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Protecting Licensed Counterfeiters

Mises Daily: Monday, November 08, 2010 by

Honest Money

[Excerpted from Honest Money (1986).Download PDF]

You shall do no injustice in judgment. You shall not be partial to the poor, nor honor the person of the mighty. But in righteousness you shall judge your neighbor (Leviticus 19:15).

Three counterfeiters are discovered. The first one is a middle-class man who owns a cheap offset printing press. He has printed 500 $20 bills and spent them into circulation.

The second one is a US government official. He works for the Bureau of Engraving and Printing. He has printed up a million $20 bills, and the government has spent them into circulation.

The third is the chairman of the board of a multibillion-dollar New York bank. His bank has loaned a billion dollars of fractional-reserve-bank money to Mexico's government-owned petroleum company, Pemex. The price of oil has collapsed, so Pemex can't pay its bills.

What happens to the three counterfeiters? The first man is convicted of counterfeiting and is sent to jail. The second man works until age 65 and is given a pension.

But what about the third man, the chairman? Here is where it could get interesting. The third man goes to the nation's central bank, the Federal Reserve System, which in turn calls the Mexican government, which immediately prints a Mexican bond for $25 million, which is then bought by the Federal Reserve System with electronic money created out of nothing. This Mexican bond then becomes part of the "legal reserve" that supposedly undergirds the US monetary system. (This was made legal in the infamous Monetary Control Act of 1980, against which only 13 congressmen voted.)

The Mexican government sends the money to Pemex, which then remits $25 million to pay this quarter's interest payment to the New York bank. Pemex pays the bank a fee for "rolling over" the loan. Three months from now, another $25 million will fall due. The chairman of the New York bank gets a round of applause from the bank's board of directors, and perhaps even a bonus for his brilliant delaying of the bank's crisis for another three months.

The $25 million then multiplies through the US fractional-reserve-banking system, creating millions of new commercial dollars in a miniwave of inflation.

This scenario could really take place, given United States law. Is this system just? Would you say that the law respects neither the mighty nor the poor man?

The Federal Reserve System

In late November of 1910 (probably November 22), a private coach carrying some of the nation's leading bankers and a US Senator pulled out of the Hoboken, New Jersey, train station and headed for Georgia. Their ultimate destination: Jekyll Island, which was owned by some of the richest men on earth as a hunting club. Membership in the club was by inheritance only.

On board that train was Senator Nelson Aldrich, the maternal grandfather of Nelson Aldrich Rockefeller. Also aboard: Henry P. Davison, a senior partner in the powerful banking firm of J.P. Morgan Co., Benjamin Strong (another Morgan employee)[1], and a European expert in banking, Paul Warburg. Representatives of two other major New York banking firms were also present.

The reporters who gathered at the train station were told nothing, except that the men were all going duck shooting. Six years later, Bertie Forbes, the man who founded Forbes magazine, reported briefly on the meeting, and most people thought the whole story was just a "yarn." Very little has been written on it since 1916.[2] (Probably the most detailed account is chapter 24 of the highly favorable biography, Nelson W. Aldrich, by Nathaniel W. Stephenson [Scribner's Sons, 1930; reprinted by Kennikat Press, 1971.])

At that secret meeting, these men designed what became the Federal Reserve System, the central bank of the United States.

As they were returning, they were met by reporters at the Brunswick, Georgia train station. Davison went to meet with them, and when he returned, he informed the group that "they won't give us away." They never did. The press never mentioned the meeting.

Senator Aldrich, a Republican, was the political middleman. His biographer Stephenson reveals this information:

How was the Reserve Bank to be controlled? The experience of the two United States Banks, in our early history, pointed a warning. The experience of a life time spoke in Aldrich's unconditional reply. It was to be kept out of politics. It must not be controlled by Congress. The government was to be represented in the board of directors, it was to have full knowledge of all the Bank's affairs but a majority of the directors were to be chosen, directly or indirectly, by the members of the association. (p. 379)

Republican Aldrich did not succeed in getting his version of the central bank through Congress in 1911 and 1912, but Democratic President Woodrow Wilson got a very similar version passed in December of 1913. Thus, in the year of the income tax was also born the Federal Reserve System, our nation's central bank.

A Big-Bank-Insurance Company

The Federal Reserve Bank is the most powerful insurance company in the United States, and perhaps in the world. Its function is to control the money supply of the United States, inflating or (hardly ever) deflating at will the total money supply. It was created, the founders promised, in order to eliminate "panics," as recessions and depressions were called in those days. The result:

  • The "panic" of 1920–1921
  • The depression of 1929–1939
  • The recession of 1953–1954
  • The recession of 1957–1958
  • The recession of 1969–1970
  • The recession of 1975–1976
  • The recession of 1980–1982

It was created, we were told, in order to supply a so-called "elastic currency" to meet the seasonal needs of business. This "elastic currency" has stretched into the hundreds of billions, ever upward.

What it was really created for was to prevent the bankruptcy of any major commercial New York bank and other major banks around the country. Only one major bank in the United States failed in the Great Depression, the private commercial bank with the official-sounding name, the Bank of the United States. But over 9,000 small banks suspended payments.

Even in the case of the Bank of the United States, we can see the hand of the big banks. This bank was financed primarily by small merchants, especially Jewish merchants. It was not an "insider's" bank. The Clearing House banks, made up of the major New York banks, at first promised to allow the faltering bank to merge with more solvent institutions, but at the last moment they pulled out of the bailout, allowing the besieged bank to suffer more runs by depositors. This created a wave of runs on other banks.

Finally, in December of 1930, the State of New York shut it down to prevent total bankruptcy. It eventually paid off over 83 percent of its liabilities after it liquidated its assets. The question can at least be raised concerning the reasons for the Clearing House banks' refusal to help it in the moment of crisis. Was it their fear of its total collapse? Or were they simply eliminating a "nontraditional," more speculative rival, who had profited from the boom of 1924–1929?

This rival eliminated, there were no more big-bank failures for the remainder of the depression.

In any case, this bankruptcy indicates the Achilles' heel of fractional-reserve banking. The money was "invested long" in long-term mortgages, but the bank's liabilities were short-term: cash on demand. But the cash was gone. Such is the reality of issuing more receipts for short-term money than there is short-term money in reserve. The Fed was also created to supply funds to keep a bank panic from spreading to the major banks. The key phrase is "supply funds" — a synonym of inflate.

The Federal Reserve Bank is a privately owned corporation whose shares of ownership are held by the member banks. It is quasi public, in that the President of the United States appoints the members of the Board of Governors of the Fed, but the directors of the 12 regional Fed banks, and especially the powerful New York Federal Reserve Bank, are not appointed by any political body. There are nine directors of each regional Federal Reserve Bank: six are appointed by local bankers and three by the Board of Governors of the Federal Reserve System.

Can the government tell the Fed what to do? If Congress and the president are agreed about what to do, yes. If there is disagreement over monetary policy — and there usually is — then the Fed does pretty much what it wants. What the origin of the Fed indicates is that the Fed does what the major multinational banks want. What the House and Senate committees on bank regulation want is usually unclear, and a majority of the members barely know what a central bank is, let alone how it functions or — wonder of wonders — who actually owns it. They don't even ask. It's considered "bad form," a breach of etiquette. I know from experience. I served as a research assistant for a congressman who was a member of the House Banking Committee.

The Monetization of Debt

This is an invention of the modern world. A government needs money. It fears a tax revolt if it raises taxes. It cannot afford to pay more interest, so it can't borrow money from the general public. It therefore goes to the central bank and says, "Buy our Treasury debt certificates."

The Treasury creates the debt certificates (usually on a computer entry: "liability"). The central bank buys them by creating another entry: "money." The computer blips are swapped.

The government has just monetized some of its debt. It pays a lower rate of interest initially to the central bank than it would have to pay if it went into the free market to compete for borrowed money.

What's wrong with this? Who gets hurt? Holders of money will be hurt. The central bank creates a reserve asset when it buys the government bond. The money is then used by the government to buy whatever it wants (mainly votes). This new money goes through the economy. If the banking system is a fractional-reserve system, the money multiplies many times over. This is the process of legalized counterfeiting we call inflation.

"The government never gets something for nothing. That means that you and I aren't going to get something for nothing. More likely, we'll get nothing for something."

The government never gets something for nothing. That means that you and I aren't going to get something for nothing. More likely, we'll get nothing for something. We will get higher prices, higher long-term interest rates, and then a recession. We will go through the boom-bust cycle that the inflated money creates.

The monetization of debt is the easy way out for the government, meaning the easy way to confiscate our capital.

The best solution: no more government debt. Owe no man anything, including as a taxpayer.

When the Fed purchases any asset (most of its assets consist of US 90-day Treasury bills), it creates the money. But it buys the bonds from a favored group of about 20 major banks and securities trading houses that deal in US securities, and which in turn collect commissions on each transaction.

On November 21, 1985, one day short of 75 years after that train pulled out of the Hoboken station, the Bank of New York, a private commercial bank experienced a computer failure. That day it had purchased $22.6 billion in US government securities from other banks and securities dealers, to be transferred to the Federal Reserve. The sales orders came in, but the bank couldn't get the money back out when its computer system "crashed."

The Fed had to loan that bank $22.6 billion over the weekend to cover the payments it owed to the other banks and dealers. The Fed paid off the other banks directly. (The bank did have to pay the Fed interest for the weekend use of the money, which amounted to several million dollars. Some computer error!)

Do you think your local bank could get a tide-me-over loan of $22.6 billion?

Question: Why doesn't the Fed buy these bonds directly? Answer: because it wouldn't generate commissions for the favored 20 banks.

The government allows the central bank, legally a private organization, to manipulate the money supply of the United States. The central banks of every nation possess this same prerogative. Why do the governments tolerate it? Because they always need money. The central banks stand as "lenders of last resort" to the government.

The government pays interest on the Treasury bills held by the Federal Reserve. It amounts to about $15 billion a year these days. At the end of the year, the Fed sends back about 85 percent of this money to the US Treasury. It keeps 15 percent for "handling." (It pays for all check-clearing transactions in the US, for example.)

The Fed's Declaration of Independence

The Fed has never been audited by any agency of the United States government. The Fed's officials have resisted every effort of any congressman or senator to impose an audit by the Government Accounting Office (GAO).[3]

The Federal Reserve Board meets to formulate US economic policy every few months. No information on the Board's decisions can be released to anyone, including the president of the United States, for 45 days. The Fed says so, and Congress won't call the Fed's bluff. It used to be 90 days, but Congress forced the Fed to speed up the reporting date. Fed Chairman Paul Volcker protested strongly. He said such a release of information interferes with the decision-making ability of the Fed.

The US money supply is totally regulated by decisions of the Board of Governors of the Federal Reserve System. The Fed establishes the "reserve requirements" of the commercial banks — 10 percent, 5 percent, or whatever, depending on where the bank is located, and whether it's a checking account or a savings account. The Fed buys or sells US Treasury bills (US government debt certificates). When the Fed buys, it increases the money supply (multiplying because of fractional reserves). When it sells, it deflates the money supply (shrinking by this same multiplication number).

But it never sells for more than a few weeks. It is almost always buying. It is almost always inflating.

Thus, the American business cycle ("boom and bust") is controlled by a handful of men who are not directly controlled by the president or the Congress, except in those rare instances when the legislature and the executive agree completely and press their decision on the Fed.

Oh yes, I forgot to mention that the Fed owns the entire US gold stock. Legally, there is no "United States" gold stock. There is only the Fed's gold stock. It is stored, not in Fort Knox, Kentucky, but at 33 Liberty Street, New York City, New York.[4] The US government has always sold its gold to the Fed, beginning in 1914.

"Where did the Fed get the money to buy the gold? It counterfeited it."

Where did the Fed get the money to buy the gold? It created it, of course. In short, it counterfeited it. But it's legal.

What is really choice is that in 1933, the US government outlawed the private ownership of gold. It bought all the gold it could forcibly collect from the public, paying the going price of $20.67 per ounce. Then it sold it to the Fed at $20.67 per ounce. The next year, the government raised the price of gold to $35.00 an ounce. Net profit to the Fed: 75 percent.

This raised the legal reserves for banks, and the money supply (so-called M1) zipped upward by 30 percent, 1933 to 1935.

"No!" you say to yourself. "It couldn't be true. The government confiscated our gold in 1933 so that a private corporation owned by the member banks could buy it at a discount? Impossible!"

All right, my skeptical friend, pick up a copy of any Friday edition of The Wall Street Journal. Somewhere in the second section (they always shift it around) you will find a table called Federal Reserve Data. Check the listing under "Member Bank Reserve Changes." You will see a quotation for "Gold Stock." It never changes: $11,090,000,000. They don't sell it, and it's kept on the books at the meaningless arbitrary price of $42.22 per ounce.

Whose reserves? Member banks. Who holds title? The Federal Reserve System. Who owns the Federal Reserve? Member banks.

This leads me to conclude that if you're going to become a counterfeiter, you might as well become an audacious one. The backyard operators risk going to jail. Central bankers don't.

Sure, by law, Congress and the President could demand that the Fed sell the gold back at $42.22 per ounce. By law. Have you ever seen anyone propose such a law? Has Congress ever brought it up for consideration since 1913? Have you seen anyone discuss the wisdom or even the possibility, of such a law, except for "kooks" who write newsletters and paperback books? Have you ever heard of a PhD-holding university economist recommending it? No? Neither have I.

Sure, Congress controls the Fed. Legally, the Fed must report to Congress. Just as the Politburo in the Soviet Union must report to the Russian people.

Congress can get its gold back any time it wants to. Just as an alcoholic can quit drinking anytime he wants to. Just as American private citizens can get their gold back from Congress at $42.22 per ounce (or even at a market price), any time we want to.

The Depositors' Insurance

The Federal Deposit Insurance Corporation came into existence in 1934, the year after the government confiscated the public's gold. The FDIC is promoted as a government-guaranteed insurance program for private citizens' bank accounts. Well, as they say, yes and no.

No, it isn't an agency of the Federal government. No, the government has never promised to bail it out if it gets swamped with banks that are going bankrupt. No, the Joint Resolution of Congress in 1980 to insure every bank account up to $100,000 isn't a law.[5] The President never signed it, so it isn't a law. There has never been any such law.

Yes, if the FDIC really did look as though it was about to go bankrupt, either the Fed or Congress would almost certainly act to bail it out. The Fed would print the money, just as it did when the Continental Illinois Bank almost went under in 1983, and it had to pump about $4.5 billion into it. The bankers don't want a bank run.

Could the FDIC bail out the banks in a panic? Of course not. It has about $1 on reserve for every $100 in deposits. This "reserve" is in fact nothing except US Treasury bills: government bonds, in other words. To get the cash, the FDIC has to cash in these bonds and get the US Treasury to pay cash. Two bankruptcies the size of Continental Illinois would deplete the FDIC's reserves to zero, or close to it.

The FDIC is an illusion whose purpose is to calm down depositors who might otherwise make runs on weak banks and crash the economy into a depression. The FDIC was created to reduce risks for bankers, so that at least the biggest banks don't face such crises. Then the bankers can go out and loan hundreds of millions of the depositors' dollars to "Third World" nations that never intend to pay back any of the money.

In a gold-standard country — none exists any more — the people can put the pressure on banks and the government to stop inflating the currency, simply by going down to the bank or the treasury and buying gold at the fixed, government-defined price. Pretty soon the government has to stop inflating. Pretty soon, a bank which has issued too many phony warehouse receipts gets threatened by a panic run.

Then one of two things happens:

  1. The bank (or Treasury) stops creating unbacked paper money, or loans, or checks. (Recession usually follows.)

  2. The bank (or Treasury) closes the withdrawal window. No more gold on demand. (Inflation usually follows.)

The second event happens at the beginning of every major war. It did in the United States in December of 1861, when the North invaded the South. It did during World War I when the US entered the war that President Wilson had promised to keep us out of in the election of 1916. They just change the rules. No more gold on demand.

Then they inflate the currency to pay for the war without raising visible taxes to cover all expenses.

Since 1933, the United States hasn't been on a gold standard for US citizens, and since 1971, it hasn't been on a gold standard for foreign central banks. This keeps embarrassing runs on banks from occurring as often.

But some day, Mexico or Brazil or some huge-debt foreign nation will default, and the biggest banks in the country will become officially bankrupt. The runs will begin. Then the Fed will step in and create the cash to stem the runs. Fed officials will inflate their way out of the crisis. On that day, you had better own gold, silver, and other similar nonpaper assets. The dollar will die.


As the system of fractional-reserve banking has become universal throughout the world, and as the banks have become more vulnerable to bank runs, governments have changed the rules in order to reduce risks for bankers, at least the biggest bankers.

The central banks gained the power to establish reserve requirements: the money that banks must keep on hand against deposits. Then the Fed lowered these reserve requirements. The Federal government abolished the gold standard in 1933. The FDIC was created as an illusion of government-guaranteed bank deposits in 1934. The international gold standard was abolished in 1971, to reduce the pressure placed on the Fed by foreign central banks to give up the gold it holds, supposedly in the name of the federal government.

Mises Academy

And with each reduction in risk for big bankers, they have made wilder and riskier loans. Today, the international commercial banking system has loaned over one trillion dollars to nations and major debtors. The Eurodollar market (a giant, unregulated, almost zero-reserve-requirement debt market) is over a trillion dollars now. It was under a billion dollars in 1959.

Thus, the world faces a crisis: either more debt to insolvent debtors, or a default. Either more inflation to make the loans, or a giant international bank run. And all of it has come about because the masters of finance and the politicians they buy refuse to honor basic principles of debt, honest weights and measures, and zero-multiple indebtedness.

Economic judgment is coming.


[1] Strong later served 14 years as a governor of the Federal Reserve Bank of New York.

[2] Editor's Note: This essay predates G. Edward Griffin's The Creature from Jekyll Island.

[3] Editor's Note: Today, it is called the Government Accountability Office.

[4] The address of the Federal Reserve Bank of New York.

[5] Editor's Note: 12 USC. § 1821(a)(1)(E), as recently amended by the Dodd-Frank law, establishes a "standard maximum deposit insurance" amount of $250,000.