1. THE ORIGIN AND NATURE OF MONEY
2. THE QUANTITY THEORY OF MONEY
3. MONEY-CREATION BY BANKS
4. HISTORY OF MODERN MONETARY STANDARDS
5. A "MANAGED ECONOMY" UNDER THE FEDERAL RESERVE SYSTEM
6. MONEY IN THE ELECTRONIC AGE
7. CONCLUDING REMARKS
8. SOME REFERENCES

  I. THE ORIGIN AND NATURE OF MONEY

The Byzantine gold solidus, introduced by Constantine the Great in 309 AD, retained its weight and purity for six centuries before beginning to be debased. The Byzantine government had a strong incentive to maintain quality in order that the golden solidus would not be displaced by other coins as a standard of international commerce.

Drachma is Greek for "handful". Originally it referred to a handful of iron nails, but it became the name of a silver coin in ancient Greece and is currently the name of the Greek monetary unit. Pound, livre, lira and ruble were originally terms for metallic weights. In the year 775 A.D., 240 silver coins known as sterlings weighed one pound — money in the Saxon kingdoms of England. The Norman conquerors later divided the pound into 20 shillings.

In the 16th century a Bohemian count who discovered silver deposits on his land began mining the metal and minting coins. He produced coins of such reputable quality — and in such quantity — that his thalers (abbreviating the name of the Joachimsthal valley) became world-renowned. Variants of the word "thaler" became the name of coins in many countries, including "dollar" in Scotland.

The silver peso was first coined by Ferdinand & Isabella of Spain. It was divided into eight reales ("pieces of eight") or eight bits — making a quarter "two bits". Because exportation of coins from Britain was forbidden by law — and because Mexico was producing half the world's silver output and operated one of the world's largest mints — Spanish pesos were the dominant currency through all the Americas. English-speaking peoples in the Americans called the coins dollars rather than pesos. Mexican silver dollars remained legal tender in the United States through most of the 19th century, despite the fact that the United States minted its own silver coins beginning in 1794. The overwriting of P (Peso) with an S (Spanish or Silver) was the probable origin of the "$" sign.

Although monies have originated from objects having commodity value, once objects are accepted as money they acquire additional exchange-value. Poker chips have little intrinsic value, but may have great exchange value as IOUs for "real money". When bank notes were issued by early reputable private bankers, they were fully backed by gold or silver and functioned as debt instruments that were more easily transported and stored than bulky gold or silver.

Modern governments have successfully separated monetary value from commodity value in the evolution of fiat currencies. (A fiat is an enforceable decree issued by a king, dictator or other government agent. Fiat money is paper or tokens made legal tender by fiat rather than by convertibility into commodity-money.) Separation of money from commodity value by governments opened the door for the inflationary practices of governments and their counterfeiting competitors.

China has had a long history of autocratic empires and emperors, so it is not surprising that money was backed by threats of violence rather than by commodity-value. Tokens made of brass or copper had square holes in the middle so they could be strung together. Printing, ink & papermaking originated in China. The world's first paper money was issued during the Tang Dynasty, reaching its peak during the Ming Dynasty. Kublai Khan issued a paper currency in 1273 backed by severe threats against any who refused to accept the bills as payment. The government confiscated gold & silver, giving paper money as replacement. Nonetheless, the abuses of fiat money finally led to it being abandoned at the end of the 14th century. Paper money was not readopted in China until the 20th century.

By 1740 twelve of the original thirteen American colonies had issued paper money (Virginia was the exception). Beginning in 1775 the Continental Congress issued Continental Currency denominated in Spanish milled silver dollars. By the late 1780s Continental notes were exchanging for as little as 250 Continental dollars per Spanish milled dollar. When the Constitution of the United States was ratified in 1787 it prohibited state governments from issuing any form of money, and it only authorized Congress to coin money. Banks, corporations, municipalities and even private individuals were not prohibited from issuing money, however. In the following years there was extensive counterfeiting as well as effort to detect and prevent counterfeiting. Some of the intricate designs and colors used in engraving at that time has not been matched to the present day. Although some questioned the constitutionality of the right of the Federal government to issue fiat paper money, this was ignored as a result of the urgency created by the Civil War. Congress authorized the issuing of notes on July 17, 1861, and private bank note companies produced the first greenbacks for the Treasury Department. The Confederate States of America also began issuing paper money in 1861. Most of the sessessionist state governments issued money during the Civil War.

At the end of the American Civil War over one third of US paper currency in circulation was counterfeit. The choice of the color green for the back of bills was due to the discovery of a chromium oxide green ink that made counterfeiting more difficult. Currently American currency notes are printed on a textile, rather than wood-based, paper — 75% cotton & 25% linen (flax), with blue & red polyester security thread. Other security features to prevent counterfeiting include designs, microprinting, watermarks, plastic strips, and special inks (including magnetic inks). (Between 0.01% to 0.02% of the U.S. notes in circulation are estimated to be counterfeit.) In 1865 the Secret Service was created as a branch of the Treasury Department charged with combating counterfeiters. (In 1906 the Secret Service was also given responsibility for protecting the President of the United States.) Most of the responsibility for issuing notes was transferred to the Federal Reserve System in 1914, but not until 1974 did the Federal Reserve assume all of the responsibility for issuance of notes from the Treasury Department.

All US paper currency has contained the words "In God We Trust" since 1963, after Congress replaced "E Pluribus Unum" as the National Motto. For a detailed explanation of the material printed on a $1 bill, click here. All bills weigh about one gram, and can be double-folded (forward then backward) about 4,000 times before tearing. The cost of producing notes varies between four to ten cents.

The average one-dollar bill remains in circulation 22 months before it is regarded as too worn for further use. As of June 30, 2004 the value of one-dollar bills in circulation was $7.765 billion (amounting to 1.1% of the total value of currency in circulation) and the number of one-dollar bills in circulation was 7,765 million (amounting to about 34% of the total number of bills in circulation). Denominations greater than $100 have not been issued since 1969. 95% of American paper money printed is for replacement of worn bills. A website called Where's George attempts to track the travels of US paper currency, often stamped with the URL "www.wheresgeorge.com", which purportedly does not count as defacement according to the standards established by the Bureau of Engraving and Printing.

In 2001 only 19% of transactions were done using cash — down from nearly 25% a decade earlier. Despite the fact that the average adult carries $100 in cash, per capita outstanding currency was over $2,000 — most of which was overseas. The rest was presumed to be used in cash-intense transactions, most of which may involve tax-evasion, drug-trafficking and other criminal activities. Increasingly, heavy cash use will be used by law-enforcement agencies to detect criminals & criminal activity. More than two-thirds of American currency is held outside of the United States, particularly in Latin America, Russia and the Middle East. The $100 bill is the denomination of choice. The Secret Service has offices in Moscow and Cyprus. The latter was created because of militant Islamic groups in Lebanon which have produced billions of dollars in counterfeit $100 notes.

Although American coins once had intrinsic value based on precious metal content, they have become a token-metal adjunct of paper fiat currency. The dime, quarter and half-dollar are mostly copper, with just under 10% nickel. The 5-cent piece is 25% nickel and the balance copper. Pennies are copper-plated zinc (97.5% zinc) (US Mint). The practice of milling (adding vertical edges) to coins worth more than a nickel began when the coins were still being made of precious metals — and could be clipped. All U.S. coins are dated with the year they were created, in contrast to U.S. paper money which is bears the year in which a Series (design) was introduced.

The Canadian penny & 5-cent piece have the same composition as their American counterparts, but the dime & quarter are pure nickel. The Canadian dollar coin (loonie) is aureate bronze and the two-dollar coin (twonie) is an inner ring of aureate bronze within an outer ring of nickel. The two-dollar coins last an estimated 20 times longer in circulation than the paper bills they replaced (Canadian Mint).

The cotton cloth character of paper money makes it very absorbent. Warmed by body heat, moistened by body moisture, and passed from hand to hand by a large variety and number of people, paper money can provide a good growth medium for microbes. A study of one-dollar bills in Western Ohio evaluated for bacteria found potentially pathogenic organisms in 94% of the bills [SOUTHERN MEDICAL JOURNAL; Pope,TW; 95(12):1408-1410 (2002)]. A similar study of 100 currency notes in India found one or more types of bacteria on 96 of the notes, and fungal contamination on 72 of the notes [INDIAN JOURNAL OF PATHOLOGY & MICROBIOLOGY; Basavarajappa,KG; 48(2):278-279 (2005)]. A study of coins from 17 countries concluded that the bacteria found did not constitute a health hazard provided care was taken to wash hands before handling food or dressing skin lesions after handling coins [JOURNAL OF ENVIRONMENTAL HEALTH; Xu,J; 67(7):51-55 (2005)].

Some people imagine that by writing a check they are creating their own currency. A check is simply a written order to transfer ownership of money that is being stored elsewhere (paper money with "backing" would play a similar role). The "backing" for a check is the "checkable deposit", which doesn't equate with currency. In the United States all checks have a nine digit transit/routing number which uniquely identifies the financial institution in the American Bankers Association (ABA) payment system for the clearing of checks. The first two digits identify the Federal Reserve district, the second two digits identify the Federal Reserve offices or collection information, the following four digits are the ABA Institution Identifier and the final digit is a verification digit.

Less than 10% of all the American dollars in the world are represented by coin or paper money. Money-supply is generally described in three categories: M1, M2, and M3. M1 is intended to refer only to money as a means of payment, whereas M2&M3 include M1 plus money market funds (such as treasury bills). M1 — currency, travelers' checks and checkable deposits — is intended as a definition of money devoted to spending. Before deregulation banks could not pay interest on M1, but now that many banks pay interest on checkable deposits the definitions are less distinct. M2 includes M1 plus savings accounts, small denomination time-deposits plus shares in money market mutual funds by individual investors. M3 includes M2 plus large denomination time-deposits and shares in money market mutual funds by institutional investors. A definition of money known as MZM (Money of Zero Maturity) includes M1 plus all credit instruments with zero maturity and redeemable at par. Oddly, most definitions of money exclude government deposits held in banks & central banks (such as money received from taxes).

The expanded definitions of money beyond M1 are based on the assumption that the more price-stable and easily-sold an asset is, the more it resembles money. Treasury bills are readily marketable for a pre-determined price, causing them to be viewed as a form of money. Although stocks & bonds can be as liquid as money-market funds, their asset value is less stable. If a sharp distinction is made between money claims and credit claims, then credit claims cannot be money because they cannot be used to directly purchase goods & services. Nor can credit claims count as reserves for monetary expansion.

Austrian economists distinguish between credit transactions and monetary transactions in defining money supply. Use of a credit card is actually a short-term loan to make a purchase. Similarly, traveler's checks (mistakenly included in M1), are credit claims on the portfolio of the financial institution which issued the traveler's checks. Demand deposits, by contrast (also included in M1) are true "money substitutes", treated by those engaged in transactions as if they were cash. Savings deposits are becoming increasingly equivalent to demand deposits, given the ease of transferring from one account to another. Monetarists & Keynesians abandon efforts at conceptual definitions of money in favor of econometric empirical ones (begging the question).

For more on controversies surrounding definitions of fiat money supply see "How Should We Define the Money Supply", "The 'True' Money Supply" and "The Mystery of the Money Supply".

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 II. THE QUANTITY THEORY OF MONEY

The quantity theory of money has been attributed to the philosopher David Hume. In this view the value of money is directly proportional to the amount of goods & services in an economy — and inversely proportional to the quantity of money. More simply, doubling the amount of money would double the price of goods. There is thus little advantage to be gained by increasing the money supply, since demand for goods will result in a "clearing price" for money, against the supply of money in an economy. In the words of Dr. Murray N. Rothbard, "Every supply of money is always utilized to its maximum extent, and hence no social utility can be conferred by increasing the supply of money".

To illustrate the quantity theory of money one can imagine a tiny economy on the island of Fantastica consisting of 1000 silver coins and a few items of commerce: bushels of coconuts costing 10 coins each, axes costing 30 coins and oxen costing 100 coins each. If there were suddenly 2000 silver coins in the economy, then the coconuts would become 20 coins per bushel, axes 60 coins each and oxen 200 coins each. Doubling the amount of coins doubled the price of goods (this assumes silver coins have no value but exchange-value — a simplification implying that coins would be no different from paper money). If the additional 1000 new coins had been discovered by someone in a treasure chest, that person would benefit disproportionately as the new money entered the economy. If Fantastica had used government paper money rather than silver coins, then a doubling of the supply of paper money by government printing or by counterfeiters would similarly double prices. In fact, such money supply increase would not only disproportionately benefit the government/counterfeiters (because they would begin spending the new money while the old prices still prevailed), but could more than double average prices because of the fear/expectation of future money supply increases by the same means.

Inflation is better described as an increase in quantity of money than as price increases. Price increases partially reflect future expectation of inflation. If the government begins expanding money supply following a long period of no such expansion, prices will take time to increase as the new money works its way through the unsuspecting economy. However, if the government has been expanding money supply on a regular basis, prices should continue to rise even after the government stops inflating because most people still have the expectation of future inflation. Apart from expectations, prices are also influenced by productivity. If a growing economy is increasing the total goods & services available and the government is increasing the amount of money, prices may remain unchanged — masking the inflation. Economists of the Austrian school distinguish between inflation and price inflation.

Yale economist Irving Fisher attempted to mathematicize a quantity theory of money with the equation MV=PT ("the equation of exchange"), where:

PT = total cost of what is bought
MV = total amount of monetary payments
P = average price for all transactions
T = number of transactions in a time period
M = quantity of money in the economy
V = number of times the money-supply is used in the period ("velocity" of exchange)

Simply put, for the economy as a whole, buying (MV, regarded as the "money" side of the equation) equals selling (PT, regarded as the "goods" side of the equation).

For example, if the average price P of transactions is $20 and the total number of transactions T performed in a time period is 5 billion and the total amount of money M in an economy is $10 billion, then the $10 billion has been used an average of V=(PT/M)=($100 billion/$10 billion)=10 times/period. If 10 billion transactions had been performed in the period — or the money supply had been $5 billion — the velocity would be doubled to 20. The longer the period of time between transactions (or the larger the amount of money held between transactions), the slower the velocity. In hyperinflation velocity becomes very high because people want to spend money as soon as it is acquired because it is losing value so fast.

The velocity concept can be justified by a scenario in which an employee could be paid either $1,000 every 2 weeks or $500 every week. In the former case, average cash holdings are $500, whereas in the latter case the average is $250 (assuming it is all spent, and spent at a uniform rate). The weekly payment schedule uses twice the velocity & half the quantity of money to achieve the same effect as the biweekly payment schedule.

Velocity of money in a real economy is typically calculated by equating PT (indexed prices relative to a base year) with GDP (Gross Domestic Product), and dividing by M, ie, V=(PT/M)=(GDP/M), where M could be M1 (V1), M2 (V2) or M3 (V3). Keynes said that V depends on interest rates and that M must be accounted-for by changes in V (a statement that would make V the independent variable, M=(GDP/V) ). Equating PT with GDP is questionable. The GDP is a government-compiled statistic that focuses on final goods & services (consumer), ignoring the transactions associated with production, GDP=C+Ig+G+X-M. [C=personal Consumption, Ig=gross Investment, G=Government spending, X=eXports and M=iMports.] In the Keynesian model, government deficit spending (keeping the money supply constant) will boost GDP and Velocity, by V=(GDP/M).

The Monetarist Milton Friedman claimed that because V is constant, VM=GDP shows that GDP can be increased by increasing M. In fact, these ideas, and those of Keynes, are a reductio ad absurdum of the equation of exchange — economic wealth is produced by increasing a nation's goods & services (and the capacity to produce goods & services), not by monetary manipulations that make GDP look larger. (Friedman's assumption that velocity is constant was based on data obtained before all forms of gold conversion was suspended by Richard Nixon in 1971 — claims have been made that velocity accelerated thereafter.) Similarly spurious is the claim that V is not constant, and that GDP can be increased by increasing V.

The concept of "velocity" is based on the idea that money "circulates". Critics have asserted that money does not "circulate", it changes hands — and money cannot change hands more often than goods change hands. Money & goods change hands rapidly in hyperinflation and in times of high speculative activity (items bought for the purpose of being resold rather than consumed), but this would not be a sign that the demand for money has increased.

The first century of Spain's colonization of America (1500 - 1600) was unusual insofar as the vast importation of newly discovered gold & silver from the Americas drove Spanish prices up 400%. During the 19th century, when most of the world was on a gold standard, prices typically fell by a small amount each year except in times of war when governments used inflated money to finance their military. The great durability of gold meant that the mining output of any one year had little effect on the total world supply of gold (which had accumulated for centuries). With the supply of goods increasing at a rate slightly greater than increases in the supply of gold, mild deflation boosted the real income and living standards of every worker.

In the year 1900 most goods in the United States were cheaper than they had been in the year 1800. In the 25 years following 1872 the cost of milk, rice, mutton, butter, tea and many other commodities had dropped about 50%. Contrast this gold-standard period with the era of government-controlled money: in 1997 a US dollar was worth only 14 cents (14%) of a 1947 dollar. Some people have argued that the supply of gold is inadequate to serve as a medium of exchange in the modern world. But market conditions cause supply to match demand at a clearing price for any commodity, including money. The price of gold would rise to meet the demand and/or other commodity-monies would enter the market to fulfill the demand for money.

Because price level corresponds to the relationship between the supply of goods and the supply of money, price inflation will result either from an increase in the supply of money or from a decrease in the supply of goods. Conversely, price deflation will result either from a decrease in the supply of money or an increase in the supply of goods. If the supply of money is increasing in tandem with an increase in the supply of goods, the money inflation will not correspond to a price inflation — prices will not change. The price deflation resulting from fractional-reserve monetary contraction in a recession has very different economic implications from the price deflation resulting from increased productivity.

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III. MONEY-CREATION BY BANKS

According to Austrian business cycle theory, fractional reserve banking lies behind the "boom and bust" cycles that have plagued the world since the establishment of central banks. Central banks underwrite and utilize fractional reserve banking. Central banks expand the money supply by adding to bank reserves rather than by printing money. A $1 billion addition to bank reserves by the central bank gives chartered banks $10 billion additional money to lend. Would-be borrowers with marginal credit find it easier to borrow. An artificial boom is created in which the monetary inflation begins to lead to price inflation. The central bank may try to stem the price inflation by withdrawing $1 billion of reserves, leaving chartered banks with $10 billion less money to lend. Companies with high levels of debt are most vulnerable to economic slowdowns. As businesses fail and the economy falters, borrowers struggle to manage their debts and banks become increasingly unwilling to risk making loans from their remaining reserves. Price deflation results from the contraction of reserves, from the reduction of reserves being loaned, and from the unsold goods & idle resources which resulted from malinvestments during the credit expansion.

The character of central banking was established early with the world's first central bank, the Riksbank in Sweden. Under the authority of the Parliament charter of 1668 banknotes from Riksbank were Sweden's only paper money, redeemable in precious metal. In exchange for this charter the bank agreed to loan money to the government. In 1720 when the government failed to repay a loan, panicked citizens tried to redeem their banknotes from the insufficient reserves held at Riksbank. To deal with the crisis, Parliament declared Riksbank notes to be legal tender that satisfies any claim to payment — without the requirement to redeem in precious metal.

Central banking in Britain arose from a more competitive tradition. In 1545 Henry VIII granted English citizens permission to charge interest on lent money. Since the early 17th century British goldsmiths had been issuing deposit receipts for gold held for safekeeping in their "strong rooms" — and these receipts were circulating as money. In 1694 William of Orange was desperate for money to finance his war against France so he authorized the creation of the Bank of England by a Scottish promoter. The Bank of England issued banknotes, most of which were used to buy government debt. Impressed by the royal authorization of the institution, many British citizens deposited their gold with the Bank in exchange for receipts or banknotes. But fractional reserve practices led to a disastrous bank-run within 2 years. The government defended the Bank of England by allowing the Bank to suspend all payments for 2 years. And the Bank of England continued to help the government with its need for financial assistance.

Private banks competing with the Bank of England received a boost in business in 1730 with the advent of the printed check. The Bank of England's efforts to finance the war against France and the outflow of bullion to private banks led the Bank of England to suspend its obligation to repay its notes in gold in 1797. The Bank did not reinstate a gold repayment system until 1821.

Central banking was formally instituted in Britain by the Peel Act of 1844. The Bank of England was granted a monopoly on the issuance of banknotes. Private banks could only hold demand deposits (checking accounts), redeemable in Bank of England notes. Britain was the first Western nation to adopt this central banking structure and the United States was the last.

Early in the revolutionary years, the American Continental Congress authorized paper bills ("continentals") which were supposed to be worth one Spanish dollar (peso). Despite threats of severe penalty for traitors who would not accept continentals, their value inflated by a factor of 75 within 4 years. In partial reaction against the tendency of governments to print inflated currencies, Article I Section 10 of the U.S. Constitution stated that "No State shall ... make any Thing but gold and silver Coin a Tender in Payment of Debt."

The Democratic Party of Thomas Jefferson stood as the defender of hard money for most of the 19th century. The Second Bank of the United States was a weak attempt at a central bank (it lacked a monopoly on banknotes), but its central banking powers were nullified by Democratic President Andrew Jackson in the 1830s. Hard-money Democrats were able to restore the gold standard in the United States in 1879. But the National Banking Acts enacted during the Civil War had destroyed the issuance of bank notes by state chartered banks and monopolized the issuance of bank notes for a few federally-chartered national banks. In 1913 (with strong backing from the Rockefeller & Morgan banking interests) the Federal Reserve Act brought a central banking system to the United States.

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 IV. HISTORY OF MODERN MONETARY STANDARDS

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  V. A "MANAGED ECONOMY" UNDER THE FEDERAL RESERVE SYSTEM

Apologists for the American central bank say that there were bank failures in the United States prior to the Federal Reserve System. This is true — where business is freely practiced, poorly run or poorly located businesses will fail. Free markets mean rapid progress through trial-and-error, rather than the stiflingly slow progress (or regress) of a controlled economy. But bank failures were far fewer under free (or semi-free) banking than under central banking. The ratio of capital to loans in American banks went from 40.5% in 1836 to 55.1% in 1842, falling to 41.3% in 1862, to 17% in 1913 and to 5.6% in 1989. In New York State, which had the largest, most free banking system, bank failures from 1838 to 1863 were less than one-third of 1% per year, on average (with customers receiving an average 75 cents on the dollar in the failures). By contrast, under central banking the rate of bank failures in the 1920s was in excess of 2% per year. And in the 1930-1933 period about one-third of all US banks failed. Depositors lost more money in the first 20 years of central banking than had been lost in the 75 years before central banking. Bank failure rate declined after 1934 when the institution of Federal deposit insurance effectively created a welfare system for bankers, allowing federal money to bail-out poorly managed banks — thereby underwriting inefficiency and encouraging risk-taking. The consequences of this moral hazard were amply demonstrated in the "savings & loan crisis" of the 1980s and the American housing boom and bust.

The Federal Reserve Act of 1913 established the Federal Reserve System (headed by the Federal Reserve Board) as the central bank of the United States ("the Fed"). Of course, this move was touted as the creation of high-minded oversight for money & banking that would rise above the petty interest of the market place. Conveniently, the Fed doubled the money supply during World War I to finance the war effort.

The inflation wrought by wartime government spending in Europe was far more severe than that in the United States — particularly in Germany, where a postage stamp for local delivery cost 100 billion marks in 1923. The inflationary crisis in Germany undoubtedly made people desperate for a New Deal from a "high-minded" leader like Hitler, who had no trouble rising above the petty interests of peoples who would be free. As has been mentioned, Roosevelt's New Deal made the possession of gold punishable by imprisonment for American citizens.

The Federal Reserve Act of 1913 forced all banks in the United States to become part of the Federal Reserve System. This meant that their reserves (for fractional reserve banking) had to be demand deposits at the Fed. US Dollars became Federal Reserve Notes, backed (fractionally) by gold. The fractional reserves of gold held by the Fed were "backing" for the fractional reserves of Federal Reserve notes (amount dictated by the Fed) for the member banks. The system was so "successful" that in the period from 1921 to 1933 more than half of the 30,000 US banks went of business. In 1938 the Fed doubled the reserve requirements for member banks from 10% to 20%, an economic shock treatment that led to disastrous credit liquidation.

Outlawing gold for American citizens was only half the battle for a truly fiat currency, however. As long as dollars went abroad, foreign governments could demand gold for the dollars. But central bankers in foreign countries were all engaged in the same struggle for independence from the discipline of the gold standard that the Fed was attempting (as described in the " History of Modern Monetary Standards" section of this essay). Once unencumbered by the gold standard in the 1970s, the Fed could back-up its reserves by printing as much money as it liked.

The Fed controls money supply not so much by the amount of money it prints, but by the amount of reserves created in the banking system — and the fractional reserve requirement dictated by the Fed. After 1980 the fractional reserve requirement was gradually lowered from 14% to 10%, which increased the money supply considerably. In March 2020 the Fed reduced the reserve requirement to zero (0%). Reserve requirements for nonpersonal time deposits and CDs were eliminated entirely in 1990.

The Fed is currently not changing reserve requirements as a means to implement monetary policy. Nor do changes in the discount rate have a significant impact on money supply. The key to the Fed's control of money supply and interest rates is through its open market operations, ie, buying and selling of US government debt instruments (bonds, T-bills, etc.) through Primary Dealers. (Just over 20 Primary Dealers are authorized to buy & sell with the Fed, including Goldman Sachs and Morgan Stanley.) The buying or selling can be either permanent or temporarily through repurchase agreements (repos) or reverse repurchase agreements. For example, the Fed could increase money supply by buying $1 billion of US government bonds. The Fed writes a check to a bond dealer for $1 billion from the Federal Reserve Bank of New York and then the bond dealer deposits the check from the Fed with a commercial bank.

But a check from the Fed does not "clear" the way other checks do. The check creates a deposit at the Federal Reserve Bank, increasing the commercial bank's reserves by $1 billion. The Fed has spent no money — it has simply written a check creating $1 billion in new money. But with a fractional reserve policy of 10%, the commercial bank was able to make $9 billion in new loans. Thus, the $1 billion purchase by the Fed has increased money supply in the economy — while helping supporting the market price of the government's bonds. Unlike the obvious inflation of printing money — which only enriches the Treasury Department — inflation through credit-expansion (lowering interest rates) enriches the Treasury from the $1 billion from the bond sale, could enrich the Fed by the interest collected on the bonds (the Fed gives the interest back to Treasury, but can keep interest or dividends from other securities), and enriches the commercial bank by the interest collected on the additional loanable funds. The purchase also ensures that the government benefits disproportionately from the new money, while others (such as pensioner's living on fixed income) are harmed disproportionately by being the last to experience the inflationary effects.

The main tools the Fed has for control of money supply & interest rates are the fed funds rate and the discount rate. In a free market, interest rates are determined by the supply & demand for monetary savings. In contemporary regulated economies, central bankers have considerable influence on interest rate through control of money & banking. When the Fed sells securities it decreases the supply of money (loanable reserves), which increases interest rates (the fed funds rate). When the Fed buys securities it increases the supply of money (loanable reserves), which decreases interest rates. The Fed indirectly controls the fed funds rate by buying or selling bonds to achieve the desired rate.

Fed funds is another name for money loaned or borrowed to maintain the Fed's mandated level of bank reserves, the deposits a bank has with its regional Federal Reserve Bank plus cash in the vault. The fed funds rate is the rate at which banks make short-term (usually only overnight) loans to each other to meet reserve requirements. The loans are made on a private financial market called the federal funds market.

On any given day a bank may have more or less reserves than its required amount (on March 2020 the reserve requirement was reduced from 10% to zero). Banks with excess reserves can loan to banks having a deficiency. The lending bank instructs the Federal Reserve Bank to charge its own account and credit the account of the borrowing bank — a transaction to be reversed the next day. No physical delivery occurs, the exchange is made through the Fed's electronic network, the "Fed Wire".

The fed funds rate is the shortest of short-term interest rates — and is the US short-term benchmark. The most common fed funds instrument is an overnight, unsecured loan between two financial institutions (commercial banks, savings banks, savings & loan associations or credit unions) on the basis of an oral agreement. When banks borrow heavily on the fed funds market, the fed funds rate will rise unless the Fed adds new reserves. The Fed tries to keep the fed funds rate within a narrow band (50 basis-points or less) through buying & selling of government securities. The Fed will continue buying or selling in a trial-and-error fashion until its desired fed funds rate is achieved.

The discount rate is the rate the Fed charges banks to borrow money from the Fed rather than from other banks. The Fed can directly control discount rate. When rates are changed, the fed funds rate and the discount rate are almost invariably both increased or decreased by the same amount at the same time. The Fed sets a new discount rate and targets a new fed funds rate. The Fed has historically discouraged banks from direct borrowing by imposing costly and time-consuming procedures, including scrutinization of the bank's creditworthiness — offsetting the cost advantage of direct borrowing and making the Fed the "lender of last resort".

But with the worsening credit crisis from 2007 to 2008 the Fed progressively gave lower interest rates and easier terms for borrowing from the discount window. In the aftermath of the 2008 financial crisis the Fed began imposing stress tests on banks to reduce credit risk, market risk, and liquidity risk under a variety of hypothetical political, economic, and financial scenarios. The Fed also began paying interest on reserves, which Fed Chairman described in 2009 as the Fed's "most important tool" to raise intestest rates [CATO JOURNAL;Ireland,PN;39(2019)].

The open market policies of the Fed are decided by the Federal Open Market Committee (FOMC), which includes all 7 members of the Board of Governors plus five of the twelve Presidents of the district Feds who serve one-year terms on a rotating basis. The Governors are appointed by the US President for a 14-year term (subject to US Senate confirmation). Because open market operations are administered through the Federal Reserve Board of New York, the President of that district bank is a permanent FOMC member, with the title of Vice-Chairman. The Fed Chairman is nominated by the US President from the Board of Governors and serves four years after confirmation by the Senate.

The FOMC meets 8 times per year to decide on interest rates. (See the FOMC "Schedule of Meetings, Statements, Minutes and Transcripts".) Banks will invariably increase or decrease their prime interest rates (ie, interest rates charged by commercial banks to their most credit-worthy customers) in lockstep with increases or decreases in fed funds rate & discount rate. Mortgage rates, bond interest and other forms of interest charge follow — although long-term interest rates tend to be more independent and subject to market forces.

The control of interest rates & money supply are powerful tools of economic regulation in a purportedly free economy. In a free economy interest rates are the "price of renting money" — and that price is determined by market forces (supply & demand). Price-fixing of interest rates by autocrats invariably results dislocation from the market price — and shocks the economy every time the change is made or anticipated. The autocrats on the FOMC undoubtedly enjoy the fawning attention of the media hanging on their every word in an attempt to second-guess the next action — but price-fixing always misallocates market resources. The FOMC meets in secret and only issues vague summaries of its meetings six weeks after they occur.

Any resemblance between the Fed Chairman and the FOMC to the Wizard of Oz is not accidental. Journalist L. Frank Baum wrote The Wonderful Wizard of Oz to satirize financial autocrats pulling levers & strings to control the economy. The players have changed since Baum wrote the book, but the game is similar. "Oz" is the abbreviation for "Gold Ounce".

The decisions of the FOMC are not only closely watched, but closely anticipated by financial markets. Interest rates are an important cost of doing business — causing the stock market to sell-off or rally on economic data which the FOMC could use in deciding whether to raise or lower interest rates.

The FOMC sees itself as responsible for engineering a "Goldilocks Economy" — not too hot, not too cold, but "just right". By the logic of the Fed, if economic growth is too great the result will be destructive inflation. Under such circumstances, interest rates must be increased to slow ("cool down") the economy. If economic growth is poor, then interest rates can be reduced as a stimulant. The Fed has been targeting an annual inflation of about 2%.

Economic data indicating "excessive" housing starts, consumer spending, and (especially) low unemployment are signals to the Fed to increase interest rates. Increasingly the Fed has become concerned about stock market prices, because increased capital gain from stock price appreciation reputedly is a "wealth effect" that stimulates consumer spending. But more money spent on stock means less money spent on goods. Withdrawing money for spending lowers stock prices. Also, the top 5% of wealth own 80% of all stock, and these people are the least likely to increase spending due to stock price appreciation. When demand grows faster than supply, prices rise (inflation). Nonetheless, the Fed has been willing to tolerate slightly more growth than previously on the basis of the idea that the "New Economy" is creating technological advances that are increasing worker productivity.

The Fed banking autocrats are called "inflation hawks" because of the aggressiveness with which they raise interest rates to "combat inflation". A look at M1 expansion might give some idea about how these fractional reserve bankers go about fighting inflation. Worried about a possible Y2K panic, the Federal Reserve created $194 billion in new currency during the 13 weeks preceding January, 2000.

Unemployment rate is a very important inflation indicator used by the FOMC in determining interest rates. The presumption is that low unemployment results in high labor demand which leads to pressure for higher wages, thereby causing inflation. But figures published by the Labor Department are questionable indicators of employment. Definitions of who is employable are highly politicized — many who are not classified as employable would become employable with the right incentives & circumstance. Moreover, high employment corresponds with high productivity, which counters inflation. Unemployed people consume goods & services without contributing to societal wealth — an inflationary effect. And crime rates drop when unemployment is low.

High interest rates certainly do slow the economy (increasing unemployment), but by increasing the cost of doing business, high interest rates are themselves inflationary. It is almost diabolical that the Fed has created a situation in which the stock market welcomes unemployment because the Fed will not raise interest rates. It is not difficult to find countries where unemployment & inflation are both high — and other countries where they are both low.

It is also destructive for the Fed to attack economic growth using high interest rates for the purpose of combating inflation. There should be no limit to the amount of growth which is beneficial to the economy. It is not true that high economic growth is inflationary and economically destructive. The association is based on the belief that central banks can genuinely stimulate the economy by expanding the money supply (see An Austrian Theory of Business Cycles). Even if wages did rise, the accompanying increase productivity would help to keep prices down. And higher wages create incentives for greater labor efficiency & mechanization — more productivity increases. Economic growth means greater wealth & well-being for everyone. Government agencies that attack economic growth on the basis of bizarre theories of the dangers of an "overheated economy" are a threat to progress & prosperity — to say nothing of freedom.

As of 2021 more than 60% of the more than $7 trillion Fed assets are U.S.Treasury securities, and more than 30% are mortgage-backed securities. The mandate of the Fed expanded beyond growth, employment, and inflation to include climate change and diversity.

(For more on the subject the causes of economic growth, see my essay Say's Law and Economic Growth.)

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 VI. MONEY IN THE ELECTRONIC AGE

Airline miles have emerged as a modern version of Green Stamps — a value given to customers to encourage patronage. Claims have been made that airline miles and smart card credits for telephone calls represent the emergence of the basis for a new commodity-based money outside of government control. Airline miles qualify as money by being an untaxed store of value, but they are not a medium of exchange, since they cannot be transferred to third parties.

Stored-value cards are a close approximation to digital money. Cash or other sources of funds are transferred to the card, and the card-issuing company is responsible for honoring the payments made by the card user. The most successful stored value card is the Hong Kong Octopus card, which can be used to pay for mass transit rides, parking meter use, and purchases from supermarkets, fast-food restaurants or vending machines.

Secure financial transactions over the Internet are greatly dependent upon cryptography. Electronic Funds Transfer (EFT) allows for direct payroll deposits to the bank accounts of employees, online bill-paying, etc. Online credit-card charges and PayPal are more sophisticated funds-transfer processes, but are not digital money.

The best examples of electronic money are digital gold currency systems that allow online payment as gold transfers. GoldMoney and e-gold are the most successful examples. Payments made by these systems are like cash transactions in that there is no time delay associated with the payment, and there can be no payment dispute or repudiation of the charge.

Mobile payment systems utilize cell phones to execute transactions. With Near Field Communication cell phones can be waived near a reader module to initiate a transfer from a bank account or pre-paid account. Such payment systems are growing faster in parts of Asia and Europe than in the United States, possibly because American authorities want to prevent money laundering and insist on mobile systems being tied to traceable bank accounts.

It is claimed that computers will reduce the transactions costs of barter, making money less necessary. Or, using government fiat currencies, encrypted digital signatures will provide the basis for an increasingly untaxed, unregulatable economy. (Even before the Internet Age, an estimated 50% of home renovations work was done by untaxed "underground economy" transactions.) Although some people may be able to subsist in cyberspace, such people are likely to remain in the minority for the near future. Companies engaged in large-scale commerce need to have a physical presence in the world which makes them vulnerable to government regulation & taxation — but also the beneficiaries of government protection of property, patents and contracts.

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 VII. CONCLUDING REMARKS

A laissez-faire attitude toward money has been criticized on the grounds that "the money supply is too important an element in economic growth and stability of nations to be uncontrolled by man". The production of food is also important, but little evidence is available that it is best done by governments — quite the opposite. Government control of money has been called "leaving the fox in charge of the proverbial henhouse" by economist Dr. Murray N. Rothbard.

Implementation poses serious problems insofar as radical actions by governments could cause great damage. Governments should repeal any restrictions between private parties or businesses contracting between themselves for monetary usage. Restrictions on banks or others to produce money should be eliminated. Ideally, competing moneys would emerge as government money recedes. But governments could not agree to accept any currency for payment of taxes without inviting the creation of worthless moneys.

The fact that most people seek the most universally accepted money militates against rapid change. Few people would care to be among the first to have a FAX machine or to speak a new language. Bad money does not drive out the good except where there are laws or costs causing both moneys to be accepted at par. Otherwise, good money would predominate. Government agents may not be very intelligent, but they should be shrewd enough to demand good money for taxes — so there should be no worry about what money governments would receive for taxes if money was not produced & controlled by government.

As long as government money is not subsidized, the market should eventually produce a superior product through free competition of media of exchange. Privatization of money & banking would be one of the greatest steps forward for freedom, progress & prosperity in the history of mankind.

(For an analysis of the economics of the digital asset bitcoin, see Bitcoin and Austrian Economics.)

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 VIII. SOME REFERENCES (by publication date)

David Friedman's Policy Analysis on money

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