by Kathleen Malloy

Economics 101: What is Money?

The most vital facet of the U.S. economy and factor contributing to the economic recession resides in the very definition and creation process behind the American dollar. What is it? After all, the dollar has had a rich history surrounded by great controversy.

The Gold Standard and Fiat Currency

Prior to 1971, the U.S. dollar remained backed by precious metals, specifically that of gold. The “hard” currency had a finite value in which only so many coins and dollars manifested based on the country’s gold reserves. It is common knowledge under the Nixon Administration the gold standard was repealed due to many economists and politicians deeming a more elastic currency necessary to the U.S. monetary system’s success.

The contemporary dollar as a result now is a fiat currency. According to G. Edward Griffin’s text, The Creature From Jekyll Island, the American Heritage Dictionary defines the term as, “paper money decreed legal tender, not backed by gold or silver.” In layman’s terms, businesses and other countries must accept the dollar for its face value although in essence it is just paper back by nothing – a promissory note to repay the full amount – whatever that may be.

As a result, Griffin indicates the American federal government can facilitate the expanding or contraction of the money supply. The negative consequence emerging from such a process centers around the fact the dollar vastly depreciates. The bright side resides in the fact that the U.S. dollar fails to stand alone. All economic systems yield such currency.

Creating the Dollar: Fractional-Reserve Lending

The simplest way to illustrate how the U.S. currency can expand emanates from the process of fractional-reserve lending: Building the American monetary system on debt rather than tangible assets. Yet where does the money come from, is it ethical?

The American Pageant, 7^th Ed. indicates the purpose behind the Federal Reserve Act includes increasing the amount of money in circulation to serve the needs of both businesses and government agencies.

Regarding the dollar creation process, Griffin’s The Creature From Jekyll Island remains the best authority at explaining the technical progression, one I believe I must share with you if we want to analyze economics together.

The Process:

First: Government debt propel currency. The U.S. federal government sells Treasury Bonds and Notes that the public does not buy to the Federal Reserve Bank. Concurrently, bonds purchased by private citizens are paid out by a certain date via interest, also generating currency once redeemed.

Second: The Federal Reserve pays out a Federal Reserve Check to the government, which is inevitably endorsed by the body. Once cashed the check also manifests Federal Reserve Notes, or dollars. Whereas this seems like a tremendous liability, Griffin indicates the exchange is viewed as an asset because the government promises to repay the debt. How? Through both levying taxes and inflation.

Third: With selling bonds to the Federal Reserve, the government is able to spend as they please. Griffin elucidates that the Federal Reserve Bank then refers to bonds purchased as “reserves,” using “them as the base for creating nine additional dollars for bonds themselves.”  Banks then use additional currency printed as money loaned to the public and businesses.

Fourth: Private citizens deposit money into commercial banks, which deem deposits bank reserves also. Griffin demonstrates that deposits represent liabilities to banks: banks must pay interest to depositors. Yet, such money assumes a dual function in which institutions lend deposits out in the form of a commercial loan – turning what was once a liability into an asset.

Fifth: Banks legally can lend out nine times the amount of deposited dollars listed on record. How? Such intuitions Griffin explains operate on the premise that depositors will never all demand repayment on their money – creating a run on the bank.

Conclusion: Through a 9:1 Reserve Ratio, banks essentially inflate the currency based on the American government’s requirements. The government has the potential to manifest countless Treasury Notes, Bills and Bonds.

If all of our private and public debts were repaid, our money literally would disappear.

Fractional-Reserve Lending – when lucidly explained in simplified terms – seems too ridiculous to comprehend. One can compare fiat currencies to Monopoly© money and it becomes hard not to laugh. Yet in all seriousness, that dollar in your back pocket endured such a birthing process from one fabulous printing press.

Case Study: The Gold Debate

Concluding an examination of the U.S. dollar, normal reactions include cynical disbelief or apathy due to how the government does what it wants – a bearish attitude – while supports think the process ingenious for facilitating globalization and advanced monetary systems – a bullish perspective.

Only through great debate, trial and tribulation did the dollar evolve to a mere promissory note. Look at the fiscal issues of the 19^th Century.

Post-Civil War America yielded a split in economic perspectives, sparking the “Cheap Money” vs. “Hard Money” debate. According to The American Pageant, northern states were easily able to redeem war bonds for gold, contrary to many southerners. Southern states wanted to keep interest rates lower in order to increase circulating currency. By 1873, $100 million of the $450 war bond funding was repaid, contracting the money supply from $19.42 per person to $19.37.

The following 20 years provided little resolution as to how to rectify the monetary issues.

The Populist Party emerged, with candidates such as William Jennings Bryan running on a bi-metalism platform in order to inflate the national currency. The American Pageant further expounds most dollars were circulating in the industrial northeast whereas southern farmers struggled to obtain funding.

By 1893, the U.S. suffered the nation’s greatest depression to date due to inflationary speculation, overbuilding, an agricultural surplus, and labor disputes. The Sherman Sliver Purchase Act of 1890 prompted a drain on the country’s gold reserve. Private citizens still had the right to redeem paper dollars – promissory notes – that were backed by gold.

The result, the U.S. gold reserve dropped below $100 million – deemed the “safe minimum” to support the $350 circulating paper currency. In 1894 the U.S. dollar became volatile in international commerce, in which President Grover Cleveland looked to famous banker J.P. Morgan to bail the dollar out.

The Depression of 1893 concluded with a small cohort of wealthy bankers including Morgan loaning the federal government roughly $65 million in gold. Their profit grossed roughly $7 million in interest.

Conclusion

Needless to say, the country’s dear dollar has had quite an evolution. Whether a proponent of the gold standard, elastic money supply, laissez faire capitalism, increased regulations, globalization, or isolationism, one easily sees how the structure of the American currency deeply impacts all aspects of our domestic economy and global standing.

References

Cohen, Lizabeth, David Kennedy, and Mel Piehl. American Pageant: A History of the Republic: Seventh Edition. Boston: Houghton Mifflin Company, 2008. Reference pages

Griffin, G. Edward. The Creature From Jekyll Island: Fourth Edition. Weslake Village: American Media, 1994. Reference pages 155, 195-200.

This column is written by Kathleen Malloy, the Managing Editor at Rowan on the Record. She is a junior majoring in Public Relations and Sociology, and has an interest in making finances an accessible topic at the college level.