A Challenge to Banking
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SECTION ONE - Dishonest Money
If we return to Mr Goldsmith and his new bank, and substitute
a hundred dollars in paper money for the gold coin, the reason
why there is no reality behind the current Western paper money
system will unfold, and we shall discover why unless the system
is altered, it will collapse. The same misrepresentation,
two receipts against one deposit, will occur as it did when
gold was the standard.
||Stock in hand:
Yet it will not be as easy to see. Under the paper monetary
system we are easily confused. The deposit looks just like
the receipt. Each is usually merely a piece of paper with
the number of units of money written on it. The logic of our
former example, however, does also apply with paper money:
although the bank's books will balance, the money supply will
actually have doubled.
We are equally easily confused when trying to determine the
value of current paper money. There is no real physically
measurable substance behind a unit of paper money. Nor, when
a loan is made, is there any real physically measurable substance
or value behind any of the newly created units of money. Nor
is there any real substance behind units which are deposited.
They are not guaranteed to be exchangeable for any fixed amount
Their value comes from their being the only legal and valid
medium of exchange. They are effectively a claim on everything
and anything that is offered for sale in the market-place.
The great difficulty is that both the amount of money and
the volume and mix of the goods and services against which
they can claim is continually changing. There is, therefore,
little opportunity to measure accurately one against the other.
If the supply of units of money were fixed, when the demand
for them increased, so too would their value; and as the demand
for them decreased, their value would also decrease. There
would be a minimum demand for units of money. It would represent
the minimum volume of exchanges required for the population
to survive. Thus, each unit of paper money would have a minimum
Each would also have a maximum exchange value. It would represent
the level of exchange value at which savers are motivated
to withdraw their money from savings and use it to take advantage
of its greater purchasing power. A withdrawal will then increase
the volume of money used in exchanges, leading to a decrease
in its exchange value.
Thus, it is possible to see how a fixed supply of paper money
can lead to a range of exchange values between this minimum
and maximum. In due course, the exchange value of a unit of
money would begin to fluctuate more and more narrowly within
this range, eventually leading to stability.
Unfortunately the money supply is not fixed. New units of
money are virtually produced according to demand. Bankers
create new units of money every time they create net new loans.
They are in business exactly for this purpose. Their normal
activity produces a continuing expansion of the money supply.
Governments are meant to control the money-creating activities
of banks. Current controls, however, are not effective.
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A system within which each bank must hold a specified portion
of its deposits in investments known as Legal Reserves has
been one of the principle mechanisms by which governments
have tried to control the money supply. Legal Reserves are
promissory notes issued by borrowers deemed least likely to
default. They are therefore the most saleable or convertible
into cash in the event of an emergency.
Under this system, a bank is theoretically limited to creating
new units of money in an amount equal to that of its excess
Legal Reserves. If, for instance, a bank had deposits of £50,000
and the reserve requirements were 20 per cent, it would be
required to hold a minimum of £10,000 in recognised
Legal Reserve instruments. Suppose the bank actually held
£15,000 in such investments. It would have another £5,000
which it would be permitted to advance as loans to its customers,
thereby creating new demand deposits.
When we look at the banking system as a whole, we immediately
expose a major weakness. The system can actually create a
much larger amount than the amount of excess reserves.
Suppose, for instance, that all of the excess reserves in
the system were lodged in one bank, Barclays perhaps, and
that each of the other banks was willing to receive new deposits
and to issue new loans to the limit of its reserves. If Barclays
had the £5,000 excess referred to above, and it created
new units by lending them to me, and I then spent them on
one purchase at Harrods, and Harrods deposited them at the
Midland, then the Midland would have a new deposit of £5,000.
The Midland would then be required to invest £1,000
or 20 per cent in Legal Reserves. It would then have £4,000
in excess reserves and could lend £4,000 to one of its
clients. Its client could spend it similarly, and Lloyds might
then receive £4,000, invest £800 in Legal Reserves,
and lend £3,200 to one of its clients. This process
could continue until approximately £25,000 had been
Thus while an individual bank is limited to the amount of
its excess reserves, the system as a whole can produce new
units in multiples of the total excess reserves within it.
Nor is this limitation absolute. If we look closely at Legal
Reserves, they are themselves loans. For instance, many types
of government securities, including Treasury Notes, are considered
Legal Reserves, and, in some cases, so are bank-endorsed bills.
Treasury notes are receipts issued by the government for money
loaned to it. The government uses the borrowed money to meet
it obligations. Bank-endorsed bills are also loans and are
used by the borrower to meet his obligations. In both cases
the money is immediately back in circulation. It will be re-deposited
and then it will be available to be loaned again. Reserve
instruments are not a protection against misrepresentation.
They are actually themselves part of the very misrepresentation
they profess to be controlling.
The only limitation imposed by the use of a Legal Reserve
system is the borrowing requirements of the issuers of reserve
instruments. Where their appetite is insatiable there is no
limitation at all.
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The production of money by Central Banks
Central banks produce new units of money via several mechanisms.
The most obvious, of course, is the minting of new notes and
coins. In most countries it is the Central Bank which is responsible
for the mint. New notes and coins are produced either to replace
old and worn or damaged ones, or to maintain sufficient cash
in the system to service the needs of the daily transactions
in the market-place. The need for cash varies from market-place
to market-place. For instance, some companies still meet their
payrolls using cash in small brown envelopes. Others use cheques.
Some shops and businesses will accept credit cards or cheques.
Others prefer cash. Each market will vary.
Nevertheless, in general, between 6 and 8 per cent of the
total money supply needs to be in cash to keep the market-place
functioning effectively. The rest can remain as entries on
the books of banks, representing the deposits held in clients
accounts. As the money-lending function of the banking system
then expands the money supply, Central Banks are required
to mint more and more cash just to keep this ratio.
Central Banks also put money into the market-place by what
they call their "open market" activities. In these
activities they buy and sell their government's debt instruments.
If, for instance, a Central Bank buys government bonds or
treasury certificates on the "open market", it is
not providing cash to the government. It is providing cash
to the former holder of the bond or certificate who will,
presumably, then either spend it or invest it. Buying, thus,
is intended to create more economic activity in the market-place.
Selling the certificates and bonds held, on the other hand,
takes money from investors and, provided the Central Bank
does not use that money for its own or government purposes,
provided that the money simply remains unused within the Central
Bank, the selling activity will reduce the amount of money
available for investment and spending, thereby reducing the
economic activity in the market-place.
From the perspective of the money supply itself, when the
Central Bank has to create new units of money to purchase
bonds or certificates, the money supply will expand. Otherwise
its activities will simply shift the location of existing
units of money from one place to another, enticing them into
savings (removing them from the market-place by a time factor),
or causing them to be withdrawn from savings and spent or
Foreign exchange transactions can also result in the production
of new units of money by Central Banks. To see how this happens,
suppose we were back in the days, when Central Banks could
claim on each others' gold. Following the agreement between
international Central Banks at Bretton Woods in the early
1940's individuals were no longer able to claim gold with
their paper money or use gold as a medium of exchange, but
governments could. Under the Bretton Woods Agreement each
currency had a fixed exchange rate with the dollar and the
dollar was guaranteed to be exchangeable for 1/35th of an
ounce of gold; or $35 per ounce.
To see how this works, suppose that General Motors in America
wanted to buy Land Rover in England, before 1971. General
Motors would want to use dollars, the English owners of Land
Rover would want to hold pounds. The English sellers, if they
accepted dollars, would exchange them for pounds at their
bank. If the bank had customers who wanted dollars, it would
then exchange the dollars for pounds. If the bank had no customers
wanting dollars, it would look to the foreign exchange markets
to exchange them for pounds. Failing that, it could exchange
them for pounds at the Bank of England.
If the Bank of England had no pounds available to offer the
commercial bank for the dollars, it would create them. The
Bank of England would then take the dollars to New York to
exchange them for gold. As a result it would receive an additional
amount of gold into its reserves. So there would be no misrepresentation
as a result of this transaction. In fact, the real money supply
(the amount of gold itself) would have increased, decreasing
the gap between the amount of gold required to satisfy all
claims and the amount of gold actually held.
The position in America would be quite different. Once the
dollars were returned to New York, the number of dollars in
the American market-place would have returned to its previous
level, but the amount of gold against which the dollars had
been issued would have decreased by the amount given to the
Bank of England in exchange for the returned dollars. So,
in America, the gap between the amount of gold required to
settle all claims and that actually available would have increased.
Had General Motors borrowed the money at its bank, there would
have been a double dose of the increase. New dollars would
have been produced against existing levels of gold, and existing
levels of gold would have been reduced by the amount transferred
to the Bank of England.
The increase or decrease in the size of the gap occasioned
by this transaction would be unlikely to have affected the
exchange value of gold in either country. In each, the level
of misrepresentation would already have been sufficiently
vast to have pushed the exchange rate of gold to its minimum
So long as the exchange rate of gold itself did not change,
and so long as both dollars and pounds were considered as
valid claims against gold, then the domestic exchange value
of dollars and pounds in their respective markets would also
be unlikely to change. Therefore, under the gold system, or
the dollar/gold system (following the Bretton Woods Agreement),
prices would not have increased or decreased as a result of
these foreign exchange transactions. Only the size of the
respective gaps would have changed.
When President Nixon closed the gold window in 1971 a new
era of the paper monetary system began. The importance of
this change has not yet been widely recognised. Dollars can
no longer be exchanged for a fixed amount of gold. Other currencies
can no longer be exchanged for a fixed number of dollars.
Each country's banking system will debase its currency at
a different rate. There can be no fixed relationships. The
floor beneath the value of the paper money has been removed.
The value of each unit can now plumb untold depths.
The same transaction under the paper money system since 1971
will produce very different results in each country. As units
of paper money are no longer freely exchangeable for gold
by the issuer, the dollars cannot now be returned to America
to be exchanged for gold. Instead they will be held by the
Bank of England as reserves.
These dollars will be held either physically outside the
United States, or on deposit with the Federal Reserve Bank
in New York. They will be deposits set aside as a store of
value for future use by the depositor. They will no longer
be part of the US domestic money supply, but they will be
part of the total US money supply. Being removed from their
domestic market-place by a geographical factor, they will
no longer have a direct affect on domestic US prices. But
they will exist.
Their position will not be dissimilar to that of units of
money removed from their domestic market-place by a time factor.
A five-year deposit, for example, will play little part in
the domestic market-place during its five-year term. The existence
of such units of money is often effectively forgotten, only
to become obvious when they mature and are redeposited as
demand deposits. If inflation becomes so high that investors
are unwilling to renew time deposits and will only redeposit
funds as demand deposits, the money supply appears to increase
dramatically. The apparent increase is false: money which
had been removed by a time factor simply returns.
Similarly when units of money which have been removed from
the market-place by a geographical factor return, the domestic
money supply increases. But until they do return, the transaction
between General Motors and the English sellers will have diminished
the American money supply and reduced the amount of money
available for exchanges unless, of course, the purchase was
financed by a loan from General Motors' American bank.
If the purchase was financed by a loan, the new money created
will have been exported. Previously existing units will not
have been exported and thus the domestic money supply in the
United States will remain unchanged.
In the meantime, back in England, the Bank of England will
also have produced new units of money. They will have issued
new pounds to exchange for the dollars received. So the British
money supply will have increased.
Following Richard Nixon's decision to close the "gold
window", the Bank of England is obliged to hold the dollars
so acquired as reserves until market conditions change and
they are needed to exchange for pounds. When they are exchanged
for pounds, the pounds received in the exchange will not be
destroyed. They will be used in accordance with the domestic
money requirements of the Bank of England, and will remain
a part of the British money supply. So the reduction in Bank
of England reserves will not bring with it a commensurate
reduction in the British money supply to compensate for the
earlier production. The inflation produced by the foreign
exchange transaction will remain in the British market-place.
When the dollars are returned to their domestic market-place,
the American domestic money supply will increase and, where
the transaction was financed by a loan, the inflation produced
by the transaction will reach its ultimate objective: its
own domestic market-place. In due course, all national currencies
must return to their own domestic market-places. So the existing
Eurodollar "mountain" can be seen as a continuing
threat to the domestic exchange value of the dollar.
On the other hand, if market conditions were such that the
dollars were required to finance a purchase in some other
country, then those dollars would enter the Central Bank reserves
of that other country. The money supply of the receiving country
would then increase, and the inflationary effects of the transaction
would be felt in yet another market-place.
Under the new paper money system, units of money removed
from their domestic market-place can move from nation to nation,
increasing each country's money supply en route, and leaving
a continuous swell of inflation in their wake.
There are two primary dangers in this process. The one which
we have already observed is the importation of inflation by
the receiving nation. This can often be signalled when the
reserves of a Central Bank increase. If these increases are
due to the accumulation of foreign paper money, they might
reflect foreign investment in the domestic market-place. If
that is the case the domestic money supply will have increased
proportionately, and it follows that the domestic purchasing
power of that currency will, in due course, decrease.
The other, which is potentially more dangerous, is the ability
of international banks and the international divisions of
multinational banks to expand any nation's money supply. Consider,
for example, Eurodollars: they are accepted as deposits and
loaned with regularity by international bankers. These deposits
and loans are unsupervised by any monetary authority. In this
wider market-place there is no international Central Bank.
So there is no lender of last resort, and no restrictions
on the expansionary money-lending activities of these banks.
The only practical limitation upon the productive capacity
of these lending institutions are the willingness of borrowers
to borrow, the credit worthiness of borrowers, and the prudence
of international bankers.
Nor does the Exchange Rate Mechanism (ERM) stop inflation.
It indexes a basket of individual currencies. Each individual
currency will be being debased by its own banking system.
Each will have no floor: have no level of depreciation beyond
which it cannot go. The rate and extent to which each will
be debased must, therefore, be different. The most that can
be said for the ERM is that it is meant to synchronise the
rate of debasement. It cannot stop it.
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If history is an accurate guide to the future, we can confidently
expect to see the number of claims, receipts or units of money
in the world expand to a point of imprudence. From an historic
perspective, first individual banks expanded their receipts
and claims to the point of imprudence. Bank failures were
experienced and the term bankruptcy was coined. Central Banks
were then established as lenders of last resort to bailout
individual banks which had reached their point of imprudence.
The effect was, by giving them a safety net, to license all
commercial banks to expand their operations to their individual
points of imprudence. Central Banks then allowed their national
money supply to be expanded in multiples, until the international
banking and monetary system as a whole reached its point of
imprudence. This brought the collapse of the gold standard
It follows logically that the international banking community
will now expand the world's paper money supply to its point
of imprudence. Thus we must each ask ourselves some serious
Will the entire system then collapse, destroying the savings
and liquid assets of everyone, including our own?
Will the system's survival instinct produce yet another palliative
which allows some parts of the banking system to survive and
continue their current imprudent and destructive practises,
while the remainder fails?
Will our savings and liquid assets be in the part that survives
or the part that fails?
Would we not be wiser to take action now to correct the system
and thus avoid the risk?
and Business Cycles
"...economic and business cycles are one of the
results of having superimposed the mechanism of money-lending
onto the system for storing and distributing money."
How the use of interest rates to control the financial
hardship and emotional suffering caused by dishonest money
creates economic and business cycles.
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