Prior to the birth of our nation gold and silver was usually the basis for the colonies monetary system. Individual colonies attempted to use paper money and it failed, through high and hyper price inflation in all instances. Just prior to and during the revolution the new nation, as a whole experimented with a fiat paper money called the Continental. Fiat money is given value by government decree; it has value because the government says it has value.
In prior examples we assumed that the paper money was backed by gold and when the holders of the paper money realized it no longer could be redeemed they immediately discarded it. In some of these early examples of paper money the links to gold were less clear. In these cases the point at which the currency could not be used was not as punctual. This brings up another aspect of money velocity.
As the users of a currency notice that its value is decreasing and cannot buy as much as it once did, they are more likely to want to get rid of it as soon as possible and get real goods or services before it goes down in value even more. The holders of the currency want to get rid of it for something else, anything else, and this increases money velocity. Picture an economic game of hot potato. This is a physiological shift of the market participants and as the velocity of money increases the loss of purchasing power increases at a greater and greater rate until the currency is worthless. This is what is termed hyperinflation, but in reality it is just the loss of purchasing power of a fiat currency, due to a loss of faith in that currency.
So it is not the government action of increasing the money supply that causes a hyperinflation but a psychological loss of faith in the currency causing a rapid rise in money velocity. I remember an adage when wrestling, that being strong isn’t necessarily essential to be a good wrestler, but it doesn’t hurt. The will to work your butt off is more important in that sport. Similarly an increase in the money supply of 10 20 or 100% doesn’t necessarily cause high or hyperinflation but it doesn’t hurt. Like the will to work hard in wrestling, money velocity is the most important factor in the shift from no or low inflation to high or hyperinflation than is money supply.
The founders of our nation learned firsthand the flaws in paper money by their experience with the Continental, a paper currency used by the colonies. The inflation of the money supply occurred by the over printing of the money by the new United States Government as well as counterfeiting by their enemy, the British. As people lost faith in the continental the resulting loss of purchasing power was exacerbated by the inevitable drop in the production of goods and services caused by the strains of the Revolutionary War. This is exemplified by the quote by George Washington that “a wagon load of continentals’ could barely secure a wagon load of supplies” and by a common phrase of the time describing items of little value “wasn’t worth a continental.”
The failure of the continental was fresh in the minds of the framers of the constitution when they decreed that only gold and silver was to be legal tender and the federal government shall not be allowed to issue bills of credit. Bills of credit in their view were similar to the receipts of the early bankers, they were a promise to pay gold and silver, and would circulate as currency. They prevented the government from directly partaking in the fraud, but unfortunately stopped short of preventing private institutions, banks, from doing the same. This has turned out to be very unfortunate.
To say that the founders installed capitalism in our American system would clearly be incorrect. Capitalism was already used under the crown and in most civilizations around the world. Its use almost seemed organic. Capitalism can be defined as using money as a medium of exchange fostering specialization through trade, and postponing consumption to invest in productive assets allowing increased efficiency.
The benefits of capitalism in my view are twofold.
First it incentivizes specialization through one’s own self-interest. A farmer for example, in the absence of capitalism will only spend enough time to produce enough grain to feed his own family, splitting the remainder of his time building and maintaining shelter, ensuring a supply of water, raising food animals for meat, etc. He may not be nearly as good at producing the other items as he is at producing grain but there is no incentive for him to produce more than he needs, until, that is, the introduction of capitalism and trade. If those around him are willing to supply the production of meat, shelter, water etc through trade the farmer can focus on grain production.
This focus or specialization will allow the farmer to become even more productive allowing for the benefit of those around him and vice versa. As the system continues the specialization will become even more focused and real growth and prosperity results.
The second and actually much related benefit of this specialization is cooperation of individuals that would otherwise be difficult. A good example is the one given by Milton Friedman that no one man can produce a simple pencil, but through the power of capitalism it is made a reality. It goes that the rubber for the eraser is produced in Brazil. The aluminum that holds that eraser to the end of the pencil is mined in Mexico and fabricated in Korea. The wood is supplied from the American North West; the graphite arrives from China, and the paint from Germany. All of these raw materials are constructed into a finished pencil in Taiwan. The people who produced the raw materials and finally put the pencil together, do not speak the same language, and if they ever met may not even be able to work together. But through the amazing power of capitalism they can cooperate to produce. It is an impressive benefit of capitalism.
At its root, you may be thinking, that specialization and cooperation are really the same thing, different sides of the same coin, and the same mechanism. You would be right, but this cooperation and trade also fosters peace, what most would strive for. One instance where someone may want war and conflict is if they are in a position to lend to countries waging war and profit from the interest paid back on those loans.
Capitalism is used in many socio-governmental systems and seems essential to be able to have any success in those systems. Capitalism can be used in monarchical, fascist, democratic, or republican forms of government. The only attempted large scale system that does not use capitalism, is communism; though in practice even the most pure communist systems allow the creep of capitalism so as to sustain the system. That said if the doctrine of communism, from each according to his abilities to each according to his need, is adhered to, the system will fail. Socialism appears to be an amalgamation of capitalism and communism. The closer to communism a socialist system gets the less prosperous, the closer to capitalism the more prosperous, though the results of a more communist system may take time to develop.
Capitalism is essential for any successful, large scale, societal structure and this is based on the failure of the alternatives throughout history, the founders seem to have agreed. We will continue now to focus on the monetary aspect of our capitalist system.
The governmental and banking interests had, prior to the revolution, found another patch that, similar to splitting the gains of fractional reserve banking with the depositors, was meant to make fractional reserve banking more resilient. It was the advent of a central bank. The main focus of the central bank was to provide a central authority to interconnect the banks and provide cooperation to sustain the system when it was showing signs of stress.
The central bank could do this by having the authority to shift money to a bank that was experiencing a bank run from one or a number of banks that were not. This could show the depositors at the bank experiencing the run that there was indeed enough money in the bank to satisfy the redemptions of the receipts, at this point commonly known as bank notes. The bank may not have had the specie to satisfy the run the day before but if the central bank had the ability to shift the gold and silver during the night and quell fears during the next day, the contagion to the other banks could be stopped. Granted if it was not successful, and it did spread, the banks that had lent the money to the bank that originated the run would fall even faster than the first. It was another patch because it was merely an illusion, a slight of hand as any street magician would use. Central banks also could supply their own bank notes, backed by the government’s treasury, or its own capital. Once again this patch was a way to continue the fraud.
The central bank did however prove useful to perpetuate the banking systems in Europe. The bankers of the United States knew this and applied political pressure for the United States to form its own central bank, which it did in 1791. This strengthened the ability of private and state banks (not federal) to be able to add to the money supply through bank notes, and thus allow the bankers to keep taking their unfair cut. Ironic since the following year in the coinage act of 1792 it was deemed that anyone who would make anything but gold and silver money would be put to death. Ironic because these bank notes circulated as money, and though they were presumed to be backed by gold and silver, any child could identify that they were not what was deemed lawful money, gold and silver coins.
This First Bank of the United States, the name of this first central bank, had shareholders, many of whom were not American, yet still were paid a dividend from the central banks’ profits. It was a private corporation not a government entity, and only operated under government charter. The United States government was one of the shareholders, but sold its shares in 1795 to raise money, leaving it even less control of the bank. This first banks governmental charter expired in 1811; it lost its central bank status, and was then completely private.
It was not long after the First Bank of the United States lost its charter that banking interests started to advocate for another Central Bank, which became a reality in 1816.
During the time of the first two central banks of this nation there was tremendous economic expansion, some possibly promoted by the expansion of credit and money supply, but the growth may have been just as impressive without the influences of the banks. It certainly would have been healthier for the economy.
One person that saw the undue gains by the bankers for what it was, was President Andrew Jackson. Far from a perfect man, he had his flaws, but became fixated on what he clearly saw as an injustice. He said of the bankers “You are a den of vipers and thieves, I intend to route you out, and by the eternal grace of god I will route you out”.
This was a brave stance, for the power held by the bankers was immense, but General Jackson was nothing if not brave. The leader and antithesis of Jackson, one who had been lulled into the trappings of fractional reserve banking, was Nicolas Biddle the president of the central bank appointed by James Monroe in 1823.
Biddle held no reservations as to the weapons he held at his disposal to fight off the president in his quest to rid the country of the central bank and thus weaken the banking system in America. He had the power to control the credit and money supply in the fledgling nation, and the ability to cause a crash. If wielded properly he could cause a crash resulting in suffering for the American people. At the same time he could use the media, newspapers of the time, to paint the economic troubles as a result of Jackson’s policies against the central bank. All the while the bank was causing the crisis on purpose. Biddle directly threatened to destroy the American economy by contracting the money supply through the removal of bank notes from the system which was well within the central banks power. Does that sound like an entity with the nation’s best interest at heart or a response from a threatened animal with its own self-interest in mind? I believe, future central banks, if put to the test would react in the same manner if they felt their existence was threatened.
Though it was a bitter battle Jackson prevailed, but there was the inevitable reduction in the money supply causing the crash of 1837. The economy recovered and prosperity regained footing.
Jackson had bravely beaten a powerful foe, the central bank was no more, and for the first time in America’s short history, the federal government paid off the national debt, it also was the only time.
Fractional reserve banking had been weakened in America, a good thing, yet it had not been destroyed. Banks continued to expand the money supply resulting in inevitable crashes every several years for the remaining 60 odd years of the 19th century.
With the banking system weakened the expansions of the money supply were short, and crashes were thus smaller than the one that occurred in ’37, and the American economy quickly would recover.
These crashes were known at the time as panics, an apt name considering they were kicked off by people panicking after a loss of confidence in their bank’s ability to pay gold and silver for the private bank notes that had been distributed.
This next point is a key take away from the booms, panics and economic turmoil of the 19th century. They were caused by the expansion and contraction of money and credit as a result of fractional reserve banking not from the use of gold as money. Critics of the gold standard and supporters of fiat money, debt, and central banks often cite these panics as proof that a gold standard is the cause of instability. But this is just not the case, the panics were caused by what they support, debt based money and fractional reserve banking.