Why The Money Monopoly is Evil
Part 2 – by Aaron Koenig
Paper Money and Fractional Reserve
Originally, banknotes were nothing else than receipts for gold or silver that were stored safely in a bank vault. Carrying heavy coins was not very practical and quite unsafe, as street robbers could easily assault you. As a result, many people preferred to keep their gold in banks. For practical reasons, people started to use the receipt they received from the bank for the stored money as a means of payment. When the buyer and seller were clients at the same bank, the gold did not even have to be moved when its owner changed. If they had accounts at different banks, the bankers were responsible for the gold’s secure transport. In both cases, the bank subtracted the amount of gold from one client’s account and added it to another one. One had to trust the bankers that they did this without cheating, but many saw this as the lesser evil than running the risk of being robbed. It also made international trade much easier.
Some smart bankers found out a new way to make money: they simply gave out more receipts than they had gold in their vaults, as it was very unlikely that all their customers would come to withdraw their funds at the same time. This enabled them to issue loans and charge interest for money that did not belong to them. In normal life, this would be called deceit. In the financial world, it is called “fractional reserve banking.” Governments legalized the fraudulent behavior of the bankers, and banks were granted the right to only keep a small part of their deposits and to speculate with the rest. In return, banks funded government wars.
But what to do if too many clients withdraw their money at the same time and the swindle gets debunked? To avoid such a “bank run,” a central bank was created as the “lender of last resort.” Its main function was to provide enough money to banks that got into trouble.
The Gold Standard
As paper money led to some financial bubbles and bankruptcies in the 18th and 19th centuries, Peel’s law of 1844 demanded that in Britain all banknotes had to be entirely backed by gold (5). Unfortunately, this applied only to physical banknotes, not to sight deposits on bank accounts, so the fractional reserve fraud could carry on.
Anyhow, due to the relatively strict rules for British banks and the dominance of the British Empire in world trade, many nations followed the British example and adopted a gold standard. Most national currencies had a fixed exchange rate to gold and therefore to each other.
The late 19th and early 20th centuries were periods of immense economic growth. International trade increased. Prices remained stable, in the USA they even dropped. Wealth in the developed world grew steadily, partially as a result of the international gold standard.
But when the First World War started in 1914, all warring nations abolished the obligation of their central banks to redeem gold for banknotes – otherwise, the war would have lasted for only a few weeks. Central banks could then print unrestricted amounts of money to cover the high costs of warfare. Had the gold standard been in place, their gold reserves would have expired in no time.
For more informative content check our most recent article, “What is Sound Money and Why it Matters?” by Kenny Fowler
Hyperinflation and World Economic Crises
The citizens paid for the huge bills resulting from the war. In Germany and many other countries, hyperinflation decimated people’s savings. By November 1923, one US dollar was equivalent to the insane price of 4,210,500,000,000 German Marks.
Some nations tried to return to a common gold standard, but their attempts failed. In 1924 Britain reintroduced the gold standard, but the British currency was overvalued due to the increase of paper money during the war. This became a high burden for the British economy and caused an economic crisis in Britain. This crisis was, however, dwarfed by the global economic crisis, which began on October 24th, 1929, or “Black Thursday.”
This crisis is a classic example of Ludwig von Mises’ theory of business cycles, which states that a boom caused by cheap loans will inevitably be followed by a bust. When investors can borrow money for an interest rate below the natural rate as defined in a free market, they will invest into ventures that are not really lucrative. Sooner or later this will show and must be adjusted, sometimes painfully.
To be continued…
This is an excerpt of Aaron’s book A Beginner’s Guide to Bitcoin and Austrian Economics
Aaron Koenig is a contributor to the Census Blog. He is an entrepreneur, consultant, writer and film producer, specialized in Bitcoin and Blockchain technology. Aaron is the author of the books A Beginner’s Guide to Bitcoin and Austrian Economics, Cryptocoins – Investing in Digital Currencies and The Decentral Revolution