FROM TIME TO TIME, usually in some large city,
counterfeit money rears its ugly head. As quickly as possible, warnings
are issued to banks, businessmen, and residents. Everyone is cautioned
to examine all bills of a certain denomination, and to look for certain
flaws by which the counterfeit may be distinguished from lawful money.
With some trepidation, people look through their
wallets, purses, and cash drawers. Counterfeit money, while it might be
interesting to see, is the last thing they want to find in their
possession. Before long, however, the scare blows over. No further
warnings are issued, and it is assumed that the counterfeit bills have
been detected and withdrawn from circulation. People are able to relax
again.
Everyone fears counterfeit money. Not only does the law
prohibit spending or keeping it, but counterfeit money represents an
immediate loss to the person who finds it in his possession. What he
thought was money turns out to be worthless paper that must be
surrendered to the authorities without compensation. The loss is both
obvious and personal.
The potential loss inherent in counterfeit money seems
almost self-evident. Yet, those who might accept it and spend it
unknowingly, before it was detected, would certainly feel no sense of
loss. Apparently, the entire loss would fall upon the unfortunate
individual who happened to be last in line when it was detected and
confiscated.
But an interesting question arises: Where is the loss
realized if the counterfeit money is never detected? Does the potential
loss simply remain potential, never to be realized? If no one is fated
to be "last in line," who can lose through the introduction and
circulation of a "Perfect" counterfeit money?
Someone Must Lose
It might be argued that there can be no such thing as a
perfect, or undetectable counterfeit. Still, it is a safe bet that, at
any given time, a certain amount of counterfeit money is in circulation,
and remains undetected. Even if that were not the case, it is possible
to postulate a perfect counterfeit and to trace its economic
significance.
We know, almost by instinct, that someone must lose.
The counterfeiters, who successfully introduce their worthless
facsimiles into permanent circulation, have obviously realized a
fraudulent gain. But at whose expense? If the counterfeit is never
detected who loses? There can be only one answer: the counterfeiters
gain, and everyone else loses.
The character of the insidious loss inherent in a
perfect counterfeit money is confoundingly difficult to recognize. We
know that the counterfeiter's gain is achieved at a loss to everyone
else, but "everyone else" feels no sense of loss. On the contrary:
everyone else feels more prosperous. There is more "money" around.
Retailers notice increased sales; they, in turn, must increase their
purchases. Business activity picks up; people have more money to spend.
Far from feeling a sense of loss, the victims of the counterfeiter's
fraud enjoy a growing sense of prosperity. As long as the quantity of
counterfeit money introduced into circulation is held to an amount that
in itself will not create suspicion, the victims will believe they've
never had it so good.
The "prosperity" engendered by the introduction of a
perfect counterfeit money is clearly a false prosperity. The increased
tempo of sales and purchases has been stimulated by a fraudulent
increase in the supply of "money." The production and exchange of goods
and services have been given a shot in the arm, but money has been
weakened by counterfeit. The value which is unwittingly given to the
bogus "money" must inevitably be taken from the lawful money. In effect,
the counterfeit steals its purchasing power from the lawful.
The result is gradual, but inexorable: the purchasing
power of all money is reduced. Prices rise. The counterfeit has
undermined the value of the lawful; the potential loss inherent in a
perfect counterfeit money has at last been realized!
But it is not recognized. The victims, unaware of the
existence of counterfeit money in their economic bloodstream, are unable
to identify the true reason why rising prices are eroding a prosperity
which they regarded as real. Understandably, they seek explanations in
visible symptoms of their problem: they blame those who raise their
prices. The real villain, the counterfeiter, is immune to criticism; no
one suspects his existence. But through the economic damage he has
inflicted upon society, he has created a cause for popular frustration
and unrest that can be expressed only in misdirected social and
political antagonisms.
The Better the Counterfeit, the Greater the Danger
There can be no rational defense for counterfeit money,
even a "perfect" counterfeit. The false prosperity which would
inevitably follow the introduction of a perfect counterfeit into
circulation would just as inevitably be followed by a collapse of that
false prosperity under the weight of rising prices. The counterfeiter
would gain, and everyone else would lose.
The crime of the counterfeiter is not that he has
usurped a prerogative which the government has taken unto itself; it
lies in the grave damage he can inflict upon the economic, social, and
political structure of the country whose money he counterfeits. The more
successful he is, the more damage he does. A perfect counterfeit would
eventually destroy the value of all money, including the counterfeit. In
doing so, it would create a condition of social and political chaos. It
is with good reason that every person in the country should fear and
abhor even the idea of a perfect, undetectable counterfeit money.
Bank-Created Credit
By an incredible paradox, our official monetary policy
supports a practice, the effects of which are precisely those of a
perfect counterfeit money. That practice, defended by economists,
businessmen, bankers, and government, is the creation of credit through
the commercial banking system.
There can be no doubt that credit plays an important
role in diversified and specialized economies. Through credit, the
entire economic cycle-from demand to production, distribution, exchange,
and consumption-can be enhanced in function and effectiveness.
Legitimate credit has a legitimate place in the economic processes by
which we survive and prosper.
There is, however, a crucial difference, in both nature
and effect, between legitimate credit, and the credit created through
the commercial banking system. Legitimate credit involves the temporary
loan of existing money between one party and another. Bank credit
involves the creation of a substitute for money. This substitute,
usually in the form of a demand deposit, is officially defined as money.
As an addition to the money supply, it is indistinguishable from any
other form of money; it becomes, in its effects, a perfect counterfeit.
The creation of bank credit is made possible by the
concept of fractional-reserve banking. Quite lawfully, today's
commercial bank need not retain all the money placed on deposit by
customers; it is required to safeguard only a small percentage of that
money as a reserve. The balance is available for the use of the bank in
its profit-making operations, primarily loans and investments.
Reserve requirements, established by the Board of
Governors of the Federal Reserve System, will vary with the
classification of the bank, the type of deposit, and the changing
monetary policy of the Fed. For purposes of illustration of the simplest
form of credit creation through the commercial banking system, assume a
10 % reserve requirement for demand deposits at THE BANK.
Mrs. A opens a checking account with THE BANK by
depositing $1000 in cash. Since cash in THE BANK's vault is counted as
part of its reserves, the ledger entry made by THE BANK would take the
following general form:
| ASSETS |
|
|
LIABILITIES |
| Reserves |
+$1000 |
|
Demand Deposits |
+ $1000 |
Since reserve requirements are 10%, or $100 of Mrs. A's
deposit, THE BANK now has $900 in excess reserves.
Mr. B, a known customer, now wishes to borrow $900. THE
BANK accommodates him by crediting $900 to his checking account. The
ledger now shows:
| ASSETS |
|
LIABILITIES |
| (Mrs. A) Reserves |
+$1000 |
Demand Deposits |
+ $1000 |
| (Mr. B) Loans |
$ 900 |
Demand Deposits |
$ 900 |
It can be seen that the $1000 deposited by Mrs. A has
resulted in checking account balances of $1900. THE BANK has created
credit, in the form of a demand deposit, of $900. Essentially, Mrs. A
and Mr. B may now spend the same "money" at the same time.
In this generalized illustration, the supply of "money"
was increased by only 90%. In practice, the supply of money is
multiplied many times, since a deposit of $1000 cash would support loans
of $10,000, given a reserve requirement of 10 %.
Confusing Debt for Money
Whether inflation is accomplished through the infusion
of perfect counterfeit dollars, or by the infusion of dollars created by
bank credit, the results are identical. Billions upon billions of
"dollars" have been injected into our economic bloodstream through
deposits created by bank credit. As a result, money has not only lost
most of its value, but has also lost most of its meaning. We have
confused debt for money, and the consequences of our error are upon us.
No economic, social, and political structure can withstand the
destructive impact of an endless flood of counterfeit money. Neither can
it survive an endless flood of artificial money in the form of bank
credit. The effects, and the results, are the same.
While counterfeiting is illegal, and universally
condemned, bank credit is not only legal, but vigorously defended as a
benefit to society. For hundreds of years, the creation of credit
through the commercial banking system has been accepted as appropriate
practice. The validity of the principle of "fractional reserves" has
received no successful challenge.
Certainly, no challenge is to be expected from the
banking community itself; created credit is the primary source of bank
profits. Neither can a challenge be expected from the business
community; bank credit is a primary source of borrowed funds.
Regrettably, no challenge can be expected to arise from government. The
commercial banking system provides the means whereby government debt is
converted to a form of "money."
If a challenge to the concept of fractional-reserve
banking is to be issued, it must come from a well-informed public: a
public which perceives the true nature, cause, and dangerous effects of
inflation. A well-informed public, if it has the courage, will defend
itself not only from counterfeit money, but from artificial money as
well. Perhaps, in time, a future generation will enjoy the economic
blessings of a real money.
If that happy condition is ever to become a reality, we
can start work by examining the validity of Fractional-Reserve Banking.
At the time of the original publication, Mr. McAdoo
was an investment advisor residing in Nevada.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
December, 1975, Vol. 25, No. 12.
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