Mr. McAdoo is an investment advisor residing in Nevada.
From time to time, usually in some large city, counterfeit money rears its ugly head. As quickly as possible, warnings are issued to banks, businessmen, and residents. Everyone is cautioned to examine all bills of a certain denomination, and to look for certain flaws by which the counterfeit may be distinguished from lawful money.
With some trepidation, people look through their wallets, purses, and cash drawers. Counterfeit money, while it might be interesting to see, is the last thing they want to find in their possession. Before long, however, the scare blows over. No further warnings are issued, and it is assumed that the counterfeit bills have been detected and withdrawn from circulation. People are able to relax again.
Everyone fears counterfeit money. Not only does the law prohibit spending or keeping it, but counterfeit money represents an immediate loss to the person who finds it in his possession. What he thought was money turns out to be worthless paper that must be surrendered to the authorities without compensation. The loss is both obvious and personal.
The potential loss inherent in counterfeit money seems almost self-evident. Yet, those who might accept it and spend it unknowingly, before it was detected, would certainly feel no sense of loss. Apparently, the entire loss would fall upon the unfortunate individual who happened to be last in line when it was detected and confiscated.
But an interesting question arises: Where is the loss realized if the counterfeit money is never detected? Does the potential loss simply remain potential, never to be realized? If no one is fated to be "last in line," who can lose through the introduction and circulation of a "perfect" counterfeit money?
Someone Must Lose
It might be argued that there can be no such thing as a perfect, or undetectable counterfeit. Still, it is a safe bet that, at any given time, a certain amount of counterfeit money is in circulation, and remains undetected. Even if that were not the case, it is possible to postulate a perfect counterfeit and to trace its economic significance.
We know, almost by instinct, that someone must lose. The counterfeiters, who successfully introduce their worthless facsimiles into permanent circulation, have obviously realized a fraudulent gain. But at whose expense? If the counterfeit is never detected who loses? There can be only one answer: the counterfeiters gain, and everyone else loses.
The character of the insidious loss inherent in a perfect counterfeit money is confoundingly difficult to recognize. We know that the counterfeiter’s gain is achieved at a loss to everyone else, but "everyone else" feels no sense of loss. On the contrary: everyone else feels more prosperous. There is more "money" around. Retailers notice increased sales; they, in turn, must increase their purchases. Business activity picks up; people have more money to spend. Far from feeling a sense of loss, the victims of the counterfeiter’s fraud enjoy a growing sense of prosperity. As long as the quantity of counterfeit money introduced into circulation is held to an amount that in itself will not create suspicion, the victims will believe they’ve never had it so good.
The "prosperity" engendered by the introduction of a perfect counterfeit money is clearly a false prosperity. The increased tempo of sales and purchases has been stimulated by a fraudulent increase in the supply of "money." The production and exchange of goods and services have been given a shot in the arm, but money has been weakened by counterfeit. The value which is unwittingly given to the bogus "money" must inevitably be taken from the lawful money. In effect, the counterfeit steals its purchasing power from the lawful.
The result is gradual, but inexorable: the purchasing power of all money is reduced. Prices rise. The counterfeit has undermined the value of the lawful; the potential loss inherent in a perfect counterfeit money has at last been realized!
But it is not recognized. The victims, unaware of the existence of counterfeit money in their economic bloodstream, are unable to identify the true reason why rising prices are eroding a prosperity which they regarded as real. Understandably, they seek explanations in visible symptoms of their problem: they blame those who raise their prices. The real villain, the counterfeiter, is immune to criticism; no one suspects his existence. But through the economic damage he has inflicted upon society, he has created a cause for popular frustration and unrest that can be expressed only in misdirected social and political antagonisms.
The Better the Counterfeit, the Greater the Danger
There can be no rational defense for counterfeit money, even a "perfect" counterfeit. The false prosperity which would inevitably follow the introduction of a perfect counterfeit into circulation would just as inevitably be followed by a collapse of that false prosperity under the weight of rising prices. The counterfeiter would gain, and everyone else would lose.
The crime of the counterfeiter is not that he has usurped a prerogative which the government has taken unto itself; it lies in the grave damage he can inflict upon the economic, social, and political structure of the country whose money he counterfeits. The more successful he is, the more damage he does. A perfect counterfeit would eventually destroy the value of all money, including the counterfeit. In doing so, it would create a condition of social and political chaos. It is with good reason that every person in the country should fear and abhor even the idea of a perfect, undetectable counterfeit money.
By an incredible paradox, our official monetary policy supports a practice, the effects of which are precisely those of a perfect counterfeit money. That practice, defended by economists, businessmen, bankers, and government, is the creation of credit through the commercial banking system.
There can be no doubt that credit plays an important role in diversified and specialized economies. Through credit, the entire economic cycle — from demand to production, distribution, exchange, and consumption — can be enhanced in function and effectiveness. Legitimate credit has a legitimate place in the economic processes by which we survive and prosper.
There is, however, a crucial difference, in both nature and effect, between legitimate credit, and the credit created through the commercial banking system. Legitimate credit involves the temporary loan of existing money between one party and another. Bank credit involves the creation of a substitute for money. This substitute, usually in the form of a demand deposit, is officially defined as money. As an addition to the money supply, it is indistinguishable from any other form of money; it becomes, in its effects, a perfect counterfeit.
The creation of bank credit is made possible by the concept of fractional-reserve banking. Quite lawfully, today’s commercial bank need not retain all the money placed on deposit by customers; it is required to safeguard only a small percentage of that money as a reserve. The balance is available for the use of the bank in its profit-making operations, primarily loans and investments.
Reserve requirements, established by the Board of Governors of the Federal Reserve System, will vary with the classification of the bank, the type of deposit, and the changing monetary policy of the Fed. For purposes of illustration of the simplest form of credit creation through the commercial banking system, assume a 10% reserve requirement for demand deposits at THE BANK.
Mrs. A opens a checking account with THE BANK by depositing $1000 in cash. Since cash in THE BANK’s vault is counted as part of its reserves, the ledger entry made by THE BANK would take the following general form:
Reserves + $1000 Demand Deposits + $1000
Since reserve requirements are 10%, or $100 of Mrs. A’s deposit, THE BANK now has $900 in excess reserves.
Mr. B, a known customer, now wishes to borrow $900. THE BANK accommodates him by crediting $900 to his checking account. The ledger now shows:
(Mrs. A) Reserves + $1000 Demand Deposits + $1000
(Mr. B) Loans + $ 900 Demand Deposits + $ 900
It can be seen that the $1000 deposited by Mrs. A has resulted in checking account balances of $1900. THE BANK has created credit, in the form of a demand deposit, of $900. Essentially, Mrs. A and Mr. B may now spend the same "money" at the same time.
In this generalized illustration, the supply of "money" was increased by only 90%. In practice, the supply of money is multiplied many times, since a deposit of $1000 cash would support loans of $10,000, given a reserve requirement of 10%.
Confusing Debt for Money
Whether inflation is accomplished through the infusion of perfect counterfeit dollars, or by the infusion of dollars created by bank credit, the results are identical. Billions upon billions of "dollars" have been injected into our economic bloodstream through deposits created by bank credit. As a result, money has not only lost most of its value, but has also lost most of its meaning. We have confused debt for money, and the consequences of our error are upon us. No economic, social, and political structure can withstand the destructive impact of an endless flood of counterfeit money. Neither can it survive an endless flood of artificial money in the form of bank credit. The effects, and the results, are the same.
While counterfeiting is illegal, and universally condemned, bank credit is not only legal, but vigorously defended as a benefit to society. For hundreds of years, the creation of credit through the commercial banking system has been accepted as appropriate practice. The validity of the principle of "fractional reserves" has received no successful challenge.
Certainly, no challenge is to be expected from the banking community itself; created credit is the primary source of bank profits. Neither can a challenge be expected from the business community; bank credit is a primary source of borrowed funds. Regrettably, no challenge can be expected to arise from government. The commercial banking system provides the means whereby government debt is converted to a form of "money."
If a challenge to the concept of fractional-reserve banking is to be issued, it must come from a well-informed public: a public which perceives the true nature, cause, and dangerous effects of inflation. A well-informed public, if it has the courage, will defend itself not only from counterfeit money, but from artificial money as well. Perhaps, in time, a future generation will enjoy the economic blessings of a real money.
If that happy condition is ever to become a reality, we can start work by examining the validity of Fractional-Reserve Banking.