The rising tide of foreign government defaults on their
overseas, dollar--denominated debt threatens to break and overflow the
sea walls of international banking and inundate the capitalistic world.
The recent Toronto convocation of international bankers
for the annual meeting of the World Bank and International Monetary Fund
considered the approaching flood, but their efforts were like those of a
platoon of Dutch school boys recruited to stick their fingers in the
leaking dykes. In desperation they shouted for more bags of the sand
that was being washed away; that is, more international credit, more
fiat money of the sort that was already being diluted into muddy liquid.
For the United States, with business bankruptcies
soaring and the banking system tottering, confidence has begun to ebb in
the power of the omnipotent Federal Reserve to control the flood.
Although it mans the sluice gates of a mighty reservoir of credit, some
see cracks in the great dam below which the economy sits like a
present-day Johnstown. One journalistic commentator declares that the
country faces its greatest economic crisis in fifty years.
The Great Debate
A popular cry is to denounce Reaganomics with its
devotion to free market economics; more radical theorists accuse the
capitalistic system and argue for authoritarian communist and socialist
forms of government.
Advocates of more government intervention, however,
face the dilemma that the crisis is severest in the Third World, most of
which is governed by Marxist or socialistic principles under
authoritarian regimes. Indeed, it is the collapse of Third World
economies, despite a thirty-five year drain of Western resources under
various foreign aid programs, that has complicated the problems of the
West; it is the defaults of Third World countries on loans from Western
banks that now threaten the international banking structure.
Advocates of more government subsidies and
intervention, however, ignore the fact that if Reaganomics has not borne
the expected fruit, it is because of its failure to extend free market
principles into the most important area of enterprise - the money
system.
Despite dismantling of many government barriers to
trade, money - which is the lifeblood of enterprise - remains under
authoritarian controls by a bureaucracy as aloof, as unrestrained, as a
Soviet Politbureau. This is the Open Market Committee of the Federal
Reserve which congeals the wisdom of twelve mortal beings enjoying long
tenure into directives as to the amount and direction of money flow;
each Friday the markets of the world await with bated breath the effect
of their deliberations.
Historical Review of System
The development of this autocratic power was gradual
and often unperceived. For twenty-seven centuries, mankind regarded as
axiomatic that the only valid means of payment is intrinsic money, that
is, coinage. Rulers throughout history, however, have wherever possible
circumvented this principle by degrading or counterfeiting the coinage.
The most pervasive effort was in 13th-century China, when the Mongol
emperors substituted paper notes for metallic coinage in circulation.
The Venetian traveler Marco Polo admired the device which, he noted,
gave the emperor enormous profits. Despite the inflation that followed,
with the notes at a discount, the practice spread to Europe; but in the
Middle East, efforts to introduce paper notes were resisted by sedition,
and in India, silver remained the standard money of account until the
British introduced paper in 1893. The British paid the price; within 20
years they nearly lost their colony but for a U.S. rescue operation.
Iran had only metallic money until the 1930s when Reza Shah introduced
central banking, a la the Federal Reserve; this monarch lost his throne
before a decade had passed.
Rise of "Scientific" Economics
The framers of the United States Constitution rejected
paper currency, but despite Constitutional doubts, paper currency was
introduced as a war measure during the Civil War; specie payments were
resumed in 1879.
Meantime, there had been growing up in the 19th century
a school of thinkers employing the concepts of mathematics and physics;
they obtained respect for their novel theories by designating them as
"scientific." Karl Marx called his theory "scientific socialism." Their
view was that man was a creature of physical wants and demands that
could be measured statistically and programmed mathematically. The
profession acquired status after World War II by the formation of an
official Council of Economic Advisers, enjoying access to the head of
state and more influential than the Secretary of the Treasury or the
Secretary of State. Added prestige came in 1969 when a Nobel Prize in
"economic science" was set up along with those in medicine and physics.
From this new profession came the philosophical
framework for fractional reserve currency which came into being in 1913
with the Federal Reserve System. With fractional reserve currency, the
Reserve banks were authorized to convert into cash the debt of member
banks. In exchange for the member bank's paper the Reserve banks could
issue legal tender notes up to 21/2 times the amount of gold money held
by the bank. The process was called discounting.
At first only short term commercial debt was generally
convertible to cash, but such was the leverage given by this new
mechanism, such was its power to create purchasing power by the stroke
of a pen, that pressure for its expansion became irresistible.
Government bonds became acceptable collateral - this helped finance
World War I - the kinds of debt expanded; if not enough debt were
offered for discount the Reserve, through the Open Market Committee,
could go into the market and buy up debt either on the excuse of
stabilizing the price level or of promoting employment. Eventually the
requirement of a gold reserve was abandoned.
The Inflationary Flood and the Economic Consequences
The commercial banks, with this ever-ready fountain of
liquidity, expanded their lending to the limits of their capital
reserves. These dropped from around 25 percent of assets to currently
less than 10 percent, with the 15 largest banks presently operating on
margins of less than 5 percent.
Not finding productive use for this financial power,
they have financed a rank and unhealthy growth of corporate
conglomerates with an economic justification no one has yet been able to
define. The system of fractional reserve currency became a world fashion
like the current rage for blue jeans and lettered T--shirts that may be
found on the Ginza and in Red Square. Countries, from Italian
principalities governing only a mountain top to continental empires like
China, engaged in the issue of currency through central bank emissions.
Despite the collapse of the system in 1933, when every
bank in the country closed its doors, such is the fascination with fiat
currency that ever-wider powers were conferred on the System. In 1980
Reserve banks were authorized to convert to cash practically any
collateral they pleased. Under this authority, the Reserve has acquired
some $2 billion of foreign government debt, and it is now being pressed
to liquidate large chunks of the debt owed to United States banks by
Poland, Mexico and others. Only John Law, in his effort in 1729 to turn
the soil of France into money, showed such effrontery.
Despite the evidence that the main cause of the current
world-wide economic debauch is fractional reserve currency adopted
everywhere, the Secretary of the Treasury continues to voice confidence
in the System. The President tentatively suggests that it should be
brought under Treasury supervision. This would be disastrous.
The correct course is to dismantle the Federal Reserve
System.
True Function of Money
The function of a monetary system is not to manipulate
the flow of credit and banking transactions to maintain a given, or even
stable, price level; nor is the function to create employment. The money
system should be managed neither in the interest of creditors nor of
debtors; neither in the interest of producers nor consumers; neither in
the interest of government nor of taxpayers. The function of government
is to maintain the integrity of the standard; its function toward money
is the same as toward the measure of length or of weight or of quantity.
It is as corrupt to vary the standard of value and deferred payments as
to change the length of the yard in the interest of cloth merchants, or
the content of a bushel in the interest of wheat farmers.
The means of maintaining the standard is the definition
of the dollar in terms of a given weight of silver or gold; since 1900,
the sole metal of the standard has been gold; the dollar is still by law
and statute defined in terms of gold. The regime under which the money
system has been corrupted came to a climax in 1934 when the mint was
closed to the free coinage of gold. The mechanism by which the
circulation is always adequate to the needs of trade is that of free
coinage. Under free coinage anyone can bring gold to the mint and have
it coined only for the cost of mintage. Under this system the free
market, rather than a bureaucracy, determines the amount of circulating
media.
Restoration of Free Coinage
The system of free coinage was established in England
in 1666; for the first time in history the government monopoly of money
ceased; during the succeeding centuries, gold flowed to England, the
circulation was always adequate, and England rose to be the principal
commercial power of the world. The same system was adopted by the newly
formed United States, and under this system the United States became the
only rival of Great Britain as a commercial and industrial power. This
is the system that should be re-established to restore stability in the
United States. It is no more necessary for an international agreement to
this end, as some argue, than for every country to agree on the length
of a meter or the weight of a kilogram; the natural effect of integrity
will compel them to do so.
At the time of the original publication, Dr. Elgin
Groseclose, a financial consultant in Washington, D.C., is the author
of Money
and Man(1934, 4th edition 1976) and America's
Money Machine (1966, 1980). He served also as executive director
of the Institute for Monetary Research.
Reprinted with permission from The
Freeman, a publication of the Foundation for Economic Education, Inc.,
January 1983, Vol. 33, No. 1.
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