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HOW TO END DEFICIT SPENDING: WITH PRIVATE BANK NOTES

HOW TO END DEFICIT SPENDING: WITH PRIVATE BANK NOTES

By Branehart

You don’t have to listen too hard to hear commentators complaining about the national debt.  Currently at $17 trillion, it is the accumulation of all of the federal government’s budget deficits over the years and certainly is worth complaining about. If left out of control it could eventually cause countries and individuals who buy United States savings bonds to stop doing so, resulting in a tremendous reduction in the amount of money available for the federal government to run the country with. This in turn will result in draconian cuts not just to welfare programs but also services that are truly needed to protect our sovereignty like a formidable military. What comes after that, take your pick: hyperinflation as the federal government tries to print and mint its way out of its cash crunch, resulting in the collapse of the dollar and the country’s economy; or hyper-taxation, which could also destroy our economy. With a weakened military and a huge debt owed to foreign governments, the United States may even face threats to its national sovereignty.

Many commentators suggest cutting federal deficit spending. But this is only a partial solution at best because it doesn’t address the root of the problem: there are no checks or controls on the federal government if it refuses to do so.  As the highest government in the land with the power to create or borrow as much money as it wants, and with the power to spend as much as it pleases with no requirement for a balanced budget, it can avoid accountability for its actions. While measures like the “Penny Plan”, supported by Sean Hannity, or a balanced budget amendment may have some effect at temporarily reining in spending, ultimately the federal government can negate their beneficial effects. For example, it can simply raise any debt limit imposed on it, or redefine “balanced” to mean on the basis of anticipated, rather than actual, tax revenues (just like it redefined “cut” to mean a decrease in the rate of spending growth), set “anticipated” tax revenues at unrealistic, sky-high levels, and get away with spending galore once again.

The federal government’s lack of accountability, combined with its power to physically create money, give it the power to spend until it puts the country’s future in jeopardy. It puts the future in jeopardy by causing what is ultimately at the root of our deficit spending problem: inflation.

Inflation is when a government inflates, or increases, the money supply by printing and minting as much money as it wants, regardless of how much wealth exists to back it up and give it value. Inflation creates problems by diluting the value of each unit of money. Money is only worth what you can buy with it.  If you print and mint more, but you don’t increase the total amount of wealth in terms of goods and services available for it to purchase, each unit of money will be able to buy a smaller share of the available wealth and will consequently be worth less.  For example, assume that all the goods and services available in the world are ten million tacos.  And, there are ten million dollars in circulation. Each taco is worth $1. Then, the government prints up another ten million dollars. The taco makers don’t increase production at all so there remain ten million tacos. But now there are twenty million dollars to buy them with. Guess what? The price of a taco just doubled, to $2 per taco.

Governments like inflation because it allows them to reward political allies for doing what they want them to, granting them a windfall when they use inflated money to purchase anything. The federal government does this primarily in two ways: either by direct grants out of the federal budget, or through the Federal Reserve, which is essentially a federal government bank created in 1913. The Federal Reserve puts inflationary money into circulation by loaning it to private banks, who in turn “lend” it, often under especially favorable terms (and often for unprofitable purposes) to politically favored borrowers. There are many such borrowers the federal government wants banks to “lend” the money to – i.e., subprime mortgage borrowers, certain third world dictators, wind and solar energy companies, companies that make healthy lunches for inner city schools in furtherance of Michele Obama’s desires, etc. – and it can use pressure from its regulatory agencies to encourage them to do so. With inflation, the federal government never runs out of money to do this.

Yet Inflation is a form of theft and a violation of the right to property.  It may be theft under color of law because it is the federal government rather than some private pirate counterfeiter who is doing it, but theft under color of law is still theft and a violation of rights nonetheless.

It is theft because, in a commercial transaction, a buyer of anything who pays the seller with inflated cash gets something from the seller, but gives the seller in essence nothing in exchange for it. In a proper commercial trade, there is a mutual exchange not just of money, but of wealth, meaning something of actual value. A seller gives a buyer wealth in the form of a product or service of some kind and the buyer in exchange gives the seller money that is backed by some wealth produced by the buyer. For example, I go into Taco Bell, pay $1.50, and receive a taco. In this exchange the $1.50 I paid for the taco as the buyer I earned by working for my clients in my legal practice.  Ultimately, it’s taco for legal services.  Wealth for wealth: with the money as just an intermediary.

But money that is indiscriminately printed by a government and then given to and spent by political allies has no wealth behind it. Although it is indistinguishable from money that has wealth behind it, it isn’t earned by the buyer as a consequence of the buyer’s productive activity; instead it’s just printed (or minted) out of thin air and given to the buyer to use.  So, when it’s used in a commercial transaction, the buyer gets wealth from the seller in the form of a product or service, but leaves the seller with no wealth in exchange; all he leaves him with is worthless paper (or metal coins).

When people use printed and minted inflationary money to purchase things, sellers inevitably have to increase the prices they charge. That’s because the “purchase” of goods or services with inflated cash has the same effect on the seller as if those goods or services had been stolen: it represents a loss because, while the seller never received anything valuable in exchange for those goods or services and thus was never really paid for them, he still had to pay one way or another to offer those goods or services for sale (either by incurring costs to produce them directly, or by purchasing them from a manufacturer). So, even though there may be a much more incremental and delayed effect than if the goods were stolen outright, he has to ultimately raise his prices to make up for the loss.

When prices increase, you end up robbed. To continue the previous example, where each taco cost $1 until the government doubled the money supply and caused the price to jump to $2, the cost for you to feed yourself just doubled if you aren’t a lucky political crony who received any of that newly printed and minted $10 million. You have the same amount of money but you can now only buy half as much with it. That’s theft, just as if a holdup man pointed a gun at you and demanded half your money or your life.

This kind of theft by devaluation of money in people’s pockets has been going on since the Federal Reserve was created in 1913. In fact, between 1913 and 1991 the dollar lost approximately ninety percent of its value. It has continued to lose value since.

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As bad as all of this is, perhaps the most devastating effect of Inflation is how it raises the cost to businesses of actually doing business. This is because, to operate, businesses rely on operating capital they borrow from lenders.  For lenders to extend capital profitably they must charge their borrowers an interest rate that is higher than the inflation rate; otherwise, they lose money to inflation. But if businesses have to borrow at higher interest rates, they have to pay more for their operating funds and will consequently have a more difficult time operating profitably.  For example, assume I manufacture and sell children’s clothing.  I borrow money at 4% from my bank for my line of credit. The inflation rate is 2%.  I can afford to sell children’s pajamas for $10, a price my customers can afford and that allows me to be profitable.  But then the inflation rate goes to 6%. My bank has raised my interest rate to 8.25%, so now my interest payments are so high relative to what they were previously that I have to charge $13 for pajamas, a price too high for about 28% of my customers to afford. Whereas before I could’ve sold a thousand pairs of pajamas at $10 each and earned revenue of $10,000, now I can only sell 720 pairs of pajamas at $13 each and earn revenue of $9360 – a 6.4% drop in my revenues.  If my profit margin had been 5% or 6% when I was charging $10 for pajamas, what – I am probably now operating at a loss. In a high-inflation environment more and more companies find themselves in this situation, with profitable operation impossible. Many go out of business, contributing to unemployment and poverty and further ruining the economy.

Deficit spending is related to inflation because it is essentially kicking the inflation can down the road: instead of printing and minting worthless money now, what the federal government does is sell United States savings bonds in exchange for hard currency now, with plans to print and mint inflationary U.S. currency in the future to meet its obligations for interest and principal payments to the bondholders. With deficit spending the federal government’s hope is that, in the meantime, the American economy will grow enough so that when the money is eventually printed and minted it won’t have too much of a detrimental inflationary effect (and nobody would be voted out of office over it, the way President Carter was in 1980). If the economy doesn’t grow in the meantime it’s back to square one, with all the bad effects of inflation.

There is, however, a way to stop the federal government’s stealing and its detrimental effects: by getting rid of the Federal Reserve, prohibiting governments from creating money, and replacing all government money with private bank notes. What private bank notes are, are dollars just like the ones we have today – only, as their name indicates, they are issued by private banks rather than the Federal Reserve or any other government agency as all dollars are now. This concept isn’t new. In fact private bank notes have been used in the United States in the past, mostly between 1837 and 1866 (known as the “Free Banking Era”). These notes had value because they were redeemable by their holders for a certain amount of precious metals, usually gold and silver, from the issuing bank’s reserves called specie.  Because it is made of a metal that has high market worth, specie is what gives otherwise worthless paper notes any value as a medium of exchange.

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There were problems with private bank notes during the Free Banking Era that can easily be resolved today.  For example, each bank’s notes looked different from those of other banks.  This made anyone unfamiliar with the appearance of notes from a particular bank, such as anyone located far away from any of that bank’s branches, reluctant to accept them for fear that they were either illegitimate counterfeits or worthless from a bankrupt bank. That problem is easily solved by having the federal government, under its power to coin money, dictate a uniform appearance of notes so they are recognizable as a medium of currency (much the way state law sets standards under the Uniform Commercial Code for negotiable instruments like checks). Related to this problem is that of determining if the issuing bank is legitimate, and solvent. This is easily resolved today with the internet, where anyone accepting notes could plug the name of any bank into a browser and find out the whole history and status of the bank.

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As I envision the reintroduction of private bank notes, unlike during the Free Banking Era all notes of the same denomination would under federal law look exactly the same regardless of which bank issued them, so they would be recognizable as legal tender by anyone everywhere and a $5 bill would be the same from Nome to Rome. The only difference would be some sort of notice on the face of the note as to who the issuing bank is. Instead of stating that it is issued by the Federal Reserve, as all dollars are now, each note would state that it is issued by a particular private bank – for example in the picture below, a $20 note has been issued by (the fictional) Southern Central Bank, a National Association. The “freely convertible” means that it is freely redeemable at the will of its holder for $20 of precious metal specie from Southern Central Bank’s reserves.  Also, under its power to coin money the federal government can set a certain weight of gold specie that would be equal to one dollar, setting the standard for conversion from paper dollars into specie and vice versa.

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With private bank notes it would be impossible for anyone to act arbitrarily and print however much money as he wants, causing inflation and deficit spending. Unlike the federal government, private banks can’t just print money willy-nilly. They have a check on how many dollars’ worth of notes they can print.  A private bank can’t print so many notes that it does not have the specie reserves available to convert the notes when the note holders want to.

Every note a bank prints and puts into circulation is a potential claim by the holder of that note against that bank’s specie reserves. Whenever a note holder wants to convert his notes into specie, the bank will be obligated to do so on-demand (and, as an aside, it will usually be a high net worth individual or company, rather than a poor or middle income noteholder, and it will often be for a high dollar amount of specie). If a bank does not have enough specie on hand to make the exchange, it is a sign that the bank is poorly managed or insolvent. Further, a bank might be civilly or even criminally liable in egregious cases for grossly overprinting notes significantly beyond what its managers know or should know is the amount of notes the bank can reliably exchange for specie.

Banks would issue their notes for the most part against their equity. Like other types of businesses, banks borrow capital to operate and provide a good or service of value to customers. They borrow capital by encouraging people to deposit their money with them for safe keeping, paying a low interest rate on the deposits to induce them to do it. The good or service they provide is loans, which they make with the deposited money.  The banks charge borrowers a higher interest rate on loans than they pay depositors.  If the loans are paid back and not defaulted on, the bank makes a profit on the difference between the amount it pays out as interest to depositors and the amount it takes in as interest from borrowers.  This profit is equity.

What banks could do is print up notes against their equity to give to depositors when they withdraw money from their accounts, and to give to borrowers for their loans. If a bank feels confident it can honor requests to transfer an amount of notes greater than its equity into specie, it can issue an amount of notes greater than the amount of its equity if it chooses to do so, though it starts to run the risk of not being able to convert the notes if it issues too many.

Banks could convert much if not all of their equity, as well as some of the amount that is in deposits that is still a liability, into enough precious metal specie so they can successfully exchange it for the amount of notes they would reasonably expect noteholders to want to convert.

With private bank notes banks would have the incentive not to please government bureaucrats by making unprofitable “loans” (essentially handouts) to political cronies, but rather to make the most profitable loans possible so as to build up their equity as much as possible.  Banks with the most equity would have the reputation as the most financially solvent and reliable at transferring their notes into specie, and would attract the most deposits and be able to make a greater share of profitable commercial loans.  This would make them market leaders.

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Contrast the built-in accountability and incentives of a financial system operating with private bank notes with the behavior of the federal government and the Federal Reserve. In the New Deal FDR made gold ownership in large quantities illegal by American citizens (though foreigners could still own it). And in 1971 President Nixon declared that U.S. dollars were no longer convertible into specie, taking away any check on the federal government’s power to print and mint money wantonly. This helped set the stage for the massive inflation of the late 1970’s under President Carter.

One of the common attacks on private banking without a central government that can print and mint as much money as it wants is that, if a bank goes bankrupt, the depositors and note holders would lose all of their money and get stuck holding worthless notes.  This won’t be the case except in very rare (and avoidable) instances.  If a bank runs into financial trouble, the way it would avoid defaulting on its obligations to its depositors and note holders is by being taken over by a more solvent, better managed bank, which would buy the troubled bank’s assets (which are basically its loans) in a transaction arranged by and conducted in a financial clearinghouse. People holding notes issued by the troubled bank would be able to redeem them for notes issued by, or specie reserves held by, the surviving bank. This way, over time banks whose underwriting and management practices are inferior will end up being replaced by those with better management, and the financial system would become even more stable over time.

Meanwhile, the solvency and quality of different banks could be evaluated and rated by various private entities like Consumers Union or rating agencies, helping to direct depositors to better, safer banks.  And the history of mergers and acquisitions of banks by successor banks could be logged, accessed and traced. All of this data could be made readily available through websites of banks and clearinghouses over the internet.

Interestingly governments are aware of the virtues of free banking and private bank notes, and have propagandized against banks to make the public favor government-controlled, inflationary banking. An example commonly cited by governments and their statist intellectual allies in academia and the media as to why free banking with private bank notes wouldn’t work is because it would allegedly encourage so-called “wildcat” banks. Wildcat banks were fly-by-night businesses run by shady characters during the nineteenth century which would take in a bunch of deposits and then close the bank, absconding with the deposits for parts unknown.

The truth, however, is that government regulations and intervention in the economy, not free banking, caused wildcat banks. Before the Federal Reserve states used to require banks to purchase state government bonds with a par value equal to the amount of their deposits. The alleged reason was to protect depositors; if the bank failed, the state would simply require the bank to assign the bonds to the depositors and pay them what they lost. The real reason, however, was because money-hungry state governments, which wanted to reward their political allies but could not create money the way the federal government could, wanted to get their hands on bank deposits to use for their own purposes.

What caused wildcat-banking was state governments forcing banks to buy their bonds at market value, which was usually very low relative to par value because state governments were a poor investment relative to more productive private entities. But then, these state governments would allow politically connected wildcat bankers to redeem their bonds at the much higher par value, enabling the wildcat banker to close down the bank, pocket the difference and abscond with the loot.

Governments and their intellectual allies in academia and the media have propagandized in favor of inflation, particularly before the inflation-ridden Carter presidency of the late 1970’s.  According to the media, inflationary cash helps to stimulate the economy, keeping banks liquid and unemployment low by making it easier for businesses to borrow money and expand their operations.

And, to scare people towards inflation and away from its opposite, deflation has been incorrectly demonized. According to the propagandists, deflation – meaning the increase in value of money from an increase in the production of wealth available for it to purchase – is some kind of unspeakably horrible thing leading to a civilization-ending ‘death spiral’. Allegedly what happens is when money begins to increase in value is prices for goods and services decrease (which is true). This decrease leads to lower revenues for businesses, which in turn leads to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price, again leading to lower revenues for businesses… and on and on, until the economy finally destroys itself. Even poor Gerri Willis of Fox Business seems to have fallen for the ruse, when regarding deflation she told Bill O’Reilly “you do not want to go there!”

The truth regarding deflation, however, is that it is actually a good thing and you do want to go there. The ‘death spiral’ is premised on an incorrect assumption: the reduced amount of dollars taken in by businesses as a result of prices dropping means less buying power for those businesses, which would cause less production. But what’s overlooked is that those dollars, though fewer, are worth more – maybe even a lot more. So the exact opposite is what happens: with deflation businesses and consumers actually have more buying power, which leads to more production, leading to higher wages and demand, leading to further decreases in prices, leading to even more buying power… and on and on, to an economic boom (which is the exact opposite result of inflation).  For example, assume a particular house is worth $1.2 million in year 2000 dollars. The same house is worth “only” $750,000 in 2025 dollars – but with each 2025 dollar worth twice as much as each 2000 dollar.  When would you want to own the home, when it’s worth $1.2 million, or when it’s worth $750,000? The answer is when it’s worth $750,000, because in 2000 dollars it would be worth $1.5 million, which is greater than $1.2 million.

All of the above is known to the propagandists so they further attack deflation by redefining it to mean any drop in prices, regardless of the reason. (They do this with inflation also, dubbing any increase in prices as “inflation”.) They then draw a correlation between falling prices and an economic calamity occurring at about the same time and then blame “deflation” as the cause.  For example, in the late 1990’s land prices in Hong Kong started to plummet, and the city’s economy was stagnating. Professors, elected officials and the media said that “deflation” was the “cause” of Hong Kong’s economic problems. However, the real reason had nothing to do with true deflation but rather with a rapidly decreasing demand for land there resulting from the Asian financial crisis, coupled with the development of Shenzhen across the border in mainland China for investment in competition with Hong Kong.

The propagandists have also blamed specie and the gold standard for causing the 1929 Stock Market Crash and the resulting Great Depression.  Because specie reserves place a limit on how much money a bank can issue and put into circulation, specie is a target for statists in governments who desire to print and spend as much money as they want without any limit.

Prior to 1929 the statists at the Federal Reserve tried for political purposes to “iron out” periodic economic downturns associated with normal business cycles. Prior to the Federal Reserve, banks periodically extended loans until their specie reserves started to become insufficient to cover their liabilities to depositors and noteholders. This would usually occur when a larger than normal amount of loans defaulted or became uncollectable, causing banks to make less revenue. In response banks would extend significantly less credit and only at higher interest rates. For about a year or two, the economy would slow down to a mild recession. Then, as banks’ financial positions improved, they would start extending credit again to businesses at lower interest rates and economic activity would pick up.  This cycle acted as a check on over-speculation by banks into risky ventures and helped to maintain stability in the financial system.

After one such downturn in 1927 the Federal Reserve decided that it should print up enough money so that the economy could boom perpetually without banks having to periodically raise interest rates and curtail their lending. This resulted in wild speculation and risky lending that by 1929 had flooded into the stock market, causing stocks of mediocre companies to become dangerously overvalued. The first few corporate bankruptcies caused panic selloffs and stock values to plummet rapidly. Speculators who had borrowed money to buy stocks defaulted and the banks that lent it to them went broke. Upon hearing about the first bank failures depositors panicked, causing a run on banks that destroyed the American financial system.

Bankers complained to the Federal Reserve, asking it to bail them out with cash so they could stay in business and pay their depositors. The Fed responded by claiming it could not do so because it was limited by its specie reserves in how much money it could create and lend, and there was nowhere near enough to bail out every bank that needed a bailout. A movement consequently started which became the official policy of FDR as part of the New Deal to abandon the gold standard and any limitations on the Fed’s ability to create money, so that any politically connected crony wanting a bailout could get it.

It’s time to cut out all this nonsense. Ultimately the truth is the proponents of unlimited printing and minting of money by governments want something for nothing – something ultimately nobody can have. So with that, everyone who believes in a limited government charged with the obligation to protect individual rights should get behind ending the ability of governments to create money. With the money supply completely in the hands of private banks and their customers, nobody will have the power to arbitrarily create money and steal from everyone the way the federal government does now. The future can be saved and inflation, deficit spending and all of their effects would become things of the past.

I would like to acknowledge the work of Richard M. Salsman, whose research and lectures enabled me to understand how the country’s monetary system operates. His book BREAKING THE BANKS: Central Banking Problems and Free Banking Solutions (American Institute for Economic Research, Great Barrington, Massachusetts 1990) was an invaluable resource for this post and is a must-read for anyone interested in free banking.

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One thought on “HOW TO END DEFICIT SPENDING: WITH PRIVATE BANK NOTES

  1. Lee Levin on said:

    Nicely written

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