(July 27, 2021) In English-speaking countries, banking evolved among merchants in the mid-seventeenth century. Shopkeepers normally stored their surplus gold in the king’s mint for safekeeping, until Charles I needed money shortly before the English Civil War in 1638. He confiscated much of the merchants’ gold, calling it a loan. Although it was eventually repaid, merchants thereafter preferred to deposit their gold with private goldsmiths who issued warehouse receipts to each depositor. Such receipts basically became paper money and were preferred in many transactions in place of bulky coins.
Soon goldsmiths realized that most of their receipts would remain in circulation and rarely be presented for redemption. Therefore, they could lend money in the form of newly issued receipts maintaining a gold inventory equal to only a fraction of the face value of receipts outstanding. Theoretically, once such loans were repaid, the amount of receipts remaining in circulation would equal the gold inventory, and the smith would have earned interest income on the loan. Pragmatically speaking, however, new loans were constantly created as old ones were paid off. As long as the receipts presented for redemption never exceeded the smith’s gold inventory, there was no harm. But if ever a holder presented a receipt that could not be redeemed in gold, public confidence in the smith’s warehouse receipts would vanish, and the paper would no longer be accepted in transactions, except perhaps at a discount to face value.
At the start of the American Civil War, about 1600 banks operated in the above manner. There were no federal minimum reserve requirements. Regulations regarding reserve ratios, interest rates, and loan activities were set by the states individually. The nation’s total currency was about $450 million, of which only $250 million was specie, meaning gold or silver coins. The remaining $200 million was composed of various private paper issues, meaning banknotes.
The enormous Civil War financing needs impelled changes to the monetary system, as federal spending grew from $80 million in fiscal year 1861 to $1.3 billion in 1865. During the war, the federal debt similarly leaped from $65 million to $2.7 billion.
The first legislated monetary change was the 1862 Legal Tender Act, which authorized greenbacks. Although greenbacks were not redeemable in specie, the federal government tried to mandate their acceptance by declaring the bills to be “legal tender for all debts, public and private.” Soldiers and government employees, for example, were paid in greenbacks. It soon became the standard currency, except for imports which still had to be paid for in gold.
The second change was the 1863 National Bank Act, which provided incentives for state banks to seek national charters. Specifically, it enabled such banks to use government bonds as reserves instead of gold. Thus, the arrangement enabled the bankers to earn interest income twice from a fixed amount of invested capital. One source was the bank’s borrowers, who paid interest on their borrowings. The other source was the federal Treasury, which paid the interest on the bonds. That lucrative arrangement remains in place to this very day. That is why banks are ever ready buyers of government bonds.
For the last thirteen years, however, interest rates have been near zero. Thus, banks are more prone to sell the bonds they buy from the Treasury. The trick to keeping the Ponzi scheme going is to find a buyer to buy the bonds from the banks at higher prices so that the banks may record a profit to their shareholders. There needs to be a sucker buyer. That’s where the Federal Reserve Bank steps in with a program called Quantitative Easing. Basically, the Federal Reserve stands ready to buy the bonds from the banks at prices that enable the banks to record a profit. Since the Federal Reserve is merely another branch of the Federal Government, the scheme basically rewards commercial banks to act a middle-men in order to disguise the fact that one branch of the government is merely buying the bonds from another branch. The Federal Reserve is essentially buying from the U. S. Treasury.
Since there is no independent buyer for the bonds, Quantitative Easing is merely another type of Ponzi scheme. Thus, the game that the 1863 National Banking Act started, may not really be perpetual. In may ultimately end catastrophically.