The Organization of Debt into Currency: On the Monetary Thought of Charles Holt Carroll
"There can be nothing more unreal in its pretensions than debt currency itself." — Charles Holt Carroll (1860)
Charles Holt Carroll defended sound money in a blazing series of essays appearing in the latter decades of the 19th century. They are collected in the book, Organization of Debt into Currency and Other Papers (newly online on Mises.org) whose introduction opens,
Little is known of Charles Holt Carroll (1799-1890) … only a shadowy figure of a man emerges. One would like to know more about this merchant who wrote so vigorously on the currency question.
What we do know of the man is his steadfast devotion to hard money and his unwavering rejection of fractional reserve banking in all its forms. As Rothbard points out in his History of Economic Thought: "A staunch adherent of free trade and laissez-faire, Carroll … was the last Jacksonian, continuing to argue the ultra-hard money cause long past the tremendous setback it received during the Civil War … "
Carroll's essays serve as a decisive critique of paper money, credit expansion, and dishonest banking.
Fractional reserve banking is a term describing the capital structure of a bank that has loaned funds that were placed there on deposit. This is problematic because deposit and loan transactions are fundamentally different. A deposit is a contract for the storage of currency in the bank to be held in safekeeping and returned immediately on demand. The deposited funds must be available at all times should the depositor wish. In contrast, a loan is a transfer of ownership and availability for a definite term. The creditor in a loan transaction has the right to invest the funds, and pays the depositor a rate of interest. These two types of contracts are mutually exclusive from a legal point of view.
When funds placed on deposit are handled as if they were loans to the bank, then the bank will attempt to earn a return on the deposits by loaning them out or otherwise investing them, while at the same time maintaining the promise of immediate availability to the depositor. In such a case, the new debtors are issued on-demand claims for the principal value of their loan, indistinguishable from the claims of the depositor whose money they have borrowed. The bank has created multiple immediate-demand claims for the same gold coins. These new notes (at least for a time) circulate at parity with their face value in gold, and therefore function as currency.
Carroll advanced several brilliant arguments against the system of "fictitious money": that it is based on a confusion in thinking; that it creates a state of permanent indebtedness; that it leads to national impoverishment rather than prosperity; that it results in price inflation; and that it inevitably leads to bank runs and then to systemic banking crises; and that it unjustly redistributes wealth from the honest and industrious to bankers and their accomplices. We will examine what he had to say on each of these.
The "organization of debt into currency", according to an essay of that name , rests on a confusion between two very different things: money and debt. Money is gold and silver, while a debt is the postponement of payment. Circulating debt as if it were money confuses money with a promise that will be settled with money some time in the future. From Financial Economy:
A promise is a debt, it is nothing else; and the attempt to make debt serve the purpose of money always has been and always will be a failure. Money and debt are as opposite in nature as fire and water; money extinguishes debt as water extinguishes fire.
Carroll drew attention to the double counting problem created by fractional reserves. When a bank loans creates debt currency, the actual money itself serves as money, while the debt created by loaning the money also circulates as money:
…there cannot be two values in the same item of capital; one in the commodity and another in the obligation to deliver it; one in money, and another in the promise to pay it. The paper promise, being merely a memorandum of an unfulfilled contract, and not the thing promised, must be an addition to the currency when issued and therefore a false measure unless the money promised is reserved against it.
A loan transaction can be recorded with a paper note of some kind. In this respect a loan has a superficial similarity to a bank deposit. A paper record of the transaction is issued in each case. However, Carroll took pains to distinguish between the legitimate form of debt — debt that remains debt throughout its lifetime — and debt that masquerades as money.
Some writers have placed promissory notes and bills of exchange in the category of currency, but it is altogether a mistake; their affinity is with circulating property, not with money. They may be exchanged for property, and so might the property upon which they are drawn; and if offered for sale for money they are still more like property; they are exchanged against money, and are more likely to have the effect of increasing the exchange value of money than of reducing it, as they would if they were of the nature of currency. They are, however, neither money, nor currency, nor property, but more records of an unfinished bargain; the purchase money is not paid, and these are memoranda or written evidences of what the debtor is to do to complete the contract. One species of property exchanges for another; this is barter, the fundamental principle of trade; and when promissory notes and bills of exchange are exchanged for money, they take the position of property as essentially different from money as the goods that were delivered for them, or for the fund upon which they are drawn.
To offer debt as payment for debt is not to settle it, but instead to roll the obligation into the future by replacing the original debt with a new debt. For a debt to be paid off with debt is in truth no settlement at all, only a perpetuation of indebtedness: "the seller is not paid for his goods in a note or a check; the exchange is not completed until his capital is restored to him in money or its equivalent as value for value."
Another fallacy exposed by Carroll's analysis is the proposition that "discounting" of debt securities for newly issued money is somehow different than other forms of debt currency. A bank "discounts" a loan when the note recording the loan is purchased from a merchant, at a discount to the note's principal value. The magnitude of the discount reflects the remaining term of the loan and the discount rate — i.e., the prevailing rate of interest compounded over the remaining term of the loan. The bank would then hold the notes until maturity, and then demand settlement, or perhaps roll them over.
Carroll was particularly harsh in addressing the promoters of the Real Bills Doctrine , a scheme in which banks discount bills and then issue demand deposits against them. Banks, according to the doctrine, would count their portfolios of discounted bills or notes as additions to their monetary reserves, against which demand liabilities are balanced. According to the adherents of this system, a bank's notes are "backed" by a sufficient quantity of total reserves, where the total reserves consists of the gold on deposit and market value of the discounted bills combined. While the gold reserves alone would be insufficient, so the bills and notes make up the difference, and are seen by advocates of this system as satisfactory substitutes for gold.
Carroll took a dim view of the school, noting, "I think no greater folly than this ever claimed the sanction of science in any department of human inquiry." While the Real Bills theorists believe that they have discovered a benign and non-inflationary form of fractional reserve banking, Carroll showed that their contrivance is no different than any other form of fractional reserve banking.
All fractional reserve systems generate price inflation, the Real Bills Doctrine being no exception. Common to all such systems is the balancing of outstanding loans as assets against demand liabilities on the bank's books; it makes no difference that the bank purchases an existing debt (as under the Real Bills Doctrine) or originating a new debt as a loan. The discounting of debt creates new currency and this currency operates on prices in the same way as any other currency:
Again, you sell a quantity of coffee for a merchant's note which you get discounted, and the net sum of the discount is added to the deposit to your credit. You check upon this sum as you did upon the coin and notes. All these items are mixed into one deposit, one power, and one effect. You make an average use of this deposit, as you make an average use of the goods in your warehouse, in the operations of exchange; and, in the long run, there will be a proportional amount and purchasing power of currency and of goods at rest in this way throughout the community. Yet all are in circulation, because all are being offered in exchange.
Note that there is no problem with a bank purchasing bills of exchange under a sound banking system, using funds that were loaned to the bank. It is entirely due to the creation of money from the discounted bills that makes the Real Bills Doctrine problematic. In Congress and the Currency , Carroll explains that the monetization of debt involves financial sleight of hand: the money used to purchase the bill is created out of nothing and the bill is used to secure the new money:
Whenever a bank [issues as a loan] a bill or security that forms the fund out of which it is itself discounted, the transaction is not banking but currency-making; and it is a cheat, for there is no such value in existence as such currency pretends to be or to represent. It is simply a fictitious credit, and it makes not a particle of difference in principle or effect whether the credit thus created is circulated in checks, or notes, or in money itself.
Finding common ground with Ricardo and modern Austrians, Carroll realized that the total quantity of money does not matter to economic production. Human well-being is only enhanced by the production of more goods. Contrary to the inflationist fallacy, an increase in its quantity brings no improvement in prosperity.
It is the quantity and quality of cultivated land, dwellings, warehouses, ships, steamers, factories, schools, utilities of all kinds, and everything that contributes to human enjoyment, which constitute wealth; this wealth is the same in value at any price; it is not, therefore, of the least importance what volume of currency we possess, so that the coins are not too diminutive or too large for convenient use, excepting the less currency the better for the convenience of handling, and because where there is the least currency relatively, money will buy the most, and where money will buy the most, business will go.
Inflationists have used the argument that a system of banking with a strict prohibition on the loan of deposited funds would not supply sufficient credit for business firms. Firms would not be able to undertake as many new investments, and economic growth would be retarded, according to this line of thought. On the contrary, noted Carroll, the manufacture of more indebtedness without more savings does not in any way increase the real means of funding for productive business ventures:
Certainly the best provision for acquiring property, and for paying debts, is constant and active employment. Work must produce capital; nothing else can: the enterprise of the merchant in distributing it, in opening new markets, discovering new wants, stimulating labor, and directing it into profitable channels, is of a character to deserve success, and would secure it, were his operations sustained by an uncontractible and sound currency.
The wealth of an individual depends on his purchasing power. And his purchasing power depends only on the ratio between the prices of what he has to sell and what he would like to buy. It is relative, not absolute prices that matter. Imagine, for example, that your wages (or the prices of the goods that you sell) were double what they are today, and at the same time the prices of all goods that you buy were also twice their current values. Then you would be no better off, nor any worse off, in purchasing power terms.
A remarkably sophisticated monetary thinker for his time, Carroll saw clearly that relative prices can be formed just as well with any quantity of money. Bankruptcy in the Currency elaborates,
It is wholly immaterial what may be the volume of the currency if it be left to the operation of natural law of value, for one-half the currency at present employed in this country would serve to transact the same business — would exchange equally well the same quantity of property, and at the same value, only at one-half the price, as the whole sum exchanges now.
Many modern economists oppose gold as a monetary system because they believe that a stable or constant purchasing power of money will enhance economic growth. In our deflation-phobic age, gold is rejected because the purchasing power of a unit of gold would most probably tend to increase over time. (Historically, the supply of gold due to mining has usually grown more slowly than the increase in the production of goods and services.) Carroll was not without an opinion on this matter. Money is a good, and as such its value fluctuates due to the supply of it and the demand for it; yet this does not prevent it from serving its role of facilitating trade as a medium of exchange:
…there cannot be inflexible value in anything, since value is necessarily relative, and all things are continually changing in cost and supply and demand, in relation to each other. Money forms no exception to this rule. The only true idea of money is the simplest, viz., that it is a commodity, as I have said already, varying in value not only by reason of change in its own supply, but in the supply of everything which constitutes the demand for it; that is to say, everything and every service offering to be exchanged.
Deflation-phobic modern economists believe that prices can go up but now down; prices are believed to be "sticky downwards". Therefore economic growth must be accommodated by an increase in the quantity of money, otherwise markets would cease to clear as prices remained stuck. Partisans of this view could take some advice from Mr. Carroll: prices must be allowed to constantly adapt to changing conditions of supply and demand for goods and for money:
We cannot be too emphatic in denouncing the idea that an increasing trade necessarily requires an increase of money, as an error and a delusion. It might be otherwise if value and price were the same, but as the value of property may be the same at a very different price at different periods, it is of very much less consequence to alter the quantity of the currency to suit the altered conditions of trade, than to restrict trade to the proper values of a stable currency. Indeed, to accommodate the currency to the continual fluctuations of trade, so as to regulate prices would be utterly impossible; while if the currency be let "severely alone," trade will accommodate itself to the currency with perfect equity.
A constant problem with the "fictitious money" system is price inflation. Debt, organized into currency influences prices in the same way as would money proper. Rising prices are the result.
It is not the payment, the mere manipulation of the paper, that operates upon the value of money and the price of things, but the whole sum of the demand debt, since the whole acts as a purchasing power precisely as the whole of any commodity in market acts upon the value of that commodity, although nine-tenths or any other portion of it may be at rest in warehouses and seeking demand all the while. Everyone operates in money or goods with reference to his means at hand.
Like Cantillon and Mises, Carroll saw that an increase in the supply of money occurs at a specific point in the financial system, and that the effect on prices moves over time as the money is spent by the original recipients, and then spent again by secondary recipients:
As nearly all commercial transactions are made through debt and credit, the fictitious addition to the currency must have time to percolate through the exchanges before the effect is felt. As a purgative requires time to change the gastric juices and become digested, this unwholesome dose of fiction is at length ejecting money from [one place] rapidly.
Carroll provided an extraordinary analysis the catastrophic macro-economic effects of the debt-based monetary system. The entire fractional reserve system is, as Carroll astutely recognized, inherently unstable, "a mad system of kiting between the banks and their customers — and an enormous superstructure of debt is built thereon, keeping almost every [merchant] in danger of bankruptcy." In his essays, he traced the connection from fractional reserve banking to bank failures, and then to a systematic crisis as the contagion spreads from bank to bank, bankrupting depositors and disrupting the general business climate.
When a fractional reserve bank creates credit obligations against its demand deposits, it is taking on the risk that more notes will be presented for redemption in gold than the quantity of gold that it has on hand. The whole corrupt scheme rests on the willingness of the public to accept paper rather than present it for redemption; and it falls apart once a sufficient number of people do so. From Financial Heresies :
When the creditors demand their money, its debtors are called upon to pay money the bank never loaned, never had to loan, and necessarily has not on hand to meet is running demand liabilities: then comes the crisis that many writers call a "panic." It is such a panic as the wasted sufferer feels whose lungs are losing their power of inflation; it is no panic; it is the inevitable crisis of death.
The system eventually results in general bankruptcy. At first, a single bank is overwhelmed with redemption demands, for which they do not have sufficient gold reserves. But the problem does not end there. Once one bank fails, confidence in the banking system will erode. Many depositors will rush to redeem the excess bank notes for a limited quantity of gold. From an 1858 dispatch:
The term "deposit," as applied to the amount at the credit of a borrower, is in truth a misnomer, for the borrower deposits nothing — there is no money in the transaction; it is simply an exchange of debt. Yet it is effectually currency to be used as equivalent to coin at any moment. In event of a bank contraction, it is apt to become a most embarrassing claim upon both bank and borrower, for real dollars that are nowhere — that never existed.
While a single lender is bankrupted by a bank run, a defaulting domino chain of bankruptcy ensues as the contagion infects one fractional reserve bank after another. There are two channels for transmission of the contagion: one is through inter-bank clearing, the other is through debt-defaulting deflation.
Inter-bank clearing is the settlement of debts between banks. To the extent that banks accept the checks or paper of other banks on par with their face value, they become creditors and debtors to other participants in a system-wide credit expansion that — once a critical number of them fail — enmeshes all others.
Contraction may begin it, but the positive and negative poles of the scheme will very soon change places. When bank accommodation fails, bankruptcy comes into play, soon takes the lead, and one tumbler here and there knocks down a whole line, until the securities, against which the deposits stand, fall, and the deposits with them. Banks being pressed with their notes must redeem them, and avail themselves of their securities in the hands of the Comptroller to purchase greenbacks or specie.
The debt-deflation mechanism exists under fractional reserve banking because, when currency is created out of debt, a default wipes money out of existence. When there is less money, there is downward pressure on all prices in the economy. It becomes more difficult for still-solvent debtors to service their outstanding debts. Increasingly, more of them default, wiping out more money.
Debt-deflation and the inter-bank clearing mechanism reinforce each other, accelerating the contagion once it starts. As the process feeds on itself, undermining confidence in banks, additional bank runs and defaults, inevitably form a systemic crisis. The crisis harms all participants — bankers to be sure, but merchants and working people as well.
But when any such scheme shall be put in operation, its two forces or elements, so to speak, will immediately change places. It will not long be the contraction of the currency that will cause the bankruptcy, but the bankruptcy that will contract the currency.
Carroll called attention to the moral dimension of fractional reserve banking, calling it "a blind scheme by which the first principles of justice and common sense in the employment of capital are reversed." During the crisis, property is redistributed in an unjust and arbitrary manner, with bankers generally coming out ahead of their depositors, whose funds they have expropriated:
Moreover, a general code of easy morality prevails among debtors in distress as to helping themselves to the property of creditors; cunning and high-handed villainy scramble in the confusion of a financial crisis; opportunity and privilege, such as may be enjoyed by a bank director or bank favorite, enable some men to avail themselves of more than their equal or just share of currency and capital; all these and other influences render an equitable settlement of debts and credits in every crisis of a factitious currency system utterly impossible.
To put and end to recurring financial crises, and to restore the nation to sound and honest principles of trade, Carroll advocated a bullion standard, with the dollar defined as a fixed weight of gold. "The true policy for every nation is to keep the currency sound and strong. As gold and silver form the acknowledged money of the world, we can do no better than to use them in their standard purity, and permit nothing to be acknowledged as a dollar that is not a dollar."
Banks, according to Carroll, should be in the legitimate business of financial intermediation: making loans of funds that were loaned to them, and earning a spread on the interest rates, "pursuing the true and honest plan of lending money only when they have money to lend," and profiting by the quality of their judgment in their choice of debtors. Banking organized along these lines would still enable banks to earn profits:
…the banker would take his proper position as the middleman between the lender and the borrower — between the capitalist and the man of enterprise, who would borrow capital of the banker in money and pay the interest properly out of his profit.
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Carroll's essays were intended as a counter-attack in the battle of public opinion against the bankers and their allies, who had bamboozled the public to the point that most people — even educated — thought of fractional reserve banking as a normal state of affairs. "It is marvelous," he wrote, "what a perfect hallucination upon this subject possesses the minds of men otherwise thoroughly intelligent."
In Currency of the United States , Carroll railed, "So completely has the idea of money in the debt currency taken possession of the public mind, that it is difficult for people to comprehend how the above incubus of debt is created, or why there is any more of it than would exist with a money currency."
By publishing his polemics, Carroll sought to raise public awareness of the perversity of this system of finance. In Carroll's time the "money question" was much debated, and all educated people had an opinion. While the incubus has grown vastly, both in size and credibility during the century and a half since Carroll's works, the state of public discourse on this issue has declined to an even greater extent. Today, fractional reserve bank administrators, such as Alan Greenspan, are revered as oracles and sages. Yet there is hope that a restoration of this under-appreciated thinker will bring this critical matter back to the center stage of public debate.
 "The advocates of a specie currency object only to the falsehood of inaugurating into money what is in fact debt, that must be collected from the banks before it can become money." ( The Gold of California and Paper Money )
 "Under an exclusively metallic system such bills would exist and be discounted by banks for money actually in their possession. The bills, if sold, would act then, as they act now, as other capital before the discount, and as money or currency in their proceeds afterwards. In their nature they are instruments of legitimate credit having no tendency to inflation whatever." ( The Currency Question in the Commercial Convention in Boston )