Chapter V:
What Happens When Paper Money Is Issued

Now that we understand capital and know how paper money is issued, let us examine in a little more detail what happens when the banker issues it.

The Currency Is Going Down

The main effect of an increase in the quantity of money is a corresponding increase in the prices of things bought with that money. If we increase the supply of money (other things equal), then the value of the money will decline. Prices expressed in that money will then be higher.

For example, during World War I the U.S. money supply was increased from $12½ billion to $24 billion. The dollar fell in value from 100¢ to 55¢ (in terms of its ability to buy the basic raw materials listed in the Wholesale Price Index), and the average price level just about doubled. The same thing happened during the Civil War, during World War II and during the decade of the 1970s. Indeed, it has happened every single time the quantity of money has been increased (as Milton Friedman has demonstrated).

However, paper money supporters stubbornly refuse to admit this connection. Ben Franklin was a good guy in creating capital, but he was a bad guy in defending paper money. He used to argue: Yes, it is true that we issued more money and that this was followed by a rise in prices. But this rise in prices was not a decline in the value of the money. It was an increase in the value of goods. Goods went up. Money did not go down.1 And the proof of this is the fact that each good went up by a different amount. Cattle went up a little. Tobacco went up a lot. If there had been a fall in money, we should have seen all prices rise by an equal amount. Therefore, the paper money had nothing to do with the rise in prices. It was just a coincidence.

Ben's argument forgets that all goods are always fluctuating. In terms of a sound currency, some are rising; some are falling. If we look at this fluctuation in terms of a declining money, we find some goods going up a lot, some going up a little and a few remaining stable or declining slightly. It is the average price level which gives us the clue to the depreciation of the currency. Thus the fact that prices rise by different amounts does not prove the currency to be stable. It is just what we should expect when the currency is depreciating, and, as history shows, it is just what we find.

As for the coincidence argument, let's examine just how big the coincidence would have to be. In a very small economy with only 1,000 goods for sale, the chances that one good will rise by coincidence are 1 out of 2. The odds that 1,000 will be rising at the same time are ½1,000. This is equal to ½1,000 which is approximately equal to (1/10)300, which is equal to 1 out of 1, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000.

I have never given much credence to the coincidence argument.

The Banker And His Friend Get the Advantage of the Productivity of Capital

The banker issues his money and lends it to a few of his businessmen friends. This is only a loan, but it gives a decided advantage to the banker's friends. They now are the movers and shakers who will decide what projects get built in your community and who will be employed. One such banker's friend, let us call him Sam Jones, may take the money and buy some of the society’s capital to employ in a business venture. He has noticed the success of a Kentucky colonel in marketing a delicious flavor of fried chicken, and he decides to imitate this with his own product — Tennessee Fried Chicken.

Mr. Jones has many disadvantages. Since he is bidding for the capital, he winds up paying slightly more than the going price. Also, he does not know the restaurant business. More important, his fried chicken isn’t too good.

Against these disadvantages, he has one important advantage. Capital is productive (as per Chapter IV). Capital creates wealth. If employed properly, it produces more wealth than was used in creating it in the first place. In a sound money economy, the extra wealth produced by an average piece of capital is expressed by the return on capital, and this figure is approximately equal to the real rate of interest.2(Indeed, the rate of interest is one form of the return on capital.) Thus, in 19th century America, where 5% was an average rate of interest for safe loans and 10% for risky loans, capital produced between 5% and 10% return per year (above its cost).3

If we consider the banker and his friend together, it is obvious that they have got the use of this capital without paying any interest. If the capital produces an 8% return, then the two of them (considered together) should be able to earn4 8% per year by employing it.5

Of course, Mr. Jones, considered alone, does pay interest. But the banker has lowered the rate in order to encourage people to borrow. (His paper money scheme only allows him to create money when he makes a loan; it won’t work if no one borrows from him.) He lowers the rate of interest from 8% (normal) to 4%. Thus, if all goes well, the banker and Sam Jones split the profit which is derived from the productivity of capital (the latter making 8% profit and giving 4% to the banker as interest). That is, the banker and his friend get the profit, not the savers who provided the capital which made the project possible in the first place.

The basic fact which the banker theories are trying to escape is that capital creates wealth. Morally that wealth belongs to the people who created the capital, the savers who were willing to postpone their consumption so that wealth might be created. Both banker economics and communism attack the creator of capital. Both erect theories which try to deny his existence, and both attempt in practice to steal the wealth which he creates. Communists argue that capital is a social product created by everyone in general and no one in particular. Banker economists argue that saving is bad for the economy but consumption and destruction (such as breaking a window or spending on the military) are good.6

The bankers’ creation of money does not increase the amount of capital in the world; it merely gives the bankers’ friends the power to transfer what capital does exist into their control, to buy it up with their newly created money. It takes the benefits of capital away from its creators and gives them to an elite with political privilege. In doing this it wastes much of the capital that exists and destroys the incentive for saving to produce new capital. Like communism, it is a system which is incompatible with economic growth.

The Inefficiency of Bank Paper

To return to Sam Jones, as noted, all does not go well with his project. In a country with a sound currency, the banker is under great pressure to separate the glib, fast talker from the competent businessman. But when profits are so easy, the pressure on the banker relaxes. He is more inclined to favor the man who puts on a good appearance than the man of substance. In this case Mr. Jones does not know the restaurant business and makes mistakes which cost ⅛ of the profit. And since his chicken is not quite up to snuff, he must spend more on advertising to get people to eat it (or lower its price, or something). Cut another ¼ from his profit.

The Tennessee Fried Chicken Corporation is down to 5% profit, and they must pay the banker 4% interest. Their margin is getting squeezed. But they have accomplished the necessary conditions for success in a paper money society. They have befriended the banker, and they have managed to complete the process of organizing a business without making too many horrendous errors with too great a cost.

Their margin is squeezed, but it is still 1%. And that is 1% better than nothing. Further, it is 1% on all the capital they have borrowed. If they can borrow more, they will make more — the royal road to wealth. Thus Mr. Jones goes back to his banker friend and asks for another loan to expand his chain.7 The banker is only too happy to oblige. He creates some additional money and makes the loan. It certainly beats productive work.

Notice that the net effect of this process is to reduce society’s wealth. Capital which was producing 8% additional wealth is now only producing 5%. The banker and his friend have gained, but society as a whole has lost. Unlike the textbook example of the free market businessman, who gets rich by making other people better off, the paper money businessman gets rich by making the rest of society worse off.

Doubtless the banker will point with pride to the Tennessee Fried Chicken Company. Paper money expansion is good, he will say.8 Look at this project which could not have been completed but for my loan. If you take away my paper money privilege, credit will be restricted, and the world will be poorer.

Indeed, so persuaded have the bankers become by their own argument that they early took to calling their newly created money capital. It is not one of the means of production, but the bankers’ influence has been so dominant that this is the name it is given in business circles.

This false label makes the bankers’ argument seem quite reasonable, e.g.:

  1. My expansion of credit adds to the world's capital (in the sense of paper money or bank promises to pay cash).
  2. Capital (in the sense of the means of production) is productive.
  3. Therefore, bank credit expansion creates wealth. (sic)

It should be obvious that the bankers’ new money is not a means of production; that is, it does not create wealth. One cannot dig foundations or roll autos off the assembly line with pieces of paper. There is a fundamental difference between capital, hard goods in the real world, and notations on the bankers’ ledger. It is the former which are productive. If the latter are given the same name (capital), they do not acquire the same capabilities. A steam shovel can dig the foundations for a factory. All the paper money in the world can not. All that the banker has succeeded in doing is to transfer control over the steam shovel (and other real capital) from the productive businessman, who can use it to increase the world's wealth by 8%, to an inefficient businessman, who only increases wealth by 5%.

The banker points to the project which has been built with his loan, a chain of restaurants, a factory, an office building, and beams with pride. But as Frederic Bastiat pointed out in a slightly different context, the banker is ignoring the project which has not been built because the necessary capital was diverted to the use of his friend. Experience shows that the latter project is more beneficial to society than the former.

The Trick of the Money Illusion

If the banker and his friend gain and if there is a loss to society as a whole, it is clear that the rest of the people must lose. But the manner in which this loss occurs is highly deceptive. If the average price of steam shovels is $90,000 just before the banker create his new money, then perhaps (a contractor working for) the Tennessee Fried Chicken Company buys one from the previous owner by paying $100 000. The owner of the steam shovel is quite happy. He feels that he has made a good bargain. He has sold a $90,000 shovel for $100,000. It is only when the price of steam shovels goes to $180,000 (a consequence of the doubling of the money supply) that he realizes that he has lost. Even here he may not fully realize it. He is a victim of the money illusion.

Since money is the yardstick by which we measure value, most people take the value of money as constant. This is understandable. We do not usually think of our yardsticks as changing while we are measuring. When the price of goods expressed in the money rises, it is a natural assumption that the money has remained constant aid the goods have gone up. This illusion, that the money keeps the same value, even continues when all of the goods in society are rising in price.

If the money really kept its value, then the bankers’ creation of money would add more real value to society. If it could do that, then perhaps no one needs to work. Just print money and let everyone get rich. What a clever economic theory.9

But because the owner of the steam shovel regards money as being fixed, he does not even realize that he has been cheated. As prices generally work their way higher, so that the $100,000 he has received for his equipment shrinks to the value of $50,000, he does not blame the fried chicken entrepreneur. He does not even blame the banker. As he dimly becomes aware that something is wrong, he may not even relate it to his decision to sell the shovel. All he knows is that some outside force is causing the price of everything he buys to go up and making life more difficult for him.10

To make the example more realistic, perhaps the other businessman never got to own the steam shovel in the first place. Perhaps the banker’s friend bought the shovel new, causing its price to rise as before. The other businessman, not being a friend of the banker, cannot afford to buy it. He puts his hands in his pockets and shuffles home never understanding why his small enterprise cannot quite make it off the ground.

In a period when the bankers are creating new money, both the bankers and their corporate friends get unearned benefits. Not only does the corporation (and it is primarily big corporations which receive the bankers’ loans) get a lower than free market rate of interest, but it repays the loan in depreciated currency. It borrows 100¢ dollars and pays back cheaper dollars (as did John Doe in Chapter IV). On the other hand, everyone who is not a direct beneficiary of the system (and who accepts the bankers’ money) is a loser. This is because they must buy things with the depreciated currency. Elderly people on fixed income find that their retirement pay does not buy as many real goods. Although workers’ wages go up, they never keep pace with prices, and wages also buy fewer goods. Small businessmen find that they are not likely to have a friend at Chase-Manhattan and cannot compete with big corporations11 in getting loans. All of these people lose enough real wealth to supply the bankers’ gains and those of their friends, as well as enough to pay for the amount wasted through loss of efficiency.

The problem with most confidence games is that, after the victim has been cheated, he realizes that he has been cheated, and he gets mad. This can cause difficulties for the con man. At best, he is unlikely to cheat the same person twice. But the paper money system provides a solution to that. It is a confidence game so subtle that even after the victim has been deprived of wealth, he does not realize who has cheated him, or even that he has been cheated. Surely, from the bankers’ point of view, here was a game worth pursuing.


  1. Suppose in 1961 you had arranged with a contractor to build a 50-foot × 40-foot house 25 years in the future. Comes 1986 and the contractor goes to work using a foot ruler one half the original size. Stop, you shout. You have depreciated the foot. You are using a smaller foot. No, he replies. It is not the foot which has depreciated. Rather all of the other buildings have inflated in size. The cause of this inflation is, (a) businessmen, (b) labor unions, (c) some ethnic group which is too small to fight back. But I want a bigger house, you respond. Hey, a contract is a contract, buddy. 50 feet × 40 feet is what you paid for, and 50 feet × 40 feet is what you get. If you buy the corresponding argument in the field of economics, then you are a normal American today.
  2. In a paper money economy, where the money is depreciating, the actual rate of interest will usually be higher to compensate the lender for the loss in buying power of his principal. The real interest rate equals the market rate minus the rate at which prices are rising.
  3. This 5%-10% does not begin to measure the total return on capital. For example, land in England which in the Middle Ages yielded 6-8 bushels of grain yields 60-80 bushels in the 20th century, a gain of 900%. The reason that capitalists today do not make 900 return on an average investment is that the operation of a free economy requires the capitalist to offer most of his increase to the consumer, the worker and the inventor of the technology in order to secure their cooperation. This is why a society with increasing capital is typically marked by an increasing standard of living.
  4. in the economic sense, not the moral sense
  5. assuming that they have average business ability
  6. Honest, they really do. If you don’t believe me, skip ahead to Chapter VII.
  7. If you have ever wondered why you see those chains of restaurants springing up all over the country each with such mediocre food, now you know.
  8. Actually, he will say credit expansion is good. He is counting on your ignorance of the fact that in order to expand credit, he has been increasing the supply of money.
  9. Our distinguished banker-economists actually believe this. The Federal Reserve states: The banking system can create more money when people wish to borrow for spending, as we shall see later. This may expand the [economy’s] output. (Keeping Our Money Healthy, pamphlet put out by: Public Information Dept., Federal Reserve Bank of New York, 33 Liberty St., New York, N.Y. 10045, 1979, p. 7.) They list the money supply as one of the leading economic indicators, meaning that when money increases, it is usually (in their view) followed by an increase in wealth. What a clever economic theory.
  10. This degree of ignorance makes him susceptible to propaganda blaming his condition on some class or racial group. For example, in the credit expansion of the late 1970s, many farmers borrowed too much money and wound up in the early 198Os unable to pay it back. This has spawned the Christian Identity movement, which attacks bankers — not for issuing paper money and lending it out but for asking that it be paid back — opposes usury (meaning all lending of money at interest), supports segregation and argues that today’s Jews are the seed of the devil. (See, The Blood of Patriots, by Douglas Hand, Harrowsmith, Sept./Oct. 1986, p. 41.)
  11. or foreign dictators