Austrian economists place the blame for the crisis of 2008-2009 on the Federal Reserve, in particular, for creating the money needed to keep interest rates low to fund the housing bubble. The federal government's policies that aimed to put every American into a house regardless of credit-worthiness was a major contributing factor. But without a seemingly endless amount of credit that only the Fed could provide, those policies would've arrived stillborn.

More crises are guaranteed because the root cause has not been addressed. It is not even discussed, yet it is well-known, at least among bankers, politicians, and economists. The source of the crises is our rejection of market money - a medium of exchange freely chosen by market participants. Market money was rejected to protect the practice of fractional-reserve banking, the practice of banks loaning, and thereby creating, more money than they actually have.

Fractional-reserve banking created the crises of the 19th century, called panics, when depositors in large numbers came running to banks to withdraw their money. Since the banks didn't have the money - most of it had been loaned out - they would either fail or seek protection from the government. The protection took the form of allowing banks to tell depositors they couldn't have their money, even though it had been promised to them "on demand." The banks, though, were still permitted to collect from their debtors.

Few people thought to ask why depository institutions were in the business of loan banking. The answer, of course, was that it was profitable - to the banks. They could literally create money ex nihilo - out of nothing - following the age-old principle of counterfeiting. When they created too much of it their depositors panicked and came running. This had to stop.

By no means did this mean giving up the practice of fractional reserve banking. Rather than abandon a practice that in any other industry would be regarded as fraudulent, bankers and politicians formed a cartel called a central bank that would impose a uniform rate of monetary inflation on all its member banks. Uniformity meant that one bank wouldn't over-extend its loans and be unable to clear its checks with other banks - and thus run the risk of alerting the public to its perpetual insolvency.

As originally devised in 1910, the solution was not perfect - from the perspective of its creators. Many in the U.S. still objected to concentrating power in a single, D.C.-located institution, such as a central bank would do. And if for some reason a member bank found itself needing emergency credit, the central bank would need to create it on the fly -- become the lender of last resort, as the textbooks say. But how could it lend money if it didn't have any? More to the point, how could it create real money by an act of will?

Politicians and bankers circumvented the first problem by establishing a central banking system with twelve regional reserve banks, telling the public their proposal was really a decentralized organization. The public bought it. The second problem required a major crisis to overcome.

To the public gold was real money, but gold was in limited supply. The public had been using paper money mostly for its convenience, but they assumed real money stood behind it, that every paper dollar they held was covered by 1/20th of an ounce of gold in a bank vault. When the inflationary spree that helped fuel the Roaring Twenties came to an abrupt end, scapegoats had to be found. In addition to the usual culprits - speculators - money itself was brought into question, at least by the inflationists. What the country needed, they said, was more money, enough to reflate the stock market, and that meant gold had to go.

When the man who "saved capitalism" came to power he ordered U.S. citizens to turn in all their gold in exchange for government paper notes, as if a market economy could function best without market money. In 1936 the Treasury Department built Fort Knox to secure the people's confiscated gold. A soothing voice convinced the public this arrangement was for their own good.

From that point on, government, through its proxy the federal reserve, could create paper claims to economic goods without concern about redeeming it for a unique kind of economic good: gold. By government fiat, real money was no longer money. By government fiat, paper money and bank deposits redeemable in paper money were now real money. The federal reserve could create money at will without worrying about an equivalent amount of metal on deposit. Member banks could continue making loans on small fractions of their deposits without worrying about suspicious depositors suddenly rushing madly to the banks for gold coin redemption.

Since the banking cartel needs government sponsorship to work, it ensures that the government is kept happy by purchasing its debt. Politicians can buy votes with spending based on debt rather than taxes, and the banks can loan more money because of the increase in their total reserves made possible by the Fed's act of magic. Except for those outside the circle of power, everyone is happy.

The man considered the greatest cheerleader for debt and inflation, J. M. Keynes, clearly understood the mechanism of currency debasement and its effects on society. As he wrote in 1919:

[T]he best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become 'profiteers,' who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the
ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Monetary inflation did not begin with paper money; it only made it much easier. The kings of old debased their coins to loot their subjects. Modern welfare states could not loot to the degree necessary if they had to rely on coin debasement for inflating the money supply. With a market money like gold, though, the people could prosper nicely.

George F. Smith

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George F. Smith is the author of The Flight of the Barbarous Relic, a novel about a renegade Fed chairman and the editor of Barbarous Relic.com.