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Money as Fiction: Money and Banking in the United States


Many of us are familiar with the children's game of paper-scissors-rock. It is a game of three-way dominance. Paper covers rock. Scissors cut paper. Rock smashes scissors. The two players simultaneously throw out one or another hand sign. The winner is the one whose sign prevails with respect to the other player's sign.

A similar relationship governs three institutions of power in society: Government, religion, and commerce. Government has power over commerce. (Government controls commerce through application of laws and regulations.) Commerce has power over religion. (Through the lures of materialistic desire, it can undermine religion's influence in personal life.) Religion has power over government. (Religion has the power to legitimize or destabilize government by giving or taking away its moral authority.) In our society, however, commerce also has power over government even if government power is supreme. The system is out of balance.

We think that money has power, but it is only as powerful as its tokens are accepted. Money in the form of paper currency is only a piece of printed paper. In the form of a coin, it is stamped metal. Even if that metal is gold or silver, there is no inherent value in it unless the public believes it has value. Ultimately, what makes the public accept money's value is government. Government declares that a particular monetary token is legal tender.

People speak of "running out of money" as if it were a physical commodity. This is a misnomer. We can no more run out of money than we can run out of inches or miles. Money is a yardstick used to measure ownership and economic power. Money is fictitious. We create money by agreeing to attach value to it as if it were an object or commodity of palpable worth. Our belief is what makes money real.

commodities that have value

The most valuable thing in the world to us is oxygen in the air that we breathe. Without it we would be dead in a matter of minutes. A close second would be clean drinking water. Again, life could not take place without this commodity. In financial terms, however, the life-sustaining air and water have little value. We simply breathe the oxygen around us; and, with a small charge, we drink water supplied by a municipal water system. In contrast, we believe that two substances of comparatively little use, silver and gold, have great intrinsic value. Their substance is recognized as a medium of exchange.

This shows the paradoxical nature of money. This commodity, whose original function was as a substitute for silver and gold, has inherently little worth. Money in itself does not even exist. It is a fiction accepted by civilized society. The fact that a certain currency is “legal tender” means a part of money’s worth is based on the fact that government is prepared to force people to accept it in exchange for the goods and services that they want.

Once money gains widespread acceptance, however, many of us make it the center of our lives. We think we are worth the amount of money that we possess. It is the basis of a socioeconomic hierarchy.

money in the form of silver and gold

Let’s go back to the beginning. Silver and gold were thought to have value because kings desired those commodities. Craftsmen fashioned precious metals into objects used ostentatiously at royal courts. Because these metals were comparatively scarce in nature, they were considered precious. To possess them in a certain quantity denoted a certain level of wealth.

But the precious commodities acquired a real function as a medium of exchange. It was more convenient to carry around silver and gold in bags than herds of cattle. In the 7th century B.C. kings of Lydia poured molten gold into molds of a certain size corresponding to a standard weight. These were the first gold coins. The king’s image and inscription upon the coins certified that the quantity of gold was as stated in the inscription. There was no need to weigh the gold coin each time. The coins became “money” in the modern sense.

For a long time, humanity thought that the wealth of nations was measured by the amount of silver and gold that their political rulers possessed. This idea has gradually been discredited. In the 16th century, Spain became nominally rich from the silver and gold mined in its American colonies. Precious metals from the New World poured into Europe and into the Ottoman empire. The effect was not wealth and prosperity but inflation. The price of goods soared in relation to a fixed quantity of metal. “Rich” Spain eventually went bankrupt.

Another problem was that governments produced coins of impure content. Instead of pure gold, the coins were mixed with base metal. People could not trust money to be what the state said. Powerful persons cut monetary corners to maintain or increase their power.

Three to four hundred years ago, paper currency was issued in Europe. Although this paper had little value in itself, it was “backed” by precious metals which the government stored in a vault. Throughout the 19th century and well into the 20th century, U.S. paper currency was convertible into silver and gold. This meant that a person holding a silver certificate could walk into a government repository and exchange the paper for its designated amount of silver. U.S. currency was fully convertible into gold. The dollar was defined by law as 15 and 5/12 grains of gold at a certain level of purity. In other words, an ounce of gold was worth $35.

Again, the association of money with precious metals had an inflationary effect when large quantities of these metals were mined and put on the market. That was the case in the United States in the second half of the 19th century. Midwestern farmers found themselves heavily in debt to the railroads and banks even as western silver mines were producing huge quantities of this metal. Populist politicians saw a way out of the financial dilemma by advocating the free coinage of silver. If silver became fully convertible into money as gold was, then farmers could pay off their debt in cheap silver.

This was the issue in the presidential election of 1896. Arguing that Americans were being “crucified on a cross of gold”, William Jennings Bryan, the Democratic candidate, advocated the unlimited monetization of silver. The Republican, William McKinley, beat back the populist challenge and, backed by eastern business interests, was twice elected President. The interests of the creditor class prevailed over those of the debtors.

For much of the 20th century, U.S. currency was backed by gold. Franklin D. Roosevelt made it illegal for U.S. citizens to own gold coins or certificates. The gold which was collected by the U.S. government was put in storage at Fort Knox, Tennessee, as backing for the nation’s currency. It gave people confidence that the money was worth something.

In the 1960s, the U.S. government started to mint quarters and dimes with a diminished sliver content. Richard Nixon took the country off the gold standard in the 1970s. Even though some Americans grumbled that their money had become worthless, it was “legal tender”, backed by the economic strength of our nation.

Today money is much more than precious metals and paper currency. Bank deposits, loans, checks, and other financial instruments are part of the nation’s money supply. Many commercial transactions do not involve exchange of physical tokens but are electronic transactions in computer-based accounts. It seems that money hardly exists though its importance in our society is unparalleled.

Some die-hard conservatives, fearing collapse of the financial system, continue to accumulate gold. The price of gold on world markets is inversely related to our sense of financial security and to wealth accumulated in other forms.

how money was created from storing gold

In the late middle ages, goldsmiths rented space in their vaults for individuals to store gold and silver. They gave the depositors slips of paper indicating that they had a certain quantity of those precious metals in the vaults. Such certificates were a receipt for physical commodities that could be redeemed at the depositors’ discretion. In other words, the depositors could present the certificates to the goldsmith and receive their gold or silver back. In practice, they seldom did that but, instead, used the certificates as tokens of wealth to be exchanged for other valuable objects. The goldsmiths’ certificates became money.

That led to what is known today as “fractional banking”. The goldsmiths noticed that few of the depositors actually requested return of their silver or gold. Occasionally someone would come to the goldsmith and trade in the certificate but the bulk of the deposits in precious metals remained untouched. The goldsmiths sensed a business opportunity. They began issuing additional certificates redeemable in precious metals and loaned them at interest to persons needing funds for business purposes. The goldsmiths were able to earn extra income from the interest charged on certificates that they themselves had created. So long as the depositors did not demand return of precious metals in excess of the quantities held in the goldsmith’s vault, the system would remain solvent.

The modern banking system operates on this principle. Commercial bankers, like the goldsmiths, receive money from depositors. From those deposits, they make interest-bearing loans to other parties. The bankers make money if their customers for loans pay a higher interest rate than that paid to depositors. They also make money from fractional banking. In other words, the dollar amount of their interest-bearing loans to customers exceeds the dollar amount of the deposits.

The banks would be in trouble if a large number of depositors came in to the bank at the same time and withdrew their deposits. In a “run on the bank”, the bank would then breach its promise to repay depositors on demand. This would create a crisis of confidence in the banking system. To guard against this situations, banks hold a certain percentage of their deposits in reserve so that they can repay depositors, even if this means a loss of profits from interest-bearing loans.

Only banks can engage in this “money-creating” activity. Commercial banks are chartered by the government. Most are chartered by the federal government although there are some state-chartered banks. (My grandfather owned one of the last banks chartered by the state of Indiana.) The idea is that the government will issue regulations ensuring that banks serve the public interest. In particular, it will require that a certain reserve ratio be maintained lest depositors lose confidence in the banking system and withdraw a dangerously large percentage of their deposited funds.

money and banking in the early days of the Republic

The Continental Congress issued debt to finance the American Revolutionary war. Many investors doubted that they would be repaid. Speculators purchased debt certificates at huge discounts. After the United States Government was established, the Washington administration decided to assume this interest-bearing debt and the debt of state governments and repay it through tariffs and excise taxes.

The Secretary of Treasury, Alexander Hamilton, was the architect of this strategy. While it had the effect of binding wealthy investors to the new government, Hamilton’s policies were not universally admired. The New England shipping industry which had prospered through foreign trade was adversely affected by the federal tariffs and promotion of domestic manufacturing.

The excise tax imposed on alcoholic beverages caused an armed rebellion by farmers in Pennsylvania’s “Wyoming Valley” (near Scranton and Wilkes-Barre). What is known as the “Whiskey Rebellion” was a protest against wealth transfer from poor farmers to rich investors in the continental debt whose interest was being paid from excise taxes targeted to farmers.

As part of its new economic policy, the federal government chartered a national bank known as the First National Bank of the United States. It practiced fractional banking with a ratio of ten dollars of loans for each dollar on deposit. The various abuses connected with this scheme caused a public uproar. The charter of the First United States Bank ran out in 1811 and was not renewed.

The war of 1812 brought economic chaos. In those circumstances, Congress chartered another national bank, known as the Second Bank of the United States, in 1816. Its headquarters were in Philadelphia. This bank operated in much the same way as the first bank. While its charter did not expire until 1836, Henry Clay sponsored a bill to recharter it in 1832. President Andrew Jackson, who was a strong opponent of the Second Bank of the United States, vetoed the bill.

Clay ran for President that year against Jackson who easily won reelection. In his second term, President Jackson removed federal funds from the Bank of the United States putting them instead in certain state banks. He also required that purchase of federal lands be made in “specie” (gold and silver as opposed to paper currency). The national bank was not rechartered.

Since Jackson, there has been a populist tradition within U.S. politics that is suspicious of banking and especially of central banks. Such banks are thought to pursue a policies of monetary expansion leading to expanded business activity.Then they change course, restricting money supply so that many businesses fail and their assets can be cheaply acquired in the ensuing credit crunch. As with casinos, the bank customers may individually make money at certain times but in the end the house dealer always wins. An additional source of complaint is that private interests, the banks, are allowed to “create money” which they can profitably lend to others at interest. And, if the banks fail, the government often bails them out.

the Federal Reserve System

If you look at a dollar bill in your wallet, you will find the words “Federal Reserve Note” printed at the top on the front side of the bill. That means that the dollar bill was issued by the Federal Reserve System, not by the U.S. Treasury Department.

The Federal Reserve System is technically not a part of the government, even though the President appoints members of its Board of Governors. It is, instead, a network of twelve regional banks which are, in turn, owned by privately owned commercial banks in the area. Most national banks and many state-chartered banks belong to the system. Member banks invest a certain amount of stock in the system and agree to maintain certain reserves. They elect two thirds of each regional bank’s board of directors. The other third are appointed by its national governing board, the Board of Governors.

The Federal Reserve System is authorized by law to create money - as much money as it chooses to create. At the same time, one of its main purposes is to keep inflation under control. The money supply in relation to the volume of national economic activity determines monetary price levels. The Federal Reserve expands the money supply when there is a need for economic expansion and restricts it when the economy becomes overheated.

Loose credit means that many unworthy projects will receive funding from the banks and many will fail. Conversely, many worthy businesses will go unfunded during periods of tight credit. It is the banker’s job to assess loan applications from the standpoint of repayment and fund those which seem likely to meet the test of the market.

The Federal Reserve System influences the lending process in two ways:

First, it requires member banks to maintain a certain ratio of reserves on deposit with the Federal Reserve System. The banks would naturally want to lend out a large multiple of its deposits in order to increase interest income. The reserves requirement sets a limit to maintain safety in the banking system.

Second, the Federal Reserve Bank sets the discount rate which is the interest rate at which member banks can borrow money from the system. The higher the discount rate, the higher the rate of interest that member banks must charge their customers. High interest rates, in turn, discourage customer borrowing and slow down economic activity. The Open Market Committee also buys and sells debt securities on the market. Such activity expands or contracts the money supply. The goal is to keep the economy on an even keel, avoiding extremes of boom and bust. Price levels would remain steady.

Even so, the Federal Reserve System has its critics. The chairman of the House Banking Committee, Louis T. McFadden, said in 1932: “Mr. Chairman, we have in this country one of the most corrupt institutions the world has ever known. I refer to the Federal Reserve Board and the Federal reserve banks. The Federal Reserve Board, a Government Board, has cheated the Government of the United States and the people of the United States out of enough money to pay the national debt. The depredations and the iniquities of the Federal Reserve Board and the Federal reserve banks acting together have cost this country enough money to pay the national debt several times over. This evil institution has impoverished and ruined the people of the United States; has bankrupted itself, and has practically bankrupted our Government. It has done this through the maladministration of that law by which the Federal Reserve Board, and through the corrupt practices of the moneyed vultures who control it".

Why such animosity? It should be pointed out that Mr. McFadden was speaking during the depths of the Great Depression. Economist Milton Friedman and others have argued that the Federal Reserve’s board of governors seriously erred in restricting credit at the outset of economic contraction when it should have been expanding credit. The board showed incompetence.

Another objection is that the federal government has assigned to a private group its power to coin and regulate money. The U.S. Constitution states in Article 1, Section 8: “The Congress shall have power ... to coin money (and) regulate the value thereof.” It would seem illegal for a privately owned institution (owned by U.S. commercial banks) to be coining or creating money.

A reason to remove the power to create money from other powers of government may be to eliminate the temptation for the U.S. Congress to spend recklessly on government programs and then print money to pay for it. A group of bankers needs to protect the public against inflation. In practice, however, the federal government regularly incurs budget deficits and the Federal Reserve Bank monetizes this debt.

Here is how it works: “If the U.S. government wants to borrow $1 million, it goes to the Fed (Federal Reserve Board) to borrow the money. The Fed calls the (U.S.) Treasury and says: Print 10,000 Federal Reserve Notes in units of one hundred dollars. The Treasury charges the Fed 2.3 cents for each note, for a total of $230 for the 10,000 Federal Reserve Notes. The Fed then lends the $1 million to the government at face value plus interest.”

The question is why the U.S. government, if it wanted more money for its operations, would not simply create the money itself and give this money to itself without charging interest? Why should the government pay interest on self-created debt to a network of privately owned banks?

Now we get into theories of sinister forces controlling the financial world. It is pointed out by critics of our banking system that the law authorizing the Federal Reserve System was pushed through Congress in 1913 during the Christmas recess when many members were absent. President Wilson was pressured to sign it by his political and financial backers.

It is alleged that the Federal Reserve System is a “private, for profit, central banking corporation owned by a cartel of private banks” aligned with central banks in several European countries; and that behind these banks stand a number of wealthy families: the Rothschilds, Lazard Brothers, Kuhn, Loeb, Warburg, Lehman brothers, Goldman, Sachs, and Rockefeller.

Kennedy's intervention

It is also alleged that, shortly before his assassination in 1963, President John F. Kennedy tried to do something to stop the encroachment upon government authority by the Federal Reserve System. On June 4, 1963, he signed executive order 11110 which stripped the Federal Reserve System of its power to lend money at interest to the U.S. Government. That order has never been amended or repealed.

Kennedy’s order gave the U.S. Treasury Department authority “to issue silver certificates against any silver bullion, silver, or standard silver dollars in the Treasury.” They were to be called “United States Notes” as opposed to “Federal Reserve Notes”. They had a red seal and serial number as opposed to green ones printed on the Federal Reserve Notes. More than $4 billion of these new notes were printed and circulated in $2 and $5 denominations. After Kennedy’s death, the notes were promptly taken out of circulation.

Kennedy’s “United States Notes” were said to be an interest-free currency backed by silver reserves in the U.S. Treasury, giving the government an ability to finance its own debt without paying interest. On the same day that he signed executive order 11110, President Kennedy also signed a bill changing the backing of $1 and $2 dollar bills from silver to gold. Ten days before his assassination, in a comment made to a class at Columbia University, the President reportedly referred to a “plot” against America’s freedom which he promised to expose before leaving office.

It is unclear whether the President Kennedy’s assassination in Dallas on November 22, 1963, was related to his dealings with the Federal Reserve System, to other grievances against the President, or even to unknown motivations of a lone gunman. Nevertheless, the fact that private interests should control the nation’s money supply and that bankers should profit from its fluctuations seems scandalous.

Money is a fiction. It is what we ourselves choose to accept. If money can be instantaneously created, it can be instantaneously destroyed. It can be reconstituted in a variety of new forms. Behind it stands the power of government, and behind government power stands legitimacy based on the will of the people.


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