Chapter 2The Fundamentals of Fractional-Reserve Banking

Over the 50 years up to the onset of the recent financial crisis in 2007, industrial production in the United States increased by a factor of roughly five.1 Over the same period, the amount of money in the economy, measured by the Federal Reserve’s M2 money supply aggregate, increased by a factor of 25.2 We can state with some certainty that all this additional money was not strictly needed. We have seen that even a growing economy does not need a growing quantity of money. Neither was this money created in response to some rapid increase in the public’s autonomous money demand. Indeed, the public could be persuaded to hold these massively expanded quantities of media of exchange as part of their voluntary cash holdings only by severely diminishing the purchasing power of every single monetary unit. The dollar lost about 86 percent of its purchasing power over this period if measured with consumer prices. In 2007, $1 bought about 14 percent of what it bought in the late 1950s.3

We remember the Bernanke quote: “The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. . . . We conclude that under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”4 President Nixon removed the last link to gold and therefore the last constraint on paper ...

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