On March 10th, one of the largest banks in the United States, Silicon Valley Bank, was shut down after major financial mistakes doomed them to oblivion. Although not the first domino to fall (two days before, Silvergate shut down its operations) and not the last (two days after, Signature bank was shut down by the Fed), Silicon Valley Bank became the poster boy of this new financial crisis. The Silicon Valley Bank and Signature Bank shut downs became the second and third largest baking failures in the history of the United States, all within the span of a couple of days. Despite what our government has been saying, the American people should not be confident in our banking system. We are set for a financial crisis the likes of which our country has not seen for a very long time.
This did not happen over-night. It happened over a century ago. In 1913, President Woodrow Wilson signed the Federal Reserve Act which gave us our central bank, the Federal Reserve. This set in place all the troubles we would face, and would invert the way we look at the economy and our finances.
It is necessary to understand what money is and how it came about. Humans, in the beginning, didn’t have money. Everything we made we used for ourselves and our tribes. The men would hunt animals; the women would collect berries and do other domestic activities. The things we did were different because each member of the tribe was better at doing one type of activity over another. In other words, a division of labor. Eventually, things changed. As the human population increased, and technology advanced, we were able to trade with other tribes and even combine tribes together to create villages and other larger human settlements. When this happened, there were more unique type of jobs and people could make a living doing them. Because of this, we invented a barter system: where a person can trade their products or services for the things they want. A farmer can trade his eggs for a dressmaker’s clothes.
However, there is a problem with this system. What happens when the farmer wants to trade his eggs for the dressmakers clothes, but the dressmaker does not want eggs? The farmer would have to trade his eggs for something that the dressmaker does want, in order to make the exchange. Let us say the dressmaker wants cheese for the clothes. The farmer would have to trade his eggs for cheese and then take that cheese and exchange it for the clothes that he wants.
Let us say that cheese is the most popular thing for people; the thing that people would be most willing to exchange their goods for in order to get the goods they want. In other words, cheese becomes the money, or the medium of exchange, between transactions.
Each society used different items as their monies based on their usefulness and desirability in that society. There are several factors that make items good for money. To continue with the example of cheese, it is good because it is divisible, meaning it can be cut up into several pieces and used as different values because cutting it into pieces does not make cheeses lose all its value, like when you cut a t-shirt in half. If a block of cheese of a certain weight is ten value, then you can easily cut it in half and have two five value blocks of cheese. This makes it more convenient to make purchases of all kinds of goods. However, there are also factors that make cheese bad as money. Cheese can expire rather quickly and so you can’t store it for very long and use it for future exchanges.
Throughout human civilization, the two items that were used the most in societies were gold and silver. They had many of the qualities that were excellent for money. They were scarce enough so that it couldn’t be inflated, but not too scarce where it wouldn’t be circulated throughout the economy. It was easy to divide them and have different values based on its weight, and, unlike cheese, gold and silver do not “go bad” and so they can be stored decades into the future and they don’t have to be used right away. Just like cheese, gold and silver had other usefulness that made them so attractive in the first place. They were used as jewelry, for example. These factors and more made gold and silver the standard money for most societies in human history.
As societies advanced and people were earning more gold, it became difficult to store all of it. This is where people came up with the idea of banks. Think of banks as a money warehouse. For every ounce of gold deposited, the bank would give the depositor a receipt representing the ounces of gold stored in the bank. As people made more money they would store it in the bank for safe keeping in exchange for those receipts which people then used to make exchanges.
Eventually, the banks figured out that if all the gold was stored in their vaults and not being redeemed because people were using the receipts to buy things, they could print out more receipts than there are gold in the vaults! For example, if a bank has 100 ounces of gold in its vaults, the bank could hand out receipts worth 110 ounces of gold, 10 ounces more than actually found in the vaults. Those extra 10 are usually loaned out to other customers. This practice is known as fractional reserve banking and it is a cause of inflation.
There is a great confusion about inflation these days, done by people who do it unknowingly or knowingly because they benefit from it. Inflation is caused when the money supply is expanded; the effect is a rise in prices because when people have more money to spend, that raises the demand for goods and services and causes prices to rise. Since it was done this way, it creates an imbalance. There were no new products or services in the market or more efficient ways to create the already existing ones to bring the prices down to justify the higher spending. There was also not any new resources or raw materials created or discovered, just new money.
Under the gold standard, which we were in for most of the first half of our nation’s history, the market took care of this problem itself. For example, if the bank issued a fake receipt to a customer of another bank, that other bank would demand the gold from those receipts. Since the bank can’t make good on its promise of redeeming all those receipts it printed for gold, it would close down. A bank run is feared by fractional reserve banks because if everyone asked for their gold back, they can’t give it because they don’t have all of it. When money cannot be printed out and issued this way, inflation won’t happen. It could only happen if more gold and silver is mined from the earth, but since that doesn’t happen at a fast pace and they are used for other reasons like jewelry, the money supply can only increase at a slow and steady pace.
If the money supply is not rapidly expanding, then that leaves businesses to try and become more efficient and productive in order to lower the costs of producing their goods and services. When business do that, they reduce the prices so that people will be more willing to part with their money.
As a result, prices were going down steadily during the first half of our countries history! People naturally saved up more because they can see that the prices of the things they want will go down and so they saved for the things they don’t need right away. Having savings also protected you if you ran into hard times. If you were unable to work, you could use those savings to take care of yourself until you recovered. The combination of prices going down and having a culture of building your savings are the recipes for a healthy and successful economy.
Once our central bank, the Federal Reserve, was put in place, everything went downhill. The world became inverted.
The Federal Reserve has changed the way we do things. With the Federal Reserve, the banks have been given the go-ahead to practice fractional reserve banking as much as they please, thus causing inflation. They can do this because they are the only body that can print money in the United States. Every single bank has an account with the fed to borrow the money they need. The fed practices fractional reserve banking and they allow the banks to do it also. And with the removal of the gold standard in 1971, the dollars we have in our pockets have no gold backing them in the bank. So now banks don’t need to give their customers gold, they just need to borrow dollars from the fed who prints it out.
We live in a society where you can expect prices to rise in the future. That takes a big incentive to save your money, away. As a result, we have spent more money than ever before and when we don’t have enough money to pay for the particular item of the moment, we borrow. More Americans are in debt now than ever before.
As mentioned before, so many aspects of our economy and the way we look at things have turned upside down. I believe understanding this is the first key to eventually living in a world where we can have prosperity again and not exchange our future for our present.
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I am, by no means, an expert on the subject, but these recent events have led me to get a better understanding of money and the economy. Some of the books I have read which I highly recommend are:
What Has Government Done to Our Money? by Murray Rothbard
The Case Against the Fed by Murray Rothbard (see a pattern here?)
How an Economy Grows and Why It Crashes by Peter Schiff
Understanding Money Mechanics by Robert Murphy
Gabriel's Blog 