There is probably no single subject that is of more interest to Americans, as a whole, than money and yet I believe it is probable that the majority of them know very little of our monetary system. In the United States, during George Washington's first term as president, money essentially meant specie, in other words coins made of various types of metal.
        I am going to explain, as briefly as I possibly can, the way an economy functions when all of its money is in the form of specie. In the interest of simplicity I will stipulate that, in this economy, all money is in the form of gold, barter is not a feature of the economy, and, initially, the effects of foreign trade will be disregarded. The explanation would be the same if other metals besides gold were used as money but gold is a very short word and this will save space. The only effect of barter would be to diminish the actual effects of variations between the total of wealth produced in the nation and the amount of money in circulation. For ease of explanation I will term this somewhat hypothetical economy an honest economy. It is hypothetical only in the sense that it includes no barter and barter was a significant factor in every economy that included no fractional reserve banking.
        The wealth of a nation does not consist of money in the hands of individuals or the nation's government. The wealth produced by any nation is the goods and services it produces. Money represents a claim on that wealth. The part of this wealth that exists at any point in time is the total wealth of that nation. Gold and other metals have some intrinsic value even if they are not used as money. When they are used as money their value increases. If gold, for example, is the coin of the realm all gold, whether or not it has been minted into coins, will increase in value. The value that this gold would have if gold were not used as money is its intrinsic value, the increase in its value when it is used as money results from the fact that it is then a claim on wealth. The total amount of wealth produced by this nation in one year can be designated, at least in this explanation, as the gross national product (GNP). Money is simply a medium used to facilitate exchanges of the wealth that exists in the nation.
        In this economy there is a very definite, and inflexible, relationship between the GNP, the amount of money in circulation (the money supply), the velocity of money and the price of any type of wealth that exists. If the money of this nation is designated in dollars then the velocity of money will be the number of transactions in which the average dollar participates, in one year. An increase in the velocity of money will have the same effect on prices as an increase in the money supply. Because the velocity of money fluctuates very slowly I will stipulate, again for the sake of simplicity, that in this economy the velocity of money remains unchanged. Having made this stipulation we can say that the price of any item of wealth will depend on the amount of the GNP, the amount of the money supply, and the supply of, and demand for,  the item in question. Supply and demand will determine the value of any given item of wealth relative to all other items of wealth but the overall level of all prices will be determined solely by the amount of the GNP and the amount of the money supply.
        If the GNP increases and the money supply remains the same, or if the money supply decreases and the GNP remains the same, or if both increase but the money supply increases more slowly, or if both decrease but the money supply decreases more rapidly, the result will be a decrease in prices. This is termed price deflation or simply deflation. It occurs because the money supply is, in each case, insufficient to meet the needs of the economy. When this situation occurs the economy automatically adjusts the prices in an effort to maintain a balance between the wealth produced and the amount of money available to accomplish the desired exchanges of that wealth. The process by which the economy does this can be easily explained but the explanation is quite lengthy so I will only say here that it is accomplished by the individual decisions of all of the people who produce and consume wealth.
        When any of the circumstances cited above are reversed, the result is an increase in prices, which is termed price inflation or simply inflation. I have defined the GNP as the total of wealth produced by this nation in one year. Today it is commonly defined as the total of all exchanges of wealth during one year and is expressed as the dollar value of all of those exchanges. This definition does not include the wealth that is not sold but is consumed by whoever produced it. In our economy today very little of the wealth produced is consumed by whoever produced it and the two definitions yield a figure that is pretty close to being the same. Two hundred years ago a considerable part of the wealth produced was consumed by those who produced it and for this reason the share of the total wealth produced that could be claimed by a given individual was, in many cases, not accurately reflected by his cash income. When the GNP is expressed as its value in money the GNP for any given year can only be compared to the GNP for another year if the dollar amount is corrected to reflect any change in the overall level of prices. We commonly speak of this correction as being an adjustment for inflation because we, in the U.S. have known constant inflation for over half a century.
        In every year some of the circulating money will be removed from circulation by people who save part of their income. Today nearly all of this saved money will be promptly invested in some way and thus returned to circulation. Two hundred years ago a fairly substantial part of this saved money was simply held in the form of gold by those who saved it. They may have been saving it in order to accumulate enough money to purchase something they wanted, or to have money available for emergencies or to enable them to retire. The rest of the money saved by individuals was either invested or lent out for interest and was thus returned to circulation.
        Prior to the industrial revolution, viable investments were somewhat limited as to availability. With the advent of the industrial revolution the demand for investment capital increased drastically. In England fractional reserve banking originated shortly before the industrial began there and in the U.S. the two began at about the same time. I suspect that when the industrial revolution began in other nations it also began simultaneously with the introduction of fraction reserve banking or following it. The one possible exception to this would be Soviet Russia, which, as a command economy, was in a class by itself. This means that there is no historical evidence to indicate how the industrial revolution would have proceeded in a nation that was otherwise capable of developing its industrial potential but chose not to permit fractional reserve banking. I am therefore going to offer my own hypothesis of how industrial development would have proceeded in the U.S. if Americans had followed Jefferson's advice and had not allowed fractional reserve banking.
        In an economy where specie is the only form of money the only money available for investment is that part of their savings that people are either willing to invest or to lend for investment. That would seem to be a truism but it is not true in an economy that includes a fractional reserve banking system. In the economy that I am discussing this means that industrial development would, initially, proceed very slowly. Because the money available for investment would be very limited only those investments with the greatest potential for profit would be made. Investors would develop ways to tap the savings of those who possessed only a small amount of capital. These people would thus realize a good return on even small amounts of capital. There would be fewer individuals amassing huge fortunes but many more people realizing a small but significant return on invested savings. The purchasing power of the middle and lower income classes would thus have been greater than it actually was during the 19th century. As the process of industrialization continued the total amount of capital available would increase at an ever faster pace aided by the ever-increasing purchasing power of the population as a whole. As this process continued, the level of industrialization reached by this economy would eventually have exceeded the level that was reached with a fractional reserve banking system. It is impossible, of course, to say just when this would have occurred but I believe it would have happened sometime in the late 19th century, especially when the effects of foreign trade are considered.
        The effects of foreign trade are quite simple when both nations concerned have no fractional reserve banking. Basically nation A will export to nation B those items that it produces cheaper than they can be produced in nation B. It will also export some items it produces which are superior in quality to those produced in nation B. Nation B, of course, will export to A those items that it produces cheaper or of better quality. Every export results in gold being transferred from the economy of the importing nation to the economy of the exporting nation. If nation A imports more than it exports, in monetary value, the money supply in nation A will be decreased and prices will fall. The lower prices make nation A's exports more attractive to nation B and they will increase. There will thus be a tendency for the trade between the two nations to seek a more or less even balance.
        Because we are interested primarily in the U.S. economy I will examine the way in which foreign trade would have affected the U.S. economy had the U.S. not permitted fractional reserve banking. Prior to the introduction of fractional reserve banking the U.S. economy was essentially similar to what I termed an honest economy. At the beginning of the 19th century the U.S. was actively trading with several nations but the bulk of its trade was with England. I will thus consider only the trade between these two nations. The circumstances of our trade with other nations were somewhat different and this explanation will not apply equally to trade with them. Some of it would apply to them and the volume of trade with them was much smaller so the end result would not be very different.
        At that time U.S. exports to England consisted primarily of agricultural products and raw materials, while imports from England were primarily manufactured products. This was due primarily to three factors. First the U.S. was a very new country and had simply had very little time to develop any industries. Secondly, the colonies, while under English rule, were prohibited by English law from engaging in many types of manufacturing. Thirdly, England had had a fractional reserve banking system for over a century and this accelerated the process of industrialization. The fractional reserve banking system in England also limited the purchasing power of the English population and made it necessary for England to seek other markets for its manufactures. England's overseas colonies were an important part of these other markets and this was, in fact, one reason for the English policy of colonization.
        In the early 19th century England usually exported to the U.S. more than they imported. If the U.S. had prohibited fractional reserve banking its money supply would have decreased as a result of this imbalance of trade and prices would have been reduced. This would mean that less money was available for investment but it would also mean that the cost of investment would be reduced so the amount of investment possible would have been about the same as it would otherwise have been. Industrialization would have proceeded very slowly initially but at an ever increasing pace. This industrialization would have expanded the economy (increased the production of wealth) and this expansion would also exert a downward pressure on prices. These lower prices would have increased U.S. exports to England and at the same time the increase in manufacturing in the U.S. would decrease imports from England. The U.S. would also have competed effectively with British manufacturers in trade with other nations.
       Decreasing prices in the U.S. would have limited the profits of investors who borrowed when the overall level of prices was higher but when this trend of decreasing prices was recognized the interest rate would have fallen to offset, at least partially, the effects of deflation.
        It should be noted here that we are accustomed to equate deflation with economic hard times because this is a part of the "business cycle" which is actually a banking cycle and will be explained later. In the absence of a fractional reserve banking system, the deflation caused by economic expansion and negative trade balances would be relatively slow and orderly and would be accompanied by a general prosperity rather than a recession.
       As this process continued most of the population would actually profit financially even as their nominal income decreased. This would be due to the fact that industrialization would be increasing the total production of wealth and decreasing the cost of producing it, while a larger part of the population would share in the profits generated by this industrialization. This is what probably would have resulted had the U.S. prohibited fractional reserve banking and now I will compare this with the actual history of the economy during the 19th century.
        Fractional reserve banking has been an integral and very important part of the economic history of the U.S. in both the 19th and 20th centuries so I will briefly explain what it actually is and where it came from. Fractional reserve banking originated in England in the 17th century. At that time people would sometimes deposit gold with goldsmiths for safekeeping. Eventually some of these depositors began using the receipts from goldsmiths in lieu of the actual gold to make purchases or to discharge any other financial obligations. This was more convenient than reclaiming the gold and using it to pay their obligations and consequently much of the gold deposited with the goldsmith remained on deposit for long periods of time. Some goldsmith, who observed that he always had a certain amount of other people's gold in his possession, began to lend out a part of this gold. The goldsmith would require the lender to put up collateral worth more than the amount of the loan which would be forfeited if the loan was not repaid. The goldsmith thus collected interest by lending gold that did not belong to him.
        Eventually these goldsmiths realized that they did not have to give the borrower possession of the actual gold. The receipt for the gold could be used in the same way as the gold itself and so they began to make their loans in the form of receipts rather than the actual gold. When they observed that these receipts were seldom presented for redemption they began to issue receipts for more than the total amount of gold in their possession. This was such a profitable business that some of the goldsmiths abandoned their trade and became bankers. They accepted deposits of gold from the public and lent out money. Eventually they began to use bank notes instead of receipts. These bank notes were printed in various denominations and stated that they were redeemable on demand for gold. The bankers circulated these notes for total amounts that far exceeded the amount of gold in their vaults. It would seem that these bankers were placing themselves in a very precarious position since they could not possibly redeeem all of the notes that they circulated. In actuality this seldom created a problem. The bank notes were very convenient to use and, since the bank guaranteed to redeem them for gold the public accepted them as the equivalent of gold. Banks would often issue $10 worth of bank notes, or even more, for each dollar of gold in their vaults.
        By this process the banks actually created money out of thin air and collected interest on it. When the loan was repaid the principle amount of the note simply disappeared. The interest on the money went into the bankers' pockets. The bankers were thus siphoning money from the economy by lending their factitous money. There were a few banks in the U.S. that operated this way in the late 18th century. In the early 19th century the number of banks in the U.S. began to increase, slowly at first and then after a few years very rapidly.
        When these banks began to proliferate the money supply increased very dramatically. Because the public recognized these factitious bank notes as being equal in value to gold the result was the same as if a large amount of gold had suddenly been placed in circulation. That result, of course, was inflation. The situation was aggravated by the outbreak of the War of 1812. The people who controlled most of the money and banks in the New England area opposed the war and thus the government found it difficult to raise money there. In other areas banks began to mushroom, finding a ready market for loans in the federal government as well as among investors in the private sector anxious to cash in on the opportunities presented by the war.
        This flood of money not only created inflation but also promoted economic expansion. Most of the money lent by banks, except for loans to the government, was invested. Borrowing for consumer purchases was virtually unknown at that time. This money had to be returned, with interest, to the banks from which it was borrowed. This meant that a great deal of money was removed from circulation by this process. By 1814 many Americans had come to doubt the ability of the banks to redeem their notes for gold. They began to present their notes for redemption and eventually, in 1814, most of the banks outside the New England area suspended specie payments. In simpler terms they refused to honor their commitment to redeem their notes for gold. The notes of these banks began to be discounted to gold. People no longer accepted them at their face value. The government acquiesced in this suspension of specie payments and this led to the creation of many new banks. The money created by these new banks was also discounted and the net result was that the money supply at this time was either decreasing or increasing relatively slowly. When the war ended the boom was kept alive, for a time, chiefly because of two factors. The first was widespread crop failures in Europe that created an increased demand for U.S. agricultural products and the second was a huge increase in government spending for the construction of federally owned facilities. Many Americans, and especially many in the Congress, were aware that the nation was heading for an economic crisis. The Republican controlled Congress in 1816 did what it had previously refused to do, it chartered a national bank. This was the second Bank of the United States. The first Bank of the United States was chartered in 1792 at the suggestion of Alexander Hamilton. This bank's 20 year charter expired in 1812 and Congress refused to renew it. Congress had no control over state chartered banks or privately owned banks and the former mushroomed in numbers and their operations were not subject to even the nominal restraint of the first Bank of the United States. In 1816 Congress chartered another national bank, and President Madison signed the charter, in the belief that the bank would be able to moderate and extend the inevitable contraction of the money supply and thus mitigate the approaching crisis. The bank probably had the ability to do this but it chose instead to join in the orgy of money creation and fast profits.
        These profits really were huge. It was not unusual for stockholders to realize a 100% return on their investment in one year and in some cases this profit was as high as 200% in one year. In these circumstances most banks lent as much as possible, which is equivalent to saying they created as much factitious money as they possibly could.
        The second Bank of the United States began operations in January of 1817. By February 20, 1817 the nation's banks resumed specie payments in exchange for promises of support from the central bank. At this point one would expect that large numbers of Americans would have redeemed their bank notes for gold. They did not, and, in answer to a question from the English economist David Ricardo, the Philadelphia economist, Condy Raguet, explained why:

        Raguet did exaggerate somewhat but there was a great deal of truth in what he said. It is probable, too, that some Americans believed that the central bank actually would be able to resolve the nation's monetary problems and avoid a crisis. The resumption of specie payments plus the temporary benefit to the economy that resulted from the creation of factitious money by the Bank of the United States was probably viewed by some as indications that the situation was under control. By the summer of 1818, however, the Bank of the United States became concerned about its own stability and began calling loans it had made to other banks. The money supply began to diminish, investment slowed and this decreased the money supply further. Prices began to fall, and soon began to fall rapidly. With the low level of prices many Americans were unable to repay their bank loans and lost everything they had. Prices continued to fall until they reached a level where the money supply was sufficient for the needs of the economy. When the prices stopped falling a few people began to make investments, using money borrowed from banks and as the money supply began to increase prices slowly began to rise. The rising prices began to stimulate more investment and the nation began the first phase of the nation's second banking cycle.
       This was the nation's first experience with the banking cycle and many Americans paid dearly for this lesson although they appeared to have learned nothing from it. Bankers, of course, lost nothing and gained a great deal. During the expansionary phase of the cycle they pocketed large amounts of interest on money they created out of thin air. When the economy contracted they either received repayment of these loans or acquired the collateral pledged for the payment of them. Some of these banks failed and in the case of these banks the stockholders lost the value of their stock. During the time the bank was operating, however, they had realized profits worth many times their investment in stock and suffered no actual loss. Some of them had purchased their stock with IOUs and when the bank failed these were simply more uncollectable loans and they had no loss to deduct from their profits.
       Some Americans, most notably Thomas Jefferson and John Taylor, tried to warn their fellow citizens, long before the panic of 1819, that permitting the practice of fractional banking would doom the nation to an endless series of bank cycles by which a large share of the nation's wealth would flow into the pockets of bankers. They were largely ignored by their contemporaries and even now, after two centuries of experience have proven how right they were, most Americans do not seem to realize the impact of fractional reserve banking on our economy.
        I will examine those 200 years of banking in the next chapter but I will end this one with a very brief review of how this banking cycle works. First the creation of large amounts of factitious money creates inflation and economic expansion. This results in an unsustainable level of investment. When this level of investment begins to falter the money supply begins to diminish. This leads to falling prices. As prices begin to fall the actual value of the money that is removed from the economy to repay these bank loans increases and this further diminishes the money supply. The purchasing power of the population diminishes and the economy contracts until prices have fallen to a level at which the money supply is sufficient to meet the needs of the economy. Prices then stabilize and the whole process begins all over.