The last time I checked, there is one face on our dollar bill: that of our great President George Washington. However, here I will make the case that our currency has not one, but two faces. Understanding what our currency truly represents can give us a clue as to how we can do our part to be responsible citizens. Where to begin? Let’s start with inflation:

Cause and Effect of Inflation

Inflation can be defined as “Too much money chasing too few goods.”

It follows that the cause of inflation can be:

  1. An increase in the supply of money, or
  2. A decrease in the supply of goods, or
  3. Some combination of the two

The primary effect of inflation is a loss in purchasing power of money, evidenced by a rise in the price of capital (assets), labor (wages), goods and services.

Consider a hypothetical scenario in which inflation takes place which is caused strictly by an increase in money supply. As a result, the price of a service increases.

Scenario:

Two men are shipwrecked on an island. One has $100 in his knapsack, and the other has $50. A pirate arrives on a small sailboat and offers passage back to civilization for $50. The sailboat can safely hold only the pirate and one other person. Only one can be brought to safety, and the other will starve before a return trip can be made.

One man offers his $50, and the other offers his $100. The pirate gladly accepts the $100, which is double his asking price.

Now let us make one change to the scenario: Before the pirate arrives, the man with $50 stumbles upon a knapsack washed ashore from the shipwreck, containing $150. He now has a total of $200. As before, he offers the pirate his asking price of $50, and the other offers his $100. Now, thanks to the change to the scenario, the first man can now increase his offer to the full $200 he has.

What just happened? First, the money supply on the island doubled from $150 to $300. The effect was that the price of the passage also doubled from $100 to $200.

Epilogue: The pirate made the return trip with the man who paid the most and killed him on the way. He used the money to buy a new hat and blue parrot.

Inflation Equals Devaluation.

An increase in the quantity of currency without a commensurate increase in goods and services is inflation. All else equal, prices will rise at the same rate as inflation, as in our scenario above in which both the rate of inflation and the price of rescue increased by 100%.

Increased prices can also be expressed as a devaluation (loss of value) of currency. We might say that prices increased by 100%, or we could just as easily say that the currency lost 50% of its value; both expressions mean the same thing. If a dollar previously bought two oranges and now buys only one, clearly the price of an orange has doubled, and the dollar has lost 50% of its value.

Two Types of Dollars

Assume that a counterfeiter can create Printed Dollars that are indistinguishable from Earned Dollars.

Both types of dollars look identical, and both can be exchanged for something of value. Only earned dollars represent actual work that has been done. These dollars can be obtained only by exchanging something of value, whether that be capital, labor, goods, or services. Printed dollars on the other hand do not represent anything of value, other than the twisted ambition to create a process to deceive others.

When the counterfeiter spends his ill-gotten printed dollars, he is essentially stealing the goods and services he buys. The victim of this theft is not the seller, as the seller can now spend the counterfeit dollars in turn. No, the true victim is anyone who is holding earned dollars, which now have been devalued due to inflation. In summary, printed dollars steal wealth from those who have rightfully earned it. Printed dollars inflate the money supply and devalue all dollars in circulation.

Removal of Backing

Gold cannot be created, and its supply cannot be quickly increased or decreased; rather it is rare and must be mined at great expense.

Money can be defined as a unit of value, a medium of exchange, and a store of value. Gold is ideal money because it serves well as all three. It is completely homogenous because it is a chemical element. It is easily divisible and transportable. It is durable and cannot be destroyed. For the purposes of our inflation discussion here, it has another key characteristic:

Gold cannot be created, and its supply cannot be quickly increased or decreased; rather it is rare and must be mined at great expense.

In other words, gold and silver cannot be “printed” like paper currency can. That has not prevented the devaluation of gold and silver coins, however. From ancient times, precious coins have been debased and diluted by the addition of base metals. This allowed for more coins to be made without using more gold or silver, thus inflating and devaluing the coinage. For a modern example, one need only compare a 1964 silver dime to its more recent equivalent, which is made of cheaper copper and nickel.  Our paper dollar was redeemable in silver through 1968, after which all backing was eliminated. This removed a key constraint on the creation of more dollars.

Legal Tender

Without recounting a history of U.S. currency, suffice it to say that our modern U.S. dollar is no longer sound money. Its legitimacy is assured through its status as “legal tender”, meaning that our laws allow for no other currency to be used for the repayment of public and private debt, the payment of taxes, the settlement of contracts, and the payment of damages and fines. The value of our currency is controlled by our central bank, known as the Federal Reserve (or the “Fed”) through its supply and demand.

The Fed is responsible for creating and destroying billions of dollars every day. Despite being charged with running the printing press for dollar bills, very few dollars are created that way. Most of the money supply is digitally debited and credited to major banks. The actual creation of money takes place when those banks loan out this money and it finds its way into the broader economy.

The Mandrake Mechanism

Mandrake the Magician

Mandrake the Magician was a comic strip character from the 1940s. He had the ability to magically create things and, when appropriate, make them disappear. Our fractional banking system, through which the Fed does the same thing with money is sometimes referred to as the “Mandrake Mechanism”; also known as the “Money Multiplier” effect. Here is how it works:

The Federal Reserve system has twelve regional member banks in various large cities throughout the country. These member banks borrow money from the Fed.  When the Fed wishes to inflate the currency, it simply lowers the interest rate it charges its member banks. The lower the interest rate, the more motivated the member banks are to borrow from the Fed and thus increase their reserves. This, in turn, allows the member banks to increase their funds on loan to commercial banks, who loan to each other and to the end customer.

When a bank makes a loan, it does not actually loan existing money. Instead, it creates, or “prints” new money. The law limits the amount that can be created; essentially saying that for each dollar a bank has on hand in one of its savings accounts, it can create another 90 cents to loan. The original dollar is still in the account and can still be withdrawn and spent by the person who owns the savings account. The 90-cent loan is then spent by the borrower, and the recipient puts it into another bank, and that bank can now loan 90% of that 90 cents, or 81 cents. This can be repeated many times, depending on the demand for loans, until it approaches its mathematical limit of 10 dollars. In essence, the original earned dollar that was deposited into the bank has been magically inflated to 10 dollars, consisting of one earned dollar and nine printed dollars. Abracadabra!

The Problem

Consider what is really taking place when you borrow money. The dollars you are borrowing are printed dollars. They were created through the Multiplier Effect; not representing any capital, labor, good, or service. But what about the dollars that you repay the loan interest with? They can be acquired only through your capital or labor. They represent your blood, sweat, and tears!

Do not be fooled into thinking we are not victimized by this exchange. On an individual level, you are made whole. After all, one can spend the printed dollars just as easily as earned dollars. However, on an aggregate basis, we are all disadvantaged by the devaluation of the earned currency we now hold.

My hope is that this article has given you a better understanding of our current money system, and the perhaps even the will to advocate for a return to sound money.

James Twining
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