“There can be nothing
more unreal in its pretensions than debt currency itself.” –
Charles Holt Carroll (1860)
Charles Holt
Carroll, a remarkable but now nearly forgotten American
bullionist writer, defended sound money in a blazing
series of essays (now online at the Mises
Institute) appearing in the latter decades of the 19th
century. Notable for his rejection of and fractional reserve
banking in all his forms, his essays serve as a decisive
critique of paper money, credit expansion, and dishonest
banking.
Fractional
reserve banking is a term describing as 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 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.
Carroll
set out to show that organization
of debt into currency 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.
Carroll
repeatedly warned that a state of permanent indebtedness results
from the system of fictitious currency. 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 with newly issued money is
somehow different than other forms of fractional reserve
banking. 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, Carroll
emphasized, the RBD 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 RBD) 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 RBD 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 Hume 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, goes 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 of an individual 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 in 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 longs 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 it 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 an 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 it
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
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.
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 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 quote is from Financial
Heresies, an 1860 article for Hunt’s
Merchants Magazine and Commercial Review.
A long out-of-print collection of his articles for
Hunt’s and other publications titled The
Organization of Debt Into Currency and other Papers, has
been restored and published
on-line by the Mises Institute.
See Jesús Huerta de Soto, Money,
Bank Credit, and Economic Cycles, chapters 1-2.
Of
the Discount Deposit
Financial
Economy
“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)
Currency
of the United States
Of
the Discount Deposit
Of
the Discount Deposit); and, “There was never a greater
mistake in any science, and never one so fatal to the stability
of property and the well-being of society.” (Financial
Economy).
The
Currency Question in the Commercial Convention in Boston
“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)
Congress
and the Currency
Currency
of the United States
Change
of the Banking Principle
The
Currency Theories of the Day
The
Gold of California and Paper Money
Change
of the Banking Principle
Financial
Heresies
Specie
Prices and Results
Financial
Heresies
Organization
of Debt into Currency
Bankruptcy
and Insolvency
Bankruptcy
and Insolvency
The
Currency Question in the Commercial Convention in Boston
Bankruptcy
and Insolvency
The
Gold of California and Paper Money
Change
of the Banking Principle
Of
the Discount Deposit
Specie
Prices and Results
See Lew Rockwell, Speaking
of Liberty, Chapter 4.
This
article originally posted on Ludwig
von Mises Institute April 27, 2006.
© 2006 Robert Blumen
Editorial Archive
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Robert
Blumen is an independent software developer based in San Francisco,
California
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