INFLATION, THE NATIONAL DEBT, AND MONETARY REFORM |

The current financial crisis, or meltdown as it is often called, has turned the attention of our country to economic matters. I wrote the original version of this essay in the 1990s, when there was a lot of focus on our National Debt, which was then between 3.5 and 4 trillion dollars, about a third of our current debt of 11 trillion dollars. As few Americans actually understand the correlation of inflation with our National Debt, and how this problem, which is related to our current financial woes, is a result of a debasement of the value of the dollar by the U.S. Government, I thought that it would be timely to revise that essay.

Inflation and the National Debt

I became interested in the problem of inflation in the early1990s. A practical understanding of the magnitude of the problem for the average American occurred to me one night during an after dinner conversation with an older friend, who, like my parents, had lived through the depression and the post-war boom. When my friend told me that he had bought a house in St. Louis in the early 1950s, I asked him for how much and his response was about $12,000, or approximately the same amount as one year’s salary. Since I knew that with the price of homes in the 1990s, few Americans then made the equivalent in salary of the purchase price of a home, it occurred to me to do a little thought experiment that might help me to understand the impact of inflation on the average American. To check my intuition, I knew that my parents had also bought their first and only house (actually they bought the land and paid a contractor to build the house) around 1950. It turned out that the total cost was around $13,000. My father made approximately that much money in a year, although he did have to borrow a little from relatives to swing the deal. In other words, he bought a house that was approximately the same price as one year’s salary. I did this thought experiment in 1993, when median home prices in California were about $200,000. In 2007, before the financial crash of 2008, median home prices had more than doubled in California to around $500,000. To get to the point of this thought experiment, I posed the question, how many people made the equivalent of $200,000 a year in 1993, or $500,000 in 2007? Why had housing prices increased at a rate far exceeding the earnings of the average American? Since very few people could afford to buy homes with savings in the 1990s, it became necessary for home buyers to borrow money from the banks. I knew that the currency had inflated quite a bit since 1950 and the banks were obviously one of the biggest beneficiaries, but I did not know to what extent until I studied the problem in more depth.

In 1971 Nixon unilaterally canceled the Bretton Woods Agreement, which ended the direct convertibility of the U.S. dollar into gold. In the nineteenth century, the United States had a bimetallic monetary system, but gold was the primary standard of exchange. With the passage of the Gold Standard Act of 1900, the U.S. officially went on the gold standard, which continued until 1933 when Franklin Roosevelt outlawed private ownership of gold (except for jewelry). The Bretton Woods Agreement was enacted in 1946, creating a fixed system of exchange rates that “allowed governments to sell their gold to the United States treasury at the price of $35/ounce” (About.com, http://economics.about.com/cs/money/a/gold_standard.htm).

When I wrote the first version of this paper, the U.S. National Debt had skyrocketed from 500 billion dollars in 1975 to 3.5 trillion dollars in 1993. It now stands at $11,298,064,846,139 (see graph figure 1) and counting (it is said that the real National Debt is somewhere between 50 – 100 trillion dollars, if you include unfunded promises like Social Security and Medicaid/Medicare). While the Democrats and Republicans play the blame game, the real cause of the skyrocketing National Debt is obscured: to understand the cause of the problem we must seek out the origins; in this case by examining the recent fiscal and monetary history of the United States, with particular emphasis on the relationship between inflation and federal indebtedness. The first clue to the resolution of the problem is that the National Debt did not grow to monstrous proportions until Nixon decoupled the dollar from its relationship with gold. Gold was $35 dollars an ounce when Nixon did this in 1971; the price of gold is now about $950 dollars an ounce, an increase of approximately 2500% in value! Why did the United States abandon Bretton Woods? The short answer is that the cost of the Vietnam War and Johnson’s “Great Society” programs accelerated inflation (the Federal Reserve expanded the money supply to pay for the increased spending), leading to the first trade deficit in U.S. history. Nixon then imposed wage and price controls in a futile attempt to curb inflation. As Murray Rothbard explained: “As European Central Banks at last threatened to redeem much of their swollen stock of dollars for gold,” Nixon terminated the U.S. commitment to redeem the dollar in gold, essentially bringing the post-war Bretton Woods Agreement to an end (What Has Government Done to Our Money? 1985, p. 103). Thus, after this brief overview, it would seem that inflation, the process by which governments (or in our case, the Fed) increase the money supply in order to finance an increase in federal spending, is the actual causes of the National Debt. The economist John Maynard Keynes, who provided much of the theoretical framework, including the concept of deficit spending, for the New Deal, wrote the following:

There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. (The Economic Consequences of the Peace, London, 1919, p. 220)

When you ask the question, “What is inflation?” a common response is an increase in the price level. Webster’s defines inflation as a “relatively sharp and sudden increase in the quantity of the money and credit, or both, relative to goods available for purchase.” Furthermore, “Inflation always produces a rise in the price level.” This is interesting because people have come to confuse cause with effect. John Pugsley has written:

People have begun to confuse what inflation is with what it does; an unhealthy change of usage, since when you confuse cause with effect you most often arrive at “solutions” that compound the problem. (The Interest-Rate Strategy, Hyattsville, MD: Phoenix Communications, 1991, pp. 19 -26)

For example, Nixon’s imposition of wage and price controls, by dealing only with the effects of price inflation, was ineffective in dealing with the cause, inflation itself.

For reasons that I’ll explain later, even Webster’s definition of “inflation” is not wholly adequate. But for now, let’s proceed with our investigation of U.S. economic and monetary policy. Examining the graph on the “Federal Debt and Consumer Prices, 1789 – 1991″ (figure 2) the lack of price inflation during the Nineteenth Century is conspicuous in its absence. Remember, “Inflation” is defined as a “sharp increase in the quantity of money.” Thus, we will define the effect of inflation, which is a rise in the price level, as “price inflation,” which is most commonly measured by the Consumer Price Index, or CPI. Now, you will also notice the uncanny degree to which the Consumer Price Index parallels the rise in the Federal Debt beginning around World War II, and rising sharply in the 1960s and l970s, where it shoots up from $400 billion to $4 trillion in l990. During the initial, relatively stable period between l789 (when the country was founded) and l913 (when the Federal Reserve Act became law), the price level rose a mere l6 percent. Yet between 1913 and 1991, in less than 80 years, the CPI rose an astronomical 1,000 percent! What accounts for this anomaly? As Pugsley observed,

Common sense forces us to face the question: if monopolies, cartels, greed and rising demand are causes of price inflation, why didn’t these things cause prices to rise in the 19^th century? Was it because these things didn’t exist a hundred or two hundred years ago? (The Interest-Rate Strategy, p. 22)

I respectfully submit that this was not the case. Pugsley concluded that “there is only one cause of the pernicious inflations that have devastated nations. That cause is the expansion of the money supply” (p. 26). From the graph (figure 2) we can draw at least two conclusions: 1) The excessive National Debt is a rather recent phenomenon, becoming a factor only after World War I; and 2) the National Debt parallels price inflation to such a degree that it suggests a strong correlation if not a cause and effect relationship. In other words, if we follow our earlier argument that inflation, an expansion of the money supply, causes price inflation, we can deduce from the effect, rising prices that the money supply was expanding. In fact, historically this was precisely the case.

Pugsley draws a third conclusion, which is not readily apparent from the graph: that there was a significant expansion in the money supply after the Federal Reserve Act became law in 1913. While it is commonly believed that to increase the supply of money, the U.S. Government just has to print more money, this is not strictly true. Although some money is printed at U.S. Mints, the bulk of money creation takes place in banks, as will be explained below. Congress actually abrogated much of its control over the money supply (in Article I. Section 8 of the U.S. Constitution) when it created the Federal Reserve (or Fed), which is actually a private corporation of central bankers. The Fed has several ways to regulate the supply of money, such as setting the Federal Funds Rate (the interest rate banks charge each other for loans), the discount rate (the interest rate regional Feds charge to commercial banks), bank reserve requirements, and Federal Open Market Operations (buying and selling U.S. government securities on the open market). Of course, government still has enormous power to effect monetary policy through the passage of new laws, such as the Federal Reserve Act and the Legal Tender Laws.

At this point, we have established a strong correlation between price inflation and the National Debt, and suggested by implication that the cause of both might be inflation, defined as an expansion of the money supply. But how did that expansion come about? To answer this question, we need to ask ourselves: What is money and how is it created?

What Is Money?

So, what is money? Money is an abstract term denoting a medium of exchange. Originally, prior to the creation of money, exchange was direct, conducted on the barter system: If you had eggs, which I wanted, and I had meat, which you wanted, we’d simply trade, valuing each item according to how plentiful or scarce it was. Needless to say, when societies developed agriculture and civilization, this was a rather inconvenient and cumbersome method, leading to the invention of money. Originally, money was a commodity, generally in the form of gold or silver coins, or some other easily transferrable but valued object.

In a speech before the U.S. Taxpayer’s Union in Sacramento in March 1979, the late Merrill Jenkins, Sr. asked: “What is the money of account in the United States?” The answer is not the dollar bill. In the first place, a dollar is a unit of measurement. As the economist Murray Rothbard has stated: “the dollar was defined as a unit of weight, approximately 1/20 of an ounce of gold”: it wasn’t that “the dollar was set equal to a certain weight of gold; it was that weight” (The Case for the 100 Percent Gold Dollar, 1991, p. 30). Rothbard added that the dollar “was not just a pure unit of weight, such as the ounce or the gram; it was the unit of weight of a certain commodity, such as gold” (p. 30n.7). Thus, the unit of measurement of an actual commodity, such as gold or silver, has become abstracted and detached from the actual thing, much as our free floating fiat money has become detached from its original gold backing. The first paper money was actually a form of warehouse receipt, for gold or silver money on deposit, generally with goldsmiths who served as the first bankers.

Now the reason that the above question – What is the money of account in the United States today? – is significant, is this: although Congress might legally have the power to make whatever it wants legal tender, toothpicks even, it still has not rescinded the Coinage Act of 1792, which established gold and silver coins as the money of account with the United States. Thus Jenkins has argued that since the last silver certificate was redeemed in June 1968, the United States has had no designated money of account (Speech before the U.S. Taxpayer’s Union, Sacramento, March 1979). Interestingly enough, the Coinage Act of 1792 was passed as a response to the hyperinflation caused by the Continental “dollar.” Jenkins gave the following examples for the price inflation caused by that monetary unit:

In 1780, one hat and a suit of clothes ran $2,000. The cost of flour had reached $1,575 a barrel. A haircut reached $150 [get back John Edwards!] . . . . [In 1781] a large barrel of rum in Boston was $8,000 and within six weeks the empty barrel was worth $12,000. (A Treatise on Monetary Reform, 1982, p. 4)

If the paper currency we carry in our wallets are not “dollars,” in that the dollar is a unit of weight of a commodity, i.e., gold, and it makes no more sense to speak of a dollar as representing a tangible asset than it would to walk into a store and ask for an ounce or a bushel – an ounce or a bushel of what? – that being the case, what do those pieces of paper represent? If you will take a “dollar bill” out of your wallet or purse, you’ll see the words “Federal Reserve Note” inscribed on the front face. Now, what’s the definition of a note? A note is a promise to pay, a debt reduced to writing, an IOU. So the answer is that what we call “money” in the United States today is debt: “monetized debt.” If every time the Federal Reserve (or Fed as it’s called), which has the sole power to create money since the Federal Reserve Act of 1913, creates more paper money (notes), it is creating more debt, is it any wonder that we have an $11,000,000,000,000 National Debt!

But don’t take my word for any of this. Let’s hear it straight from the “horse’s mouth,” the Federal Reserve. The following quote is from Modern Money Mechanics, a publication of the Federal Reserve Bank of Chicago:

In the United States, neither paper currency nor deposits have value as commodities. Intrinsically, a dollar bill is just a piece of paper, deposits merely book entries. Coins do have some intrinsic value as metal, but far less than their face value.

What then, makes these instruments – checks, paper money, and coins – acceptable as face value in payment of all debts and for other monetary uses? Mainly, it is the confidence people have that they will be able to exchange such money for other financial assets and real goods and services whenever they choose to do so.

The actual process of money creation takes place in commercial banks. As noted earlier checkable [demand] liabilities of banks are money. (p. 3)

Thus, the value of our money is now based solely on public confidence. As Jenkins has argued, our current monetary system is one huge “confidence game.” (Responding to the current financial crisis, Wen Jiabao, the Chinese premier, was on to something when he told the Financial Times: “Confidence is the most important thing, more important than gold or currency.”) Actually, according to Jenkins, the term “monetization of debt” to describe the process by which government debt is financed by the creation of new money, was first used by the former President of the Federal Reserve Bank of St. Louis, Darryl Francis, in a hearing before the House Banking and Currency Committee in July 1974 (Jenkins speech). Incidentally, Mr. Francis was later removed from his position after exposing the inflation risk of this policy, indicating a possible cause and effect relationship between his outspokenness and his removal. Pugsley was fundamentally in agreement with Jenkins’ explanation when he wrote:

Where formerly the only asset that was used to back banknotes was gold, a commodity of limited supply, the Fed could now use debt securities as reserves. Obviously, there is no limit to the supply of IOUs. (p. 27)

Pugsley concluded: “The explosion of price inflation in the 20^th century lies completely with the Federal Reserve” (Ibid.). In fact, I would argue that one cannot consistently take the position that a large National Debt is an undesirable thing, while at the same time favoring the Federal Reserve policy of creating money out of nothing by “monetizing the debt.” It is illogical and inexcusable once one knows what “money” really is.

The excuse that “there isn’t enough gold” to run our economy, which was used as a justification for the Fed in 1913, simply won’t wash. No, there isn’t enough gold to create an 11 trillion dollar debt! Anyone who holds the above position simply doesn’t understand what inflation is. Inflation is irredeemable paper “money,” also known as “monetized debt.” It is created out of nothing, and nothing can create nothing. It causes price inflation, and it has created, out of thin air, our monstrous National Debt. To elaborate on this process: If as the Chicago Fed stated above, the “liabilities of banks are money,” then whenever a bank makes a loan to a borrower, that increase in liabilities is actually the money creation process; the money supply increases when banks loan money, hence the expression that money is “monetized debt.” And it’s even worse than that; when a bank creates money in the form of a loan to a customer, and the customer deposits that money in the bank, fractional reserve banking allows the bank to keep only 10 percent of that money on deposit, while they loan out the other 90% to someone else, a process that is continued ad infinitum until the remainder is used up!

Gold, on the other hand, is a commodity, and as Pugsley has explained, using the example of the barter system, you simply cannot have inflation in such a system because an increase in the price of an individual commodity never results in a general increase in the price level:

Assuming no change in the usefulness of a commodity, the relative quantity alone determines its exchange value (price). Assuming other quantities remain equal, a good tends to fall in price if its quantity increases, and rise in price if its quantity decreases. (p. 25)

The barter system operates according to the law of supply and demand, without the distortions created by inflation. So it really doesn’t matter what the so-called price of gold is now. Once a certain unit of weight of gold or silver is established as money, the price of other commodities will adjust accordingly. The only way you can create inflation out of gold or silver coins is by shaving or otherwise debasing them. Of course, if banks are allowed to practice fractional reserve banking, as they have done since the 1800s, they are still able to lend more money than they actually have in gold backed reserve, but the threat of bank runs seems to have had enough of an anti-inflationary effect until the twentieth century.

Following the above argument, the inadequacy of Webster’s definition of inflation becomes apparent. “It is not the quantity of money per se that is the problem,” Jenkins has written, “It is the nature [or quality] of money that permits there being a quantity excessive.” In other words, if we correctly perceive a system of precious metal coinage as being merely a more sophisticated form of barter, it becomes apparent that in such a system the excessive expansion of the quantity of money could not be the problem that it is today. The case for the gold standard can be substantiated historically, as James Dale Davidson has written:

As gold standard critic Theodore Burton wrote in 1902, “An excess of expenditures is immediately felt in the decrease of gold reserve.” And that meant recession. So long as the money supply was tethered to gold, unruly deficits could lead to a drop in the amount of money in circulation, which depressed business conditions and therefore harmed the political standing of incumbents.

The last remnant of the original monetary constitution was the gold reserve standard, repudiated by Richard Nixon on Aug. 15, 1971. . . . Even in its final, mongrelized form, the gold reserve standard stood in the way of deficits. It was scrapped for precisely that reason. It is no coincidence that the budget has never been balanced since. (The Wall Street Journal, June 4, 1992)

In conclusion, my intention has been to dispel some of the mystery surrounding the creation of our National Debt. A lot of rhetoric has been expended on this subject, some of it well-intentioned, some of it not. I have attempted to demonstrate, using the work of John Pugsley, that the creation of the National Debt is linked inextricably with inflation, and that in fact, following Merrill Jenkins’ reasoning, inflation is itself a form of “monetized debt.” Thus, irredeemable “money” is by its very nature inflationary.

To expect our politicians to resolve our National Debt crisis is analogous to putting the fox in charge of the chicken coop. Most politicians, as insiders, either know that our “monetized debt” currency is responsible for our National Debt, or they are too stupid or ignorant to do us any good. The conditions to debase our currency were set up between 1913, when the Federal Reserve Act was made law, and 1933, when Roosevelt repudiated the gold redemption clause in government obligations. The bankers and politicians knew exactly what they were doing. To rectify matters, we the people must put pressure on our representatives to abolish the Federal Reserve Act and repeal the Legal Tender Laws that gave the Fed the power to create money out of nothing, by monetizing debt. But if this is economically and politically unfeasible at present, as James Dale Davidson observed: “Even in its final, mongrelized form [in 1971], the gold reserve standard stood in the way of deficits.” Obviously, none of this would be easy to do, and the will to do it probably won’t come about without a total financial collapse. Unfortunately, the Keynsian solution of stimulating the economy by creating more debt money, will only postpone the reckoning for a future time or generation. The end result will be massive inflation, a debauched currency, and a National Debt so immense, that it will basically bankrupt this country. That day may be here sooner than we think.

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