Chapter 27: Bank-Issued Money
Updated: 4/13/20
If you lend money to any of my people among you who are poor, you must not be like a moneylender to him or charge him interest. If you take your neighbor's garment in pledge, you must return it to him before the sun goes down, for that is his only covering; it is his garment for his body. What else can he sleep in? When he calls out to me, I will hear him, for I am compassionate (Exodus 22:25–27).
I have analyzed this passage in Chapter 49 of my commentary on Exodus. This series of prohibitions applied in the Mosaic economy to a special form of loan: a zero-interest charitable loan. Such loans were collateralized by an individual’s freedom. If he failed to repay the loan on time, the creditor could enslave him for up to six years. Only in the seventh, sabbatical year was the loan repudiated by law, and the man allowed to go free. This form of loan was not a profit-seeking loan (Deuteronomy 15). [North, Deuteronomy, ch. 36] Despite the fact that this debt law applied to charitable loans rather than business loans, this passage is extremely important for understanding the Bible’s opposition to what is known today as fractional reserve banking. This law reduced the likelihood of a specific form of deception by a debtor. He might claim that he had collateral for a loan. He might do this with several lenders. By receiving loans from several lenders on the basis of this single piece of collateral, he would have been involved in a form of fraud. The fraud was multiple indebtedness on a single piece of collateral. The following analysis is an extension of what I wrote in the third volume of my economic commentary on the book of Exodus: Tools of Dominion (1990).
Consider the case of a poor man who comes in search of an emergency loan from his neighbor. The neighbor assesses the man’s character, and concludes that the man is likely to repay the loan. The lender has made a mistake. The man may visit several people to ask for an emergency loan. If he collects from all of them, he may waste the money. Even if he repays these loans, he has dealt fraudulently with lenders by accepting numerous loans. They have unknowingly borne added risk. (This was the opinion of the twelfth-century Jewish scholar, Ibn Ezra, who cited Saadia Gaon.) But what if the lender suspects that the borrower is somewhat unreliable? The lender wants to honor God, so he intends to make the loan. But he wants collateral. He wants to give the borrower an economic incentive to repay the loan as soon as possible.
The borrower is poor. He has no collateral of value. But the lender can still demand the man’s garment (coat). In contrast, he is not allowed to take the widow’s coat (Deuteronomy 24:17). What good is this coat to the lender? He must return it in the evening, when the man needs it. It cannot be sold. But it has two important economic functions. First, the borrower has to come every evening to get back his coat. This is an inconvenience. He will have an added incentive to repay the loan. Second, because the garment is in the possession of the lender during the day, it cannot be used as collateral with another lender. One piece of collateral can be used for only one loan at a time if the first potential lender demands collateral. If the borrower kept it, and simply signed a note saying that it stands as collateral for the loan, he might sign several such notes for several lenders. If he defaults, they cannot all collect their collateral. Therefore, by permitting the lender to demand half a day’s collateral, biblical law reduces the temptation on the part of borrowers to commit fraud.
The lender was not required to demand the borrower’s coat for collateral. That was at the discretion of the lender. But the lender did have the legal authority to make such a request before extending a charitable loan at zero interest to the borrower. If a lender was allowed to do this with a poor man, then he surely had the right to make this request of someone who was asking for a business loan which would pay a rate of interest. The lender wanted to be sure that he would be repaid. By requiring a piece of property that the lender would want to use, the lender was increasing the likelihood that the borrower would repay the loan as promised.
Modern banking is based on a flagrant flouting of the prohibition against multiple indebtedness. For every asset (loan) a bank owns, there are many legal claims (deposits) against that asset. The bank keeps fewer reserves on hand to meet demands of lenders to the bank—depositors—than the bank has promised to deliver on demand. This is called fractional reserve banking. It is the universal form of Western banking, and it has been since around 1300. It was an invention of the Renaissance.
Depositors believe that their money is available on demand. The banks have promised them that it is available on demand. But it isn’t. If every depositor came to the bank one day and began to withdraw his money, the bank would go bankrupt [bank + rupture]. The bank has loaned out the depositors’ money in order to earn interest on the loans. Part of this return is paid to depositors as interest on their accounts. The depositors know this, but they all assume (as do the bank’s managers) that not all depositors will try to get their money out of the bank on the same day. They assume that withdrawals will tend to equal deposits on any given day. Usually, this assumption is correct. But on the day when men lose faith in the solvency of the bank—the bank’s ability to repay those few depositors who demand their money—a bank run ensues. Everyone wants his money at once. The bank defaults. It has run out of “garments.”
Fractional reserve banking is inflationary, for it creates credit money—money that is backed heavily by faith. When a person deposits his money on the condition that he can write a check and spend it, monetary inflation is about to begin. The banker loans, say, 90% of this money to a borrower. The borrower then spends the money. Whoever gets the borrower’s money then either spends it or deposits it in his bank, and the process continues. As a theoretical limit (though not always in practice), for every dollar deposited in a banking system with a 10% reserve ratio, nine additional dollars will eventually come into circulation. The process is described here.
Thus, fractional reserve banking is inherently inflationary. It also creates inflationary booms and their inevitable consequences, depressions. I discuss this in Chapter 35.
The following is a just-so story. It appears in many academic discussions of the origin of fractional reserve banking. I am aware of no detailed historical studies of specific cases of warehouses for gold and silver becoming banks. But the story does explain the process of fractional reserves.
1. Safe Storage
There are risks associated with transporting gold and silver. Thieves threaten the net worth of someone who is heavily invested in gold coins, and who then moves these coins from one location to another. There are also risks of storage. “Do not store up for yourselves treasures on the earth, where moth and rust destroy, and where thieves break in and steal. Instead, store up for yourselves treasures in heaven, where neither moth nor rust destroys, and where thieves do not break in and steal” (Matthew 6:19–20). There is great responsibility in owning gold and silver.
Some owners seek ways to transfer some of this risk. They hire specialists in storing and transporting gold safely. Owners of gold turn over their gold to these specialists, who issue receipts. These receipts take on the characteristic features of money. They can be bought and sold as if they were gold. Because the receipts are exchangeable for specified quantities and fineness of gold, they become monetary alternatives to gold. These receipts can be printed on paper. They can also be stored digitally. The risk of loss cannot completely be transferred, but risk of loss through theft can be reduced.
If a storage company issues receipts to a specific quantity and fineness of gold, it makes its money by means of storage fees and ownership transfer services. The owner of the gold ingots or coins pays for these services. He is responsible; therefore, he must pay someone to accept some of the responsibilities of ownership, including storage. The person paying for a service is paying primarily for the specialized knowledge possessed by the seller. The seller knows what must be done to protect the coins. The owner of the coins does not.
The receipt may begin to function as money. If people trust the warehouse, they will accept a receipt for all or part of this gold in payment for goods and services. A piece of paper authorizing the bearer to collect a specified amount of gold is just about the same as the actual ounce of gold. The gold is safer in storage, and pieces of paper are more convenient than pieces of metal.
As long as the warehouse company does not issue receipts in excess of the gold or silver stored in its vaults, this does not increase the money supply. The metal coins are taken out of circulation. They are no longer used to bid for the purchase of goods and services. They are replaced by receipts, which are used to bid for the purchase of goods and services. The metallic-based money supply remains stable. There is no redistribution of wealth.
2. The Great Temptation: Counterfeiting
A problem threatens the warehouse receipt system. What if the warehouse owner recognizes that people in the community trust him? They know that he has guards watching everything. He has always been scrupulously honest. He then betrays this trust. He writes warehouse receipts for gold for which there is no gold in reserve. He then loans these receipts to borrowers. The receipts serve as money. People accept them in exchange for goods and services. These warehouse receipts are considered “as good as gold.” Why? Because they are always exchangeable for gold upon demand. Just take the piece of paper to the warehouse, and get your gold, minus a small storage fee or a transaction fee. No problem! But now there is a problem. There are more receipts for gold than there is gold in reserve to pay all the potential bearers on demand. These “demand deposits” are now vulnerable to that most feared of financial events, a bank run. Depositors who have receipts may demand repayment. There is not enough gold in reserve to meet the total demand. The warehouse has placed itself in a position similar to that of the poor man who immorally secures loans from numerous lenders on the basis of one piece of collateral.
The warehouse owner has become a banker. He makes loans, for which borrowers agree to pay him interest in the future, along with a return of the principal. But the money, once loaned out, is gone until the day that repayment comes. The warehouse is vulnerable to a run on the deposits. The warehouse owes gold to the depositors. It is indebted to them. The deposits are legal liabilities to the bank. The bank has become multiply-indebted.
When the warehouse owner issues a warehouse receipt for gold when there is no new gold on deposit, he has thereby increased the money supply in the community. No one has come to the warehouse and deposited gold (taken it out of the day-to-day economy). So, the unbacked receipt is inescapably inflationary. It adds money to the economy. I am defining “inflation” as “an increase in the money supply,” the way that dictionaries and economists defined it before 1940. The result is either: (1) rising prices, or (2) prices will not fall as far as they would otherwise have fallen.
The warehouse receipt circulates as if it were gold. If the warehouse owner is very cautious, and he issues only a few extra receipts, probably nobody will find out. He will collect a little interest from borrowers. Prices of goods (as denominated in gold) will not rise. But if he continues to issue receipts, this will tend to raise prices. But gold bullion’s currency-denominated price does not rise, since all of the unbacked receipts to gold are “as good as gold,” and therefore supposedly identical to gold. The increase in circulation of these receipts does not initially push up gold’s paper money-denominated price.
Those who hold gold get hurt initially. They see the paper money-denominated prices of other goods rising, but the market price of gold is unchanged. It looks as though lots of newly mined gold is coming into the market. But statistics are available to show that this is not true. The increase must be coming from the issuers of warehouse receipts. So, receipt-holders do the rational thing: they start buying goods and services before the price of these goods gets any higher. This puts upward pressure on prices, as denominated in gold receipts. That is to say, the market value of these receipts falls. Holders of these warehouse receipts try to pass them to other people. The decline in their market value continues.
3. The Contraction of Money
Then what happens? Store owners continue to take in a lot of paper receipts. They steadily deposit them with their local banks. Unlike the general public, bankers understand how the fractional reserve system works; at least they understand the risks associated with issuing more receipts for gold than there is gold to redeem the receipts. They become increasingly suspicious of each other’s gold receipts. Too many receipts are being deposited by their customers. Many of the bankers know that there is not this much new gold coming into circulation. They demand payment in gold.
What if the public figures this out, too? Depositors think to themselves,“Maybe it would be prudent to cash in these receipts and demand delivery of gold, just in case some receipt-issuing competitor is hit with a bank run.” They start demanding gold for the receipts issued by suspected banks. This places added downward pressure on the gold-related price of some banks’ receipts, and possibly on many banks’ receipts. Thus, the bankers have an incentive individually to pull the plug on their own fractional reserve scheme. So do market speculators. Specialist traders suspect that the price of gold will rise when the deception is discovered, once the general public starts cashing in their warehouse receipts for their hoped-for gold. Thus, depositors, bankers, and speculators begin the run on the banks’ gold hoards—a run that the bankers fear the public will initiate if the bankers do not get in line first. They dearly want to get in line first. This is why bankers and other sophisticated holders of gold receipts eventually go to the warehouses and start demanding their gold. They understand that at least some of the banks are technically insolvent. They are not sure which ones are weakest, so all the banks risk getting hit. Receipt-holders want their gold now, while they can still get it on demand. The run on the warehouses begins. Warehouse receipts for gold continue to fall in value compared to gold. Other people then rush down to get their gold (which is now rising in value compared to the warehouse receipts people are holding). The insolvent banks collapse, or else they are forced to delay repayment to receipt-owners.
This declaration of insolvency (insufficient reserves) is similar to the action of the wicked coat owner who has multiply-indebted himself, and then leaves his creditors standing out in the cold. Fractional reserve banking violates two biblical principles: (1) honest weights and measures, and (2) no multiple indebtedness. Fractional reserve banking is inflationary while people accept the checks, and deflationary when confidence in the banks finally collapses. The evil of fractional reserve banking is not created by the phenomenon of interest (time preference) as such. It is not money-lending as such that is condemned by the Bible; rather, it is borrowing with collateral that you do not have and lending what you do not have (i.e., issuing receipts for commodities not held in reserve).
Bankers are like businessmen in every field. They want to reduce competition. They want to reduce the number of new competitors who would otherwise come into the industry when they recognize that members in the industry are reaping above-average profits. So, they band together as a special-interest group in order to persuade governments to restrict the entry of new competitors into the field. They claim that only through government intervention into the banking sector of the economy can uninformed depositors be protected from unscrupulous bankers.
In no nation do we find the banking industry operating without extensive government regulation. These regulations are written by the banking cartel’s lawyers. They are the experts, so politicians allow them to have input on what kinds of regulation should be in force. This is true of every regulated industry. There is a close relationship between the regulated industry and the regulators in the government. This is especially true because in most nations, senior regulators in the government are able to work for the high-paying firms in the regulated industry when they resign from the government. This is called the revolving door effect. It is how industries capture government regulatory agencies. In no industry is this capture more secure than banking.
Banking is correctly perceived by politicians and bureaucrats as the most important single profit-seeking sector of the economy. If there is a serious crisis in the banking industry as a whole, it will affect the entire economy negatively. So, the regulation is intense. This keeps newcomers from entering the market. It grants to existing banks the power to earn above-average returns. Banking is therefore the most important cartel in every nation.
Banking is the largest cartel in the world. This is the central industry in every nation because it controls the money supply. Bank money is used in almost all transactions. This means that a single cartel in a nation is the dominant source of economic output. If there were a crisis in the banking system, it would threaten the national economy. It could create a depression. This is what happened in the West in the 1930s.
In each nation, a central bank writes the rules for banking. It controls the nation’s monetary system. It is the agency of enforcement for the banking cartel. A handful of banks are dominant in this cartel—perhaps five or six. They have a majority of all deposits. If any of these large banks should go bankrupt, this would shrink the money supply of the nation. It would create a financial panic in the capital markets. This panic would spread to the general economy. Therefore, the central bank’s primary function is to make certain that these few banks do not go bankrupt. This is the supreme unofficial goal of central banking. This is never mentioned in any public document. The largest commercial banks want protection against bank runs by their depositors. The central bank provides “liquidity” in a crisis, meaning counterfeit money, which it supplies to the largest banks whenever they are come under assault by their depositors. These banks are considered too big to fail.
Central banking is an extension upward of fractional reserve banking in general. It secures the banking system from bank runs. It was deliberately designed to keep market forces from bankrupting large insolvent banks. Without the protection of national government agencies, fractional reserve banking would face the prospect of bank runs, as lenders (depositors) would lose faith in overextended (multiply-indebted) banks. The most important form of collateral a bank should have is its reputation for honesty and conservative (minimal fractional reserves) investing policies. In the early twenty-first century, however, a commercial bank’s most important form of collateral is the legal backing by the government, which stands ready to repay individual depositors (but not large investment funds) in bankrupt banks—a guarantee that is ultimately backed up by the fiat money of the nation’s central bank.
1. The Quid Pro Quo
Beginning in 1694 in Great Britain, bankers organized a central bank. The central bank was set up in order to protect banks from bank runs by depositors. The central bank would intervene in order to keep insolvent banks solvent, so that there would not be the spread of a banking panic throughout the economy. This was a privately owned, profit-seeking bank. Promoters of the bank promised Parliament that the bank would create a sure market for government debt. In return, the central bank would receive the right to create money out of nothing in order to purchase the government’s debt. The government would then pay the central bank a rate of interest for the newly created money. The bankers promised that this would enable the government to sell its debt at low interest rates. That was because the bank could create the money out of nothing and lend it to the government. The government accepted this arrangement. The Bank of England was nationalized after World War II, but from 1694 until 1946, it was a privately-owned bank that profited from counterfeiting.
A central bank creates money out of nothing in order to purchase any asset, which is usually government debt. The money is transferred to the government’s account in commercial banks. The government immediately spends this money on whatever projects the government is subsidizing. The money immediately flows into the commercial banking system, and it begins to multiply through the fractional reserve banking process.
In the days when central banks were allowed to retain interest paid on government debt, central banking was extremely profitable. It literally was a license to print money. But during World War II and immediately after, this tremendous benefit for large central banks was removed either by law, in the case of the Bank of England, or by the willingness of the Federal Reserve System to turn over all money not used to pay for central bank operations to the government at the beginning of the calendar year.
2. Protecting the Largest Banks
In every nation, the nation’s central bank intervenes in order to save the banking system from bank runs in times of crisis. The government accepts this protection scheme as a matter of policy. The government therefore has turned over most of the regulation of the banking system to the nation’s central bank. The central bank is the enforcing agency of the banking cartel. If a somewhat smaller bank is threatened by a bank run, the central bank arranges an orderly sale of the assets of the insolvent bank, which means all of its loans, and then it provides whatever money is necessary for larger commercial banks to buy these assets.
This system of protection against bank runs encourages the policy-makers of the largest banks to make high-risk investments that pay above-average rates of return. The bankers know that their banks will not be closed if these investments should prove to be ruinous in a time of crisis. Always, the largest banks are protected from bank runs in whatever form they occur. This is referred to as “moral hazard.” The phrase was coined in 1873 by a British journalist, Walter Bagehot.
Because the central bank is created by government law, and because it has a monopoly over the creation of what is called monetary base money, the bank’s policy-makers have enormous influence in the economy. The trouble is, it is no longer clear which policies produce long-term economic growth. Keynesian economics favors the expansion of the monetary base at all times, and especially during economic crises. The only school of economic opinion that opposes central banking is the Austrian School. It has no influence in academia or in central banking.
None of this is discussed in any college-level textbook. The chapter on cartels is always hostile to cartels, but there is no mention of the fact that commercial banking is a cartel, and in fact is the dominant cartel in every nation. The central bank is never discussed as an enforcing agency of the banking cartel. It is always praised as an independent agency, meaning independent from the legislature of the national government. In this, central banking is unique. Textbooks on economics and political science are always in favor of democracy. There is only one exception to this: central banking. The central fact of the central bank is rarely discussed by academic economists. For all of the technical sophistication of the analyses that we find in introductory economics textbooks and even advanced economics textbooks, they all avoid discussing banking as a cartel and the central bank as the agency of enforcement of this cartel.
You understand how the initial deposit was the first step in the process of deposit creation through fractional reserves. Perhaps you asked yourself a question: “Where did this depositor get his money to deposit?”
The fractional reserve banking system can increase the total money supply by lowering the reserve ratio. The nation’s central bank sets the legal reserve ratio. But what if the reserve ratio is fixed? The banking system should no longer be inflationary. The reason why modern banking is inflationary is because of the central bank’s creation of new money when it purchases a debt certificate issued by any national government. When the central bank makes the purchase, the commercial bank used by the national treasury receives a deposit. This deposit begins the process of fractional reserve pyramiding. The government spends this money immediately. This reduces its bank account, but someone receives this money. He receives this money in the form of a check or a direct digital deposit in his bank account. The increase in the money supply that was initially created by the central bank's purchase of a government debt becomes the foundation of a new wave of monetary expansion through the commercial banking system.
The central bank reduces its holdings of government debt by selling the debt or refusing to purchase substitute debt when existing government debt instruments expire. This does not happen often. When it does, this has the effect of reducing the monetary base, which in turn reduces the money supply in the economy. The multiplication effects of fractional reserve banking then reverse. The inverted pyramid of money begins to shrink. This can set off the contraction phase of the business cycle, which I discuss in Chapter 35.
Usually, central banks do not deflate the monetary base. Governments want to sell their debt certificates at the lowest possible interest rate. Therefore, they pressure the central bank to buy at least some of the debt. The central bank can do this without initially raising interest rates. Of course, if the central bank continues to do this, the counterfeit money injected into the banking system will eventually raise consumer prices. When that happens, long-term interest rates rise because lenders do not want to lend their money and then be repaid in money of reduced purchasing power. This is the price inflation hedge component of market interest rates. The longer the term of the loan, the more likely that lenders will lend only at a higher interest rate.
If the central bank refused to buy any additional debt certificates, thereby stabilizing the monetary base, the fractional reserve banking system could not increase the amount of money in circulation unless the central bank lowered the reserve requirement. In short, the central bank is in charge of the primary components of the nation's money supply.
Banking in the modern world is not based on gold. It has not been based on gold coins in the West since the outbreak of World War I in 1914, except for the United States. It has not been based on gold coins in the United States since the ownership of gold was unilaterally declared illegal by newly inaugurated President Franklin Roosevelt on March 6, 1933 at 1 AM, eastern time. It has not been based on gold bars owned by foreign central banks and governments ever since August 15, 1971, when President Richard Nixon unilaterally abolished the post-World War II gold exchange standard, which was created by an international agreement at a hotel in tiny Bretton Woods, New Hampshire in 1944.
1. Powerless Small Depositors
With the abolition of the gold coin standard in 1914 and 1933, there was no way for citizens to go to their banks and withdraw gold coins in exchange for bank accounts or paper money. This reduced the threat of bank runs by the public. Second, with the abolition of the 1944 Bretton Woods agreement by Richard Nixon in 1971, there was no further threat of a run against the gold held by the United States government. The removed international restraints on the expansion of money by the Federal Reserve System.
The general public has no influence on the money supply. So few people have a significant amount of money deposited in local banks that the common man is not a relevant factor in the decision-making of commercial bankers. The key players in modern banking are large-scale depositors of digital money: investment funds. The most important aspect of modern fractional reserve banking is not the issuing of checks or even credit cards. The most important aspect of modern fractional reserve banking is the mismatch between the short-term liabilities of the largest banks to depositors (investment funds) and the banks’ policy of investing in long-term assets and highly leveraged credit instruments that will not be salable in a crisis.
There used to be limits to the expansion of banknotes and checks drawn on banks. The main limit was the threat of a bank run: the withdrawal of currency. For small banks, bank runs by common depositors were always a threat until the development of government-based deposit insurance. This came in the United States in 1934. After that, there were no more bank runs by average depositors. The major threat to banks today is the threat of large depositors transferring their accounts to rival banks. This can take place with an announcement by a large depositor that it will not roll over its short-term deposits when they mature in a few days. On that day, the depositor can transfer his entire account digitally to other institutions. Under these circumstances, a bank can go out of business in a matter of days. It has to sell assets, and these assets may not be highly marketable. They fall in value rapidly. The bank then cannot meet its obligations, and it is forced into bankruptcy.
The problem is leverage. Banks gain high profits by purchasing investment assets that are not salable in a short period of time. The bank is “borrowed short.” Depositors have the right to remove their money digitally at any time. The bank has purchased assets that cannot be converted rapidly into digital money. The problem comes when large depositors lose trust in the portfolio of a particular bank. These depositors can transfer their money in a matter of hours. The leverage gained by the bank prior to the bank run becomes a liability when the bank run begins.
The public does not see a bank run in progress. There are no lines in front of banks. Frantic depositors with a few hundred dollars in the bank are not lining up to withdraw paper money. This was the case in the Great Depression in the early 1930s, but it is no longer the case. There is almost no warning.
2. Central Bank Enforcement
Today, most deposit-taking banks are part of the national banking system. They are under the jurisdiction of numerous government agencies, but the most important jurisdiction is the nation’s central bank. The central bank sets the rules on what loans are legitimate and what loans are not legitimate. Today, most central banks are lenient with respect to the purchase of highly leveraged investment assets. They do not know whether or not these assets will be salable in the case of a bank run. Central bankers assume that the assets that are being sold by a bank that is suffering a bank run will be purchased by whatever banks are the recipients of the digital money being removed from the threatened bank. But there is no guarantee that this will be the case. The suspect bank may go out of business. Then the central bank must intervene and find ways of enabling other banks to purchase the discounted assets of the now bankrupt bank. The problem is this: the bankrupt bank may have more dead assets on its books than the central bank can easily purchase with the expansion of its own digital counterfeit money. If it does expand the supply of its own digital money in order to compensate for the losses sustained by the now bankrupt bank, this may increase prices for the general public. Monetary inflation will produce price inflation.
Any bank that is suspected of having invested in highly risky securities is subject to a bank run when large depositors become convinced that it is insolvent. They do not wish to be late in the process. But the process may take only days to be completed. The bank runs out of rapidly marketable assets, and is unable to honor requests by depositors to transfer the digital money to a different bank. If the bank is declared insolvent, or is functionally insolvent, other banks could become subject to the same kinds of fears by depositors. They could become the targets of digital bank runs.
With each collapsed large bank, the money supply shrinks if the central bank does nothing. If the central bank does not intervene in some way by creating digital money out of nothing, so that the banking system as a whole does not shrink the money supply because of failures of a few large banks, this leads to monetary deflation in a very brief period of time. This is why central banks always intervene. But there is no guarantee that they will be able in every case to intervene with a sufficient amount of digital money to preserve trust in large, highly leveraged banks.
Fractional reserve banking creates opportunities for high profits by skilled bankers. But these opportunities for high profits are subjected to enormous risks of bank runs. This in turn subjects the entire economy to the risk of large-scale bankruptcies of banks and massive monetary deflation, which in turn lead to bankruptcies of over-indebted borrowers, especially business borrowers. This creates an economic recession with widespread unemployment of people, raw materials, and capital goods.
When a bank suffers a run by large depositors, it refuses to lend out money as debtors pay off their loans. It builds up its depleted reserves. If this bank has the ability to call in loans on demand, as is usually the case with business loans, the businesses have to find enough money to pay off their loans. If a business has deposited money temporarily as working capital in another bank, it will demand payment from its bank, so that it can pay the loan off to the bank that lent the business the money. So, the next bank is threatened with a run. It calls in loans. This series of withdrawals creates an implosion in the banking system. This is deflationary.
All schools of economic opinion argued until 2010 that there is a close relationship between the expansion of the money supply and a rise of prices. Different schools of opinion debated over the extent of this connection, but all of them affirmed this. The most forthright statement was made by Milton Friedman in 1970: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” In 1983, Murray Rothbard wrote in Chapter III of The Mystery of Banking, “An increase in the supply of money, then, will lower the price or purchasing power of the dollar, and thereby increase the level of prices.”
This did not take place in the United States, Japan, and Western Europe in the aftermath of the recession of 2008/2009. The Federal Reserve System expanded the monetary base from $900 billion in October 2008 to $4 trillion in September 2014, but there was little price inflation: about 2% per year. The European Central Bank expanded its monetary base by a comparable amount: four to one. So did the Bank of Japan: over four to one. Yet none of the regions experienced significant price inflation. Japan’s consumer price index was almost unchanged over the next decade.
The vast expansion of the money supply by the People’s Bank of China from 1999 over the next 20 years had little effect on retail consumer prices. The increase in M-1 was over ten-fold. The increase in M-2 was over 20-fold. Consumer prices did not rise appreciably. The international exchange rate of China’s currency did not fall. By 2012, China had become the largest exporter in the world, which means that it had goods to export. Therefore, the absence of a rise in the consumer price index was not the result of price controls. If there had been price controls in China, China would not have been able to export goods. There would have been massive shortages of goods. China’s experience has obliterated the monetary theories of all schools of economic opinion. All schools of opinion had argued that monetary expansion on this level would have created mass price inflation in China, which had full employment.
At present, all schools of economic opinion have remained mute on this issue. They have no answer, so they do not talk about it. It is almost as if this experience had not taken place. In economic treatises, authors pretend that the major theoretical problems have cogent answers. Mine does not. If there is one area of economic theory in which an obvious anomaly will force younger economists and outsiders to rethink the tenets of economic theory, it is this discrepancy. High monetary inflation did not create comparable price inflation in the first two decades of the twenty-first century.
An economist would be unwise to say that price index hyperinflation is impossible. But it appears that the hyperinflation of prices in Western industrial nations is much less likely than major recessions that are the result of prior inflations of national monetary bases. There have been hyperinflations in non-Western countries. The worst case was in Hungary in 1946. Zimbabwe came in second in 2008. Venezuela suffered severe price inflation after 2015. These were small countries that did not have high output or large populations.
Monetary inflation still has disrupting effects in the capital structure of a nation. The initial expansion of money creates an economic boom. Businesses go into greater debt. Governments go into greater debt. The result is a misallocation of capital resources. These misallocations result in recessions. Conceivably, they could result in a worldwide depression. So, there are still negative consequences of dishonest money, but hyperinflation of prices seems unlikely to be one of them in the industrial West and Asia.
The policies of monetary inflation have led to a vast expansion of debt, especially government debt. But this also includes corporate debt. Around the world, this vast increase in debt has been funded by central-bank policies of low interest rates. This has increased the vulnerability of the international economy to a breakdown in the structure of liabilities. While monetary inflation has not created a comparable rate of price inflation, it has created a willingness on the part of decision-makers to rely upon debt to achieve the goals of the institutions that employ them.
By creating money, central banks and fractional reserve banks persuade decision-makers to adopt policies that they would not otherwise have adopted, if the expansion of the money supply had not pushed down interest rates. This is an aspect of a misallocation of capital. Entrepreneurs as well as politicians have adopted long-term programs that could not have been funded by the private sector. The rate of savings would not have sustained these projects. These projects were subsidized by the expansion of money.
Central banks have been most at fault for adopting policies of vast monetary expansion. With the exception of Austrian School economists, academic economists have not sounded the alarm. It is likely that the worldwide disruptions caused by default and bankruptcies in the private sector, coupled with default on the part of governments because of unfunded liabilities, will force a reconsideration of monetary theory. The economic crisis of the 1930s led to the adoption of the economics of John Maynard Keynes. There has been no comparable international economic disruption since the 1930s. When it arrives, as it surely will, there will be a real possibility of persuading the younger generation of economists and political decision-makers of a different approach to economic theory.
Fractional reserve banking is universal in the modern world. It is a system in which bankers are able to extend credit that their banks have created out of nothing. Bankers are able to gain an interest return on money that their banks have created through a process of legal counterfeiting. This is highly profitable banking.
Fractional reserve banking is a system of leveraged debt. In biblical banking, debt is not leveraged. For every debt, someone has made a deposit. A banker cannot safely lend more money than he has taken in from depositors. The depositor is a creditor to the banker. The banker is a debtor to the depositor. The threat of a bank run restricts the lending policies of profit-seeking bankers. Without the protection of national governments’ central banks, fractional reserve banking would face the prospect of bank runs, as lenders (depositors) lose faith in overextended banks.
The biblical principle that allows a lender to demand some form of collateral from a borrower is protection against the pyramiding of debt. Even if the form of collateral is not useful to the lender as a tool of production, it does restrict the borrower from indebting himself to multiple lenders on the basis of one piece of collateral. This principle is foundational to safe banking practices. Fractional reserve banking creates great vulnerability for the solvency of individual banks, and it also creates vulnerability for the entire banking system. Central banks have used monetary inflation on a massive scale in the second decade of the twenty-first century to keep the banking systems of the West from collapsing. This has encouraged the largest banks to continue their policies of high leverage and high profits that would otherwise have bankrupted these banks if there had not been intervention by the central banks to bail them out.
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The complete manuscript is here: https://www.garynorth.com/public/department196.cfm