Fractional Reserve Banking
What is the nature of this fraud? Counterfeiting. Banks are government-licensed institutions that issue bogus IOUs. Because these IOUs function as money, they are counterfeit money. This is the heart, mind, and soul of all modern banking.
There is only one textbook in money and banking that states explicitly that all fractional reserve banking rests on fraud: Murray Rothbard's The Mystery of Banking. It is not used in any university. It never has been. It was published in 1983. It went out of print almost immediately. It is online here.
Rothbard takes the reader through the traditional T-account exercise that is common to all upper-division textbooks in money and banking. Unlike all the others, his book shows how the process of making deposits and lending the money involves counterfeiting whenever the depositor has the legal right to withdraw his money on demand.
This is not the same as a life insurance contract in which you can borrow against your built-up reserves. The company treats the policyholder as it would treat another borrower. It raises money to make the loan.
The withdraw-on-demand banking process has the same effect as counterfeiting gold and silver coins by adding base metals (pp. 48-51). It has the same effect as issuing paper money that has no backing in gold or silver (pp. 51- 55). It has the same effect as issuing warehouse receipts for goods stored for which there are no goods stored (pp. 88-90).
The banking system issues multiple IOUs to depositors and borrowers, yet these IOUs are based on the same initial deposits. Traditional textbooks describe this process, but they refuse to identify the process as counterfeiting. They also refuse to mention that this process of monetary inflation is the sole basis of all booms and busts: the business cycle. This was Ludwig von Mises' insight as far back as 1912 in his book, The Theory of Money and Credit.
Rothbard makes it clear why fractional reserve banking is fraudulent. This is why no professor assigns his book to his classes.
The irresistible temptation now emerges for the goldsmith or other deposit banker to commit fraud and inflation: to engage, in short, in fractional reserve banking, where total cash reserves are lower, by some fraction, than the warehouse receipts outstanding. It is unlikely that the banker will simply abstract the gold and use it for his own consumption; there is then no likelihood of ever getting the money should depositors ask to redeem it, and this act would run the risk of being considered embezzlement. Instead, the banker will either lend out the gold, or far more likely, will issue fake warehouse receipts for gold and lend them out, eventually getting repaid the principal plus interest. In short, the deposit banker has suddenly become a loan banker; the difference is that he is not taking his own savings or borrowing in order to lend to consumers or investors. Instead he is taking someone else's money and lending it out at the same time that the depositor thinks his money is still available for him to redeem. Or rather, and even worse, the banker issues fake warehouse receipts and lends them out as if they were real warehouse receipts represented by cash. At the same time, the original depositor thinks that his warehouse receipts are represented by money available at any time he wishes to cash them in. Here we have the system of fractional reserve banking, in which more than one warehouse receipt is backed by the same amount of gold or other cash in the bank's vaults.It should be clear that modern fractional reserve banking is a shell game, a Ponzi scheme, a fraud in which fake warehouse receipts are issued and circulate as equivalent to the cash supposedly represented by the receipts (pp. 96-97).
Modern economists do not acknowledge that fractional reserve banking is a gigantic system of counterfeiting. They do not apply the same analysis to fractional reserve banking that they would apply to counterfeiting if they discussed counterfeiting. They rarely discuss counterfeiting. This is because they know that bright students can make the analytical connection. The students will be tempted to conclude what is in fact the case, namely, that fractional reserve banking is a form of counterfeiting.
BORROWED SHORT AND LENT LONG
The banker offers a deal to holders of currency. (Prior to 1914 in Europe and prior to 1933 in the United States, the public held gold coins.) Here is the offer.
If you will deposit your money in my bank, I will lend it out at interest. I will share some of this interest with you by guaranteeing you a fixed rate of return.
So far, so good. But then comes the kicker.
The banker knows what the economics professor knows:
almost no one can think through the implications of this
promise. Both the banker and the professor of money and
banking strive to keep people in the dark. They promote
the mystery of banking. What are a few implications? Here is one. When the
bank lends money to a borrower at a fixed rate of return,
it lends for a specific period of time (commercial loans)
or else no deadline (credit card loans). It cannot get
this money back on demand. Yet it owes money on demand. The depositor can demand immediate payment. Yet the
money is gone. The bank has therefore issued two IOUs to
the same deposit. The depositor can pull out his money at
any time. The borrower, who has the money sitting in his
account, can do the same thing. How is this possible? Because the government or the
central bank allows the bank to set aside a small
percentage of reserves on the deposit. The bank does not
have to keep 100% of the on-demand money in reserve. With a 10% reserve requirement, if a bank gets a $100
deposit and sends $10 to the central bank as a reserve, it
can legally lend $90. When the borrower spends this $90,
the receiving bank sets aside $9 and lends $81. The
initial $100 deposit leads to $900 in new money, if banks
lend all of the money they are legally allowed to lend. If the banker had added the following statement, there
would be no fraud. There would be no counterfeiting.
This offer would make it clear to the depositor that
there is no such thing as a free lunch. He cannot get the
return of his money until the bank gets it back from the
borrower. The same deposit still serves as money: for the
borrower, not for the depositor. The banker makes the offer of payment on demand
because he knows that few depositors will demand their
money most of the time. Those who do demand their money
can be paid out of the money deposited by today's
depositors. Is this a Ponzi scheme? In part, yes. It is
a Ponzi scheme that can go on much longer, because the bank
possesses the power to create money. The bank has borrowed short -- "withdraw the money on
demand" -- and has lent long: "pay the money back on time."
This is fraudulent.
CONTRACTS OVER TIME All contracts have a time component. A contract is a
promise to perform an action in the future. What about an exchange that is instantaneous? In the
most radical form, a seller of money holds out a wad of
currency. A seller of a good holds out the good. Each of
them takes hold of both items, using different hands. On
the count of three, each person releases the item he is
offering to the other. Each person hopes the other will
turn loose of the item on three. Yet even here, there is a time component. Each
participant promises to let loose on the count of three.
If there were no agreement -- either formal or implied --
there would be no exchange. A contract that promises to do the impossible is
fraudulent. If it is part of a series of identical
contracts, only a few of which can be consummated on the
same day, then all of the payment-on-demand contracts are
fraudulent. The creditor cannot distinguish his claim from
all the others, other than by "first come, first served."
That principle encourages bank runs. Whenever a prospective depositor goes down to the bank
to make a deposit, he should sing to himself the song that
every fractional reserve bank has as its anthem regarding
its depositors, who are its creditors. The banker silently
sings to every depositor: This is the chorus. But those of us from the late
1950's remember what followed. Fractional reserve banking may be a mystery, but Buddy
Holly has provided the key to understanding the system. Bankers woo depositors with promises of everlasting
commitment. The proof of this everlasting commitment is
the promise of withdrawal on demand. Then they take the
depositors' money to woo borrowers with promises of what
would otherwise have been below-market interest rates. Why
below market? Because depositors have been lured into
parting with their money by means of a promise -- a promise
that cannot be fulfilled because of the time discrepancy
between borrowing short (depositors' accounts) and lending
long (borrowers' accounts). The basis of this monetary philandry is the
discrepancy between the rival promises of time. To understand modern banking, think of a full-time
philanderer with one mid-town apartment, four mistresses,
and three keys. We can call this a 25% reserve
requirement. Three mistresses live in the suburbs. His
favorite lives in mid-town. One key is for him; one is for
the mid-town girl; and one is for the other three
mistresses. This key is kept on reserve at the desk
downstairs. He assumes that out-of-towners will not all
show up on the same day at the same time. This plan works until a rumor gets out about the
nature of the arrangement. Then all three out-of-towners
show up to make sure they have a key.
INFLATION AND BAD INFORMATION Counterfeiters increase the money supply. This is
inflationary. They defraud holders of the non-counterfeit
currency. How? By lowering the market price of the
currency already in circulation. The slogan is: "More
money chasing the same amount of goods." But, as Mises showed, there is more to it than this.
The added money, when lent to producers, leads to a
transfer of wealth to the producers. They start bidding
for production goods: land (including raw materials),
labor, and capital (land plus labor over time). They can
make higher bids. They supply goods and services to match
expected demand. This creates an economic boom, but when
the counterfeiters stop counterfeiting, expected demand does
not appear. This creates a bust. Counterfeit money distorts information. How? Because
prices convey information. Prices should convey accurate
information. When decision-makers have accurate
information, they can find ways to lower the transaction
costs of their decisions. They can search out better ways
to cut expenses. They can become more efficient. When prices convey inaccurate information, individuals
find that they make more mistakes. They make decisions in
terms of information that is misleading. This is why
prices should be based on decentralized decisions in which
individuals making the decisions are responsible for the
outcome of their actions. This is the defense of
free-market capitalism. But, when it comes to banks, the
economists refuse to follow the logic of this principle of
individual responsibility and performance. Defenders of
central banking and fractional reserve banking are
necessarily defenders of inaccurate information.
CENTRAL BANKING A central bank provides emergency money to commercial
banks. This reduces the threat of bank runs. Central
banks intervene to save large banks. This is why no large
American bank went bust in the Great Depression, while over
6,000 small banks did. Central banks are the enforcing arm of the fractional
reserve banking system. Central banks determine which
banks survive and which do not in a national bank run.
Their job is to protect the largest commercial banks. This
is a form of central planning by a government-licensed
monopolistic agency. When central planners substitute their judgment for
individual decision-makers, we see a centralization of
power over the market. The terms of exchange are not being
set by individual participants who are responsible for
their actions. The terms of exchange are being set by a
distant committee. They are immune from negative feedback
for their own decisions. This arrangement is guaranteed to reduce the accuracy
of information that is conveyed by prices. Furthermore,
when the intervention in question relates to the control of
the money supply, we can be certain that the information
conveyed by the decision of the committee will be less
accurate than the information conveyed by individual
decision-makers. Fractional reserve banking creates blindness. Central
banking extends this blindness. Any economy that relies on fractional reserve banking
is flying partially blind. This blindness becomes
permanent when a central bank protects large commercial
banks that are regarded as too big to fail.
CONCLUSION Fractional reserve banking is inherently fraudulent.
It inflates the money supply. It creates the boom-bust
cycle. Through central banking, it transfers planning
authority to bureaucrats with only an indirect stake in the
outcome of their decisions. It is the basis of the modern economy. The booms and
busts get worse. The dollar depreciates. Central planning
increases. Information becomes more distorted. This will end badly. Worse, it may start over again.
______________________________ Published on October 10, 2009. The original is here.
You will not be able to get your money back on
demand until the contract runs out for the
borrower. As he repays interest, you will get
your share. If he refuses to repay, I will pay
you your principal based on bank reserves. But,
of course, if the bank goes bankrupt, you will
not be repaid.
Yes, that'll be the day, when you make me cry.
You say you're gonna leave, you know it's a lie.
'Cause that'll be the day when I die.
All your hugs and kisses and your money too.
Well, you know you love me baby
Until you tell me, maybe
That some day, well, I'll be through.