The Creature from Jekyll Island: A Second Look at the Federal Reserve

Chapter 8 defines and explains fiat and fractional money. Fiat money is paper money decreed by the government to be money, which is not backed by gold or silver. Griffin describes the early American colonial experiments with fiat money, all of which resulted in economic disaster because of massive inflation. He focuses on how the return to gold and silver led to prosperity and economic stability, even under the pressure of war. Legal tender laws passed at the time of the American Revolution similarly created inflation and deflation cycles which the founders sought to eliminate in the Constitution by preventing the Federal Government from creating fiat money.

Griffin offers his third law: Fiat money leads to economic destruction.

Griffin now turns to fractional money, which he defines as money only partially backed by an intrinsically valuable tangible item. (The standard definition of “fractional money” is banknotes issued in units of less than one dollar.) The origin of banking and fractional money is identical: Goldsmiths who stored gold for a fee began to loan out the coin in their vaults for an interest charge. They would issue receipts to borrowers, just as to depositors, and those receipts would be exchanged in the marketplace as money. This form of banking is referred to as fractional reserve because the bankers only hold a fraction of the original deposits in their vaults, trusting that only a few people at a time will demand their money, and loan out the rest. Fractional money is an intermediary between receipt money fully backed by precious metals and fiat money not backed by precious metals.

This leads to Griffin’s closing with his fourth law: fractional money always becomes fiat money.

Looking in more depth at banking history, Griffin relates the story of the Venetian bank established by the government which sustained itself solely through fees rather than interest. The bank was restricted from loaning money. When accepting a deposit, the bank would confirm with expertise the value of the deposited coin. As a result, the receipts from the Venetian bank were worth more in the marketplace than other receipts, or even coins, since the receipt value was reliable. This bank was put out of business by a government-created bank that had permission to loan money.

The Bank of England was given the responsibility of managing government-issued exchequer bills which were backed by the government’s gold stores. The Bank preferred its own banknotes and gradually those fractional bills replaced the government currency. Other banks were granted charters, but only the Bank of England was favored enough to be bailed out when close to failure. The reason for this favor was that the Bank was established to loan money to the government to avoid taxing the public during wartime. Because of fractional money, the bank was able to make private loans and earn interest from both types of loans. This relationship made the Bank of England the first central bank and the English government relied on the bank as much as the bank relied on the government. 

Griffin defines what he means when he says money is created out of nothing. In a fractional reserve system, money is created by lending. When the banker lends money to a borrower in a fractional reserve or fiat money system, new money is created and placed in the economy. All United States currency is fiat money. The Federal Reserve’s own publications clearly state that US currency cannot be exchanged for gold in the treasury. Federal Reserve Notes are not an asset, instead they are an IOU, and if all debts were paid there would be no money in circulation. The Federal Reserve has no desire to see all debts paid, as the primary function of the institution is to manage debt.

Griffin argues that debt is not necessarily a problem, but the banking system as it stands is morally if not legally fraudulent. The banks have no money of their own to lend and instead are lending money deposited by others. They charge interest to borrowers to create profit. Griffin believes that neither the depositor nor the borrower understands how the bank uses the money at their disposal. As a result, the banks make a profit, while the depositor assumes all the risk. Griffin argues that all bank loans under the fiat system are inherently usury, or excessive interest, because it’s unearned fiat money. Griffin argues that the profit the banks acquire is generated by human labor, but that profit stays with the bank rather than the laborers.

The Fed creates fiat money to purchase government bonds which they categorize as reserves. This created money enters the economy, through government spending and bank loans, which cause inflation. There are three methods the Fed uses to create money from IOUs or debt: the Discount Window, purchase of bonds, and adjusting the reserve ratio.

Banks use the Discount Window to shore up their assets if their reserves are depleted by a bank run, a currency drain, or other depleting event. The Fed then loans the bank money to bring their reserves to required levels at a relatively low interest rate. The banks can loan that money at a higher interest rate to make a profit and increase their assets on the books, which increases their reserves.

The primary method of money creation, though, is the buying and selling by the Fed of government bonds, which Griffin names the Mandrake Mechanism. The US government issues bonds—certificates that promise a specific payout on a given date—for sale on the bond market. The Fed purchases these bonds with a Federal Reserve Check which is deposited into the government’s account in the Federal Reserve. The money in that account is dispersed as government payments to individuals who deposit that money into their accounts at commercial banks.

The commercial bank is only required by the Fed to keep a certain number of deposits, currently 10%, as reserves, and so can lend out 90% of total deposits. The 90% of each deposit is considered excess reserves. That money enters the economy via bank loans. Those loans are then deposited in the borrower’s accounts, again allowing for additional loans of 90% of the deposited value. This process happens again and again until the new money entering the economy is up to 10 times the original debt issued by the Treasury. When that fiat money enters the economy, it drives prices up because there is more money in circulation which decreases the spending power of each dollar. That decrease in spending power is inflation. If the Fed sells rather than buys bonds, or borrowers pay off their debt and save rather than spend, prices will fall because the fiat money in the economy reduces. That cycle of prices rising then falling based on currency circulation, Griffin argues, causes the boom-and-bust cycle, because increasing amounts of currency in circulation (inflation) artificially stimulate the economy creating an economic bubble, while decreasing amounts of currency in circulation (deflation) contracts the economy which bursts the bubble.

Although federal debt and inflation are often connected, they are distinct and either can exist without the other. Federal debt in the form of bonds can be purchased by private citizens or corporations, and in that case, there is no money creation and no automatic inflation. Griffin says that eventually all the bonds bought by private entities with real money will come due, and the Fed will have to create fiat money to cover them.

The Fed can also create fiat money without buying government debt through the Discount Window by loaning money directly to banks. Additionally, the Fed can buy treasury bonds from other nations which use the money they receive to pay off interest on loans from American banks in the same process as US government bonds. The government need not be in debt for the Fed to create money. However, the Fed’s primary purpose is to ensure money is available for Congress to use at its discretion, and so the money in the US economy is generally dependent on US federal debt.

The inflation caused by the Fed’s money creation primarily negatively affects low- and middle-income Americans. As a result, Griffin says it is a tax that is both invisible and unfair and that is a fourth reason to abolish the Fed and the system it perpetuates. Griffin contends that this “tax” is so large that it has negated the necessity for direct tax income for the Federal government. However, taxes remain in place for two reasons: to avoid public curiosity about inflation and to serve social planning.