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Money, Money, Who Makes the Money (Editor's note: "Money, Money, Who Makes the Money" is the third chapter of a book by Mr. Pugsley entitled "The Alpha Strategy", written twenty-eight years ago. We intend to post a chapter each week. -JSB)
The items that emerge as primary trading articles are not selected by the elders of the village, the chief, the Congress or the president. They emerge naturally as the most convenient items individuals can find for this purpose. The qualities that make a good medium of exchange are durability, consistency of quality, ease of identification, portability, divisibility without loss of other basic characteristics, relative stability of supply and finally, usefulness for something other than money. In primitive societies, people instinctively select as money those things that are available but are relatively scarce or hard to produce and which have the qualities mentioned above. In early America, the colonists had several things they used as money including salt, hides and Indian wampum but the most common was tobacco. (They would have used gold and silver and did to a small extent but those precious metals were so scarce in the colonies that they didn't lend themselves to active trading.) Tobacco kept well, was easily recognized, could be divided into various-sized lots for making purchases of different kinds and could be carried about without too much trouble. In some primitive cultures such things as cows, wives, stones and even tree bark have served as the medium of exchange. Obviously, most of these things are not convenient and their use slows down trade. As societies evolve, they move more and more towards the most convenient trading commodities for exchanges and they usually wind up with the metals. Metals make far better commodity money than most other things because they can be stored indefinitely, divided into large or small pieces, are easily recognized and can have their weight and purity stamped right on them. The three metals that have the best characteristics for use as money are gold, silver and copper. Gold and silver are both relatively scarce, meaning a small amount has a high value and thus you don't have to carry around great weights in order to make large purchases. All three are corrosion resistant and are easily recognized and tested for purity. As groups of people gravitate toward the use of these metals, they experiment with different physical forms. Initially, metals are traded in the form of dust, chips or bars. Gradually, it is found to be most convenient to mint the metals into coins of given weights and purities. As the metals become widely used, some individuals find they can earn a living by specializing in buying and selling them; thus, the goldsmiths and money exchangers get their start. Concurrent with the increased usage of these metals in any society comes the problem of their storage and safekeeping. Since the goldsmiths tend to have secure vaults, individuals begin to use them as depositories. A person leaving his gold or silver with the goldsmith needs a record, so the goldsmiths issue warehouse receipts. Two natural consequences follow. First, individuals soon find it more convenient to trade receipts rather than to go to the trouble of withdrawing their gold from the goldsmith's vault in order to make a trade, since after an exchange the party receiving the gold is likely to take it right back to the goldsmith's. Second, as transactions in these receipts become more common, the goldsmiths (or banks as we have come to know them) begin to issue bearer receipts in the form of banknotes of specific denominations. Thus, John Smith can deposit ten ounces of gold with the goldsmith and instead of getting a receipt that says John Smith has ten ounces of gold on deposit, he can get ten individual banknotes for one ounce each, redeemable by whomever holds the note ("payable to the bearer on demand"). When money is a real commodity, like metal, whoever holds it holds real wealth. To obtain this real wealth, he has only three options. He can create it through his own effort, either by mining it or trading for it; someone can give it to him; or he can steal it by force or by fraud. In the early days, as banks became more popular repositories of gold and silver, the attraction of all that real wealth in one place stimulated the efforts of the more clever thieves. The game became a question of how it could be taken without detection. The best criminal minds in history have worked on this puzzle and the schemes that have evolved almost defy discovery. Of course, governments were among the first to solve the puzzle. The Early Embezzlers Tribal chiefs and kings discovered early in history that there were great advantages to controlling the issuance of money. They started by minting the money metals into coins, usually stamped with their own likenesses. Ostensibly, this was the king's guarantee that there was a certain amount of gold or silver in the coin. In practice, the politicians soon found a way to turn a profit from the business. First, they profited from "seniorage," a price charged for minting the raw metals into coin form. This was a very small percentage, though, usually not much more than the actual costs involved in the minting operation. The real profits came from debasement or clipping. After years of use, individuals would begin to trust these government coins, accepting them as being of a certain weight and fineness without weighing them. Anytime the king could not raise enough taxes to finance his wars or his preferred standard of living, he would tamper with the coinage. As the coins came through the royal treasury, he would secretly file a bit of the metal off each coin and then pass the coins off again at full value, while taking the filings and minting a few new coins. The crafty monarch might also issue new coins in which the gold or silver was alloyed with cheaper metals. Some resorted to "clad" or "sandwich" coins, in which they plated cheaper metals with gold or silver to simulate the real thing. Or again, a kind might simply issue new coins of smaller size, while calling them by the same name as the older, larger coins. In all cases the supply of gold or silver in circulation remained the same but the supply of coins increased. The king, being the first user of the new coins, gained by the amount of real goods those new coins bought. The public, however, now had fewer goods but more coins. The result was an increase in the supply of coins that eventually led to a lower value for each coin. In other words, rising prices. The king was a thief. Of course, the kings and politicians were not the only culprits in the game of coin debasement. Coin filing and counterfeiting was popular rip-off among the population at large; however, the politicians wanted a monopoly on this sport and consequently tampering with the coinage by anyone but the government was deemed illegal and the non-government coin debasers were swiftly pursued and harshly punished. You may recognize some of the old kings' tricks. It has not been that long since our own politicians used the same ploys on our coins. Gold coins were devalued, then removed from circulation. The silver content of our silver coins was first reduced, then we received copper coins clad with silver, then copper clad with nickel and then in 1979, the infamous little Susan B. Anthony dollar. It seems politicians do learn from history but unfortunately they learn the wrong lessons. Banking Coin debasement by the State was just one of many forms of fraud the money dealers developed. The bankers found an even more clever device, still in use today, called "fractional-reserve banking." Originally, a bank was simply a depository for gold and silver and it charged a fee to the depositor for safe storage. Bankers soon learned, however, that most of the gold and silver left in their care was never removed; depositors left it in the vaults and traded the warehouse receipts instead. If someone did make a withdrawal, someone else would probably make a deposit. A banker could loan the gold out, charge interest for the loan and put it back again without the temporary loan being noticed. It became common practice for the banks to do this and as long as the banker did not loan out so much that his stocks were too low to meet any requests for withdrawal by depositors, no one seemed to be hurt by the practice. In fact, the banks soon stopped charging for the safe storage of their metal and began paying interest instead. You will soon come to realize, however, that the payment of interest was no great gain to the depositors, for the loss in purchasing power that accompanied the fraud far outweighed the interest earned. The more loans the bank could make, the more interest the banker earned. The less prudent bankers tended to make high-risk loans. These same imprudent bankers also tended to lend out more gold than was really justified by the amount of deposits they held. If a depositor became suspicious that the banker might be taking too many risks with his money, he would present his deposit receipts and demand his gold back. Needless to say, if the banker had too much loaned out and too many depositors asked to withdraw their funds at once, the banker would not have enough gold on hand to meet all the withdrawals. At that point, his bank would collapse and any depositors who got there too late would lose their funds. This practice of lending out part of the reserves held by the bank came to be known as fractionalreserve banking, a term which indicates that banks lend out some part of their deposits and keep only the remaining fraction in reserve to meet withdrawals. In the early days of banking, the banker himself determined what fraction of his deposits he would keep in reserve to meet withdrawals. Today that fraction is usually set by the central bank or federal government of the country involved. Although the minute details of banking may be complex, the concept is really quite simple. Today's banks are merely financial middlemen. They borrow money and they lend money. They are money brokers and in their regular banking activities have nothing whatsoever to do anymore with the safe storage of wealth. When you deposit your money in a bank you receive an IOU from the banker. It may be in the form of a checking-account deposit receipt, a savings-account passbook or a certificate of deposit (CD). The IOU is a contract in which the banker promises to repay your deposit at some specific time and at some specified rate of interest. he will normally promise to repay your checking account deposit anytime you request it, so all you need to do is write a check to withdraw it. When you deposit your money in a savings account, the contract normally says the banker doesn't have to return it to you for six months or longer, even though in practice he may give it to you sooner. When he borrows your money under a CD he may not be required to return your money for a year or longer. Bankers profit by borrowing money from depositors at one interest rate and lending it to their customers at a higher rate. They act as financial intermediaries. Hypothetically, you could bypass the bank and lend your money to a neighbor at the rate the bank would charge, thus earning a higher return but this is not your field of expertise. You would have to know how to check the person's credit and would need to handle all the paperwork involved. Furthermore, you would have to be willing to undergo a loss if the person didn't repay the loan. The banker provides the credit checking service, handles all the paperwork and takes the loss if a borrower defaults. For this he gets the interest rate differential to cover costs and provide him a profit. At first glance it would seem that bankers provide a rather routine service between lenders and borrowers and it might be hard to imagine how they could increase the money supply or how they could play a role in inflation or recession. In fact, they are an important and misunderstood piece of the economic puzzle. When the banker takes your deposit, he makes an agreement with you that he does not know for certain he will be able to keep. He agrees to return your money to you whenever you demand its return in the case of a checking account or within a period of a few months in the case of savings and CDs. He then takes your money and loans a large portion of it (all that he is not required to keep in reserve) to someone else under a loan agreement that may not require the borrower to repay the money for as long as twenty or thirty years. If the other party doesn't repay the loan before you demand your deposit back, where will the banker get the money to repay? By borrowing from you on a short-term agreement and lending to someone else on a longterm payback, he is effectively insolvent all the time. In practice, the banker relies on the fact that there will always be new depositors putting money in, and if you demand yours back, he can pay it out of the new depositors' money. Usually this works. However, it does not change the fact that the banker borrows short-term from his depositors and lends long-term to his clients. The banker thus makes a profit by promising something he cannot deliver unless things go just right. The law says that it is illegal for you to write a check unless the money is already in your account to cover that check. When the banker borrows short and lends long, he is essentially doing exactly what he has made it illegal for you to do. This is a perfect example of plunder. The public is not aware that the banker is insolvent, for the contract between the bank and its depositors does not state that if the bank makes bad loans, the depositor may lose his deposit. When you put money in the bank, you assume that the banker will be able to repay you when you decide to withdraw your funds. If you loaned your money directly to your neighbor, you would be fully aware that the safety of your money depended on your neighbor's ability to repay, and you would make your financial plans accordingly. However, when you lend your money to the banker, and he then lends it to your neighbor, the risk becomes camouflaged. It doesn't seem to you that you, in reality, loaned the money to that neighbor, and that you stand any risk if he defaults. But you do. When a bank makes loans, it is really risking its depositors' money. The result of this camouflage is that people make assumptions about the safety of their money, and make personal and business decisions accordingly. When economic conditions change, and when a bank suddenly finds that loans are going bad, and its depositors are withdrawing funds more rapidly than they are making new deposits, the bank can quickly go bankrupt. How Banks Create Money Before banks were regulated by the Federal Reserve Bank, a bank could open its doors with a small amount of gold on reserve and immediately begin making loans by issuing its own banknotes. These notes would simply say that such-and-such a bank promised to redeem the note for the specified amount of gold, on demand. The notes would circulate as money, and thus the bank was expanding the money supply in the community even though the amount of gold remained constant. A community could experience a significant business boom because of the activities of its banks, a boom which would carry on until someone decided to turn in the notes for the promised gold. If demands for withdrawal exceeded the gold in the bank's vaults, the bank would go bankrupt, and the remaining notes would be worthless. At one time in this country there were thousands of banks issuing their own banknotes, each one valued according to the public's estimate of the creditworthiness of that particular bank. There were periodicals published that did nothing but rate the banks issuing notes and list the market prices at which the public traded these notes. Each note may have proclaimed it was worth a given amount of gold, but that had no bearing on the rate of exchange at which they would be accepted by the public. Today, individual banks are no longer permitted to issue banknotes - the Federal Reserve now has the monopoly - but they still have the ability to expand the money supply through the mechanism of fractionalreserve banking. When you deposit $100 into your checking account, the banker credits you with that amount of money. As far as you are concerned, you own the money and make plans accordingly. You may decide to spend it at any time, and can do so by writing a check or making a withdrawal from your savings. The moment you make the deposit the banker loans a major portion of it (about $84 under the current reserve requirements) to someone else by making a credit entry in their checking account. This new borrower then has the power to write a check on the $84. In other words, you deposit $100 in your checking account, and the banker then deposits another $84 in someone else's checking account. The money supply has been expanded. There was originally only $100 and now there is $184. It goes even further. When that $84 gets deposited in the other person's checking account, the banker then has the ability to loan $70 of that $84 to a third person, and so on down the line. By continuing to lend and re-lend that same original deposit over and over again, the banking system can expand an original deposit over six times. You might argue that the moment you withdraw your money by writing a check, the process must reverse, and the money supply must contract. Not quite, because you probably write that check to someone who then deposits it in his bank, and your withdrawal is offset by an equivalent deposit in another bank. It may be in a different bank but it is within the same banking system, which makes it act as though it were the same bank. This expansion of the money supply has the same effect that any increase in money has. It lowers the price of money in terms of real goods, which means raising the price of real goods relative to money. Remember, price is an exchange ratio. Fractional-reserve banking is the Number Two cause of money supply expansion in society today. Now let's look at the Number One cause. The Federal Reserve System In the nineteenth century established banks struggled under two burdens. First, they were engaged in a vicious competitive struggle with each other, and with new banks that attempted to gain a share of the market. Second, because individuals were generally distrustful of banks and would withdraw deposits the moment they suspected a bank might be issuing too many notes, banks were faced with the constant threat of bank runs. Using the argument that the public was often defrauded by charlatans who opened new banks and then fled with depositors' funds or who failed due to lack of sound banking practices, the established banks lobbied for government regulation of the banking industry. Of course, the established banks did not want to be controlled, they just wanted the legal power to make it difficult for new banks to enter the field, and wanted to prevent the banks that did get in from engaging in competitive practices that would affect the established banks' profits. The established banks drew up a set of suggested banking regulations which they successfully promoted in the state legislatures. Most states then passed laws regulating the formation and operation of banks, and these laws effectively prevented upstart banks from engaging in competitive practices that would infringe on the profits of the established banks. The problem of bank runs was approached on the federal level. Just after the turn of the century, the political power of the banking industry grew to the point where bankers were able to pressure Congress into creating the Federal Reserve System (the Fed), a central bank to control all banks in the country. The Federal Reserve System was set up by Congress as an independent, private organization made up of the banks that belonged to it. Membership was not mandatory, but conferred certain privileges upon the member banks, and consequently most banks joined. The president was given the power to appoint a Board of Governors to oversee the affairs of the banks, and that board was empowered to establish certain rules that both member and nonmember banks had to follow. The board sets the reserve requirement (the percentage of deposits each bank has to hold in reserve), lends money to member banks, and can buy and sell U.S. Treasury securities in the public market. It is disturbing to realize how few people understand the true purpose and interests of the Fed. Even trained economists and financial analysts mistakenly assume that the published objectives (that is, protection of the public, stabilizing the economy, etc.) are the true reasons for Federal Reserve actions. Even those who imagine that the Fed is somehow a tool of a vast conspiracy of international financiers and industrialists, fail to understand that the Fed is simply a mechanism whereby self-interested people, in this case bankers, use government to protect their interests at the expense of consumers and potential competitors. Its promoters claimed its purposes were to eliminate panics (or recessions as we call them today) by stabilizing the supply of bank credit, and to protect the public from charlatans and crooks. In reality, the purpose of the Fed was to protect the bankers from the public. If the public could be lulled into a belief that the Fed would protect them, the established banks could expand their deposits with much greater freedom. Federal regulation of banks (1) enlarged the ability of the established banks to expand their deposits and loans without the danger of bank runs and (2) further restricted competition. The result was the Roaring Twenties, and the aftermath was the Great Depression. The Federal Reserve (in concert with a few other federal and state banking agencies) determines which banks are qualified to operate, what types of products can be offered, and what rates can be charged. Also, in its role as overseer of the nation's banks, the Fed has ultimate control of the expansion of the U.S. money supply. It is in this role that the Fed most affects your life, for as we pointed out earlier, it is the expansion of the money supply that is the root cause of rising prices. When the Fed wants to change the supply of money, it has three tools at its disposal:
This last tool is the most important way in which the Fed affects the money supply, and the way in which the Fed is linked to the spending policies of the federal government. To understand where the majority of our inflation originates, it is essential to understand the link between federal borrowing and the Federal Reserve. Turning Federal Debt into Money When Congress spends more money than it raises through taxes, it authorizes the Treasury Department to borrow from the public by selling Treasury bills, bonds, and notes. The Treasury offers these securities for sale at public auction, and they are bid for and purchased by banks, pension funds, trusts, corporations, individuals, and even foreign interests. These are the safest IOUs around. They are guaranteed by the government. Inasmuch as the securities are offered at auction, there is no chance they will not be purchased. The Treasury offers such a high rate of interest that people are induced to sell their other debt securities such as bonds, savings accounts, and certificates of deposit, and buy the government IOUs. Sale of government securities thus soaks up the savings of individuals and corporations. The more government borrows, the less money there is left over for other borrowers, and so other borrowers must offer higher and higher rates of interest in order to attract funds. Rising interest rates cause the costs of doing business to rise, loans are harder to get and, as a result, business activity slows down. Both businesses and consumers curtail spending, and the economy moves toward recession. Recessions are politically unpalatable. Idled workers and distraught businessmen hound their government representatives to do something. What they want is the availability of more money. The only way the politicians can meet the demands of their constituents is to borrow more money and spend it to subsidize business, to pay unemployment benefits to the idled workers, or to issue government contracts to buy products from the distressed companies. The government takes a dollar from one person and gives it to another as a pretense of fighting the recession. In fact, it makes things worse. Additional federal borrowing further depletes the supply of available credit and amplifies the recession. It is widely believed that the Fed is sympathetic with the problems recessions create for politicians, and lowers interest rates in order to keep those politicians in favor with the public. That is not the case at all. The Fed is relatively insulated from political pressure and has other reasons to act. A recession means bad times for the banks. People stop borrowing, corporations lose business, and bank profits drop. When borrowers get into trouble, banks get into trouble. If the recession turns into a full-scale depression, widespread bank failures may result, as they did in the 1920s. Since the Fed is an organization made up of banks, it is clearly in the best interests of those running it to ward off the recession by expanding the money supply. When the Fed determines that interest rates should be lowered, or at least prevented from rising any further, it contacts private dealers who by and sell U.S. government securities, and offers to purchase Treasury bills and bonds. (Remember, these are the same T-bills and bonds that created the rising interest rates in the first place by absorbing the savings of individuals and corporations.) The Fed purchases these government securities and pays for them with a check. That check is given to the private dealer, and he deposits it in his bank. The bond dealer's bank forwards the check to the Fed (where it has its own reserves on deposit), and the Fed then credits the reserve account of that bank. Now the bank has new reserves against which it can make loans. These fresh reserves are just like a new deposit by a customer, and can be expanded by the same process that all bank deposits are expanded. Under reserve requirements in effect in early 1980, these reserves can be expanded by approximately six to one; thus, when the Federal Reserve buys $1 billion in U.S. Treasury securities, the banks can loan out up to $6 billion to borrowers. Where did the Fed get the money to buy the Treasury securities? It created the money out of thin air. It credits the reserve account of the bank by a simple bookkeeping entry. What does the Fed have to back up its IOUs? It has the IOU of the U.S. Treasury, that is, the Treasury bills and bonds. The Federal Reserve accounts thus balance: they show a liability of the bank reserves and offsetting asset of Treasury securities. The Federal Reserve Notes in your pocket or checking account mean that the Fed owes you money, and these are in turn backed up by the T-bills they hold that mean the government owes the Fed money. The U.S. government continues to issue more and more IOUs to cover its ever-growing deficits, and the Fed continues to buy these up and issue its own notes in their place. This whole process is known as monetizing the debt. This means the debt of the federal government is turned into money. The government borrows money to meet its deficits, and the IOUs it issues eventually are converted into Federal Reserve Notes in your pocket. Those greenbacks in your wallet that you think of as money are only government IOUs broken up and reissued by the Fed. Give it a little thought and you should see that there is no difference in the long run between the government fighting a recession by borrowing money from Peter and giving it to Paul, and the Fed fighting the recession by buying up Treasury bills and giving the banks new reserves. The only difference is a time difference. The effects of government borrowing are almost instantly offset by the effects of government spending. But when the Fed monetizes the government debt, it takes a year or more for people to offset the influx of new money by raising their prices. The Fed action just postpones the inevitable a bit longer than the government action does. Federal deficits, then, are the root cause of continued inflation of the money supply. Once the banks have loaned out depositors' money to the maximum limit set by reserve requirements, the only source of new dollars is the Federal Reserve. The Federal Reserve, therefore, is the real engine of inflation. Its need to inflate, however, is a consequence of federal deficits. The Future of Inflation Now that we have identified the mechanism by which deficits are turned into money and that money multiplied, we are in a position to peer into the future and forecast the trend of prices. If we determine that the federal budget is being brought under control and deficit spending will end, we can be confident price inflation will end. If, however, we look ahead and find more or greater deficits in the future, then we must conclude inflation will continue. An estimate of future deficits should give us some indication of the inflation problem we face in the future. Figure 1 is a graph showing the history of federal deficits in this country during the last thirty years. It is widely believed that deficits show an upward trend during wars, and usually a downward trend afterward. The upward trend during the 1960s might have been explained by the war in Vietnam, but the trend failed to change course after the war. In fact, the graph shows the opposite. During the first five years of the 1960s, deficits totaled $21 billion. During the last half of the 1960s they almost doubled, totaling $36 billion. In the first five years of the 1970s they almost doubled again, to $70 billion, and then in the last five years, ending in September of 1979, they totaled a staggering $310 billion - more than double the total of the prior fifteen years. Why are deficits rising at such a frightening pace? Because the government is spending an increasing amount of money each year. The government is growing in size, and its role in the private economy is growing. This growth, however, is not the result of evil designs of power-mad politicians and bureaucrats. It is the result of an explosion in the demands made by individuals. People make the demands; politicians meet the demands. Each year brings an increasing belief that there is such a thing as a free lunch. The government is perceived as a source of wealth. More and more people wait in line at the Treasury. The automaker requests a subsidy, the student asks for an interest-free loan, the farmer asks for price supports, the conservationist asks for a wilderness area, the ecologist for a program to stop pollution, the general for a larger defense force, the oil company for diplomatic intervention in a foreign country, the poor for food stamps, and the handicapped for job training. Just as tiny grains of sand pile up one at a time to form a desert, so the individual requests of millions and millions of people gradually pile up, layer upon layer, until monstrous, uncontrollable bureaucracy is created to meet their individual request. Demands grow so large that soon they exceed the willingness of taxpayers to support them. Rather than cut back on benefits, politicians turn to deficit spending. It would seem that the public could be educated to recognize that government has no wealth, and anything it provides to one individual, it must first confiscate from some other individual. If the majority of individuals understood this, and further understood what disastrous long-term consequences emanate from the theft of an individual's property, then enough of them might voluntarily stop making demands on government to cause a reversal in the trend of government growth. Eventually, this would eliminate deficits and prices would stabilize. Although this is a goal to be worked for, such a change will require some method of education totally different from what has been used in the past. There is absolutely no evidence to suggest that this type of understanding is growing either in the United States or in any other country in the world. The evidence indicates just the opposite: more and more people everywhere, every year, are becoming convinced that government should provide solutions to their problems. Consequently, every year government gets bigger and bigger, and the deficits continue to expand. On this basis alone, we must project increasing inflation in our future. The Hidden Deficits It would appear that demands for government spending will make it hard, if not impossible, for any politician to eliminate deficits (and thus inflation). Public ignorance is not the only thing between a balanced budget and deficits, however. There is another factor that guarantees incredibly larger deficits ahead. The growth in deficits over the past few years has been accelerating, as the chart indicates. What is not revealed, however, is a critical factor causing this sudden acceleration. The government has chosen to report its expenditures in a way that totally camouflages the true extent of the deficit problem. To understand what they are doing, it is necessary to understand something about accounting and since most of us know little about this subject, the bureaucrats have been fairly safe with their secret. So that you may be fully aware of the problem facing you, let me expose their little subterfuge. In accounting, there are two methods of reporting gains and losses. One is the cash method, and the other is the accrual method. If you want to find out how you fared financially during the last year, you may use either method. To use the cash method, you simply add up all the income you received during the period, and subtract from it the total of all the bills you paid. This is the way you keep your checkbook every month. You record deposits, and subtract the checks written, and the difference is your balance. if you write more checks than you cover with deposits, you have an overdraft (a deficit). The government uses the cash method to keep its books and to report its surpluses and deficits. When the government reports a $25 billion deficit, all you know is that $25 billion more was paid out than was received. Large businesses rarely use the cash method of accounting, preferring the accrual method instead. Why? The businessman cannot afford to kid himself. He must realistically assess his profits and losses in order to stay in business, and so he uses the most accurate method for doing so. Under the accrual method, actual cash income and cash expenses are not used to determine profits and losses for the year. Instead, the business totals up all the income promised to it that year under the terms of its contracts, and for which it has delivered merchandise, and counts this as income. Obviously, this income figure might differ from cash actually received by the firm if some customers received merchandise but delayed payment past the end of the year. On the expense side, the company shows as outgo any money it contracts to pay for goods it receives and consumes that year, regardless of whether the bill has been paid that year or not. Thus, if the company buys something but does not have to pay for it until some future year, the item is still shown as an expense in the current year. This method of accounting makes sense for any businessman who really wants to know whether he is operating at a profit or loss. If a baker bakes 10,000 loaves of bread in a year and sells them at $1 per loaf, and receives the money in that year, he will show $10,000 of income. If he buys the flour to make that bread on credit, and does not have to pay for it until next year, his books will not show a check written for the flour. If he uses the cash method, he will show income of $10,000, but no offsetting expense for the materials used to produce that income. His profit picture is thus distorted because he has failed to take into account the real expense of earning that $10,000. Instead, the wise baker uses the accrual basis, and show the flour as an expense, even though he will not pay for it until next year. In this way, his profit for the year is realistically shown, and he can better plan for the future. Since the federal government uses cash-basis accounting, anything it consumes in one fiscal year but does not have to pay for until some future fiscal year does not show up as an expense. Arthur Andersen & company, a major national accounting firm, called attention to this subterfuge in 1975 in a lengthy report titled Sound Financial Reporting in the Public Sector. Their auditors painstakingly reviewed the U.S. federal budgets for fiscal years ending June 30, 1973, and June 30, 1974, and came up with some shocking figures. Using the cash basis of accounting, the government reported federal deficits of $14.3 billion for 1973 and $3.5 billion for 1974. Arthur Andersen & Company recalculated the budget deficits according to the accrual method, and found that the 1973 deficit jumped from $14.3 billion to a staggering $86.6 billion, a jump of over $70 billion! The 1974 budget was even worse. The deficit jumped from $3.5 billion to just over $95 billion, an increase of over $90 billion! Thus, in just two years, the government had underreported its deficits by more than $160 billion. Based on this Arthur Andersen report, the Treasury, under William Simon, began publishing a Consolidated Financial Statement that included accrual liabilities. These Treasury statements show Social Security debts alone (not counting veterans benefits, military pensions, or government employee pensions) of $121 billion in fiscal 1976, and $177 billion in fiscal 1977. Although these statements are published two years after the fact, conservative extrapolation suggests that the fiscal 1981 accrual deficit will exceed $250 billion. Add to this the cash basis deficit, and the true 1981 deficit winds up near $350 billion! This is grim news for you and everyone else. No matter how sincere a political candidate appears when he promises a balanced budget in the future, he will be powerless to bring it about. A true balanced budget would require a $350 billion dollar budget cut! It is a political impossibility. Expect the largest budget deficits in the history of the nation during the next five years. Summary An increase in the money supply is the only cause of inflation in the long run. Money is created by banks through fractional-reserve banking, and by the Federal Reserve as it monetizes federal deficits. The future rate of inflation is primarily a function of the size of deficits, since the Federal Reserve is duty-bound to monetize them. The message should be clear. past debts and future demands of the public are going to drive the federal deficits beyond comprehension. The Federal Reserve will be completely helpless to resist a massive expansion of bank reserves in order to avert a banking system collapse. The money supply is going to soar, and with it will come inflation rates that will make the 1970s seem like a period of price stability. By 1985, prices will have doubled from their 1980 levels. By the end of the decade, prices may be ten times their current levels. Hyperinflation could happen here.
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As society grows, the inconvenience of barter becomes overwhelming. Things such as automobiles and accounting services are just plain difficult to barter with, especially when all you want is a quart of milk or a pencil. Consequently, as the population and number of products increase, individuals naturally select certain commodities to use in making exchanges. These items, by popular mandate, become money.
John Pugsley is chairman of