The Process of ‘Creating Money’

August 11, 2003 – Thirty-two years ago this week, President Nixon changed the course as well as the innate qualities of the dollar. The dollar, which is a money that predates the Constitution, had always been a precise weight of precious metal – silver until 1900 and gold thereafter. All that changed in 1971. But it was just one of several changes over the centuries that have made what we today call the ‘dollar’ the mere shadow of its former self.

Even before being chosen by the Framers as the monetary unit of account for the Constitution, the dollar was a widely circulated coin weighing 371¼ grains of pure silver. One of the first acts of the newly formed Congress was to adopt in 1792 the dollar as the standard unit of account for the different states. Recognizing that the two objectives of the Constitution were to provide for a common defense and to create a common market between the states to enhance commerce (much like the economic objective for establishing a common market in Europe), it was understood that a common currency was needed, so the dollar was chosen by Congress to fill that role, thereby reaffirming the choice of the Framers. The 1792 act established that a silver coin called the dollar would be used as the standard in commerce.

When dollars were created back then, silver would be taken to a mint – in the free-market for money that existed back then, private mints competed with the government’s mint – and a coin was produced. It was a called a dollar, or a silver dollar, and it was money in the true sense of that word because people understood that it was precious metal, a tangible asset, in contrast to paper currency which was only a money-substitute, not money itself. In other words, a silver coin is no one’s liability, but a piece of paper circulating in place of a dollar is a liability of the bank issuing that paper.

There were of course reasons to use paper instead of metal. It was more convenient, but this convenience came with a cost. Paper was risky because one never knew whether the paper could be redeemed for metal as promised by the issuer of the paper. Holding a promise to pay metal is obviously not as good as holding the metal itself.

These risks of holding paper arose because of a practice called ‘fractional reserve banking’. The banks would issue more promises to pay metal (they created liabilities) than they had precious metals (their assets) on hand. Therefore, to better understand and to try quantifying these risks, it was necessary to look at each bank’s balance sheet.

The general rule-of-thumb that developed (which was established mainly by the Bank of England based on the various runs against it over the years) was to maintain at a minimum 40% of its assets in metal against all the paper currency outstanding (readers may recognize that this ratio is the basis for my Fear Index). This 40% reserve was, based on their experience, adequate to enable the Bank of England to get through even the most severe run, where holders of their liabilities clamored to redeem this paper currency for metal.

The banks understood though that holding metal produced no profit for them. So banks were constantly trying to centralize the metal they held, to use it in a way that enabled them to expand credit to the fullest extent possible, and central banks were useful to help banks accomplish this objective. Their goal of centralizing the gold reserve was an important motivation behind the establishment of the Federal Reserve in 1913, which itself was a major step in allowing the practice of fractional reserve banking to become part of the American economy.

The dollar by this time was defined as a weight of gold (23.22 grains). Silver served a subsidiary role for minor coinage. So to create money, gold and silver would be taken to the US Mint (private mints had been outlawed by the federal government, which by then had made clear its intent to achieve monopolistic power over money) and coins produced. These coins circulated side-by-side with paper money substitutes, principally Federal Reserve Notes.

The point is that when these notes were printed and issued into circulation, everyone understood that it was currency being created, not money. And it is this very point that is largely lost on almost everyone today.

So far this year the Federal Reserve and the banks have created $382 billion of so-called money. But the reality is that these new dollars are not even a money-substitute, they don’t circulate in place of precious metal. What’s worse, no new wealth is created by this new $382 billion. Milton Friedman established this point years ago in what I like to call the ‘helicopter theory’ of creating money. It goes like this.

Assume that while a community was sleeping, a helicopter flew by dropping money into the community, so that when everyone woke the next morning, they had twice as much money as the night before. Sounds good, but is everyone twice as rich?

No, of course not, because only the quantity of money was doubled, not the supply of goods and services. As this new money was spent, people would quickly realize that the money supply was inflated, and that in time the market would again stabilize with the price of goods and services twice the level they were before the helicopter flew through their community. The people who spent their money quickest had the biggest advantage in purchasing power, because they used their money before the full force of the inflation hit the community. Those who saved their money did the worst because they received no advantage from the newly created money.

Using this example to explain the creation of $382 billion, who is benefiting? I suppose that you are not surprised to learn that it is mainly the US government. Its debt so far this year has increased by $302 billion, which has been ‘monetized’ into dollar currency by the Fed and the banks, and these dollars have been spent. Their purchasing power has been maximized by putting these dollars into circulation hardly before the helicopter disappeared over the horizon and while most everyone was still asleep. Except of course those of us who own gold and understand this process of creating fiat currency.

Ads for New York’s Citibank claim that ‘the Citi never sleeps’. What these ads don’t say is it’s because Citi and the other banks are flying that helicopter 24-hours a day. But by owning gold for the major portion of our money needs and holding only the minimal dollars required for our immediate currency needs, we gold owners can sleep soundly despite that ever-present helicopter. We own money, and not the mere shadow of the once proud dollar.