How Governments Play with your Money for Their Own Benefit
In this article we’ll discuss the history and meaning of both fiat money and fractional reserve money. These technical issues help to explain how the US Treasury can basically create money at will and how their decision to do so impacts all who use that money. If you haven’t already, you may want to read the last article entitled What is Money?
What is Fiat Money?
Fiat money is paper currency that is deemed legal tender without being backed by something else of value, such as gold. Basically, it’s money because someone said it’s money. In the case of the US Dollar (USD), our currency is deemed legal tender by the US government and since 1971 has not been backed by or otherwise tied to gold as it was traditionally. By decreeing fiat money legal tender, governments essentially require their citizens to accept it in financial transactions.
Following a military campaign in the 17th century, the Massachusetts Bay Colony was desperate to raise money. Knowing that the colonists wouldn’t be receptive to being taxed, they instead decided to just print more money. The government promised that they would allow the colonists to redeem the currency for gold or silver and that they wouldn’t print any more money. A few months later they printed six times as much money. It took 40 years before they allowed people to redeem the money for gold or silver.
Other colonies began to follow suit, printing their own money and requiring colonists to accept it as legal tender, even if the colonists preferred to deal with gold and silver coins. All of this printing of money led to rampant inflation. As more money entered the system, sellers demanded more of it to part with their goods. This was in an effort to maintain the value of those goods and in response to increased demand with no change in supply. If lots of people want something and you only have so much of it to go around, you can charge more.
In the 1750’s, prices in Connecticut rose 800%. They rose 1000% in Massachusetts and 2300% in Rhode Island. Eventually, the Bank of England stepped in and removed all the colonial money from circulation and the colonists either used British currency or returned to using gold and silver coins.
Once the American Revolution began though, the colonies went back to printing money. They needed cash to fund the war and the $12 million they had in the treasury at the time wasn’t enough. So over a course of five years, they printed another $425 million.
At first, things looked great and the soon-to-be new nation was prospering. But things quickly caught up with them as inflation set in. In 1775, one Continental was equal to one dollar in gold. Four years later, a Continental was worth less than a penny. Shoes cost 5000 a pair.
Inflation as a Hidden Tax
If the fledgling nation had the money in their savings account (i.e., the Treasury Department), having previously collected it by taxing the people, then they wouldn’t have to print money. The take home message here is that the Continental Congress found a way to purchase what they wanted (in this case resources for the war) without having to tax its citizens.
When you think about where that newly printed money comes from, it comes from inflation, or a decrease in purchasing power. When more money is printed, the demand for goods increases (more people have more money to spend). This leads to higher prices and means that the money each of us already have is worth less (i.e., it won’t buy you as much). This is similar to being taxed, where the money you earn from working isn’t what you can actually go out and spend. You can only spend a portion of what you earn, because the government collects taxes from your paycheck. Based on this line of thinking, many people consider inflation to be a sort of hidden tax.
Historically, goldsmiths were responsible for storing the physical gold and silver owned by their neighbors. This allowed them to not have to carry around large amounts of heavy metal coins. Instead, they would use “receipts” from the goldsmiths when buying goods from merchants. These receipts could be cashed in for the precious metals, at any time, and by whoever held the receipt.
As people began to become more comfortable with the idea of trading paper receipts instead of heavy coins, fewer and fewer people actually redeemed the physical coins, or at least they did so less frequently. That meant that the coins were just sitting in the vault. At this point, people decided to put those coins to use by lending them out. If the goldsmiths knew that on average no more than 10-15% of the coins were likely to be redeemed at any given time, then they felt comfortable lending out the balance.
This is where things get a little more complicated. When a person got a loan, the coins were taken out of the vault and lent to the borrower. But the borrower didn’t want the physical coins. They wanted the much easier to carry around paper money and so they immediately turned around and deposited their loaned coins. When they did so they received a receipt. But this wasn’t a receipt for their own money, it was a receipt based on borrowed money. In other words, there were now two receipts (two IOUs) that had been issued on the same physical coins. The original depositor and the borrower each had a claim to the same gold coins.
To keep things simple, if there was one receipt for one coin, we would have a 1:1 ratio, meaning that 100% of the paper money was backed by gold. But if every coin was lent out, thus creating a second set of receipts for that money, there would now be two receipts for every coin, meaning that only 50% of the paper money could actually be redeemed for gold. Basically, whoever got to the bank first would get the gold coins. Since the paper currency now represented a fraction of the gold it used to represent, this concept was labeled “fractional money” or fractional reserve banking.
Since the paper receipts were being used as currency, these lenders had, whether they realized it or not, created money. Once again, adding money to the system led to inflation.
Using Debt to Create Money
Just as was done historically, bankers today use fractional reserve banking. They realize that when people deposit money there will always be some money left untouched sitting in the bank. Bankers can use this money to create loans. Again, things get complicated when borrowers turn around and deposit the loan proceeds (either at the same bank or a different one).
Once a borrower deposits money, that bank can again lend out a portion of it, and the cycle continues. Think of it this way. Imagine that a bank has $1 million in depositor funds. Because some people will withdraw their money, they won’t lend out the entire $1 million. Instead, they lend out perhaps $900,000. Once that $900,000 is lent out, the borrowers deposit that money back into the bank. If the bank again uses a 10% reserve (meaning they hold onto 10% of whatever money is deposited for withdrawals and lend out the rest), they can now lend out another $810,000. In the next rounds, they could lend out $729,000 and then $656,100. Each time they do so more “money” is entered into circulation, money that simply didn’t existed before the loan was made. As you can see, the amount adds up quickly and well exceeds the originally deposited amount (in our case the original $1 million).
Just as with fiat money where a government basically prints money, the government can allow bankers to lend more money at lower reserves as a way of putting more money into the economy, again without having to label it as a tax. Banks are willing to go along, because they know that the more loans they write, the more they can collect in interest and fees.
All of this creates inflation and so the people still pay a price, but officials blame others, such as claiming that raw materials or shipping costs are becoming more. They also hide behind the complexity of a system that the average person doesn’t understand to avoid taking responsibility for their role in causing inflation.