Governments, in contrast to all other organizations, do not obtain their revenue as payment for their services. Consequently, governments face an economic problem different from that of everyone else. Private individuals who want to acquire more goods and services from others must produce and sell more of what others want. Governments need only find some method of expropriating more goods without the owner’s consent.

In a barter economy, government officials can only expropriate resources in one way: by seizing goods in kind. In a monetary economy they will find it easier to seize monetary assets, and then use the money to acquire goods and services for government, or else pay the money as subsidies to favored groups. Such seizure is called taxation.1

Taxation, however, is often unpopular, and, in less temperate days, frequently precipitated revolutions. The emergence of money, while a boon to the human race, also opened a more subtle route for governmental expropriation of resources. On the free market, money can be acquired by producing and selling goods and services that people want, or by mining (a business no more profitable, in the long run, than any other). But if government can find ways to engage in counterfeiting—the creation of new money out of thin air—it can quickly produce its own money without taking the trouble to sell services or mine gold. It can then appropriate resources slyly and almost unnoticed, without rousing the hostility touched off by taxation. In fact, counterfeiting can create in its very victims the blissful illusion of unparalleled prosperity.

Counterfeiting is evidently but another name for inflation—both creating new “money” that is not standard gold or silver, and both function similarly. And now we see why governments are inherently inflationary: because inflation is a powerful and subtle means for government acquisition of the public’s resources, a painless and all the more dangerous form of taxation.

• 1Direct seizure of goods is therefore not now as extensive as monetary expropriation. Instances of the former still occurring are “due process” seizure of land under eminent domain, quartering of troops in an occupied country, and especially compulsory confiscation of labor service (e.g., military conscription, compulsory jury duty, and forcing business to keep tax records and collect withholding taxes).

To gauge the economic effects of inflation, let us see what happens when a group of counterfeiters set about their work. Suppose the economy has a supply of 10,000 gold ounces, and counterfeiters, so cunning that they cannot be detected, pump in 2000 “ounces” more. What will be the consequences? First, there will be a clear gain to the counterfeiters. They take the newly-created money and use it to buy goods and services. In the words of the famous New Yorker cartoon, showing a group of counterfeiters in sober contemplation of their handiwork: “Retail spending is about to get a needed shot in the arm.” Precisely. Local spending, indeed, does get a shot in the arm. The new money works its way, step by step, throughout the economic system. As the new money spreads, it bids prices up—as we have seen, new money can only dilute the effectiveness of each dollar. But this dilution takes time and is therefore uneven; in the meantime, some people gain and other people lose. In short, the counterfeiters and their local retailers have found their incomes increased before any rise in the prices of the things they buy. But, on the other hand, people in remote areas of the economy, who have not yet received the new money, find their buying prices rising before their incomes. Retailers at the other end of the country, for example, will suffer losses. The first receivers of the new money gain most, and at the expense of the latest receivers.

Inflation, then, confers no general social benefit; instead, it redistributes the wealth in favor of the first-comers and at the expense of the laggards in the race. And inflation is, in effect, a race—to see who can get the new money earliest. The latecomers—the ones stuck with the loss—are often called the “fixed income groups.” Ministers, teachers, people on salaries, lag notoriously behind other groups in acquiring the new money. Particular sufferers will be those depending on fixed money contracts—contracts made in the days before the inflationary rise in prices. Life insurance beneficiaries and annuitants, retired persons living off pensions, landlords with long term leases, bondholders and other creditors, those holding cash, all will bear the brunt of the inflation. They will be the ones who are “taxed.”2

Inflation has other disastrous effects. It distorts that keystone of our economy: business calculation. Since prices do not all change uniformly and at the same speed, it becomes very difficult for business to separate the lasting from the transitional, and gauge truly the demands of consumers or the cost of their operations. For example, accounting practice enters the “cost” of an asset at the amount the business has paid for it. But if inflation intervenes, the cost of replacing the asset when it wears out will be far greater than that recorded on the books. As a result, business accounting will seriously overstate their profits during inflation—and may even consume capital while presumably increasing their investments.3 Similarly, stock holders and real estate holders will acquire capital gains during an inflation that are not really “gains” at all. But they may spend part of these gains without realizing that they are thereby consuming their original capital.

By creating illusory profits and distorting economic calculation, inflation will suspend the free market’s penalizing of inefficient, and rewarding of efficient, firms. Almost all firms will seemingly prosper. The general atmosphere of a “sellers’ market” will lead to a decline in the quality of goods and of service to consumers, since consumers often resist price increases less when they occur in the form of downgrading of quality.4 The quality of work will decline in an inflation for a more subtle reason: people become enamored of “get-rich-quick” schemes, seemingly within their grasp in an era of ever-rising prices, and often scorn sober effort. Inflation also penalizes thrift and encourages debt, for any sum of money loaned will be repaid in dollars of lower purchasing power than when originally received. The incentive, then, is to borrow and repay later rather than save and lend. Inflation, therefore, lowers the general standard of living in the very course of creating a tinsel atmosphere of “prosperity.”

Fortunately, inflation cannot go on forever. For eventually people wake up to this form of taxation; they wake up to the continual shrinkage in the purchasing power of their dollar.

At first, when prices rise, people say: “Well, this is abnormal, the product of some emergency. I will postpone my purchases and wait until prices go back down.” This is the common attitude during the first phase of an inflation. This notion moderates the price rise itself, and conceals the inflation further, since the demand for money is thereby increased. But, as inflation proceeds, people begin to realize that prices are going up perpetually as a result of perpetual inflation. Now people will say: “I will buy now, though prices are `high,’ because if I wait, prices will go up still further.” As a result, the demand for money now falls and prices go up more, proportionately, than the increase in the money supply. At this point, the government is often called upon to “relieve the money shortage” caused by the accelerated price rise, and it inflates even faster. Soon, the country reaches the stage of the “crack-up boom,” when people say: “I must buy anything now—anything to get rid of money which depreciates on my hands.” The supply of money skyrockets, the demand plummets, and prices rise astronomically. Production falls sharply, as people spend more and more of their time finding ways to get rid of their money. The monetary system has, in effect, broken down completely, and the economy reverts to other moneys, if they are attainable—other metal, foreign currencies if this is a one-country inflation, or even a return to barter conditions. The monetary system has broken down under the impact of inflation.

This condition of hyper-inflation is familiar historically in the assignats of the French Revolution, the Continentals of the American Revolution, and especially the German crisis of 1923, and the Chinese and other currencies after World War II.5

A final indictment of inflation is that whenever the newly issued money is first used as loans to business, inflation causes the dread “business cycle.” This silent but deadly process, undetected for generations, works as follows: new money is issued by the banking system, under the aegis of government, and loaned to business. To businessmen, the new funds seem to be genuine investments, but these funds do not, like free market investments, arise from voluntary savings. The new money is invested by businessmen in various projects, and paid out to workers and other factors as higher wages and prices. As the new money filters down to the whole economy, and the people tend to reestablish their old voluntary consumption/saving proportions. In short, if people wish to save and invest about 20% of their incomes and consume the rest, new bank money loaned to business at first makes the saving proportion look higher. When the new money seeps down to the public, it reestablishes its old 20-80 proportion, and many investments are now revealed to be wasteful. Liquidation of the wasteful investments of the inflationary boom constitutes the depression phase of the business cycle.6

• 2It has become fashionable to scoff at the concern displayed by “conservatives” for the “widows and orphans” hurt by inflation. And yet this is precisely one of the chief problems that must be faced. Is it really “progressive” to rob widows and orphans and to use the proceeds to subsidize farmers and armament workers?
• 3This error will be greatest in those firms with the oldest equipment, and in the most heavily capitalized industries. An undue number of firms, therefore, will pour into these industries during an inflation. for further discussion of this accounting-cost error, see W.T. Baxter, “The Accountant’s Contribution to the Trade Cycle,” Economica (May, 1955), pp. 99-112.
• 4In these days of rapt attention to “cost-of-living indexes” (e.g., escalator-wage contracts) there is strong incentive to increase prices in such a way that the change will not be revealed in the index.
• 5 On the German example, see Costantino Bresciani-Turroni, The Economics of Inflation (London: George Allen and Unwin, Ltd., 1937).
• 6For a further discussion, see Murray N. Rothbard, America’s Great Depression (Princeton: D. Van Nostrand Co., 1963), Part I.

For government to use counterfeiting to add to its revenue, many lengthy steps must be travelled down the road away from the free market. Government could not simply invade a functioning free market and print its own paper tickets. Done so abruptly, few people would accept the government’s money. Even in modern times, many people in “backward countries” have simply refused to accept paper money, and insist on trading only in gold. Governmental incursion, therefore, must be far more subtle and gradual.

Until a few centuries ago, there were no banks, and therefore the government could not use the banking engine for massive inflation as it can today. What could it do when only gold and silver circulated?

The first step, taken firmly by every sizeable government, was to seize an absolute monopoly of the minting business. That was the indispensable means of getting control of the coinage supply. The king’s or the lord’s picture was stamped upon coins, and the myth was propagated that coinage is an essential prerogative of royal or baronial “sovereignty.” The mintage monopoly allowed government to supply whatever denominations of coin it, and not the public, wanted. As a result, the variety of coins on the market was forcibly reduced. Furthermore, the mint could now charge a high price, greater than costs (”seigniorage”), a price just covering costs (”brassage”), or supply coins free of charge. Seigniorage was a monopoly price, and it imposed a special burden on the conversion of bullion to coin; gratuitous coinage, on the other hand, overstimulated the manufacture of coins from bullion, and forced the general taxpayer to pay for minting services utilized by others.

Having acquired the mintage monopoly, governments fostered the use of the name of the monetary unit, doing their best to separate the name from its true base in the underlying weight of the coin. This, too, was a highly important step, for it liberated each government from the necessity of abiding by the common money of the world market. Instead of using grains or grams of gold or silver, each State fostered its own national name in the supposed interests of monetary patriotism: dollars, marks, francs, and the like. The shift made possible the pre-eminent means of governmental counterfeiting of coin: debasement.

Debasement was the State’s method of counterfeiting the very coins it had banned private firms from making in the name of vigorous protection of the monetary standard. Sometimes, the government committed simple fraud, secretly diluting gold with a base alloy, making shortweight coins. More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of “pounds” or “marks,” but of a lighter weight. The leftover ounces of gold or silver were pocketed by the King and used to pay his expenses. In that way, government continually juggled and redefined the very standard it was pledged to protect. The profits of debasement were haughtily claimed as “seniorage” by the rulers.

Rapid and severe debasement was a hallmark of the Middle Ages, in almost every country in Europe. Thus, in 1200 A.D., the French livre tournois was defined at ninety-eight grams of fine silver; by 1600 A.D. it signified only eleven grams. A striking case is the dinar, a coin of the Saracens in Spain. The dinar originally consisted of sixty-five gold grains, when first coined at the end of the seventh century. The Saracens were notably sound in monetary matters, and by the middle of the twelfth century, the dinar was still sixty grains. At that point, the Christian kings conquered Spain, and by the early thirteenth century, the dinar (now called maravedi) was reduced to fourteen grains. Soon the gold coin was too light to circulate, and it was converted into a silver coin weighing twenty-six grains of silver. This, too, was debased, and by the mid-fifteenth century, the maravedi was only 1.5 silver grains, and again too small to circulate.7

• 7On debasement, see Elgin Groseclose, Money and Man (New York: Frederick Ungar, 1961), pp. 57-76.

A. Bimetallism

Government imposes price controls largely in order to divert public attention from governmental inflation to the alleged evils of the free market. As we have seen, “Gresham’s Law”—that an artificially overvalued money tends to drive an artificially undervalued money out of circulation—is an example of the general consequences of price control. Government places, in effect, a maximum price on one type of money in terms of the other. Maximum price causes a shortage—disappearance into hoards or exports—of the currency suffering the maximum price (artificially undervalued), and leads it to be replaced in circulation by the overpriced money.

We have seen how this works in the case of new vs. worn coins, one of the earliest examples of Gresham’s Law. Changing the meaning of money from weight to mere tale, and standardizing denominations for their own rather than for the public’s convenience, the governments called new and worn coins by the same name, even though they were of different weight. As a result, people hoarded or exported the full weight new coins, and passed the worn coins in circulation, with governments hurling maledictions at “speculators,” foreigners, or the free market in general, for a condition brought about by the government itself.

A particularly important case of Gresham’s Law was the perennial problem of the “standard.” We saw that the free market established “parallel standards” of gold and silver, each freely fluctuating in relation to the other in accordance with market supplies and demands. But governments decided they would help out the market by stepping in to “simplify” matters. How much clearer things would be, they felt, if gold and silver were fixed at a definite ratio, say, twenty ounces of silver to one ounce of gold! Then, both moneys could always circulate at a fixed ratio—and, far more importantly, the government could finally rid itself of the burden of treating money by weight instead of by tale. Let us imagine a unit, the “rur,” defined by Ruritanians as 1/20 of an ounce of gold. We have seen how vital it is for the government to induce the public to regard the “rur” as an abstract unit of its own right, only loosely connected to gold. What better way of doing this than to fix the gold/silver ratio? Then, “rur” becomes not only 1/20 ounce of gold, but also one ounce of silver. The precise meaning of the word “rur”—a name for gold weight—is now lost, and people begin to think of the “rur” as something tangible in its own right, somehow set by the government, for good and efficient purposes, as equal to certain weights of both gold and silver.

Now we see the importance of abstaining from patriotic or national names for gold ounces or grains. Once such a label replaces the recognized world units of weight, it becomes much easier for governments to manipulate the money unit and give it an apparent life of its own. The fixed gold-silver ration, known as bimetallism, accomplished this task very neatly. It did not, however, fulfill its other job of simplifying the nation’s currency. For, once again, Gresham’s Law came into prominence. The government usually set the bimetallic ration originally (say, 20/1) at the going rate on the free market. But the market ratio, like all market prices, inevitably changes over time, as supply and demand conditions change. As changes occur, the fixed bimetallic ratio inevitably becomes obsolete. Change makes either gold or silver overvalued. Gold then disappears into cash balance, black market, or exports, when silver flows in from abroad and comes out of cash balances to become the only circulating currency in Ruritania. For centuries, all countries struggled with calamitous effects of suddenly alternating metallic currencies. First silver would flow in and gold disappear; then, as the relative market ratios changed, gold would pour in and silver disappear.8

Finally, after weary centuries of bimetallic disruption, governments picked one metal as the standard, generally gold. Silver was relegated to “token coin” status, for small denominations, but not at full weight. (The minting of token coins was also monopolized by government, and, since not backed 100% by gold, was a means of expanding the money supply.) The eradication of silver as money certainly injured many people who preferred to use silver for various transactions. There was truth in the war-cry of the bimetallists that a “crime against silver” had been committed; but the crime was really the original imposition of bimetallism in lieu of parallel standards. Bimetallism created an impossibly difficult situation, which the government could either meet by going back to full monetary freedom (parallel standards) or by picking one of the two metals as money (gold or silver standard). Full monetary freedom, after all this time, was considered absurd and quixotic; and so the gold standard was generally adopted.

B. Legal Tender

How was the government able to enforce its price controls on monetary exchange rates? By a device known as legal tender laws. Money is used for payment of past debts, as well as for present “cash” transactions. With the name of the country’s currency now prominent in accounting instead its actual weight, contracts began to pledge payment in certain amounts of “money.” Legal tender laws dictated what that “money” could be. When only the original gold or silver was designated “legal tender,” people considered it harmless, but they should have realized that a dangerous precedent had been set for government control of money. If the government sticks to the original money, its legal tender law is superfluous and unnecessary.9 On the other hand, the government may declare as legal tender a lower-quality currency side-by-side with the original. Thus, the government may decree worn coins as good as new ones in paying off debt, of silver and gold equivalent to each other in the fixed ratio.The legal tender laws then bring Gresham’s Law into being.

When legal tender laws enshrine an overvalued money, they have another effect; they favor debtors at the expense of creditors. For then debtors are permitted to pay back their debts in a much poorer money than they had borrowed, and creditors are swindled out of the money rightfully theirs. This confiscation of creditors property, however, only benefits outstanding debtors; future debtors will be burdened by the scarcity of credit generated by the memory of government spoilation of creditors.

• 8Many debasements, in fact, occurred covertly, with governments claiming that they were merely bringing the official gold-silver ratio into closer alignment with the market.
• 9“The ordinary law of contract does all that is necessary without any law giving special functions to particular forms of currency. We have adopted a gold sovereign as our unit.... If I promise to pay 100 sovereigns, it needs no special currency law of legal tender to say that I am bound to pay 100 sovereigns, and that, if required to pay the 100 sovereigns, I cannot discharge my obligation by paying anything else.” Lord Farrer, Studies in Currency 1898 (London: Macmillan and Co, 1898), p. 43. On the legal tender laws, see also Mises, Human Action, (New Haven: Yale University Press, 1949), pp. 32n. 444.

The compulsory minting monopoly and legal tender legislation were the capstones in governments’ drive to gain control of their nations’ money. Bolstering these measures, each government moved to abolish the circulation of all coins minted by rival governments.10 Within each country, only the coin of its own sovereign could now be used; between countries, unstamped gold and silver bullion was used in exchange. This further severed the ties between the various parts of the world market, further sundering one country from another, and disrupting the international division of labor. Yet, purely hard money did not leave too much scope for governmental inflation. There were limits to the debasing that governments could engineer, and the fact that all countries used gold and silver placed definite checks on the control of each government over its own territory. The rulers were still held in check by the discipline of an international metallic money.

Governmental control of money could only become absolute, and its counterfeiting unchallenged, as money-substitutes came into prominence in recent centuries. The advent of paper money and bank deposits, an economic boon when backed fully by gold or silver, provided the open sesame for government’s road to power over money, and thereby over the entire economic system.

• 10The use of foreign coins was prevalent in the Middle Ages and in the United States down to the middle of the 19th century.

The modern economy, with its widespread use of banks and money-substitutes, provides the golden opportunity for government to fasten its control over the money supply and permit inflation at its discretion. We have seen in section 12, page 20, that there are three great checks on the power of any bank to inflate under a “free banking” system: (1) the extent of the clientele of each bank; (2) the extent of the clientele of the whole banking system, i.e., the extent to which people use money-substitutes, and (3) the confidence of the clients in their banks. The narrower the clientele of each bank, of the banking system as a whole, or the shakier the state of confidence, the stricter will be the limits on inflation in the economy. Government’s privileging and controlling of the banking system has operated to suspend these limits.

All these limits, of course, rest on one fundamental obligation: the duty of the banks to redeem their sworn liabilities on demand. We have seen that no fractional-reserve bank can redeem all of its liabilities; and we have also seen that this is the gamble that every bank takes. But it is, of course, essential to any system of private property that contract obligations be fulfilled. The bluntest way for government to foster inflation, then, is to grant the banks the special privilege of refusing to pay their obligations, while yet continuing in their operation. While everyone else must pay their debts or go bankrupt, the banks are permitted to refuse redemption of their receipts, at the same time forcing their own debtors to pay when their loans fall due. The usual name for this is a “suspension of specie payments.” A more accurate name would be “license for theft;” for what else can we call a governmental permission to continue in business without fulfilling one’s contract?

In the United States, mass suspension of specie payment in times of bank troubles became almost a tradition. It started in the War of 1812. Most of the country’s banks were located in New England, a section unsympathetic to America’s entry into the war. These banks refused to lend for war purposes, and so the government borrowed from new banks in the other states. These banks issued new paper money to make the loans. The inflation was so great that calls for redemption flooded into the new banks, especially from the conservative nonexpanding banks of New England, where the government spent most of its money on war goods. As a result, there was a mass “suspension” in 1814, lasting for over two years (well beyond the end of the war); during that time, banks sprouted up, issuing notes with no need to redeem in gold or silver.

This suspension set a precedent for succeeding economic crises; 1819, 1837, 1857, and so forth. As a result of this tradition, the banks realized that they need have no fear of bankruptcy after an inflation, and this, of course, stimulated inflation and “wildcat banking.” Those writers who point to nineteenth century America as a horrid example of “free banking,” fail to realize the importance of this clear dereliction of duty by the states in every financial crisis.

The governments and the banks, persuaded the public of the justice of their acts. In fact, anyone trying to get his money back during a crisis was considered “unpatriotic” and a despoiler of his fellowmen, while banks were often commended for patriotically bailing out the community in a time of trouble. Many people, however, were bitter at the entire proceeding and from this sentiment grew the famous “hard money” Jacksonian movement that flourished before the Civil War.11

Despite its use in the United States, such periodic privilege to banks did not catch hold as a general policy in the modern world. It was a crude instrument, too sporadic (it could not be permanent since few people would patronize banks that never paid their obligations)—and, what’s more, it provided no means of government control over the banking system. What governments want, after all, is not simply inflation, but inflation completely controlled and directed by themselves. There must be no danger of the banks running the show. And so, a far subtler, smoother, more permanent method was devised, and sold to the public as a hallmark of civilization itself—Central Banking.

• 11See Horace White, Money and Banking (4th Ed., Boston: Ginn and Co., 1911), pp. 322-327.

Central Banking is now put in the same class with modern plumbing and good roads: any economy that doesn’t have it is called “backward,” “primitive,” hopelessly out of the swim. America’s adoption of the Federal Reserve System—our central bank—in 1913 was greeted as finally putting us in the ranks of the advanced “nations.”

Central banks are often nominally owned by private individuals or, as in the United States, jointly by private banks; but they are always directed by government-appointed officials, and serve as arms of the government. Where they are privately owned, as in the original Bank of England or the Second Bank of the United States, their prospective profits add to the usual governmental desire for inflation. 

A Central Bank attains its commanding position from its governmentally granted monopoly of the note issue. This is often the unsung key to its power. Invariably, private banks are prohibited from issuing notes, and the privilege is reserved to the Central Bank. The private banks can only grant deposits. If their customers ever wish to shift from deposits to notes, therefore, the banks must go to the Central Bank to get them. Hence the Central Bank’s lofty perch as a “bankers’ bank.” It is a bankers’ bank because the bankers are forced to do business with it. As a result, bank deposits became not only in gold, but also in Central Bank notes. And these new notes were not just plain bank notes. They were liabilities of the Central Bank, an institution invested with all the majestic aura of the government itself. Government, after all, appoints the Bank officials and coordinates its policy with other state policy. It receives the notes in taxes, and declares them to be legal tender.

As a result of these measures, all the banks in the country became clients of the Central Bank.12 Gold poured into the Central Bank from the private banks, and, in exchange, the public got Central Bank notes and the disuse of gold coins. Gold coins were scoffed at by “official” opinion as cumbersome, old-fashioned, inefficient—an ancient “fetish,” perhaps useful in children’s socks at Christmas, but that’s about all. How much safer, more convenient, more efficient is the gold when resting as bullion in the mighty vaults of the Central Bank! Bathed by this propaganda, and influenced by the convenience and governmental backing of the notes, the public more and more stopped using gold coins in its daily life. Inexorably, the gold flowed into the Central Bank where, more “centralized,” it permitted a far greater degree of inflation of money-substitutes.

In the United States, the Federal Reserve Act compels the banks to keep the minimum ratio of reserves to deposits and, since 1917, these reserves could only consist of deposits at the Federal Reserve Bank. Gold could no longer be part of a bank’s legal reserves; it had to be deposited in the Federal Reserve Bank.

The entire process took the public off the gold habit and placed the placed the people’s gold in the none-too-tender care of the State—where it could be confiscated almost painlessly. International traders still used gold bullion in their large-scale transactions, but they were an insignificant proportion of the voting population.

One of the reasons the public could be lured from gold to bank notes was the great confidence everyone had in the Central Bank. Surely, the Central Bank, possessed of almost all the gold in the realm, backed by the might and prestige of government, could not fail and go bankrupt! And it is certainly true that no Central Bank in recorded history has ever failed. But why not? Because of the sometimes unwritten but very clear rule that it could not be permitted to fail! If governments sometimes allowed private banks to suspend payment, how much more readily would it permit the Central Bank—its own organ—to suspend when in trouble! The precedent was set in Central Banking history when England permitted the Bank of England to suspend in the late eighteenth century, and allowed this suspension for over twenty years.

The Central Bank thus became armed with the almost unlimited confidence of the public. By this time, the public could not see that the Central Bank was being allowed to counterfeit at will, and yet remain immune from any liability if its bona fides should be questioned. It came to see the Central Bank as simply a great national bank, performing a public service, and protected from failure by being a virtual arm of the government.

The Central Bank proceeded to invest the private banks with the public’s confidence. This was a more difficult task. The Central Bank let it be known that it would always act as a “lender of last resort” to the banks— i.e., that the Bank would stand ready to lend money to any bank in trouble, especially when many banks are called upon to pay their obligations.

Governments also continued to prop up banks by discouraging bank “runs” (i.e., cases where many clients suspect chicanery and ask to get back their property). Sometimes, they will permitted banks to suspend payment, as in the compulsory bank “holidays” of 1933. Laws were passed prohibiting public encouragement of bank runs, and, as in the 1929 depression in America, government campaigned against “selfish” and “unpatriotic” gold “hoarders.” America finally “solved” its pesky problem of bank failures when it adopted Federal Deposit Insurance in 1933. The Federal Deposit Insurance Corporation has only a negligible proportion of “backing” for the bank deposits it “insures.” But the public has been given the impression (and one that may well be accurate) that the federal government would stand ready to print enough new money to redeem all of the insured deposits. As a result, the government has managed to transfer its own command of vast public confidence to the entire banking system, as well as to the Central Bank.

We have seen that, by setting up a Central Bank, governments have greatly widened, if not removed, two of the three main checks on bank credit inflation. What of the third check?the problem of the narrowness of each bank’s clientele? Removal of this check is one of the main reasons for the Central Bank’s existence. In a free-banking system , inflation by any one bank would soon lead to demands for redemption by the other banks, since the clientele of any one bank is severely limited. But the central Bank, by pumping reserves into all the banks, can make sure that they can all expand together, and at a uniform rate. If all banks are expanding, then there is no redemption problem of one bank upon another, and each bank finds bank expansion of one bank upon another, and each bank finds that its clientele is really the whole country. In short, the limits on bank expansion are immeasurably widened, from the clientele of each bank to that of the whole banking system. Of course, this means that no bank can expand further than the Central Bank desires. Thus, the government has finally achieved the power to control and direct the inflation of the banking system.

In addition to removing the checks on inflation, the act of establishing a Central Bank has a direct inflationary impact. Before the Central Bank began, banks kept their reserves in gold; now gold flows into the Central Bank in exchange for deposits with the Bank, which are now reserves for the commercial banks. But the Bank itself keeps only a fractional reserve of gold to its own liabilities! Therefore, the act of establishing a Central Bank greatly multiplies the inflationary potential of the country.13

• 12In the United States, the banks were forced by law to join the Federal Reserve System, and to keep their accounts with the Federal Reserve Banks. (Those “state banks” that are not members of the Federal Reserve System keep their reserves with member banks.)
• 13The establishment of the Federal reserve in this way increased three-fold the expansive power of the banking system of the United States. The Federal reserve System also reduced the average legal reserve requirements of all banks from approximately 21% in 1913 to 10% by 1917, thus further doubling the inflationary potential—a combined potential inflation of six-fold. See Chester A. Phillips, T.F. McManus, and R.W. Nelson, Banking and the Business Cycle (New York: The MacMillan Co., 1937) pp. 23 ff.

Precisely how does the Central Bank go about its task of regulating the private banks? By controlling the banks’ “reserves”—their deposit accounts at the Central Bank. Banks tend to keep a certain ratio of reserves to their total deposit liabilities, and in the United States government control is made easier by imposing a legal minimum ratio on the bank. The Central Bank can stimulate inflation, then, by pouring reserves into the banking system, and also by lowering the reserve ratio, thus permitting a nationwide bank credit-expansion. If the banks keep a reserve/deposit ratio of 1:10, then “excess reserves” (above the required ratio) of ten million dollars will permit and encourage a nationwide bank inflation of 100 million. Since banks profit by credit expansion, and since government has made it almost impossible for them to fail, they will usually try to keep “loaned up” to their allowable maximum.

The Central Bank adds to the quantity of bank reserves by buying assets on the market. What happens, for example, if the Bank buys an asset (any asset) from Mr. Jones, valued at $1,000? The Central Bank writes out a check to Mr. Jones for $1,000 to pay for the asset. The Central Bank does not keep individual accounts, so Mr. Jones takes the check and deposits it in his bank. Jones’ bank credits him with a $1,000 deposit, and presents the check to the Central Bank, which has to credit the bank with an added $1,000 in reserves. This $1,000 in reserves permits a multiple bank credit expansion, particularly if added reserves are in this way poured into many banks across the country.

If the Central Bank buys an asset from a bank directly, then the result is even clearer; the bank adds to its reserves, and a base for multiple credit expansion is established.

Undoubtedly, the favorite asset for Central Bank purchase has been government securities. In that way, the government assures a market for its own securities. Government can easily inflate the money supply by issuing new bonds, and then orders its Central Bank to purchase them. Often the Central Bank undertakes to support the market price of government securities at a certain level, thereby causing a flow of securities into the Bank, and a consequent perpetual inflation.

Besides buying assets, the Central Bank can create new bank reserves in another way: by lending them. The rate which the Central Bank charges the banks for this service is the “rediscount rate.” Clearly, borrowed reserves are not as satisfactory to the banks as reserves that are wholly theirs, since there is now pressure for repayment. Changes in the rediscount rate receive a great deal of publicity, but they are clearly of minor importance compared to the movements in the quantity of bank reserves and the reserve ratio.

When the Central Bank sells assets to the banks or the public, it lowers bank reserves, and causes pressure for credit contraction and deflation—lowering—of the money supply. We have seen, however, that governments are inherently inflationary; historically, deflationary action by the government has been negligible and fleeting. One thing is often forgotten: deflation can only take place after a previous inflation; only pseudo-receipts, not gold coins, can be retired and liquidated.

The establishment of Central Banking removes the checks of bank credit expansion, and puts the inflationary engine into operation. It does not remove all restraints, however. There is still the problem of the Central Bank itself. The citizens can conceivably make a run on the Central Bank, but this is most improbable. A more formidable threat is the loss of gold to foreign nations. For just as the expansion of one bank loses gold to the clients of other, non-expanding banks, so does monetary expansion in one country cause a loss of gold to the citizens of other countries. Countries that expand faster are in danger of gold losses and calls upon their banking system for gold redemption. This was the classic cyclical pattern of the nineteenth century; a country’s Central Bank would generate bank credit expansion; prices would rise; and as the new money spread from domestic to foreign clientele, foreigners would more and more try to redeem the currency in gold. Finally, the Central Bank would have to call a halt and enforce a credit contraction in order to save the monetary standard.

There is one way that foreign redemption can be avoided: inter-Central Bank cooperation. If all Central Banks agree to inflate at about the same rate, then no country would lose gold to any other, and all the world together could inflate almost without limit. With every government jealous of its own power and responsive to different pressures, however, such goose-step cooperation has so far proved almost impossible. One of the closest approaches was the American Federal Reserve agreement to promote domestic inflation in the 1920s in order to help Great Britain and prevent it from losing gold to the United States.

In the twentieth century, governments, rather than deflate or limit their own inflation, have simply “gone off the gold standard” when confronted with heavy demands for gold. This, of course, insures that the Central Bank cannot fail, since its notes now become the standard money. In short, government has finally refused to pay its debts, and has virtually absolved the banking system from that onerous duty. Pseudo-receipts to gold were first issued without banking and then, when the day of reckoning drew near, the bankruptcy was shamelessly completed by simply eliminating gold redemption. The severance of the various national currency names (dollar, pound, mark) from gold and silver is now complete.

At first, governments refused to admit that this was a permanent measure. They referred to the “suspension of specie payments,” and it was always understood that eventually, after the war or other “emergency” had ended, the government would again redeem its obligations. When the Bank of England went off gold at the end of the eighteenth century, it continued in this state for twenty years, but always with the understanding that gold payment would be resumed after the French wars were ended.

Temporary “suspensions,” however, are primrose paths to outright repudiation. The gold standard, after all, is no spigot that can be turned on or off as government whim decrees. Either a gold-receipt is redeemable or it is not; once redemption is suspended the gold standard is itself a mockery.

Another step in the slow extinction of gold money was the establishment of the “gold bullion standard.” Under this system, the currency is no longer redeemable in coins; it can only be redeemed in large, highly valuable, gold bars. This, in effect, limits gold redemption to a handful of specialists in foreign trade. There is no longer a true gold standard, but governments can still proclaim their adherence to gold. The European “gold standards” of the 1920s were pseudo-standards of this type.14

Finally, governments went “off gold” officially and completely, in a thunder of abuse against foreigners and “unpatriotic gold hoarders.” Government paper now becomes the fiat standard money. Sometimes, Treasury rather than Central Bank paper has been the fiat money, especially before the development of a central banking system. The American Continentals, the Greenbacks, and Confederate notes of the Civil War period, the French assignats, were all fiat currencies issued by the Treasuries. But whether Treasury or Central Bank, the effect of fiat issue is the same: the monetary standard is now at the mercy of the government, and bank deposits are redeemable simply in government paper.

• 14See Melchior Palyi, “The Meaning of the Gold Standard,” The Journal of Business (July 1941) pp. 299-304.

When a country goes off the gold standard and onto the fiat standard, it adds to the number of “moneys” in existence. In addition to the commodity moneys, gold and silver, there now flourish independent moneys directed by each government imposing its fiat rule. And just as gold and silver will have an exchange rate on the free market, so the market will establish exchange rates for all the various moneys. In a world of fiat moneys, each currency, if permitted, will fluctuate freely in relation to all the others. We have seen that for any two moneys, the exchange rate is set in accordance with the proportionate purchasing-power parities, and that these in turn are determined by the respective supplies and demands for the various currencies. When a currency changes its character from gold-receipt to fiat paper, confidence in its stability and quality is shaken, and demand for it declines. Furthermore, now that it is cut off from gold, its far greater quantity relative its former gold backing now becomes evident. With a supply greater than gold and a lower demand, its purchasing-power, and hence its exchange rate, quickly depreciate in relation to gold. And since government is inherently inflationary, it will keep depreciating as time goes on.

Such depreciation is highly embarrassing to the government—and hurts citizens who try to import goods. The existence of gold in the economy is a constant reminder of the poor quality of the government paper, and it always poses a threat to replace the paper as the country’s money. Even with the government giving all the backing of its prestige and its legal tender laws to its fiat paper, gold coins in the hands of the public will always be a permanent reproach and menace to the government’s power over the country’s money.

In America’s first depression, 1819-1821, four Western states (Tennessee, Kentucky, Illinois, and Missouri) established state-owned banks, issuing fiat paper. They were backed by legal tender provisions in the states, and sometimes by legal prohibition against depreciating the notes. And yet, all these experiments, born in high hopes, came quickly to grief as the new paper depreciated rapidly to negligible value. The projects had to be swiftly abandoned. Later, the greenbacks circulated as fiat paper in the North during and after the Civil War. Yet, in California, the people refused to accept the greenbacks and continued to use gold as their money. As a prominent economist pointed out:

“In California, as in other states, the paper was legal tender and was receivable for public dues; nor was there any distrust or hostility toward the federal government. But there was a strong feeling ... in favor of gold and against paper ... Every debtor had the legal right to pay off his debts in depreciated paper. But if he did so, he was a marked man (the creditor was likely to post him publicly in the newspapers) and he was virtually boycotted. Throughout this period paper was not used in California. The people of the state conducted their transactions in gold, while all the rest of the United States used convertible paper.”15

It became clear to governments that they could not afford to allow people to own and keep their gold. Government could never cement its power over a nation’s currency, if the people, when in need, could repudiate the fiat paper and turn to gold for its money. Accordingly, governments have outlawed gold holding by their citizens. Gold, except for a negligible amount permitted for industrial and ornamental purposes, has generally been nationalized. To ask for return of the public’s confiscated property is now considered hopelessly backward and old-fashioned.16

• 15Frank W. Taussig, Principles of Economics, 2nd Ed. (New York: The MacMillan Company, 1916) I, 312. Also see J.K. Upton, Money in Politics, 2nd Ed. (Boston: Lothrop Publishing Company, 1895) pp. 69 ff.
• 16For an incisive analysis of the steps by which the American government confiscated the people’s gold and went off the gold standard in 1933, see Garet Garrett, The People’s Pottage (Caldwell, Idaho: The Caxton Printers, 1953) pp. 15-41.

With fiat money established and gold outlawed, the way is clear for full-scale, government-run inflation. Only one very broad check remains: the ultimate threat of hyper-inflation, the crack-up of the currency. Hyper-inflation occurs when the public realizes that the government is bent on inflation, and decides to evade the inflationary tax on its resources by spending money as fast as possible while it still retains some value. Until hyper-inflation sets in, however, government can now manage the currency and the inflation undisturbed. New difficulties arise, however. As always, government intervention to cure one problem raises a host of new, unexpected problems. In a world of fiat moneys, each country has its own money. The international division of labor, based on an international currency, has been broken, and countries tend to divide into their own autarchic units. Lack of monetary certainty disrupts trade further. The standard of living in each country thereby declines. Each country has freely-fluctuating exchange rates with all other currencies. A country inflating beyond the others no longer fears a loss of gold; but it faces other unpleasant consequences. The exchange rate of its currency falls in relation to foreign currencies. This is not only embarrassing but even disturbing to citizens who fear further depreciation. It also greatly raises the costs of imported goods, and this means a great deal to those countries with a high proportion of international trade.

In recent years, therefore, governments have moved to abolish freely-fluctuating exchange rates. Instead, they fixed arbitrary exchange rates with other currencies. Gresham’s Law tells us precisely the result of any such arbitrary price control. Whatever rate is set will not be the free market one, since that can be only be determined from day-to-day on the market. Therefore, one currency will always be artificially overvalued and the other, undervalued. Generally, governments have deliberately overvalued their currencies?for prestige reasons, and also because of the consequences that follow. When a currency is overvalued by decree, people rush to exchange it for the undervalued currency at the bargain rates; this causes a surplus of overvalued, and a shortage of the undervalued, currency. The rate, in short, is prevented from moving to clear the exchange market. In the present world, foreign currencies have generally been overvalued relative to the dollar. The result has been the famous phenomenon of the “dollar shortage”—another testimony to the operation of Gresham’s Law.

Foreign countries, clamoring about a “dollar shortage,” thus brought it about by their own policies. It is possible that these governments actually welcomed this state of affairs, for (a) it gave them an excuse to clamor for American dollar aid to “relieve the dollar shortage in the free world,” and (b) it gave them an excuse to ration imports from America. Undervaluing dollars causes imports from America to be artificially cheap and exports to America artificially expensive [Ed. Note: this sentence was truncated in the 4th edition]. The result: a trade deficit and worry over the dollar drain.17 The foreign government then stepped in to tell its people sadly that it is unfortunately necessary for it to ration imports: to issue license to importers, and determine what is imported “according to need.” To ration imports, many governments confiscate the foreign exchange holdings of their citizens, backing up an artificially high valuation on domestic currency by forcing these citizens to accept far less domestic money than they could have acquired on the free market. Thus, foreign exchange, as well as gold, has been nationalized, and exporters penalized. In countries where foreign trade is vitally important, this government “exchange control” imposes virtual socialization on the economy. An artificial exchange rate thus gives countries an excuse for demanding foreign aid and for imposing socialist controls over trade.18

At present, the world is enmeshed in a chaotic welter of exchange controls, currency blocs, restrictions on convertibility, and multiple systems of rates. In some countries a “black market” in foreign exchange is legally encouraged to find out the true rate, and multiple discriminatory rates are fixed for different types of transactions. Almost all nations are on a fiat standard, but they have not had the courage to admit this outright, and so they proclaim some such fiction as “restricted gold bullion standard.” Actually, gold is used not as a true definition for currencies, but as a convenience by governments: (a) for fixing a currency’s rate with respect to gold makes it easy to reckon any exchange in terms of any other currency; and (b) gold is still used by the different governments. Since exchange rates are fixed, some item must move to balance every country’s payments, and gold is the ideal candidate. In short gold is no longer the world’s money; it is now the governments’ money, used in payments to one another.

Clearly, the inflationists’ dream is some sort of world paper money, manipulated by a world government and Central Bank, inflating everywhere at a common rate. This dream still lies in the dim future, however; we are still far from world government, and a national currency problems have so far been too diverse and conflicting to permit meshing into a single unit. Yet, the world has moved steadily in this direction. The International Monetary Fund, for example, is basically an institution designed to bolster national exchange control in general, and foreign undervaluation of the dollar in particular. The Fund requires each member country to fix its exchange rate, and then to pool gold and dollars to lend to governments that find themselves short of hard currency.

• 17In the last few years, the dollar has been overvalued in relation to other currencies, and hence the dollar drains from the U.S.
• 18For an excellent discussion of foreign exchange and exchange controls, see George Winder, The Free Convertibility of Sterling (London: The Batchworth Press, 1955).

Many people believe that the free market, despite some admitted advantages, is a picture of disorder and chaos. Nothing is “planned,” everything is haphazard. Government dictation, on the other hand, seems simple and orderly; decrees are handed down and they are obeyed. In no area of the economy is this myth more prevalent than in the field of money. Seemingly, money, at least, must come under stringent government control. But money is the lifeblood of the economy; it is the medium for all transactions. If government dictates over money, it has already captured a vital command post for control over the economy, and has secured a stepping-stone for full socialism. We have seen that a free market in money, contrary to common assumption, would not be chaotic; that, in fact, it would be a model of order and efficiency.

What, then, have we learned about government and money? We have seen that, over the centuries, government has, step by step, invaded the free market and seized complete control over the monetary system. We have seen that each new control, sometimes seemingly innocuous, has begotten new and further controls. We have seen that for governments are inherently inflationary, since inflation is a tempting means of acquiring revenue for the State and its favored groups. The slow but certain seizure of the monetary reins has thus been used to (a) inflate the economy at a pace decided by government; and (b) bring about socialistic direction of the entire economy.

Furthermore, government meddling with money has not only brought untold tyranny into the world; it has also brought chaos and not order. It has fragmented the peaceful, productive world market and shattered it into a thousand pieces, with trade and investment hobbled and hampered by myriad restrictions, controls, artificial rates, currency breakdowns, etc. It has helped bring about wars by transforming a world of peaceful intercourse into a jungle of warring currency blocs. In short, we find that coercion, in money as in other matters, brings, not order, but conflict and chaos.