, government payments, etc.

public in general

deposited in the commercial bank

checking accounts

Federal Reserve creates money by authorizing the printing of dollar bills (Federal Reserve notes).

New money is lent to the Government via the purchase of Government securities

The Federal Reserve System starts the process by issuing (legal tender) bank notes (Illustration II). This is the money which we carry in our wallets and which constitutes our society's cash. The Fed lends these to the Government to finance the Federal budget deficit (which started at the same time that central bank notes became legal tender and the current system was erected). They are spent by the Government (in its normal course of business) and go into general circulation.

Once these notes reach the people, they pass from pocket to pocket, constituting the normal money of the country. But about a quarter of them are deposited in the commercial banks.7 Although this money belongs to the depositors, the banks regard it as their own and use it as a base to create checkbook money (demand deposits) in amounts up to 8 times as much.

ILLUSTRATION III

money supply circa 1987

A

$220 billion in Federal Reserve notes (cash) and credit in wallets around the nation

cash goes back and forth from people's pockets to the banks

B

$75 billion in Federal Reserve notes (and credit) in the banks

pyramid of $550 billion in promises backed by $75 billion in cash

C

$550 billion in demand deposits or checkbook money in the banks

MONEY SUPPLY = A + C

To compute the country's money supply, we simply take the Federal Reserve notes created at the beginning of this process (A) and add them to the checking accounts created at the end (C) not counting the Federal Reserve notes (and credit8) held in the banks (B). Or as the economist would say it, money supply = demand deposits plus currency in circulation.9 In our example, $220 billion in Federal Reserve notes add to $550 billion in checkbook money to give a total money supply of $770 billion.

This is the important thing to understand about the present U.S. money supply. The legal tender notes in your wallet or purse make up one part of it. The money listed in your checking account makes up the other part.10 Both parts are controlled by the bankers.

How It Happened

This system evolved over time in a series of political battles, but the law which did the most to shape it was the Banking Bill of 1933, passed in the early days of the New Deal. Shortly before F.D.R. was to take office, a group of bankers met in a secret session with Secretary of the Treasury designate William Woodin (himself a banker) and drew it up. Then F.D.R. used his prestige as a newly elected President to ram it through Congress. Members of the House didn't even have written copies of the bill to read before they voted on it, but they passed it in 40 minutes, and it went through the Senate later in the day. Here is the New York Times report of the debate:

“Congress hardly knew what was in the bill it passed today. In the House there were no copies of the measure, and it was read and explained on the floor by Representative Steagall. There was no time to study the implications and ramifications.

“In the Senate copies had been printed by the time consideration began, and members followed the clerk's reading with an attention seldom devoted to a measure offered for their action.

“In both chambers, with slight differences, the members gave the impression of men who like poker players, throw in some of their last chips in the belief that they will win.

“They were glad to place the responsibility for action in the hands of one man, happy that a man had offered to assume that burden, and showed in their demeanor their hope that the revolutionary means they were adopting would bring to the country some surcease from growing economic casualties.

“Representative Steagall voiced this feeling when, with arms widespread and voice ringing through the large chamber of the House, he said:

'We rely on leadership whose fate is lifted to the skies.’"11

When this system began, the total amount of money in the country was $20 billion. The bankers have increased the money supply until today (1991) there is $86O billion. And the value of the money -- which had remained essentially the same for 145 years under the partial gold standard which was traditional in American history -- has fallen to less than 1/10 of what it had been.

The full paper money system instituted in 1933 was moderated in 1944 due to the influence of Cordell Hull, who introduced a tie to gold via the Bretton Woods System. Foreigners were permitted to treat American dollars as promissory notes for (1/35 oz. of) gold even though Americans had to treat them as legal tender. Thus, when foreigners acquired U.S. dollars, it frightened the bankers. They feared that some of these foreigners would ask them to keep their promises, and of course, they did not have enough gold to do so. This fear operated to slow the bankers' creation of money for 27 years. But, as noted in Chapter I, the bankers won a major victory over the people by abolishing this tie to gold on August 15, 1971. That action restored the pure paper money system of the 1930s and set us again on the path to disaster.


NOTES

  1. For example, a gold certificate circulating as money in the early 1930s might contain the following legend: “This certifies that there have been deposited in the Treasury of the United States, twenty dollars in gold coin repayable to the bearer on demand."(Theodore Kemm, The Official Guide of United States Paper Money, fifth edition, (New York, HC Publishers, Inc., 1971), p. 120. 9) Twenty dollars was defined in law at that time as 516 grains of gold 9/10 fine (about 1 ounce).
  2. This is normally considered to be paper money. However, what was accepted as money was the promise to pay coin. Often such promises are written on paper, but that is not the essential feature.
  3. The pound was (is) the British unit of currency and had been (before it was debased) 1 pound of sterling silver.
  4. The same thing was done in the U.S. in 1933. See Chapter 10.
  5. In 1695, two years after it had authorized the Bank of England, the British Parliament called in the adulterated coin which had circulated throughout the Middle Ages. This ended the king 5 power to debase the currency.
  6. One of the lies which the bankers told to the people at this time was that the Federal Reserve was not a central bank. Of course, it was not a bank at all; it was a system of banks. But it had the two essential features of central banks; it was the lender of last resort to the sovereign; and it lent cash to the private commercial banks to tide them over a period of tight credit. The pretense that the Federal Reserve System was not a central bank was maintained until the early 1960s.
  7. It is the modern commercial banks which correspond to the ancient goldsmiths and expand money. Traditionally, savings banks and savings and loans did not do this; but since about 1980, with NOW and other transaction accounts, they have started to get into the act.
  8. Federal Reserve credit should be viewed as the authority to issue notes; it is treated the same as Federal Reserve notes by the banks.
  9. The Government makes some minor adjustments in this figure when it reports its version of the Money Supply (M1). It exempts its own deposits from the total of demand deposits (why is not exactly clear). Included are travelers checks, NOW, ATS accounts, credit union drafts and demand deposits at thrift institutions. The various other M’s you hear about (M2, M3,. . .etc.) are meaningless figures based upon adding the money supply to various items of credit. As we will see later, money and credit are two completely different things, and anyone who would try to add them together to come up with a meaningful total does not understand the principles of economics.
  10. As the Federal Reserve itself states: “One institution -- the commercial bank -- creates new money -- checkbook money -- when it lends. Producers and workers borrowing from commercial banks put this new money into circulation."(The Story of Money, Federal Reserve Bank of New York, Public Information Dept., 1981, p. 4.) These “producers and workers” tend to be people like, General Motors, IT&T, Ibn Saud or the Government of Brazil.
  11. “Spirit of Congress Grim in Bank Task,” New York Times, March 10, 1933, p. 1.

This material is made available with the generous permission of Howard Katz (1931-2012).