Earlier I wrote about how money originates as a commodity through the barter system. While the origins of money may be clear, the idea of money may still be abstract for some. This is because our concept of money has changed dramatically from its original form. Our current system consists of a fiat paper currency which is nonredeemable for any commodity by the institution who issues it. That is, our “money” is simply ink on paper which the government forces us to use through legal tender laws. This paper money is issued by the Federal Reserve Bank, but the Federal Reserve will not redeem that money in any commodity other than an identical paper note.
Legal tender laws which establish the paper money as fiat money require that it be accepted as a form of payment for debts. This means that if fiat money was offered as payment for a debt, the courts will consider that debt paid. The courts will not enforce payment in any other form, even if that form of payment was specified in a contract (ever heard of the gold clause?...It was made irrelevant by legal tender laws).
The evolution of a commodity-based monetary system to a fiat paper money system is somewhat complicated, but I will try to explain the process as best I can. Originally, when gold was used as money, banks issued paper receipts to customers so that they could return and claim their gold at any time. People eventually began simply trading the receipts themselves as if they were gold because it was easier than withdrawing the gold to pay for everything.
Eventually, banks figured out that they could issue more receipts for gold than gold that actually existed in their vaults because virtually no one ever came to withdraw the gold. This led to what is called fractional reserve banking. That is, banks only held a fraction of the receipts in circulation in gold, but this practice was not particularly legal when it first started. This is because it was considered fraud. The receipts were titles to the property that existed in the bank vault. The bank was essentially committing fraud by issuing new titles to the same gold. The system became legalized through a partnership of the government and banks so that banks could provide quick and easy credit to governments to finance this project or that war.
However, there were problems with this type of system. Occasionally, banks expanded their credit or their paper receipts far beyond their actual reserves. When people started realizing this, they began to withdraw their gold from the bank before it was too late. If the panic grew, there was a “run on the bank,” causing the bank to fail. This wiped out the savings of those who falsely thought their money was safe in the bank because suddenly their paper notes where not worth anything as they were issued by an institution that didn’t exist anymore.
But instead of abolishing the system of fractional reserve banking, the government sanctioned it and setup a central banking system that linked all banks and regulated their activities. Central banks made sure banks kept a certain amount of gold in reserve and offered individual banks infusions of gold if problems arose. The problems with this solution may be obvious. The government could not prevent a full-scale bank failure (one that targeted all banks) it could only prevent isolated bank failures. Because the system was fully based on a fractional reserve, there would never be enough gold to cover the receipts, no matter how centralized the system was.
This led to the temporary, and eventually complete, suspension of redemption for gold of the paper notes. But this is not the end of the story; today we have moved into a whole new phase of currency evolution. Not only is our paper money not redeemable in gold in any way, our paper money itself has replaced gold as the reserve unit. That is, banks no longer hold gold in reserve, they hold paper money. They don’t even have to hold enough paper money to cover all their checking and savings accounts.
This new form of fractional reserve banking goes way beyond the old kind. But it is also somewhat strange, because it is, in a sense, also a 100% reserve system inasmuch as accounts are insured by the FDIC. The whole way that this came about is pretty complicated, as I said, but suffice it to say that the natural laws that govern money circulation and usage have come to bear on our current fiat paper monetary system. In order to prevent bank runs, the government has insured deposits, essentially removing the worries that one will lose his deposits’ nominal value. However, the government has not eliminated the workings of the fractional reserve system, such that banks can still lend more money than they have and collect interest on more money than existed in the first place.
In effect, this has created a monetary mess that can honestly only end in disaster for our currency. Returning to sound money, which is not subject to these weaknesses and caprices, would prevent a monetary disaster, but the transition would not be simple or easy. In the next part on money, I will give some of my ideas about how we can return to sound money.
What other weaknesses does our current system have? What are the benefits of our current system?