If we are to understand and solve our social problems, nothing is more important than understanding the impact of our monetary system—and nothing is more difficult. By “monetary system” I mean the fundamental concepts about the creation of money. Our monetary system has strongly shaped our government, economic, and social structures, and has done so in ways that are difficult to see. Our most serious problems would not exist, or would exist in a more moderate form, under a different monetary system. We are wrong, therefore, if we imagine we can fix our problems without reforming our monetary system.
Our monetary system and financial system are inextricably linked because one cannot exist without the other. However, the monetary system precedes the financial system. Our financial system developed from the monetary system and would be drastically different under an alternative monetary philosophy. Nonetheless, over the past seventy years, every attempt to address economic problems has focused on the financial system rather than the more important, underlying monetary concepts. Until we appreciate this difference, any solutions will add to the national debt without fixing anything.
We are not alone in our struggle to understand money conceptually. History records debt crises at least 2500 years ago. History records the fall of regimes and the collapse of societies because of cheapened money. Those in power have always tried to use the monetary system to further their power. In our age, we may have perfected the use of the monetary system for power, but the perfection of a dangerous power amplifies the damaging consequences.
Three points are necessary for understanding money: its origin, government involvement, and impatience of consumption.
The first step in understanding money is to know that it is not the creation of government. Money is a social institution developed over millennia to facilitate one of the oldest of social activities: the exchange (trade) of goods and services among people. For most of history, money has been something of intrinsic value such as cattle, shells, or gold (or any number of other fascinating examples). Over time, people settled on precious metals (gold and silver) as the best money.
Second, as rulership became larger and more formal, it served the useful role of certifying the weight and purity of money. It was useful because a small percentage of people are willing to rob others out of greed, in this case by cheating on the true value of money. As human nature provides the greedy, so it provides the power-hungry. Thus, when a government managed to gain control of money, those in power looked for ways to cheapen the money. An early, common method involved using cheaper base metal. For example, if the king took in gold that would produce one hundred honest coins, he might mix a base metal with the gold and produce 105 coins. Continuously throughout history, many governments have tried to rob the citizens by using one method or another to cheapen the currency.
Third, it is part of human nature to improve our conditions, and the commensurate actions are forms of consumption. As a rule, people are impatient for consumption. Thus, if a person has the possibility of going into debt to consume, a large portion of most societies will do so. Evidence for the ubiquity and consequences of debt shows up in the oldest law codes. The records from ancient Greece reveal a debt crisis permeating society. History also teaches that the more options a society has for consumption the more they want to consume. It is easy to get caught in a borrow-consume-borrow cycle. Especially in modern times, this impatience for consumption has conspired to produce widespread and problematic debt.
Code of Hammurabi. circa 1750 BC.
Sample: “If the cultivator do not plant corn or sesame in the field, the debtor’s contract is not weakened.”
Each of the above points reveals an aspect of human nature. The first point reveals a positive aspect in which people work together naturally to improve society. The second point reveals a dark aspect of human nature in which the desire for greed or power in some people makes them willing to rob from others. Societies address dark aspects by moral teaching and punishment.
The third point reveals a weakness in human nature in which delayed gratification is difficult. Societies address weaknesses by moral teaching and by allowing natural consequences.
We cannot comprehend our current monetary system without a broad understanding of the development of money. What follows is for that purpose. The actual history, of course, does not break cleanly at these lines. I will use “gold” to mean any precious metal currency. While the outline reflects the development of money in the Western world, the lessons are universal.
For simplicity, we will consider three eras. The first begins over three thousand years ago in 1000 BCE and ends in 1700 CE. During this time, money was gold. If paper certificates were used to represent gold, they were supposed to be backed 100% by gold. Anything less was fully recognized as deceitful. The representative money-cheapening process was the use of base metals as noted above. Everyone understood this. The king knew what he was doing and why. The people developed ways to discern cheapened coins. They tended to hoard the older coins and spend the newer ones. That is, the people were not fooled; they knew they were being implicitly taxed. The king and his immediate court benefited in power and wealth, everyone else lost.
During this time, both those who loaned and those who borrowed understood the principles of debt. Money that was loaned represented true savings. The saver gave up possession of the saved gold to the borrower. That is, the saver gave up the possibility of present consumption in favor of receiving the loan amount plus interest later.
The beginning date for the era could be debated. I chose 1700 because it is commonly accepted that central banking began with the creation of the Bank of England in 1694. The era ends in 1971 when President Nixon removed the last vestige of gold-backed money. While the use of honest coins and honest money certificates continued for much of this era, the representative money-cheapening process was the use of currency and other money-type certificates that were only partially backed by gold. In the two hundred years from 1700 to 1900, the financial and legal framework was developed for what we now call fractional reserve banking (FRB).
Rulers developed FRB for the same reasons that kings debased coins: power and wealth. In fact, the Bank of England was started to help fund the government of England, which had serious financial problems. Something else was happening in the same timeframe, the Industrial Revolution. Economic development was a major social force. As usual, the rulership and economic structures interacted. It was not long before FRB worked to the advantage of those who were in charge of large economic ventures and who were also connected to government. In this stage of monetary development, both the rulership and the top of the economic structure benefited, but again at the expense of the common person.
During this era, the meaning of debt began to change. Because money was still partially backed by gold, there was still a connection between the person who saved and the person who borrowed. It was only a partial connection, however, because banks could create more new money than savers had actually deposited with the bank. The owner of a bank estimated how much money he needed to have in reserve to meet the demands of customers who wanted to withdraw money. If the bank underestimated the reserve, customers could not get their money back. It was this aspect of the monetary and financial system that brought about many bank runs over a period of 150 years.
The last twenty-five years of the second monetary era provided the transition to the third era. Following World War II, the Allies created the Bretton Woods Agreement, which was a new monetary system. It established the US dollar as the reserve currency with a supposed gold-backing guaranteed by United States. The guarantee did not apply to US citizens because Franklin Roosevelt outlawed gold for the average person in 1933.
As with all governments, the United States could not responsibly handle monetary power. The Vietnam War, The Great Society, and other government spending injected many new dollars into the world economy. When other countries that were members of the Bretton Woods Agreement started exercising their rights to convert excess dollars to gold, the United States was in trouble. It did not have enough gold to fulfill the commitments. President Nixon, in 1971, “closed the gold window.” Thus began the third era in the development of money.
For the first time in the history of the world, no money of any country was tethered to something real. The name given to this reality was fiat monetary system, fiat because money could now be called into existence by the diktat of rulers. What rulers had attempted for thousands of years had now been perfected. They could concentrate power more quickly and acquire wealth because they could create money at will and at no substantial cost. As always, those who would pay the price were the average citizens.
Today, not only can money be cheapened at will, but the reserve requirement for banks is also very low. That is, the amount of reserves they must have on hand is a small percentage of the amount of money people have deposited with them. Why then do we not have more bank runs now than we did 120 years ago when the effective reserve percentage was higher? The answer is that the Federal Reserve can now create money to rescue any bank that gets in trouble and for which the Federal Reserve judges a rescue to be appropriate.
Now we must deal with a crucial question. For thousands of years, the average citizen knew they needed to protect their money from the rulership, not only from direct taxation but also attempts at implicit taxation through a depreciating money. They were vigilant in this regard. With democracy, when citizens won the right to be rulers, why did they lose this awareness and vigilance? Speaking specifically of the United States, why did citizens quietly accept the 1933 prohibition to own gold? Why have they accepted a steadily depreciating dollar? Why have they accepted an ever-growing national debt?
A comprehensive treatment of those questions is beyond the scope of this article. The part of the answer that is relevant here comes from looking at the steady growth of the formal debt and the informal obligations of the United States government during this entire third monetary era. The growth has been particularly illuminating since 2008. The evidence suggests that citizens adopted the mindset of all rulers throughout history. Because citizens were now rulers, they fell into the trap of believing that they could benefit from cheaper money. “The government” could, for example, use created money to pay for education, healthcare, social programs, business subsidies, and bailouts from economic recessions and pandemics. The fallacy, of course, is that in a democracy, the citizens are both the ruler and the ruled. That is, whatever benefit may have accrued to them through cheap money must be paid by them—or their children—at some later time. However, most of the benefits of created money did not flow to average citizens but to those in government and government-favored institutions.
Money creation under the fiat regime changed society far more than simply transferring wealth from a large group of citizens to a much smaller group. We are just beginning to appreciate the scope of damage. We will look briefly at the most important ways in which current monetary philosophy has shaped society. Future articles will look at these in more detail.
Few Americans have any memory of, let alone experience with a monetary system different from what we now have. Even though the fiat system officially started in 1971, the behavior and mindset that brought it about began at least a decade earlier. Furthermore, the years of World War II and immediately following presented an exceptional historical moment which contributed to the confusion. Thus, as citizens we have no other experience from which to generate monetary intuition. All our education, formal and informal, explains and normalizes our monetary system. Our experience with money is totally within the fiat framework. Consequently, we must work hard to understand its effects on our society.
How has our understanding of borrowing changed? One part of the understanding stays in place. A person or business that borrows money knows they must repay the debt, or the lender will take legal action. However, as citizens we have lost that same intuition about the debt of the federal government. The trendline of government debt for the past seventy years is strongly upward. That is, we have no meaningful experience in paying off that debt. Rather, our experience is that the government (we the citizens) can always borrow money to pay off any retiring debt plus fund a steadily increasing deficit.
Today, more than fifty years into the fiat money era, we need to understand the systemic social and economic effects of borrowing. In the first monetary era, when money was gold, a person could only borrow what another person had saved. If Sally lived beneath her means for an extended time, she would have saved gold coins which she could lend to Joe. In the second monetary era, it was different because banks could loan more money than people had deposited with them. For example, if the typical reserve ratio were 50%, the bank could loan two dollars for each dollar that was deposited. The trend in the second era was for the effective reserve ratio to move lower. The lower the ratio, the less connection there was in the economy between the saver and the borrower. Today, that ratio is effectively less than 10%.
(For two reasons, I have used cheapen to stand for the devaluation of money. First, it instructively ties back to the original mechanisms used, that is, to the use of cheap metals in coins. Second, it provides a more concrete image than the word we use today, inflation. Today, the government looks at changes in prices and reports the increase as inflation. Inflation is a poor attempt to measure the impact of money-cheapening within society. Interestingly, we have become so accustomed to the concept of cheapening that we willingly accept a monetary policy which intentionally devalues the dollar a minimum of two percent per year.)
Here is the crucial concept that is widely underappreciated. Borrowing moves future consumption into the present. Borrowed money gives the borrower power to buy existing resources. Extending the scenario above, assume that rather than Joe borrowing coins from Sally, he managed to make high-quality counterfeit coins. He could use those coins to buy the labor or land of other people. If Joe only made a few coins at a time and especially if he mixed those with genuine coins, he might get by with his deceit for a long time. Nonetheless, each time he used a counterfeit coin, he would steal economic resources from other citizens. Joe is getting richer at the expense of everyone else. This is why many societies impose severe penalties for counterfeiting.
I am not suggesting that fractional reserve banking is counterfeiting. It is legal, having been duly authorized by law. People who borrow money created via FRB are not doing anything illegal. In fact, they are doing what society has explicitly approved and encouraged. Nonetheless, the effect on the economy is like Joe using his counterfeit coins. A justification for the system follows this line. Instead of counterfeiting coins, Joe borrows money from the bank. He pays a price, interest, for using the newly created money. Everyone hopes that Joe uses the new money in ways that produce benefits for society that outweigh the “counterfeiting effect.” This is the critical assumption: a large net benefit to society. Thus, citizens agree to the implicit tax of created money in exchange for a hopefully expanding and productive economy.
Whether or not that assumption is true—and I suggest that it is no longer true even if it once was—there is a subtle and more important problem. When the link between savers and borrowers is broken, as it is now, the average citizen loses one type of economic voting. Decisions about the structure of production and the associated consequences for employment and the pace of change, are made primarily by those in the financial industry. If money for investment in the economic structure could only come from the savings of many citizens, then the nature of that structure and the pace of change would be contingent on the financial well-being of citizens. If the average citizen could not save or was not motivated to save, the entire structure would be different. In a fully linked monetary system, the interests of industry, entrepreneurs, and the average citizen are more closely aligned. Thus, the monetary system is a fundamental reason for the economic contention so prevalent today.
That is not all. Our current monetary system guarantees the centralization of power in the federal government, the finance industry, and the largest of corporations. Concentration of power, especially in the federal government, works against the freedom and well-being of the average citizen. This power goes far beyond determining the structure of the economy as discussed above. When the power is sufficiently strong, as it has been for a few decades, the entire social structure is altered. The effects from our monetary system discussed above combined with its role in distorting feedback signals within society have contributed to the problems we now experience in education, healthcare, employment, immigration, productivity, and the breakdown of the family, to name a few. The multiple and diffuse symptoms are often captured in the single word “inequality.”
I am not, of course, saying that all our problems are totally caused by our monetary system. I am saying that none of them could have progressed to their current severity if we had a more sound monetary system. As will be discussed in other articles, our fiat monetary system is an important reason that we did not see or understand early feedback from developing problems. Our system allowed the distortion and postponement of consequences.
As we work to become citizen-rulers and gain understanding proper to that role, one of the things we must address is how to reform our current monetary system. Without reform, no real solutions to specific problems will be possible. However, not just the United States but the entire world is operating with economic and geopolitical structures built upon and depended upon a fiat monetary system. I think only a crisis will change the philosophy of money. So, what can we do in the meantime?
Our first task is to unlearn our current understanding of the monetary system and how it relates to society. At the same time, we can develop a more proper understanding. We will need some citizens who are willing to invest the time and effort needed to gain this understanding and communicate with fellow citizens.
Second, we can accept the reality that in a democracy, the citizens determine the government. Therefore, it is not an abstract “the government” that will solve our problems but rather we as citizen-rulers must do so.
Third, printing money and increasing debt does not solve problems. It postpones consequences and makes problems more difficult. Thus, we can move toward a requirement that the federal government operate with a balanced budget. We need to augment what “budget” means for the federal government. It is a narrow measure of current expenditures. It reflects nothing of future obligations such as Social Security, Medicare, and the pensions of government employees. Interestingly, the methods and rules used for accounting by the federal government are considered illegal when that same government looks at private companies.
Continuous focus and effort on those three things can begin making improvements within a few years. More importantly, they can immediately slow down the growth of existing problems. Finally, they will reduce the burden we are shifting to the next generation.