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12. The Economics of Violent Intervention in the... > 11. Binary Intervention: Inflation and Business...

E. The Government as Promoter of Credit Expansion

Historically, governments have fostered and encouraged credit expansion to a great degree. They have done so by weakening the limitations that the market places on bank credit expansion. One way of weakening is to anesthetize the bank against the threat of bank runs. In nineteenth-century America, the government permitted banks, when they got into trouble in a business crisis, to suspend specie payment while continuing in operation. They were temporarily freed from their contractual obligation of paying their debts, while they could continue lending and even force their debtors to repay in their own bank notes. This is a powerful way to eradicate limitations on credit expansion, since the banks know that if they overreach themselves, the government will permit them blithely to avoid payment of their contractual obligations.

Under a fiat money standard, governments (or their central banks) may obligate themselves to bail out, with increased issues of standard money, any bank or any major bank in distress. In the late nineteenth century, the principle became accepted that the central bank must act as the “lender of last resort,” which will lend money freely to banks threatened with failure. Another recent American device to abolish the confidence limitation on bank credit is “deposit insurance,” whereby the government guarantees to furnish paper money to redeem the banks’ demand liabilities. These and similar devices remove the market brakes on rampant credit expansion.

A second device, now so legitimized that any country lacking it is considered hopelessly “backward,” is the central bank. The central bank, while often nominally owned by private individuals or banks, is run directly by the national government. Its purpose, not always stated explicitly, is to remove the competitive check on bank credit provided by a multiplicity of independent banks. Its aim is to make sure that all the banks in the country are co-ordinated and will therefore expand or contract together—at the will of the government. And we have seen that co-ordination of expansion greatly weakens the market's limits.

The crucial way by which governments have established central bank control over the commercial banking system is by granting the bank a monopoly of the note issue in the country. As we have seen, money-substitutes may be issued in the form of notes or book deposits. Economically, the two forms are identical. The State has found it convenient, however, to distinguish between the two and to outlaw all note issue by private banks. Such nationalizing of the note-issue business forces the commercial banks to go to the central bank whenever their customers desire to exchange demand deposits for paper notes. To obtain notes to furnish their clients, commercial banks must buy them from the central bank. Such purchases can be made only by selling their gold coin or other standard money or by drawing on the banks’ deposit accounts with the central bank.

Since the public always wishes to hold some of its money in the form of notes and some in demand deposits, the banks must establish a continuing relationship with the central bank to be assured a supply of notes. Their most convenient procedure is to establish demand deposit accounts with the central bank, which thereby becomes the “bankers’ bank.” These demand deposits (added to the gold in their vaults) become the reserves of the banks. The central bank can also more freely create demand liabilities not backed 100 percent by gold, and these increased liabilities add to the reserves and demand deposits held by banks or else increase central bank notes outstanding. The rise in reserves of banks throughout the country will spur them to expand credit, while any decrease in these reserves will induce a general contraction in credit.

The central bank can increase the reserves of a country's banks in three ways: (a) by simply lending them reserves; (b) by purchasing their assets, thereby adding directly to the banks’ deposit accounts with the central bank; or (c) by purchasing the I.O.U.'s of the public, which will then deposit the drafts on the central bank in the various banks that serve the public directly, thereby enabling them to use the credits on the central bank to add to their own reserves. The second process is known as discounting; the latter as open market purchase. A lapse in discounts as the loans mature will lower reserves, as will open market sales. In open market sales, the people will pay the central bank for its assets, purchased with checks drawn on their accounts at the banks; and the central bank exacts payment by reducing bank reserves on its books. In most cases, the assets purchased or sold on the open market are government I.O.U.'s.125

Thus, the banking system becomes co-ordinated under the aegis of the government. The central bank is always accorded a great deal of prestige by its creator government. Often the government makes its notes legal tender. Under the gold standard, the wide resources which it commands, added to the fact that the whole country is its clientele, usually make negligible any trouble the bank may have in redeeming its liabilities in gold. Furthermore, it is certain that no government will let its own central bank (i.e., itself) go bankrupt; the central bank will always be permitted to suspend specie payment in times of serious difficulty. It can therefore inflate and expand credit itself (through rediscounts and open market purchases) and, by adding to bank reserves, spur a multiple bank credit expansion throughout the country. The effect is multiple because banks will generally keep a certain proportion of reserves to liabilities—based on estimates of nonclient redemption—and a general increase in their reserves will induce a multiple expansion of fiduciary media. In fact, the multiple will even increase, for the knowledge that all the banks are co-ordinated and expanding together decreases the possibility of nonclient redemption and therefore the proportion of reserves that each bank will wish to keep.

When the government “goes off” the gold standard, central bank notes then become legal tender and virtually the standard money. It then cannot possibly fail, and this, of course, practically eliminates limitations on its credit expansion. In the present-day United States, for example, the current basically fiat standard (also known as a “restricted international gold bullion standard”) virtually eliminates pressure for redemption, while the central bank's ready provision of reserves as well as deposit insurance eliminates the threat of bank failure.126 In order to insure centralized control by the government over bank credit, the United States enforces on banks a certain minimum ratio of reserves (almost wholly deposits with the central bank) to deposits.

So long as a country is in any sense “on the gold standard,” the central bank and the banking system must worry about an external drain of specie should the inflation become too great. Under an unrestricted gold standard, it must also worry about an internal drain resulting from the demands of those who do not use the banks. A shift in public taste from deposits to notes will embarrass the commercial banks, though not the central bank. Assiduous propaganda on the conveniences of banking, however, has reduced the ranks of those not using banks to a few malcontents. As a result, the only limitation on credit expansion is now external. Governments, of course, are always anxious to remove all checks on their powers of inducing monetary expansion. One way of removing the external threat is to foster international cooperation, so that all governments and central banks expand their money supply at a uniform rate. The “ideal” condition for unlimited inflation is, of course, a world fiat paper money, issued by a world central bank or other governmental authority. Pure fiat money on a national scale would serve almost as well, but there would then be the embarrassment of national moneys depreciating in terms of other moneys, and imports becoming much more expensive.127

  • 125. There is a fourth way by which a central bank may increase bank reserves: in countries, such as the United States, where banks must keep a legally required minimum ratio of reserves to deposits, the bank may simply lower the required ratio.
  • 126. Foreign central banks and governments are still permitted to redeem in gold bullion, but this is hardly a consolation for either foreign citizens or Americans. The result is that gold is still an ultimate “balancing” item between national governments, and therefore a kind of medium of exchange for governments and central banks in international transactions.
  • 127. The transition from gold to fiat money will be greatly smoothed if the State has previously abandoned ounces, grams, grains, and other units of weight in naming its monetary units and substituted unique names, such as dollar, mark, franc, etc. It will then be far easier to eliminate the public's association of monetary units with weight and to teach the public to value the names themselves. Furthermore, if each national government sponsors its own unique name, it will be far easier for each State to control its own fiat issue absolutely.