Private Inflation: Counterfeiting Money Certificates

1. Debasement

Before the age of banking, debasement had been the standard form of inflation. Debasement is a special way of altering coins made out of precious metal. To debase a coin can mean either one of two things: (a) to reduce its content of fine metal without changing the imprint; and (b) to imprint a higher nominal figure on a given coin.

Debasement can be either intentional or unintentional. Suppose a coin maker erroneously puts the stamp “1 ounce of fine gold” on a quantity of less than one ounce. He then produces a false coin; the certificate does not correspond to the content. False certification might occur here and there, but in practice it is extremely rare. In virtually all the cases of debasement, the coin-maker acts in full conscience of his deed. He certifies that the coin contains a certain quantity of fine metal, but he knows full well that it contains in fact less than this quantity. Such intentional falsification of certificates is commonly called counterfeiting.

We have stressed that people cause inflation because it benefits them, though at the undue expense of their fellow citizens. This is of course also the reason why people become counterfeiters. The counterfeiter plans to sell the debased coin without informing the buyer about the debasement, so as to obtain in exchange for it the same amount of goods and services that one could buy with a sound coin. The fraudulent intention behind most practical cases of debasement is obvious from the techniques that are usually applied. The debaser does not take away some metal from the sound coin and turn it into a smaller debased coin. Rather he substitutes some base alloy for the precious metal he has taken away, to preserve the false impression that the debased coin is a sound one.

In the Western world, debasement was the standard form of inflation until the seventeenth century. It was widespread and perennial in all phases of the history of ancient Rome and under virtually all dynasties of medieval Christendom. And the only reason for its absence in more recent times is that modern counterfeiters could rely on the much more efficient inflation techniques of fractional-reserve banking and paper money.^[1]

In many cases, the counterfeiters have been private individuals—ordinary criminals. But in the larger cases, the counterfeiters have been the very persons who were supposed to act as guardians of the soundness of the currency—the government. For reasons that we will discuss in more detail when talking about fiat money, governments have played a far greater role in debasing money than private citizens. Notice however that inflation in the form of debasement was moderate in comparison to the extent of inflation in the age of banking, and especially in comparison to inflation in our present age of paper money. From 1066 to 1601, the English silver pound was debased by one third.^[2] In other words, in this period stretching over more than 500 years, the English kings inflated the money supply by the factor 0.3. By contrast, in the subsequent 200-year period, which saw the emergence of modern banking, that factor was in the order of 16. And in the mere 30-year period from January 1973 to January 2003, the U.S. dollar (M1) increased almost by a factor of 5.^[3]

2. Fractional-Reserve Certificates

Let us now turn to the important case of the inflation of certificates that are not physically integrated with the monetary metal. As in the case of debasement, we can here distinguish between intentional and unintentional inflation, emphasizing again that the latter case is of no great practical importance.^[4] Virtually all the false certificates that are disconnected from the certified money are counterfeit certificates. The issuer of these certificates knows that he does not hold enough reserves of money to redeem all of his certificates at once. The amount of money he keeps on hand to satisfy any demands for redemption represents just a fraction of the amount that he certified he had on hand. We can therefore call his certificates “fractional-reserve certificates.” Although fractional-reserve token coins and other physical embodiments have played a certain role in monetary history, they cannot match the importance of fractional-reserve banknotes and fractional-reserve demand deposits. We will therefore largely focus on the latter.^[5]

From a counterfeiter’s point of view, falsifying money certificates that are physically connected with the certified quantity of money has two great shortcomings: it is relatively expensive, and it is relatively easy for the other market participants to discover the fraud and avoid using the coins. These problems dwindle once our counterfeiter turns to falsifying certificates that are not physically connected to the money. Falsifying banknotes, for example, might require a considerable initial investment in time and money to create a suitable prototype. But once the prototype is there, it can be reproduced in virtually unlimited numbers and at great profit, because the marginal cost of producing additional banknotes is close to zero. Moreover, in the case of paper certificates, extensions of the money supply are more difficult to perceive than in the case of certificates directly attached to the metal. Debased coins, even when the counterfeiting is done with great care, not only have a slightly imperfect imprint, but also differ from good coins in respect to color and, in the case of gold coins, to their sound when flipped with the thumbnail. Most importantly, the certificates can easily be tested any time by cutting or punching them, or by melting down the coin. Thus even for laymen it is relatively easy to distinguish sound coins from falsifications. Not so in the case of paper certificates.

3. Three Origins of Fractional-Reserve Banking

As in the case of debasement, banknotes have been falsified both by ordinary criminals and by the “guardians” themselves. Banknotes came into existence on a larger scale when money warehouses were established in Venice and other northern Italian cities in the late sixteenth, and then in a number of commercial cities north of the Alps in the early seventeenth century, for example, in Amsterdam, Middelburg, Nuremberg, Hamburg, Delft, and Rotterdam. During the sixteenth century, inter-regional trade had grown to such an extent that the merchants were in touch with one another not only during the times of the great fairs, but throughout the entire year. Now it became necessary to settle accounts on a daily basis, and the most practical way to do this was through money warehouses. Each merchant held an account, and payments from and to other merchants were made by simple book entries at the local money warehouse.^[6]

These institutions were called “banks,” but in their beginnings they were not banks in the modern sense, but money warehouses. Some of them kept this character for a long time. For example, the Bank of Amsterdam (established in 1609) remained a warehouse until 1781, when it started issuing banknotes in excess of its money holdings, yet without changing the outer appearance of the banknotes. Thus in 1781 the Bank of Amsterdam started counterfeiting its own banknotes. It was no longer a money warehouse. It became a fractional-reserve bank.

Other banks did not wait nearly as long as the Bank of Amsterdam to enter the lucrative business of counterfeiting. The London goldsmith bankers, who multiplied in the 1630s, very quickly made that move. So did the Bank of Stockholm (established 1656), which a few years after its inception managed to create a large circulation for its notes. But the same bank was also one of the first to experience the perennial nemesis of fractional-reserve banking—the bank run. The fundamental practical problem of fractional reserves is that it is impossible for the issuing bank to accommodate all demands for redemptions at the same time (as warehouse banks can). If the bank customers have the slightest suspicion that they might not get their money back, they “run” to the bank to be among the happy few who are still granted redemption of their banknotes. This happened to the Bank of Stockholm in 1664. But it did not stop the proliferation of fractional-reserve banking in the subsequent decades and centuries.

Thus fractional-reserve banking can arise as a perversion of money warehousing. But it can also originate as a perversion of credit banking. We have already talked about credit money and argued that it is unlikely to have any larger circulation because of the default risk and especially because most market participants prefer cash to credit instruments in spot exchanges. Now in order to make good for the latter deficiency, the banker might offer to redeem his IOUs on demand, that is, before maturity is reached. From the point of view of the customer, then, these IOUs can be turned into cash almost as securely as money certificates. We have to say “almost” because it would of course be impossible for our banker to comply with redemption requests that exceed his cash holdings—a problem that cannot arise in money warehousing, where every certificate is backed by a corresponding amount of money in the warehouse.

So how does this practice appear from a juridical and moral point of view? It depends on whether the banker is affirmatively candid about the nature of his business. If he takes care to inform his customers that the redeemable IOUs are not money certificates and that he—the banker—remains the rightful owner of the money for the entire duration of the credit, then the practice seems to be unobjectionable. By contrast, if he insinuates that his IOUs are money certificates, we would certainly have to say that this is a case of fraud.

Historically, it seems as though dissimulation has been more important than outright misrepresentation. On the oldest known paper note from the Bank of Scotland, dated 16 April 1776, we read: “The Governor & Company of the Bank of Scotland constituted by Act of Parliament Do hereby oblige themselves to pay to [name] or the Bearer Twelve pounds Scots on demand.” The crucial wording here is “oblige themselves to pay”—on later banknotes we often find the expression “promise to pay.” Thus the least thing we can say is that these notes are mute about the precise nature of the product. The “promise to pay” is not a feature that would distinguish a credit bank from a money warehouse.^[7] To keep the market participants fully informed, it would be necessary to state as clearly as possible whether the promised payment will be made out of a small (fractional-reserve) cash fund, or out of a warehouse. Similarly, it would be necessary to state who will be considered to be the owner of the money in case the banker proves to be unable to comply with all redemption requests.^[8] If our credit banker knowingly and deliberately dissimulates the precise nature of his IOUs, he abuses the good faith of his trading partners and thereby infringes upon their property rights. He thereby turns himself into a fractional-reserve banker.^[9]

So far we have presented fractional-reserve banking as springing exclusively from the misguided choices of warehouse managers and credit bankers who fell prey to temptation. But it is also conceivable that these choices were in turn caused by a third event, in particular, by the threat of government-sponsored robbing of money warehouses. As Jesús Huerta de Soto has argued for the case of the sixteenth century banks of Seville, the ruthlessness of bankers was by no means the only cause for the introduction of the fractional-reserve principle:

… it is no less true that the inauspicious imperial policy, by transgressing the most elementary principles of property rights and directly confiscating the stocks of money kept in the vaults, merely provided an even bigger incentive for the bankers to invest the greater part of the deposits received in loans, which became a habitual practice: if, in the final analysis, there was no guarantee that the public authorities would respect the part of the cash reserve which was kept in the bank (and experience showed that, when times were difficult, the Emperor did not hesitate to confiscate this reserve and substitute it by compulsory loans to the Crown), it was preferable to devote the greater part of the deposits to loans to private industry and commerce, thus avoiding expropriation and obtaining greater profitability.^[10]

Thus the introduction of fractional-reserve banking might be seen as a free-market reaction against, and attenuation of, government interventionism. It is true that, even under the threat of imminent expropriation, fractional-reserve banking might not be justifiable per se; but at least the presence of such a threat would diminish the guilt of the protagonists, and it would certainly explain their actions in other terms than original sin.

Much more historical research is needed to establish the relative importance of the three possible causes of fractional-reserve banking that we have discussed in the preceding pages. There are good reasons to believe that the third cause—government-sponsored robbing of money warehouses—has played a rather pervasive role. But we must leave the answer to that question to future research.

4. Indirect Benefits of Counterfeiting in a Free Society

Counterfeiting is in the true sense of the word a popular inflation technique. All sorts of people who have dextrous hands or who can afford to hire people with such hands—bankers, governments, merchants, goldsmiths, artisans, etc.—can try it out. And the history of money illustrates that all sorts of such people have tried it out, with the harmful consequences analyzed above: unjust distributions of income and misallocations of capital. Thus counterfeiting exists in all types of economies, be it the market of a free society or the centrally planned economy of a totalitarian state. Unlike fiat money, of which we will speak below, it cannot be abolished through political measures. It can be repressed by the prospect of severe punishment. But it cannot be entirely eliminated by such external means, because it springs from the internal human condition of original sin.

Yet in a free society counterfeiting is not without certain positive consequences, even though the counterfeiters themselves do not plan to bring them about. In particular, the very danger of falling prey to a counterfeiter plays the useful social function of making the citizens vigilant about their money. The function of counterfeiters resembles the function of the many viruses that subsist in a healthy human body. Fighting the virus keeps the body alive and strong. Similarly, the ever-present danger of counterfeiting stimulates vigilance in monetary affairs and thus helps to preserve sound money. People watch their gold and silver coins closely because they know that counterfeiting affects them directly. They strive to learn more about distinguishing good coins from bad coins, and good banknotes from bad ones. They apply such knowledge and teach it to their families and others. And once they discover any sort of fraud, they stop using the fraudulent coins and banknotes, and switch to other certificates.

Counterfeiting is usually detected very quickly. When people are free to choose their money, it cannot create much damage. But this important natural limitation on inflation exists only in free societies, as we shall see in more detail.

5. The Ethics of Counterfeiting

Debasement and fractional-reserve banking are unjustifiable. No theory of ethics defends lies or, for that matter, counterfeiting. It is true that a few moral philosophers have tried to justify lies that are meant to prevent greater harm. But which harm could be avoided through counterfeiting? Or does counterfeiting convey any special advantages to the community of money users? Nobody has ever ventured to answer these questions affirmatively; and thus we do not need to deal with them here. As far as counterfeiting per se is concerned, there cannot be the slightest doubt about the Christian stance. The Eighth Commandment tells us about intentional falsification of certificates: “You shall not bear false witness against your neighbor.” And many other passages from the Old Testament spell out what this means in the context of certificates that attest quantities of precious metals.^[11]

These general ethical principles were applied with great rigor to the case of money in Nicholas Oresme’s “Treatise.” The author noted that falsifying the imprint of a coin was a penal offense, and even a legitimate cause of war. He held that a “change of names” (debasement) was scandalous and should never be done. An alteration of the weight without changing the name was similarly “a foul lie and a fraudulent cheat.”^[12]

Bishop Oresme made no exception to his condemnation of false money certificates. Even the government could not, for any reason, falsify money certificates and thus inflate the money supply. He argued that any alteration of money through the government was unjust in itself, and that the government necessarily gained at the expense of the community.^[13] The government thus turns into a tyrant:

… from the moment when the prince usurps this essentially unjust privilege, it is impossible that he can justly take profit from it. Besides, the amount of the prince’s profit is necessarily that of the community’s loss. But whatever loss the prince inflicts on the community is injustice and the act of a tyrant and not of a king, as Aristotle says. And if he should tell the tyrant’s usual lie, that he applies that profit to the public advantage, he must not be believed, because he might as well take my coat and say he needed it for the public service. And Saint Paul says that we are not to do evil that good may come. Nothing therefore should be extorted on the pretence that it will be used for good purposes afterwards.^[14]

Oresme stresses here a fundamental fact. As we have pointed out above, the additional money benefits the first owners at the expense of all other money owners. It is true that this is so irrespective of whether the additional money results from natural production or from inflation. But inflation is not just an extension of the money supply. The crucial point is that it extends the money supply through a violation of property rights. Inflation provides not just gains; it provides illegitimate gains. Its alleged benefits are not really different from the benefits of robbery and fraud.^[15]

Oresme also argued that counterfeiting was a far more serious moral offense than the sins that are most frequently associated with the use of money, namely, money changing and usury. Money changing and usury might be tolerable under certain special circumstances. But counterfeiting was inherently unjust and therefore never permissible. It actually stimulated money changing and further counterfeiting by people who seized on the general confusion created by the initial counterfeiter.^[16]