The mechanics of the current system are well-documented, and are not an arcane secret. But we first have to distinguish carefully between actual paper dollars which you put in your wallet, and the intangible, electronic dollars in bank accounts.
The paper dollars with which we are all familiar are printed by the United States Bureau of Engraving and Printing -- separate from the United States Mint, which (until the Civil War) produced only gold and silver coins. The Constitution gives Congress the power to "coin" money. In 1789, its drafters had vividly in mind the poor reputation of the paper "Continentals" printed to finance the Revolutionary War when England had forbidden the Colonies to create their own money, and tried to cut off the supply of pounds sterling. Congress responded by printing the paper currency, and printed too much at once, with the result that it immediately depreciated. This damage to its image was exacerbated by the British, who (according to Benjamin Franklin) skillfully counterfeited the bills in huge quantities in New York, in an attempt to bring down the Revolution. That attempt failed, and the Continentals, even though greatly depreciated, were essential to the new republic's survival, and eventual victory in the War. The aftermath of the counterfeiting took its real toll after the War was over in 1783, and individuals tried to profit from the huge quantities of look-alike currency that Britain had introduced into the New England colonial economy.
From the founding of the United States in 1789, until the Civil War made huge new expenditures necessary, the government's mint produced only hard coinage, in denominations of silver and gold. (Attempts to operate a national bank under the aegis of the federal government, authorized to issue its own paper notes, came to an end when President Andrew Jackson refused to renew its charter. There were other private banks which also issued their own paper notes, but when those banks failed, their notes became worthless.)
Salmon P. Chase, who as Secretary of the Treasury under President Abraham Lincoln, had overseen the issuance and distribution of paper "demand notes" to finance the Union's cause (called "greenbacks" because of the color printed on their reverse side, and bearing his picture on the obverse!), joined (after Lincoln had elevated him to the Supreme Court) a majority which initially ruled that the authorization of the greenbacks had been unconstitutional (!). That 4-3 decision was itself overturned just a year later in the Legal Tender Cases, by a vote of 5-4, after President Grant had appointed two more justices to the Court, pursuant to an act of Congress which had increased the number of justices from seven to nine. In that manner, the verb "to coin" as used in the Constitution was held to subsume, when it came to money, the verb "to print."
Eventually, nearly all the greenbacks ($250 million worth) issued to finance the Union during the Civil War were exchanged for gold or silver coin, and so (contrary again to the popular understanding), our first national venture into paper money did not turn out badly. (Any greenbacks which remain outstanding are still valid legal tender today, though they are worth far more unredeemed.) Paper money on a national scale was not introduced again until after Congress had created the Federal Reserve Bank in 1913.
Paper succeeded as money for only two reasons at first: (1) it was much more convenient to carry, say, a $10,000 paper bill than the equivalent amount in gold coins; and (2) every paper bill contained a legend that made it fully exchangeable on demand, at any branch of the Federal Reserve, for its equivalent in gold or silver. When I was growing up, the paper money I used bore the legend "Silver Certificate", and specified that it was exchangeable for an equivalent amount of silver coin, "payable . . . to the bearer on demand":
Over time, the convenience of paper money gradually overcame the need for its exchangeability. The latter was assumed, but rarely put to the test in practice. The function of the paper currency, however, did not change. By virtue of its original exchangeability for a form of hard currency, paper currency came to be seen as the equivalent of the real thing -- silver and gold.
The function of a paper dollar, however, was subtly different from the function of a silver dollar. The latter could be exchanged, but primarily for goods and services; a paper dollar could also be so exchanged, but its value in being so capable of exchange derived from the fact that any person holding it could at any time, with no questions asked, obtain its equivalent in actual silver coin.
It is at this point that we come to a fundamental distinction about money, which must be drawn if we are to understand the faults of the current system. This distinction may be expressed as the difference between value and wealth.
Properly speaking, wealth is everyone's goal: to acquire sufficient assets to have no worry for future needs or concerns. Superficially, and commonly, we are used to measuring wealth in units of money. That is only a convention, however, which allows all of the complicated mix of a typical person's collection of assets to be valued in terms of a single unit of value, the dollar. The assets are each converted to dollar values (through appraisals, or index look-ups, or whatever means is appropriate), and the total of the individual values represents the measure of that individual's wealth, expressed in dollars.
Wealth, properly understood, does not consist of dollars. Dollars are the measure of one's wealth. And the measure the dollar makes at any one point in time depends on the dollar's relative value with respect to other commodities, currencies, and exchangeable assets. If government inflates the supply of dollars in a given economy, prices will go up, because there are more dollars seeking to be exchanged for real goods and services. Someone who holds only dollars as assets will be made poorer by inflation: his dollars will buy less and less at the store. So that is why dollars can never be regarded as wealth. And the distinction is crucial if we are to understand what our current "money" is, and what function it serves.
Strictly speaking, money is a means of exchange. If you are starving on a desert island, with a trunk full of pirates' gold, you may have lots of money, but it is worthless to you in that situation. You cannot eat it, or use it to stay alive in any fashion. Its value comes solely from your ability to exchange it for something else which you value more, namely, food and water. As we all know, the value of the latter can increase greatly in times of famine and shortage, and require us to exchange much more in money to obtain them than we might in more normal circumstances. Money -- in whatever form -- is therefore useful only insofar as it will (a) retain enough value so that we can exchange it for what we need in any given situation; and (b) -- what comes to the same thing -- resist or hinder any attempt to depreciate it.
Money has taken all kinds of forms over time, depending on the environment in which it is used. People have used shells, rocks, beads, and all kinds of other objects which had the properties of being (a) relatively scarce to begin with, and (b) difficult to acquire or augment. In a sort of Darwinian survival of the fittest, the development of money has been an evolutionary process, with the most convenient and durable forms winning out over all the others.
The process continues apace, so that what was convenient twenty or thirty years ago is continually being replaced by something that serves the purposes of money better today. And this continued evolution has tended, in our society, first to favor paper dollars over gold and silver ones, and more recently, electronic and digital dollars over paper ones.
But another development has occurred at the same time, which (if known beforehand) could never have been rationally intended. On the model of the old "silver certificates", the government has seen fit to retain paper currencies as "promises to pay." Beginning in 1964, however, we no longer could demand performance of that promise by delivery of an amount of silver equivalent to the total paper bills surrendered. Silver certificates were taken out of circulation in 1964, and the "new money", in the form of "Federal Reserve notes", was introduced in its place:
These new forms of paper currency were no longer "certificates", but "notes." And a note is a promise to pay. But -- pay what? When I look at the picture of the Federal Reserve note just reproduced, what is it a note for? What will I get if I "collect" on the note?
As I said, you will no longer get an equivalent amount of silver. Your Federal Reserve note is officially exchangeable only for another one of like kind. A note is replaced with another note -- and so it remains perpetually a promise to pay. When you pay for some goods in cash, you pass those promises to pay on to the seller of the goods, who accepts them so that he or she may pass them on to another in turn. Welcome to the world of fiat currency, where currency ("legal tender for all debts, public and private", as is printed on each note) is whatever the Government by law says it is -- in this case, Federal Reserve notes.
Notice that fiat currency divorces the value of money from its medium. Gold and silver coins maintained their value, because they could always be melted and sold as the metal itself. There is no inherent value to speak of, however, in the paper on which our currency is printed. We ascribe whatever value paper money has to what it can buy us in goods and services, and not to the medium in which it is embodied.
In this post, we have contrasted the difference between coined money and paper money, or fiat currency. In the next post, we will look at the difference between paper money and electronic money. Then we will finally be in a position to understand just what money is. And that knowledge will help us see what is so wrong with our current monetary system.