Economics

The Demise of Money and Credit

Modern banking's math and myths.

By From the May 2013 issue

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LATELY WE HAVE BEEN engulfed by headlines reporting financial turmoil on every continent, in almost every nation, large and small. The commissars of central planning who so marred the history of the 20th century have been replaced by central banks in the 21st. In Cyprus, the new leadership now dares to confiscate citizens’ wealth with a one-time tax of up to 60 percent on bank deposits above 100,000 euros. Self-interested prime ministers blame continental monetary policies for instigating the currency wars that they themselves surreptitiously carry on.

Central banks worldwide, led by the U.S. Federal Reserve, mint new money ceaselessly to bail out insolvent governments, insolvent banks, and insolvent but politically powerful corporations and labor unions. This new money goes first to insiders in the financial sector, who exchange the cheap credit for commodities, stocks, and real estate at ever-rising prices. This is the so-called carry-trade, monopolized by a financial class that uses free money from the Fed to front-run the authorities for insider profits.

From the beginning of the American republic until not long ago, dollars could be exchanged for gold at a parity established by congressional statute (1792–1971, but from 1934–1973 convertible by foreigners alone). Currency convertibility to gold, enforced by law, established a finite limit to the money supply. Inflation—caused by the issue of excess money and credit—would lead citizens to promptly cash out for gold, thus reducing the money supply and ending the rise in prices. In a sense, the system was self-regulating.

With an unlimited money supply, the insolvency of national banking institutions has become an endemic global problem. Depositors are at risk of loss or arbitrary confiscation by panicked political authorities, as in Cyprus. Taxpayers are involuntarily dragooned in to bail out the banking system, as at the start of America’s recession. And if the central bank credit bubble collapses, systemic deflation will be the profound and destructive consequence.

The expropriation in Cyprus, the problems in the eurozone, the unrest in Iceland, and the crisis of the American banking system are but a few examples of legions of insolvencies engendered by the unrestrained and unlimited issue of inconvertible money and credit balances by central banks that are not restrained by effective institutional limits—except that of collapse itself.

This has not always been the case. The institutions of money and credit evolved over a period of three millennia, and the story of their origin suggests that stability and trustworthiness were once paramount goals.

In the Beginning, There Was Barter
FORERUNNERS OF MAN LIVED on the planet several million years ago, but unique social order emerged only 4,000 to 5,000 years ago. Historical and archeological evidence suggests that the institution of money evolved coterminously with civilization. From the standpoint of the 100,000-year history of Homo sapiens, civilization and money are but young and fragile reeds.

In the beginning, there was barter: the moneyless exchange of one man’s goods for those of another. Each family stored varied supplies—wheat, wood, or venison—to exchange directly for others—cows, tools, or coal. But barter cannot always work. For example, the meat one man produces might not be desired by the person with whom he tries to trade.

Thus other, more indirect forms of commerce developed. Under a system called potlatching, practiced by natives in northwestern North America, one party gives a gift with the hope but not the certainty of a return. There is no guarantee of an immediately satisfying exchange, but in a tight-knit community, reciprocal faith acts as a sort of invisible currency—the “money” of a moneyless community. Gifts are given in exchange for unwritten promissory notes, implied liabilities that the grateful debtors repay in the future with gifts in return.

Potlatching amplifies barter and indirectly tends to encourage growth. All members of a community freely make goods for one another, which are often repaid in kind and more. As George Gilder puts it, this productive circle of givers increases the sympathy of its members for the special needs of one another.

Money evolved through a historical process not unlike that of trial and error or natural selection. But standardized and certified coins originated with an act of human creativity around 650 b.c.

The first such coins appeared in Lydia, Asia Minor, at a time when the original Sumerian civilization was in its fourth millennium of development. The Lydians minted coins using a natural mixture of gold and silver called electrum. Lydian coins exhibited specific properties that made them uniquely suitable as a medium of exchange: They were small, portable, and enduring. Made of scarce precious metals, they were beautiful and cherished. Men had exerted great effort and intelligence to produce them, giving them intrinsic value.

The test of time proved the lasting worth of Lydian coins. Merchants came freely to select these coins for their intrinsic monetary properties, and they became increasingly accepted in ever-widening trade by people of many tongues in the Levant and Near East.

Coins became a useful yardstick by which to measure the value of the other products of human intelligence available on the market. Their high value, relative to their small size and low weight, made them easy to transport and store. History taught the ancients that the value of these precious metals endured, and that their purchasing power remained reasonably stable from year to year, even generation to generation.

Money enhanced the options of all those who toiled, augmenting their freedom to provide for themselves as they pleased. Workers could defer purchases because they held concrete tokens encompassing an irrevocable right to demand future goods. They could even leave a surplus for their children. Real money lasted. It could be inherited and passed on.

Indeed, the concept of money that emerges from dusty history books is no ivory tower abstraction. No one from the local Bureau of Engraving inaugurated it for purely abstract considerations. No one foisted it upon civilization. Until recently, money was real—a tangible article of wealth.

Along with the wheel, money joined parochial communities to one another, enlarging the fellowship of production by trade. In a mere 4,000 years, money transformed the closed economy of the tribe into the open and integrated economy of the whole world. Money became the permanent link among work, family, past, and future. It was no less than the lifeblood of an enduring culture, the hemoglobin of commercial civilization.

The practice of trading on credit goes back nearly as far. By early modern Europe, man had mostly developed the institutions of credit as we know them today. The essential instrument of commercial credit arose because the entrepreneur often did not have the money to pay for the supplies needed to produce his goods. The materials in question—say, cloth—could act as visible security for a loan. Thus the supplier of the cloth would ship his goods to the textile maker, who could not pay cash, accompanied by a bill of credit. The cloth was pledged as collateral until the textile maker could complete production and sell the finished goods for cash. Therewith payment was remitted to the shipper—whereupon the bill of credit was requited and canceled.

The process entailed a credit risk, but it was relatively low, since the exchange was legally secured by the goods themselves. So once the bill of exchange had been signed and secured, the claim itself could then circulate as currency among merchants and banks until it was paid at maturity. Coin and bullion were thereby conserved.

The Math of Modern Banking
A COMMERCIAL CIVILIZATION gradually engirdled the earth, money and credit continued to evolve. Double-entry bookkeeping, in which debits and credits are recorded separately, was invented in 14th-century Italy, and allowed for the development of more complex institutions.

By the 17th century, goldsmiths had realized that most of the clients who, for a fee, deposited money in their vaults for safekeeping did not need it immediately. Though deposit receipts or bank notes could be presented on demand to reclaim the gold, never were all the receipts presented for redemption simultaneously. Thus, goldsmiths developed the practice of lending with interest a portion of the depositors’ money to others for short terms, holding only a prudent fraction in reserve. (Hence the phrase “fractional reserve banking.”)

Rules of thumb were developed from experience, and bankers came to believe that a certain percentage—say, 10 percent of deposits—should be held on reserve to meet the demand for coin or bullion. But this rule was no more than the distillation of historic wisdom about the recurrence of demands for redemption.

In this way, European goldsmiths and silversmiths of the 17th century, acting as depositories, were in part the forerunners of modern commercial bankers, just as producers, merchants, and shippers—at about the same time—elaborated more intricately the ancient practice of trading on credit. Commercial banking joined these two practices in an organic fusion that to this very day confuses the concepts of credit and money.

The 17th century banker not only accepted deposits of coin and bullion, but he also purchased bills of credit from merchants who wanted money right away. Thus suppliers were able to receive cash promptly for the sales of their goods, even if the purchasers were buying on credit.

Commercial banking grew out of the desire (inspired by the profit motive) to conserve cash and, by means of credit, to provide financial elasticity in the commercial process of exchange. That is, all producers who desired true money instead of the short-term promissory notes of their customers could, through the mediation of goldsmiths and merchants turned bankers, obtain real money.

Inflation Means Destruction
DURING THE MODERN ERA, merchants and bankers learned to substitute inexpensive and easily handled fiduciary paper for coin. At first paper money consisted of bank notes or bills, exchangeable at a constant rate into a specific weight of gold and silver. By means of the lawful stamp of convertibility to gold, a near worthless paper was suffused with a monetary life of its own. It circulated in place of coins and bullion because it was even more convenient, equally divisible, and above all secured by the substance of real money. Moreover, convertible paper and deposit currencies conserved still further the scarce mineral, labor, and capital resources previously invested in the production and circulation of precious bullion or coins. One sees in this evolution that money became a unique conservator, and the effective mechanism of growth of a civilization born of scarcity.

But because money is based on trust, it entails moral obligation. Not all forms of money are equally acceptable to free men; those without real substance tend to break down, leading to depreciation of value, decline in long-term purchasing power, and ultimately disorder.

Inflation means the destruction of an essential instrument of the marketplace: the political institution of stable, trustworthy money—which is to say, money that preserves purchasing power over the long term. The endurance of civilization is linked to a stable monetary standard. Inflation or monetary depreciation entails a price revolution. It often precedes, and indeed it may cause, a more thoroughgoing political revolution.

Inflation prevails in America and the world today because of a breakdown of the institutions of trust that convertibility to gold once provided for the dollar. People no longer gladly accept and hold the dollar for long periods. They try to get rid of it in favor of something real: commodities, automobiles, real estate, equities, art, antiques, or coins. Producers and consumers have lost faith in the dollar because the government and the Federal Reserve have created more dollars than participants in the market desire to hold. Government overproduced money and credit in order to finance its colossal deficits and manipulate the economy, prices, demand, and employment levels. As a result, the paper dollar has ceased to be real money. Paper money is neither an article of wealth requiring labor to be produced, nor is it today linked permanently to anything of real value. The marginal cost to the Federal Reserve of adding one more paper or deposit dollar is zero.

Ours is an era wherein stable monetary institutions have broken down, and historians will recall our era as an Age of Inflation. 

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About the Author

Lewis E. Lehrman is a senior partner at L. E. Lehrman & Co. and chairman of the Lehrman Institute.