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8. Central Banking: Removing the Checks on Inflation
Central Banking is now put in the same class with modern plumbing and good roads: any economy that doesn't have it is called "backward," "primitive," hopelessly out of the swim. America's adoption of the Federal Reserve System—our central bank—in 1913 was greeted as finally putting us in the ranks of the advanced "nations."
Central banks are often nominally owned by private individuals or, as in the United States, jointly by private banks; but they are always directed by government-appointed officials, and serve as arms of the government. Where they are privately owned, as in the original Bank of England or the Second Bank of the United States, their prospective profits add to the usual governmental desire for inflation.
A Central Bank attains its commanding position from its governmentally granted monopoly of the note issue. This is often the unsung key to its power. Invariably, private banks are prohibited from issuing notes, and the privilege is reserved to the Central Bank. The private banks can only grant deposits. If their customers ever wish to shift from deposits to notes, therefore, the banks must go to the Central Bank to get them. Hence the Central Bank's lofty perch as a "bankers' bank." It is a bankers' bank because the bankers are forced to do business with it. As a result, bank deposits became not only in gold, but also in Central Bank notes. And these new notes were not just plain bank notes. They were liabilities of the Central Bank, an institution invested with all the majestic aura of the government itself. Government, after all, appoints the Bank officials and coordinates its policy with other state policy. It receives the notes in taxes, and declares them to be legal tender.
As a result of these measures, all the banks in the country became clients of the Central Bank.12 Gold poured into the Central Bank from the private banks, and, in exchange, the public got Central Bank notes and the disuse of gold coins. Gold coins were scoffed at by "official" opinion as cumbersome, old-fashioned, inefficient—an ancient "fetish," perhaps useful in children's socks at Christmas, but that's about all. How much safer, more convenient, more efficient is the gold when resting as bullion in the mighty vaults of the Central Bank! Bathed by this propaganda, and influenced by the convenience and governmental backing of the notes, the public more and more stopped using gold coins in its daily life. Inexorably, the gold flowed into the Central Bank where, more "centralized," it permitted a far greater degree of inflation of money-substitutes.
In the United States, the Federal Reserve Act compels the banks to keep the minimum ratio of reserves to deposits and, since 1917, these reserves could only consist of deposits at the Federal Reserve Bank. Gold could no longer be part of a bank's legal reserves; it had to be deposited in the Federal Reserve Bank.
The entire process took the public off the gold habit and placed the placed the people's gold in the none-too-tender care of the State—where it could be confiscated almost painlessly. International traders still used gold bullion in their large-scale transactions, but they were an insignificant proportion of the voting population.
One of the reasons the public could be lured from gold to bank notes was the great confidence everyone had in the Central Bank. Surely, the Central Bank, possessed of almost all the gold in the realm, backed by the might and prestige of government, could not fail and go bankrupt! And it is certainly true that no Central Bank in recorded history has ever failed. But why not? Because of the sometimes unwritten but very clear rule that it could not be permitted to fail! If governments sometimes allowed private banks to suspend payment, how much more readily would it permit the Central Bank—its own organ—to suspend when in trouble! The precedent was set in Central Banking history when England permitted the Bank of England to suspend in the late eighteenth century, and allowed this suspension for over twenty years.
The Central Bank thus became armed with the almost unlimited confidence of the public. By this time, the public could not see that the Central Bank was being allowed to counterfeit at will, and yet remain immune from any liability if its bona fides should be questioned. It came to see the Central Bank as simply a great national bank, performing a public service, and protected from failure by being a virtual arm of the government.
The Central Bank proceeded to invest the private banks with the public's confidence. This was a more difficult task. The Central Bank let it be known that it would always act as a "lender of last resort" to the banks— i.e., that the Bank would stand ready to lend money to any bank in trouble, especially when many banks are called upon to pay their obligations.
Governments also continued to prop up banks by discouraging bank "runs" (i.e., cases where many clients suspect chicanery and ask to get back their property). Sometimes, they will permitted banks to suspend payment, as in the compulsory bank "holidays" of 1933. Laws were passed prohibiting public encouragement of bank runs, and, as in the 1929 depression in America, government campaigned against "selfish" and "unpatriotic" gold "hoarders." America finally "solved" its pesky problem of bank failures when it adopted Federal Deposit Insurance in 1933. The Federal Deposit Insurance Corporation has only a negligible proportion of "backing" for the bank deposits it "insures." But the public has been given the impression (and one that may well be accurate) that the federal government would stand ready to print enough new money to redeem all of the insured deposits. As a result, the government has managed to transfer its own command of vast public confidence to the entire banking system, as well as to the Central Bank.
We have seen that, by setting up a Central Bank, governments have greatly widened, if not removed, two of the three main checks on bank credit inflation. What of the third check?the problem of the narrowness of each bank's clientele? Removal of this check is one of the main reasons for the Central Bank's existence. In a free-banking system , inflation by any one bank would soon lead to demands for redemption by the other banks, since the clientele of any one bank is severely limited. But the central Bank, by pumping reserves into all the banks, can make sure that they can all expand together, and at a uniform rate. If all banks are expanding, then there is no redemption problem of one bank upon another, and each bank finds bank expansion of one bank upon another, and each bank finds that its clientele is really the whole country. In short, the limits on bank expansion are immeasurably widened, from the clientele of each bank to that of the whole banking system. Of course, this means that no bank can expand further than the Central Bank desires. Thus, the government has finally achieved the power to control and direct the inflation of the banking system.
In addition to removing the checks on inflation, the act of establishing a Central Bank has a direct inflationary impact. Before the Central Bank began, banks kept their reserves in gold; now gold flows into the Central Bank in exchange for deposits with the Bank, which are now reserves for the commercial banks. But the Bank itself keeps only a fractional reserve of gold to its own liabilities! Therefore, the act of establishing a Central Bank greatly multiplies the inflationary potential of the country.13
- 12. In the United States, the banks were forced by law to join the Federal Reserve System, and to keep their accounts with the Federal Reserve Banks. (Those "state banks" that are not members of the Federal Reserve System keep their reserves with member banks.)
- 13. The establishment of the Federal reserve in this way increased three-fold the expansive power of the banking system of the United States. The Federal reserve System also reduced the average legal reserve requirements of all banks from approximately 21% in 1913 to 10% by 1917, thus further doubling the inflationary potential—a combined potential inflation of six-fold. See Chester A. Phillips, T.F. McManus, and R.W. Nelson, Banking and the Business Cycle (New York: The MacMillan Co., 1937) pp. 23 ff.