The Rise of the Central Banks

Last month we covered the two basic types of money: commodity money and fiat money. Commodity money, such as gold and silver, are based on something tangible and has intrinsic value. Fiat money, such as paper money, is based on whatever a government says it is worth. Commodity money keeps its value for years and is stable. Fiat money loses value from the time it is printed and eventually becomes worthless.

Though not as long-lived as commodity money, fiat money nevertheless has a long history as well. As mentioned in Part 1 of this series, villagers used to keep their gold and other valuables in the lord’s castle for safekeeping. Periodically, when the lord was short of cash, he would “borrow” the village’s gold and give them an IOU or “script” in return. This paper money could be returned at a later time, frequently for less gold than was taken from them.

To avoid this problem, villagers started to give their gold to the local goldsmith and get a receipt in return. These receipts were then used as money to buy and sell other things. These gold notes could ultimately be redeemed minus a small handling fee. However, goldsmiths soon learned that not all the gold would be redeemed at the same time and started to make up receipts for nonexistent gold that he could use to purchase other items. This was the start of what is called “fractional banking.”

It was the Knights Templar that ran the best known medieval central banking system.¹ The Knights ran an innovative system that utilized the first form of bank checks. Pilgrims going to the Holy Land were always in danger of being robbed on their way to Jerusalem. To make themselves less of a target, pilgrims would deposit their money with the Knights at the start of their journey. They would then be given a coded piece of paper that only the Knights Templar could decode. When they reached their destination, they would turn in their “check” and be given the value of the check, minus a handling fee. The Knights Templar developed a network throughout Europe and the Middle East and soon became the wealthiest group in the Western World. Eventually, their wealth became an attractive target to the Pope and kings indebted to them. The Knights were arrested, their property confiscated and the Order was disbanded. The Order may have disappeared, but the financial system they left behind survives to this day.

After the Knights Templar, there were other organizations that functioned as banks, but in 1609 the Bank of Amsterdam was formed as the first central bank. Later, the Bank of Sweden was formed (1664), followed by the Bank of England (1694), with both institutions still operating today. While most central banks are associated with fiat money, these three banks and the other central banks formed through the early twentieth century operated on the gold standard. Since they were on the gold standard, the currencies were stable and inflation was kept under control.

In the United States, early banking was carried on by the individual colonies and operated on the gold standard, but the economic pressures brought on by the Revolutionary War caused the colonies to start printing paper money to cover the costs of the war. The Continental Congress also started printing paper money, known as Continental Currency, to cover its costs. Both the state and continental currencies depreciated rapidly, becoming practically worthless by the end of the war. The term “Not worth a Continental,” meaning something of little of no value, came from this period.

In 1790, at the end of the Revolutionary War, Alexander Hamilton was the Secretary of the Treasury and Thomas Jefferson was Secretary of State. Hamilton wanted a strong central government bank; Jefferson was opposed to it. At the same time, Jefferson wanted the nation’s capital to be on the banks of the Potomac River in Virginia, which Hamilton opposed. So, a deal was struck. In return for Hamilton’s support in moving the capital from New York to the new District of Columbia (Washington, DC), Jefferson would not oppose the new federal government assuming the war debts of the former colonies and the founding of a central bank. Thus, the First National Bank of the United States was formed.

This bank didn’t last long. The charter for the bank was allowed to lapse and was later followed by the Second National Bank of the United States. This was the bank that President Andrew Jackson successfully shut down. President Jackson thought that a central bank had no right to create money out of thin air. In his veto message, Jackson wrote,

“Congress [has] established a mint to coin money and passed laws to regulate the value thereof. The money so coined, with its value so regulated, and such foreign coins as Congress may adopt are the only currency known to the Constitution.”²

It was the Panic of 1907 that served as the reason to create the third central bank, called The Federal Reserve in 1913. (This bank is neither a “federal” institution, nor a “reserve” for gold.)

Other central banks soon followed: Australia established its first central bank in 1920, Colombia in 1923, Mexico and Chile in 1925 and Canada and New Zealand in the aftermath of their Great Depression in 1934.³ Printing money wasn’t restricted to just countries. One barrio on the outskirts of Caracas, Venezuela has created a “popular bank” and is going to issue a “communal currency”; currency printed on “little pieces of cardboard.”⁴

The Federal Reserve began a course of inflationary policies by printing paper money that was not backed by gold but nonetheless promised to be redeemed for gold. In 1933, during the administration of Franklin Delano Roosevelt, it became illegal for U.S. citizens to own more than $100 in gold coins or bullion ($1,660 in today’s dollars), thus making the dollar bills irredeemable for gold in the United States, but not for overseas investors.⁵

On August 15, 1971, President Richard Nixon officially took the U.S. off the gold standard.⁶ From then on, U.S. currency has been backed by the “full faith and credit of the United States Government.” This didn’t seem to be a problem for the bankers and lenders of the world. The U.S. dollar was the de facto currency standard for the world. All major transactions done around the world was based on the dollar. “Sound as a dollar” was used as a popular expression for something of quality.

What happens though when people have little faith in a currency and the country has no credit? The United States is about to find out. The United States has run a budget deficit every year, except for a four-year period during the Clinton and G.W. Bush administrations, since 1968.⁷ The total federal debt this year will exceed the total gross domestic product of the entire country.⁸ Over 18% of all government payments will go to interest on the debt.⁹

The states of California, Illinois, Michigan, and New York are all close to defaulting on their obligations and are looking to the federal government to bail them out. The price of gold is at an all-time high and people continue to buy gold no matter how much it costs. Moody’s Investor Service has warned that if the situation doesn’t change, the United States will lose it AAA credit rating.¹⁰ The “faith and credit” of the United States is shaky at best.

Normally, when a country expands its money supply, it will offer bonds to other countries. The lending countries will buy the bonds and then the borrowing country will use that money to issue paper currency to the lending banks at a set interest rate. The problem many countries have now is that lending countries are not buying. This puts the borrowing country in a bind. Since slowing the rate of increase of the money supply will invite a recession (a way for the economy to readjust itself back to reality), politicians will want to “boost” the economy by increasing the money supply. With no one buying a country’s debts, the debtor country is reduced to printing money that is backed by nothing. This is called “monetizing the debt.”

Ben Bernanke, the chairman of the United State’s central bank, the Federal Reserve, has been accused of gearing up the printing presses. Of course, in these days of electronic funds transfers (EFT), a printing press isn’t even required. A simple computer entry into a balance sheet will suffice.

In the last two years, the United States has put $2.5 trillion into the world’s economy.¹¹ Continuing to expand the money supply in such a manner could cause a hyperinflation only seen in recent history in developing nations and post-World War II Germany. (We will visit the topic of hyperinflation and its effects on society in the third and final section of this series.)

Monetizing the debt does have a short-term advantage in the opinion of those who favor manipulating the money supply to regulate an economy, the so-called “Keynesians”¹²; you can set an interest rate to be whatever you want it to be.

When the Federal Reserve lends money to the member banks, the lending interest rate is at least equal the borrowing rate, plus additional percentage points to account for inflation and profit. If you monetize the debt, you don’t even have to charge interest.

That is where the United States is now. The Federal Reserve is lending money to banks at 0% interest. Some economists ask, “What does that even mean”? Lending money at 0% interest in an economy with an inflation rate of 2.3% means the borrowing banks are actually being paid to take the money. Some economists feel that this is the best way to “stimulate” the economy. Others feel this is a terrible idea.

The “housing bubble” that the United States experienced over the last few years is an example of what happens when the money supply is increased. While the problem in housing started in the late 1970s with the Community Reinvestment Act in the Carter Administration,¹³ the problem went into overdrive in the last few years. When housing prices in major metropolitan areas began to “soften” (read that “return to a realistic level”), the Federal Reserve increased the money supply by lowering the interest it was charging for its money. This in turn lowered the interest rate offered to home owners, often to people who could not afford to buy the homes. These people were told that they could actually afford these homes, by “creative financing.”

People were offered short term (3-5 year) loans with low interest rates and payments not even covering the monthly interest. The thinking was that when these loans came due, the equity in their homes would increase enough that they would be able to get another mortgage and catch up on their payments, because the increased value of their home would help pay down the original loan balance.

Others used their homes as a personal piggy bank, taking out second mortgages to buy consumer goods such as a second home, a car, a boat or to pay off credit card debt. This frenzy in the housing market would not have occurred had the monthly payments bore some semblance to reality. Once the housing market was saturated, home prices became stagnant and then began to fall as demand began to fall. Home owners found themselves in “upside-down” mortgages where they owed more money on the house than it was worth.

Many people then did what they thought was the only rational thing—they walked away from their mortgages. Mortgage holders (usually investment funds used for retirement savings, etc.) quickly found out that the AAA bonds they held, backed by home mortgages, were nothing more than junk bonds. The monetary policy of the central bank, put in place for political purposes, was a house of cards that started to collapse.

That house is still collapsing today. The credit collapse in the United States caused a ripple effect around the world. We are seeing the effects in Europe with the bailout of Greece (and possibly Portugal, Italy and Spain), the austerity programs in Britain and Ireland, and the calls from China, Russia, and others to move away from the U.S. dollar as the world’s reserve currency. This last event could have devastating consequences.

The politicians in Washington, of both parties, don’t seem to realize just how serious the problem is as they are continuing to spend money they don’t have. They are continuing to say the only cure for an economy sick from borrowing too much money is to borrow more. This was the same thinking that brought disastrous consequences to Germany in the 1920s and ultimately to the entire world.

In the third and final part of this series, hyperinflation and its effects on a culture will be investigated.