There is, however, something more important than the fact that a large number of people simply do not understand money and credit and the related institutions and tools. After all, you don't really need to understand how or why a thing works as long as you know how to use it properly, and the people who put it together designed it right and assembled it correctly. As a character in Herman Wouk's novel, The Caine Mutiny (1951) described the Navy, it is "a master plan designed by geniuses for execution by idiots." A number of drivers would say the same thing about the automobile.
Not knowing how to use a tool properly is a virtual guarantee that the tool will not only be misused, sometimes egregiously, but will cause harm to the user and, often, to others. Nowhere is this more evident than with a social tool, such as the State or the central bank, that has repercussions far beyond the immediate user and those surrounding him or her. An incompetent driver can kill him- or herself as well as a number of other people. An incompetent design engineer can put together something that adversely affects thousands of people as well as the company manufacturing the item. Those in charge of the State or the central bank, however, can destroy the fabric of society itself, bringing about chaos and the dissolution of the social order.
Perhaps paradoxically, and to take away a little of the enormous mystique that has grown up around money, credit, and banking, all three are actually quite easy to understand, as is private property. We do, however, first have to make the effort to free ourselves of the baggage of the past. We need to stop accepting assertions that in calmer moments we know to be nonsense, once we compare them with what we know to be true through the use of our reason.
Money, for example, is very easily understood as anything that can be used in settlement of a debt. To be legitimate, money must therefore convey a private property right. That is because no one can settle his or her debts with something that he or she does not own and which belongs to someone else. "Money" is thus best understood as a symbol for (a derivative of) something of value in which someone has a private property right.
Credit is simply the loan of money, whether out of existing accumulations of savings or through the "monetization" of the present value of an asset. If the loan of money is used to finance a project that pays for itself and thereafter generates profits, the owner of the existing accumulation of savings or the asset with a present value is due a share of the profits as a right of private property — the right to enjoy the "fruits of ownership," that is, to control the use of the thing owned and receive any benefits generated by what is owned.
Money can, of course, be something valuable in and of itself, such as a cow, a hogshead of tobacco, or a gold coin. In the modern age, when such items, despite their obvious utility and value to many people, are clumsy, undesirable to some, or not in sufficient supply, we tend to use "pure" money. That is, for convenience we generally use something that, while generally or relatively worthless in and of itself, conveys the promise to deliver a stated value on demand or when due.
This sort of money, which can take the form of a verbal agreement, a handshake, a token coin, or a piece of paper, is "pure" money. We call it "pure money" because it conveys nothing except the promise to deliver value, without mixing in any factors other than the good credit of the maker of the promise. Similarly, "pure" credit is a promise to repay the loan of money created without the use of existing accumulations of savings out of future profits generated by a productive project financed by the proceeds of the loan.
A problem arises with pure money and credit, however, when the social network within which a promise circulates, or in which it passes from hand to hand until redeemed by the holder in due course, grows too large for everyone in that society to be familiar with everyone else, and everyone doesn't know the individual promise makers. The promises — money — they create do not circulate readily throughout the society, thereby hampering the utility of the promises as money. When that happens, some form of bank must be invented. There are two basic kinds of banks, each performing a specific task and thus filling a particular and essential role in an economy that has developed any appreciable size and complexity.
The simplest type of bank is the "bank of deposit." This is the easiest type of bank to understand. Consequently, many people assume that it is the only kind of bank. A bank of deposit serves to "intermediate" between savers and borrowers. A saver deposits his or her accumulation of promises — savings of money — with the bank. The bank aggregates the savings and lends the money out to borrowers, taking a fee for the purpose, and passing a portion of the interest through to the savers. Thus, a bank of deposit is defined as a financial institution that takes deposits and makes loans.
A more complex institution is the "bank of issue." Where a deposit bank takes deposits and make loans, a bank of issue (also called a "bank of circulation") takes deposits, makes loans, and one more thing: issues promissory notes, that is, creates money. A prospective borrower brings something that has a present value to the bank that the borrower wishes to turn into money. A loan officer examines whatever the borrower has brought and, if he or she determines it has present value and the borrower's credit is good, authorizes the creation of new money (a promissory note) in exchange for a lien on the asset. Typically, the promissory note may be in the form of a banknote, or (more common today) be a demand deposit — a "checking account."
This is called "discounting." The term comes from the fact that it is customary for a bank to take its fee up front by subtracting it from the face value of the note, and handing over only the net amount to the borrower. For example, at a 2% "discount rate," a borrower would receive $98,000 of a $100,000 loan, while the bank would receive $2,000 as a fee for providing the service of monetizing the borrower's asset and, usually, another fee to compensate the lender for the risk that the loan would not be repaid. The borrower spends the money (preferably on something that generates its own repayment) and, when the time comes to redeem the lien, pays back the face amount of the loan. The bank then cancels the money. The most common type of bank of issue today is the modern commercial bank.
There is a third kind of bank, a hybrid institution known as a central bank. In theory, central banks take deposits and issue promissory notes, but do not (usually) make loans. The primary purpose of a central bank is to issue promissory notes (create money) to rediscount — purchase — primary issuances of commercial paper for qualified industrial, commercial, and agricultural loans made by commercial banks. Rediscounting is carried out only between commercial banks and the central bank. Of course, it may be necessary at times to purchase the same sort of securities after commercial banks have issued them and changed their character from “primary” issues to “secondary” issues — i.e., securities out on the “open market.” As a backup to its rediscounting power, then, a central bank usually has the power to engage in “open market operations.” In neither case, that is, in rediscounting or engaging in open market operations, should a central bank be dealing in government securities. This circumvents the taxation and appropriations process, and renders the State unaccountable to its citizens to that degree.
Central banks evolved from national banks. National banks were private institutions specially designated to carry on the State's banking business — usually in exchange for agreeing to float some or all of a government's debt. The fact that a national bank was privately owned and operated presumably kept the State from being able to borrow money at will. In reality the presumed independence of a national bank frequently meant little or nothing, as they were almost always required to hold a portion of their assets in the form of government securities to back any note issues, and it generally required only the threat, real or implied, of withholding a charter or to deny the renewal of a charter to persuade a national bank to lend more money to the State.
When national banks were supplanted by central banks, every effort was made to ensure that central banks would be independent of the sponsoring governments. A central bank has much more control (in the sense of defining and setting the standard of value, not management) over the currency and the rest of the money supply than a national bank. Its manipulation by the State is consequently much more dangerous. Like a commercial bank of issue, a central bank has the power to issue promissory notes, that is, to create money. Again, a central bank, however, is not supposed to do this for ordinary customers, even the State, but only for commercial banks of issue in order to ensure a uniform currency that passes at par regardless which bank issued the original promissory note.
Most simply put, a central bank in its pure form is a bank of issue for banks of issue — but for no other customer. A central bank purchases qualified loan paper issued by commercial banks for industrial, commercial, and agricultural purposes, creating the money to purchase the paper by issuing a promissory note. The promissory note, as is the case with an ordinary commercial bank, can take the form of an actual banknote, or a demand deposit. This is called "rediscounting." As Dr. Harold Moulton explains the role of the central bank, "In a word, the Federal Reserve bank thus does for the member bank precisely what the member bank does for its customers — advances the face value of the note, less interest until maturity." (Harold G. Moulton, Financial Organization and the Economic System. New York: McGraw-Hill Book Company, Inc., 1938, 370-371)
The hybrid nature of the institution comes in because a central bank also functions as a bank of deposit for the State — but (again) for no other customer. A central bank is, paradoxically, a public institution that the public cannot use directly, rather like the armed forces that operate for the common good under the direction not of any citizen or group of citizens, but of the State itself.
A central bank like the Federal Reserve System is a very carefully designed tool intended to serve specific purposes. A central bank cannot be diverted from these purposes without risking immense harm to the common good in general, and the economy in particular. Unfortunately, the people in charge of the Federal Reserve System and who control its operation today do not understand the tool they are using. As Moulton cautiously points out after explaining the "pure" operation of the Federal Reserve System in accordance with the original purpose of the institution (i.e., furnish an "elastic currency" and rediscount commercial paper — Preamble to Public Law No. 43, 63rd Congress, H.R. 7837, "The Federal Reserve Act of 1913"),
In the foregoing illustration of the elasticity of Federal Reserve notes we have been giving the impression that these notes are secured exclusively by commercial paper. Such, however, is not strictly the case, although the theory of the law was undoubtedly to make such paper the fundamental basis of the elastic note currency. The provisions governing paper that is eligible as security for note issues have in the main been identical with those governing paper that is eligible for rediscount in general. These provisions have been continually broadened as the years have passed. Rediscounts may now be made on the basis of "any sound assets." (Financial Organization and the Economic System, op. cit., 373-374.)The term "any sound assets" clearly refers to federal government securities. Reading the entire description of the operation of the Federal Reserve in Moulton's Financial Organization and the Economic System, as well as The Financial Organization of Society (Chicago, Illinois: The University of Chicago Press, 1921, 1930), the previous textbook of which Financial Organization and the Economic System was a major revision, we are drawn to an inescapable conclusion. That is, despite his careful word choice, Moulton was extremely critical of the shift in Federal Reserve policy and practice from providing an elastic currency for the private sector through the operation of the real bills doctrine of the Banking School, to providing the State with as much money and credit as it desires under the tenets of the Currency School. In Chapter XXVIII of Financial Organization and the Economic System, "The Position of the Government in the Credit System," Moulton observes that, "From 1933 to 1937 inclusive the volume of new security flotations by private enterprises (refunding operations excluded) has averaged only about 620 million dollars as compared with 5,715 millions in the period 1925 to 1929." As he continues,
The most striking financial phenomenon of recent years has been the extraordinarily low level of interest rates on government issues and in the money market generally. It would seem as thought the credit of the Government is in inverse ratio to the size of the Treasury deficits and the magnitude of the public debt — for the rates at which the Government has been able to borrow have steadily declined since 1933. This phenomenon has been a source of endless confusion, and has beguiled many into the belief not only that the financial position of the Government is as sound as the proverbial rock, but that the wells of public credit are endlessly deep. (Financial Organization and the Economic System, op. cit., 473-474.)Moulton was more explicit in the four-volume set on recovery from the Great Depression he and others at the Brookings Institution wrote to present an alternative to the New Deal (America's Capacity to Produce, 1934, America's Capacity to Consume, 1934, The Formation of Capital, 1935, and Income and Economic Progress, 1935). Textbooks, after all, are supposed to be objective. Moulton even gives a précis of Keynesian multiplier theory (used to dismiss Say's Law of Markets and the real bills doctrine), presenting it as the currently accepted theory, despite the fact that he had disproved it in The Formation of Capital (1935). The reader, however, still concludes that those in charge of the system are both misunderstanding and misusing an extremely powerful social tool.
This lack of understanding of how to use the Federal Reserve dates from the origin of the system's operation. The design incorporated certain features that were intended to prevent an effective State takeover and the diversion of the Federal Reserve System away from its main purpose of providing the private sector with liquidity. Through a combination of the redefinition of money and reserves the politicians were able to circumvent the clear intent to avoid using the institution to finance government deficits. Consciously or unconsciously (and some would say even with the best motives) politicians were able to leverage people's aversion to direct taxation as the source for all government funds and cause them to acquiesce in subverting the Federal Reserve to serve as the primary — if indirect — lender to the State, giving the State the ability to mortgage future tax revenues to raise funds instead of being forced to live within its means.