The End Of Fractional Reserve Banking?

United States Treasury Notes were recently auctioned off for a yield of 0%. That means that very smart people running mutual funds, brokerage houses and other very large organizations were willing to invest lots of money and get nothing in return other than a return of their principal. We can probably rule out the motives of benevolence or Christmas spirit. There must be some other reason.

Those smart people are investment managers, who’s job it is to make money for the organizations through their investing. With the extreme volatility of the stock market, those people would rather sit on their cash than risk it on companies that will likely lose a significant portion of their share value. That is not irrational. However, considering the fact that there are brokerage commissions and fees involved in buying treasury notes, those managers are losing money for their organizations by investing at 0%. Why would they not just keep their cash at 0% and not pay the commissions? It doesn’t seem to make sense.

An organization that has $100 million of cash doesn’t have a room full of twenty dollar bills. They have a bank account with some accounting entries. With all of the turmoil in the banking industry, it is not unreasonable for these money managers to feel a little queasy about leaving that money in a bank. FDIC deposit insurance only covers the first $250,000. The other $99,750,000 is unsecured. If the bank goes belly up, they may or may not get all of their money back, and if they do, they have no idea how long they would have to wait.

With that in mind, it makes sense that large scale investors would rather own treasury notes that appear to have a high level of safety, even if they lose a little money on the transaction. It sounds perverse, doesn’t it? If you understand fractional reserve banking, you can understand why it actually is so perverse.

When you put your money in a checking account at a bank, you do so with the understanding that it is still all your money. You have a right to withdraw it in any amount, at any time. This is opposed to investing in a Certificate of Deposit at the same bank. With the CD, you are actually loaning the bank your money. You do not have a right to withdraw it without penalty before the due date.

Banks have figured out that, on average, their depositors will not be withdrawing all of their money. Only a fairly small fraction will be taken on a given day. The bankers believe that all of that money should not be just sitting around collecting dust. They say “Someone should be making money from it, it might as well be me.” So they take a portion of that money and lend it out to other customers at interest to be paid over time. That’s pretty clever. In any other setting, that is called embezzlement, but in banking it is called generally accepted business practice.

At any point in time, every bank is technically bankrupt. Most of its liabilities, the deposits due to customers, are very short term. Most of its assets are very long term, such as loans. Mortgages that a bank lends out for 30 years are balanced by a checking deposit that is due today. In normal times it is not an issue because people are pretty predictable. In abnormal times, like now, people aren’t so predictable. They may have very valid reasons for pulling out their cash, such as believing that the bankers won’t have their money when they need it.

Unfortunately, that is a very valid concern. The underlying problem has nothing to do with market psychology or confidence or any such nonsense. The core issue is that, due to the bank’s systematic embezzlement, they do not have the cash available to meet their contractual obligations.

Using taxpayer money and the FDIC to secure a portion of deposits against banker fraud is not the solution to the problem. The solution is not to use billions, or even trillions, of taxpayer dollars to bail out banks who did stupid things with the money they embezzled. The solution is to make the embezzlement illegal, to stop the fraud.

The fractional reserve system allows banks to leverage reserves and rapidly expand money and credit. We witnessed that with the current housing bubble, the 1990’s stock bubble and every other bubble market before that. Rapid credit expansion is a two edged sword. Once the bubble bursts, there is a rapid deflation as irresponsible loans go bad and reserves diminish. They can’t hide the embezzlement in the downside of the bubble, because people want their deposits and banks don’t have them to give.

There is a very simple way to prevent future bubbles and economic crises, or at least minimize them. If banks were forced to live by the laws that everyone else must live by, bank runs would be very unlikely, even in the worst economic conditions. People could always get their money because it would always be there. There is a fairly simple cause and effect relationship. A simple policy change of requiring 100% reserves for all banks would prevent a meltdown like we are suffering through today.

It would be a fairly easy policy to implement, if there was the political will to do so. Given that the banking industry is one of the most wealthy and powerful lobbyists in Washington, that is not likely until taxpayers and voters connect the dots, and get fed up with footing the bill and bearing all the pain.

28 comments to The End Of Fractional Reserve Banking?

  • Raymond


    Money is not even taught in schools, much less banking practice. We’ll need a knowledgeable political body before we can expect them to exercise political will. How many legislators even know how our banking system work today?

  • It seems that you and some of the other writers on CE should be ideal candidates for sharia-style (Islamic) banking that is increasingly gaining accetance world-wide.

    Think of it – NO INTEREST (no usury allowed – haram!), 100% reserve requirements, sharing risks and profits, careful adherence to religious rules … although no specific gold standard, much attention is paid to gold as an asset!

    Why bother with unproven “principles” and theories when there is an ideal, centuries-old, proven system that works in practice, even though fractional reserve lending arose from gold in the first place and usury was forbidden by all three Western faiths!

    It requires politicians, not economists, to change the “system!”

    Given the tenor of American politics and “Joe the Six-pack plumber,” sharia banking is unlikely to gain much acceptance unless most of that “conservate” electorate shifted their deposits from conventional to Islamic banks. They can (and are, in most cases) FDIC insured, but do not have to be a member of the Fed! There is currently somewhat less than a billion in assets in U.S. sharia banks.

    Oh, yes, if you want to open an account in one of the institutions, you have to sign an agreement to abide by sharia principles. Doubt any “principled” Americans would still still for that clause!

  • Hi Stephan,

    I would have expected a little more thoughtful and logical critique from you rather than an appeal to emotionalism.

    Here are the underlying assumptions:
    1. The central bank induces inflationary bubbles with below market interest rates.
    2. Fractional reserve banking magnifies the swings in money and credit creation.
    3. Depositors are defrauded and damaged when banks cannot keep their commitments.
    4. Elimination of fractional reserves will eliminate the cause of much of the periodic damage.

    Read through the explanation and poke holes in it. I am always willing to learn.

    The first assumption implies that interest rates are inherently a market phenomenon. Manipulation of rates by a central bank amounts to price controls that distort normal market signals in the supply and demand for money and credit.

    The whole point of the article is the very real and indisputable fact that fractional reserve banking leverages new reserves from the central bank. It whipsaws the market with hyper fluctuations in the money supply. In the deflationary portion of the cycle, it is also an indisputable fact that banks don’t have enough money to pay everyone, even though they have a contractual obligation to do so, because they lent it out to someone else over a longer period. That’s where we are right now.

    If the reserve ratio is 10%, then $1 billion dollars in new reserves created by Fed open market operations becomes $10 billion after the creation of credit with the 90% that the banks are not required to hold. In many cases, the reserve ratio is less than that, exaggerating the inflationary effect even more.

    That leverage acts to exacerbate the inflationary portion of the central bank induced cycle. For every dollar of new loans made under fractional reserve, there is a dollar of new money created out of thin air. The original depositor owns the money and the new borrower also owns the same money. Where there once was one dollar, there now are two.

    Say you deposit $1 million in a bank with a 10% reserve requirement. The bank is only required to keep $100,000 of it. The bank can lend $900,000 to someone else. When that person deposits that money, the bank only has to keep $90,000 of it and can lend out $810,000 of it. The process continues until the bank, or more likely the network of banks, has $10,000,000 in deposits and $9,000,000 in new loans from the original $1,000,000 deposit. The fact is that $9,000,000 of money was created from nothing and can happen over a fairly short period of time. That is the inflationary part of the cycle.

    Fractional reserves also leverages the deflationary portion of the cycle. If a $1 million loan goes bad, that reduces the bank’s reserves by $1 million. If reserves are reduced by $1 million, with that same 10% reserve ratio, the bank must, by law, reduce its loans by $9 million. It must sell its loans to another bank, but the purchase of the $9 million in loans reduces the available reserves of the purchasing bank by $9 million, which means it has that much less to support its portfolio. The money and credit is reduced in a rapid, leveraged way, the opposite of the rapid, leveraged inflation.

    That is the unwinding portion of the cycle that we are living through now. That is the very source of the severe deflationary pressures the markets are reeling from.

    The bubble market exists because prices were bid up far beyond the value that could be supported by normal wages, good and services in the overall market. Real estate prices (or stocks in the 1990’s) were bid up to extreme levels because of low interest rates and easy credit. Lots of people and businesses shouldn’t have gotten the loans they did. It is conventional wisdom that the Fed should pump trillions of dollars into the markets to reflate, in other words, to prop up the absurdly high prices. That would only mean that responsible people would not be able to afford them and the market will remain frozen.

    The only long term solution is to allow the market to adjust, for prices to deflate, for bad loans to go to bad, for credit and money to decline, so people will be in a position to get on with their lives again. It would be painful but it would be over in a short time, as most depressions were before social engineers began trying to “help” the situation in the 1930’s. It would cause no more pain than what we are being put through now, it just wouldn’t be in slow motion.

    Fractional reserve banking does not have the sterling history that you seem to attribute to it. John Law was a very brilliant man and showed us just how effective fractional reserve banking was back in the 1700’s. It was very effective in devaluing the currency at the expense of the people, making himself very wealthy and providing his government with a seemingly unlimited amount of money to spend. That is until it reached its limits. Then it crashed. It has been crashing, inflating and crashing again, ever since, wherever it has been instituted.

    There are those who try to burnish the story to make John Law a hero and the fractional reserve system look like the best thing since sliced bread. Where you see significant economic turmoil, however, look also for central banks or fractional reserve banking and inflationary credit. They are probably there, lurking in the shadows.

  • Raymond and Stepahn,

    You are right, it will take a political solution. Not many people understand it. An even smaller portion of politicians know or would care even if they did know.

    That is why it is important to let people know that banking fraud is the source of many of the economic problems. Politicians will change only when there is political pressure to change.

    Everything that is being talked about today is hackihg at the leaves of the problem. The root is thriving and grinning.

  • Dan – You seem to think I was being “emotional?”

    I was not. Nor was I being facetious.

    Sharia banking is a very real and growing phenomenon, and exists under Islamic law from Saudi Arabia to Jakarta to th U.S.

    Look it up, and see which countries suffered the least impact of the recent financial crisis.

    Also look up (if you don’t know it already) the history of fractional reserve measures, from the classic “Goldsmith” principle to the present.

    There is nothing wrong with the system per se and it has been proven time and again, stimulating growth and overall well-being, no matter whether in the U.S. or other nations. Booms and bust have occurred in most countries.

    The problem lies with the individuals running the system, not the system (or theory) itself. Your argument seems to lie with the Fed specifically, and central banks, in general.

    One of my gurus at the University of California was the late Don MacLaughlin, one of the greatest experts on gold then extant (1960’s, Chairman of Homestake Mining Co.)

    He described gold, central banking, fractionnal reserve systems, etc. in both the classroom and private meetings in his home, in terms both applicable and realistic. He did not point to the “evils” of bankers or the Federal Reserve. He did point out the folly of some of the politicians … and some of the constituents!

    If properly administered sans greed and corruption and the general ignorance of the voter, you and some of the other writers beg the question with the
    somewhat naive assumption of the “free market” and the benign results resulting from merely eliminating some of the systems.

    I certainly do not advocate a communist or even socialist political system.

    However, under your definition, do you really believe a “free market” would truly benefit the whole of this large and diverse society?

    The average voter (esp. in the U.S.) looks immediately to “the government” to fix all their ills, from segregation to medical ills to “free” education and more. The voters bask in prosperity and balk at any adversity.

    Who should set the rules and what rules should be enacted? At what penalty aceptable to the individual?

    While you see the central banks and fractional reserves and lack of a gold standard as one of the roots of the problem, I continue to believe that the core is people – not systems.

    Why not attack the system of taxes, which certainly is one of the key elements at the core of the problem?

    Why not attack the unions and their dislocating effect on the economy, from the AMA to the ABA and the UAW? Any economist can clearly and simply explain the effects of unions on an industry.

    Why not attack the myopic immigration policy which affects the U.S. (and other countries) without attention to the economic fundamentals (supply and demand) instead of catering to paranoic, xenophobic voters and politicians?

    It all comes back to the responsibility of “people” and their individual and collective choices. That is both the curse and blessing of living in a democracy.That is one of the lating fundamental difference in the Jefferson – Hamilton feuds in the beginning of this country.

    Islamic sharia provides a means for provinding for societies social and banking needs and the system works. As an inevitable price for stability, Islam forces a strict, simple adherence to the system.

    So does the American democracy.

    Before microeconomics was even considered “worthy” of being taught, macroeconomics was essentially left to the “free” market an “intellectuals” in universities.

    The result? Massive depression, recessions or boom times.

    Immense social inequality, wealth and poverity as a means of conveying “the warnings of G-d” as a means of justifing ills,

    If we are going to change humanity, it would be toward a global society. If not, check very closely how “free” the free market was in the U.S. even before the Fed was ever enacted.

  • Dirk

    It is true that $1M in Fed deposits can turn into $10M if the reserve requirement is 10%.

    It is also true that there will then be $10M- plus interest- in promises of payments from production. The borrowers now have incentive- and capital- to produce. If they can’t produce, they give the money back, and, unless they go through bankruptcy, will eventually have to produce enough to pay back the balance.

    Fractional reserve banking creates more opportunity and growth- what’s wrong with that? Oh yes, the ability of the Fed to artificially constrain economic activity based on their whims (a valid complaint I think we all share). But as the old saying goes, “better to have loved and lost than to never have loved at all…”.

    It seems to me that Stephen’s post provides a reasonable explanation as to why our economy is so much larger and creative than Islamic economies (even with the benefit of our discovery of oil on their land for them).

  • Frederic

    Are you all out of your mind? Sharia finance is only the first step before a total enforcement of sharia in the West.
    You are either muslims in disguise for saying this or complete fools. I’m not interested in having banks that won’t pay me interest. It’s a return to the dark age of money under the mattress! Muslims are currently rejoicing over the subprime crisis which they see as the downfall of the US imperialism they despise so much. The fractional reserve system is wonderful and has certainly contributed to the exponential innovations of the latest century and beyond. Booms & busts are part of the business and you just need to learn to surf through the cycles. I want no sharia in the West.

  • Hi Stephan,

    I understand you were not emotional, but it actually was an appeal to emotion to support your claim, because Islam and Sharia banking have nothing to do with the discussion. Because two things have something in common does not mean they are the same. That is like saying that a Mercedes Benz is like a bicycle because they both have wheels.

    From the article: “The core issue is that, due to the bank’s systematic embezzlement, they do not have the cash available to meet their contractual obligations.” Can there be any question of the fact that banks cannot meet their contractual obligations because they did not keep the funds in trust for their clients? Surely you cannot be questioning that. That is an easily observable phenomenon. As far as calling it embezzlement, is there a better, more descriptive word? They used money that wasn’t theirs in order to make a profit.

    Would you have a problem with the term “embezzlement” if a department store manager “borrowed” funds so he could make some money from it, even if he intended to pay it back? There is no difference, other than one is legally protected and the other is not.

    The fact that goldsmiths and banks have been doing it for a long time doesn’t make it not embezzlement. It doesn’t make it any easier on depositors who cannot get their money back because banks embezzled it from them.

    One thing from your comments may shed a little light on the issue, however. Those countries that rely on 100% reserve requirements have not suffered much from the depression, as fractional reserve systems have. That is an important insight. The implication that you make that they are all backward countries, however, is not at all due to lack of fractional reserve banking, but lack of secure property rights and economic freedom. Look at the various reports on economic freedom in the world.

    I think banking is extremely important in a modern economy. It is essential. I also think that banking could easily be organized to provide all of the important services needed without the severe negative effects inherent with fractional reserves.

    Banks could charge fees for the services they render to depositors. Banks could still be involved in the loan process, but more as a natural intermediary, a broker, aligning the needs of borrowers with those of the depositors with excess cash that they would like to make extra income from. The individual lender would get the interest from the loan, the bank would get fees for connecting borrower and lender. There are all sorts of scenarios that would work.

    There is a tremendous pool of money which can be used for investing, but the limits of the pool would put natural restraints on bubbles by letting the market decide what interest rates should be. There would never be a crash because there wouldn’t first be a bubble. Inflationary bubbles only cause distortion and not long term growth. There couldn’t be a crisis of confidence because everyone would be assured that their money was there when they need it. If not, it was because of their own choice.

    One of your key statements was “If properly administered, sans greed and corruption…” That is a mighty big if. From my perspective, I cannot understand why you call a faith in the markets naïve, when you put your faith in politicians and bankers operating their system without greed or corruption. That is totally ignoring the whole pathetic record of politicians and bankers. Why would people put faith in politicians and bureaucrats when they have proven themselves wrong, corrupt, immoral, unprincipled, etc, etc time after time. That strikes me as being pretty naïve.

    The fact is that I have attacked the unions, the AMA and the ABA. Any organization that uses government coercion for their competitive advantage is immoral and is the antithesis of free markets. They are mercantilists. You can’t blame the markets for things not done by the markets.

    I audited banks back in my CPA days. I have a pretty good understanding of how they operate. Even then, however, I didn’t understand all of the implications of money creation. I have since done a great deal of research, and I believe that I have a pretty good grasp of how things work.

    Two of the many books that have informed my views:

    “Money, Bank Credit and Economic Cycles” by Jesus Huerto de Soto, comprehensive theoretical treatment.

    “The Mystery of Banking” by Murray Rothbard, more readable and interesting.

    I have also read justifications of fractional reserves, and they just don’t seem to fit for me. The massive depressions, recessions and boom times seem to coincide with fractional reserve banking, central banks and inflationary credit creation.

    Intellectualism in universities has largely become a repudiation of economic laws. Everyone tries to build a new economic model, but they can’t work because they fly in the face of principles that have been show to us long ago. Trying to force society into their models is the problem. It’s like trying to force people not to fall when they jump off a bridge. If you ignore natural law, you pay the consequences.

  • Hi Dirk,

    “Better to have loved and lost than to never have loved at all’ translates into “Better to have taken out that big mortgage to buy the vastly overpriced house and subsequently gone bankrupt than to wait for a reasonable market and not go bankrupt.” It doesn’t make sense.

    I will be a pretty hard sell to get me to believe that the housing market was not severely overpriced, and that the severe overpricing was not due directly to the artificially induced inflationary credit bubble. The way to get houses selling again is to let the prices deflate to a level that real, ordinary people can afford on their real, ordinary income.

  • Hi Frederick,

    The whole idea of comparing this to sharia law is merely an emotional attack over a pretty straight forward issue that lends itself well to debate.

    Sharia law is a repudiation of individual rights and has absolutely no place in a free society. Fractional reserve banking is also a repudiation of the property rights of depositors. The banks refuse to honor their legal obligation because they have used the money for their own profit. In that sense, it is just as wrong as Sharia law, but their embezzlement is protected by our law. There would be no loss of confidence and no bank runs if banks always had depositor’s money on hand. It is unlikely that there would be much, if any, of a business cycle.

    Booms and busts are not inherent to free markets, but are actually an inherent flaw of the fractional reserve system. It acts like an accordion rapidly expanding and contracting. Everybody doesn’t just surf through the cycles, many people get wiped out, and it is totally unnecessary. You might want to study the posts above regarding mathematics of credit and money creation before you are too critical.

    I think you miss the whole point about interest. How satisfied are you with 1/2 % interest on your savings? Your savings accounts now get significantly less interest when the central bank artificially lowers interest rates to stimulate the boom. You would get more interest, and more people would be encouraged to save, if the interest rates were not artificially held down, but rather to be determined by the market. The greater savings would be available for investment in further non-inflationary growth. People lament the low savings rate in America, but can’t quite make the connection that artificially low interest rates will cause artificially low levels of savings.

  • Raymond

    Picture a wagon full of gold being rushed from bank to bank, ahead of the bank examiner.

    Even when bank notes were still redeemable in specie, bankers would habitually issue notes exceeding their backing of specie. I seriously doubt they’re promoting growth and opportunity, nor economic theory.

    Bank runs were routine, but the damage was localized until the arrival of the Federal Reserve System in 1913.

    The bankers succeeded in legalizing what was their old illegal practice and sway public opinion to pass their banking “reform”. What cunning.

    Results: Debased money and Trillions in debt , with calls for more of the same. Astonishing.

    100% reserve on demand deposits is a good place to start

  • Frederic

    “I think you miss the whole point about interest. How satisfied are you with 1/2 % interest on your savings?”

    Better than 0% as in full reserve banking where I will actually have to PAY for the safeguarding of my money.

  • Mr. Dan McLaughlin, Your exposed, denuded & bald
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    100% Reserve Requirements – Awesome!

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  • Hi Mario,

    Thanks for your support, but from what I can see, a mathematically perfected economy rests on the same fallacy as fractional reserve banking, the idea that a solution can be imposed from an authority. Though admittedly I have not studied everything you say, from what I can see, you would probably not be so supportive of everything I say.

    I think that where our views coincide is that basing the entire money supply on debt makes it too easy for government to finance its ever growing tentacles. It is a self reinforcing cycle. It is obvious that disaster awaits if we keep feeding the beast.

    I believe, however, that interest is a market phenomenon, it is merely people’s time preference. It is not bad or good. It is a fact of life that everyone, including you, would rather receive their wealth today rather than next year or ten years or 50 years. The rate of interest, as determined by people transacting in an economy, is only a measure of how strongly people feel about the future and the level of risk that they feel the present transaction holds for them. Nobody can know that but the parties involved at that moment.

    To me, there is no such thing as usury, outside of coercion, usually of the state. In a free market, if someone charges too high a rate, the prospective borrower has the choice of finding a more cooperative lender or not borrowing. If the borrower cannot find a lender for what he considers a reasonable interest rate, that means that that borrower is too high a risk, and needs to change the way he does his business with others.

    That borrower has no right to coerce the lender, through government or otherwise, to give him money, except on terms that both voluntarily agree upon, just as the lender has no right to coerce the borrower, except on terms he agrees to. Forcibly redefining interest payments into principle payments is a central planner’s manipulation of the market and will destroy any lender’s incentive to lend. Preventing interest payments between willing borrowers and lenders will certainly destroy markets.

    The economy is not someone’s plan. The economy is billions of individual transactions that are planned only by individuals. A central planner cannot possibly know, much less plan for, the needs of every individual in society. A central planner can only distort the markets upon which individuals rely to make their own plans. The welfare of the people in an economy can only be maximized when they are free to act and when the markets are free from distortions imposed from forces other than the actors.

    Two resources that illustrate my point of view:

    The Pretense Of Knowledge – Friedrich A Hayek Nobel Acceptance Speech

    Riskonomics – A Window On Spontaneous Order –Daniel Klein

    Both are easily available on any search engine.

    The answer is much less government and central planning, monetary or otherwise, and taking away the power of the government to make free money for itself at the expense of the people.

  • H Frederick,

    You may have heard the old saying “There is no such thing as a free lunch.” That applies very well to the situation you are discussing. Just because you don’t have monthly fees deducted from your account doesn’t mean that nobody pays the expenses related to your accounts.

    The bank incurs expenses for every service they offer. The way the system is set up now, the burden of the bank fees is borne by borrowers. The banks collect the fees in the form of interest from customers. You, like me or anyone else, do not like to pay bank fees. But just because you don’t like to pay them doesn’t mean that borrowers should be forced to pay your fees so you can have free checking.

    A bank should be able to operate as it wants, to charge whatever fees it wants to whoever it wants. It must, however, compete on the marketplace and try to offer a better deal to potential customers. One thing a bank should never have a right to do is use, for its own profit, the money that it has in trust for its depositors.

    If a depositor writes a check against his account with no money in it, and refuses to pay it, he will absolutely go to jail. By the same token, and in all fairness, if a bank does not have any depositor’s money on hand whenever it is demanded, the person in charge should go to jail for embezzlement, because that is what it is. That is the one and only reason for loss of confidence and multiple bank failures in an economic downturn. They did stupid things with the money they embezzled from depositors.

  • Interesting that my reference to sharia banking evoked such intense reaction! Maybe I should have simply used “Arabic banking” to point to the similarity between your intended economic goals – the elimination of central banking and fractional reserve lending – and Arabic banking.

    I certainly don’t subscribe or recommend sharia as a philosophy for myself or as a way of life for others. That is the individual’s choice.

    But I do respect and recognize the fact that other societies and cultures have the unfettered right to believe and act for themselves as they might wish. Even in Islam, there are gulfs of difference between interpretations in the faith, just are there are in Christianity or Judaism.

    That makes the fact that your economic views and actual Islamic practices in banking so interesting since they coincide..

    Both the Misean vision of an essentially stateless society based on some unhampered “free market” and that of sharia are based on philosophical premises.

    Those premises, of course, are anathema to each other since their respective outlooks on man and God certainly differ. Neither the thought of obeisance to a vengeful god nor a free, unrestrained populace are particularly appealing!

    However, in economic reality, it is sharia that has been proven to work in an economic system. The ideas concerning the destruction of central banking and the fractional reserve have either never been tried in western society or thoroughly disproven in logic and fact.

    After all, formal central banking has been a fact of life since Sverige Reichsbank was established in 1656, the Bank of England since 1694, Banque de France since 1800, and so forth. China, Russian and Japan adopted the model as has the majority of the world, including the Middle East.

    Fractional banking is an equally undeniable, economic fact, lodged in factual reality centuries longer.

    A sad commentary, indeed, if all of Western economic thought is administered by “embezzlers” as you maintain, especially in democratic societies. That suggests some interesting thoughts about the nature of democracy and the voters.

    I suggest that the purpose of economics is to maintain a semblance of regulated order throughout the world based on accepted logic. VonMises and sharia principles, capitalism and communism all attempt to do this. The end goal is the same. The means and perspectives on man’s nature are obviously different and subject to the inevitable vagaries of man.

  • Raymond

    Mr Z

    Before central banks, ancient Kings would shave off the realms coins to fill their treasuries.

    Central banks just made it easier for rulers to obtain money they would not otherwise collect trough taxation.

    Is this regulated order based on accepted logic?

    They’re cheating the people then, and they’re cheating the people now. You make it sound like there is some higher purpose to this. If you’re in a card game and you can’t figure out who the patsy is — it’s because it’s you.

    And for man’s perspective, try $10 Trillion in US government debt with no end in sight.

  • Stephan,

    Thanks. That certainly was a well thought out response, and it makes sense, base on your assumptions.

    My view of economics is a bit different than yours, however. I believe that the purpose of economics is not, at all, to maintain order in society. It is, rather, to make plain the immutable economic laws that direct all of society, just as physics attempts to make plain the physical laws. We can predict, with amazing accuracy, what will happen when we combine elements and technology in a process of nuclear fusion. That doesn’t mean that a nuclear physicist should direct the use that knowledge to coerce an unwilling populace to obey him in what he thinks is good or right.

    That knowledge has been used by politicians to change the course of events in the world, but whether or not you agree with those politicians, the laws of physics still hold. Those laws of physics can be used for good or bad. It is the job of the physicist to make sure that people understand the implications of their actions, to know the outcome of particular inputs. If people use the laws of physics for evil, the people are evil, not the laws.

    By the same token, the purpose of economics is to make sure that everybody knows the implications of their actions. When someone uses the laws of economics for evil, those people are evil, not the laws. It has been very well established that when the price of an item is held below the market equilibrium rate, the quantity demanded will be higher and the quantity supplied will be lower, creating shortages. The opposite will occur for price floors where prices are held above the market rate. It will create gluts. It doesn’t matter how good the intentions are of the person or body doing the manipulating, the end result will always be shortages, as in Hurricane Katrina supplies and rebuilding with price gouging threats, or gluts in labor supplies, commonly known as unemployment, due to minimum wages, or gluts in financial markets when interest rates are held below the market. The laws are absolutely neutral. They must always be followed.

    The very large and glaring difference between any Islamic society and free societies is the idea of freedom. There are some libertarians who hold as the ideal the stateless society. I am not one of those and I think it can be fairly easily demonstrated that Mises was not one of those. He believed that a very minimal state was necessary for protecting the rights of individual actors in society.

    There are definitely evil people in any society, those that would defraud, coerce, rob and kill. I believe that it is necessary to have some body to protect the rights of life, liberty and property. The problem is that people in that authoritative body can very easily be those that would defraud, rob and kill, so must be limited with a very short leash.

    Mises did realize the danger inherent in political power, the idea that government, like fire, is a dangerous servant and a fearsome master. When people use political power to impose their idea of what is good, they transform from dangerous servant into terrible master. Whether or not they know economic laws, they and their victims are still bound by the laws o economics, as much as they obey the laws of physics when they are pushed off a ledge.

    With freedom, people can believe whatever they want and choose whatever lifestyle they want. They can’t, however, choose the results of those actions and choices. Those results are dictated by immutable natural laws.

  • Dan – We finally agree! I have often separated the philosophical aspects of economics from the factual “laws”, such of supply and demand, just as you suggest for the laws of physics or any other hard science. I consider the latter as economometrics – i.e., the factual gathering of empirical evidence.

    The interpretation and potential physical or moral consequences of economics I consider “political economics” as so many did in Europe.

    That separation of facts and philosophy is probably the hardest aspect to teach, but the most satisfying whenever a student “got it!”

    The facts just need to be gathered, proven as much as possible as factual, and marshaled in his/her argument.. The philosophical application then simply becomes a personal decision by the individual.

  • Dirk


    We agree on more than we disagree, but I think this disagreement is central- when an economy grows, money must grow. And when money grows, it needs to be injected into the economy- and what better way than to issue it to people who promise to produce to pay it back?

    If we were all reduced to trading ever smaller chunks of gold as supply grows, we’d still be a stone age economy.

    That the middle eastern countries are much closer to that than we (well, except for those dealing in dollars)is as good an example as any. Our central banking mechanism that allows money to grow with supply so that the price stickiness of relatively deflating resources doesn’t plunge those into recession, constraining parts of the economy with it, is a key reason our economy (and living standards) are superior to the vast majority of the rest of the world.

  • Hi Dirk,

    I think we do have a lot in common. I have a couple of comments and then a serious request. First the comments.

    When money is injected into the economy, it is not injected to producers who borrow money to actually produce things. The injection is to banks who create money out of nothing. They get the injection with absolutely no production whatsoever. They use other people’s money and create new money from it. The banks then charge interest on money that they get for free. Once the banks make the money from credit creation based on deposits, it is immediately in circulation. Granted, the loan recipient is not hurt as bad from the new money as the poor and those on fixed incomes, but they are not the primary beneficiaries of free money. The banks are. It is a very straight forward and explainable process.

    Second, as the value of a dollar increases, meaning it can buy ever more goods, there will be fewer dollars needed to buy any particular good. But rather than having to use ever smaller chunks of gold or whatever, there could be smaller denominations, such as a half cent or, say, a mil, one thousandth of a dollar, and so on. That is the rationale for quarters, dimes and nickels, and it could be expanded upon indefinitely as money became more valuable. It would be the reverse of the devaluation process in place now.

    Third, people react to reality over time. It is true that severe deflation will distort markets and make it impossible for people to predict the results of the actions they take in the short term, just as severe inflation distorts markets. The price stickiness you are talking about, however, results from people being programmed to believe that inflation is inevitable. They expect higher prices and transact their business with that expectation. It is just as rational, however, to expect that the parties to transactions would easily adjust their actions and expectations to a mild and steady deflation. If prices decline, the costs would also be bid down on the inputs, because everything becomes cheaper in deflation. The result could easily still be a profit.

    Now for the request. Tell me why, specifically, that money must grow in order for an economy to grow. It really is not at all apparent to me why that should be so.

  • Dan Wilkinson

    The fundamental problem with FRB is that it requires constant growth in the money supply (and thus constant growth in production) order to remain stable, since 90%+ of the money supply is in the form of bank loans that bear interest. Unless the money supply grows there won’t be enough money to repay the principal plus interest. The system is unstable for this reason.

    This simple fact often gets confused with the issue of fiat money. Fiat money is not the cause of the problem. If the money supply were created by the state and spent into existence rather than lent, then there would be no more money-as-debt, and no requirement for constant inflation.

    It would however leave some flexibility in the hands of the state to increase the money supply carefully in line with production thereby retaining stable prices over time with the need for the kind of zero sum results you get from a gold standard (i.e. a one good increases in value another good decreases). 100% reserve banks would be free to set their own interest rates.

    The Austrian School will complain that this system is not going to work since centrally planned government will ruin it. While this may be true it is important to separate the economics from the politics, and see that this system is in itself stable, sustainable, flexible and has many advantages over gold backed money.

    The only arguments that can reasonably be made against this system is that government can never be trusted, and fiat money systems always collapse. There is of course plenty of evidence to support both these statements. However on the flip side, removing all economic constraints from individuals as advocated by the austrian school is not going to produce a sustainable economy from an environmental point of view since individuals acting alone and competeing with one another will never price in environmental depletion.

    Austrian thinkers justify this attribute of their system by saying that
    future generations have no rights, so sustainability is not a valid goal. However this philosophy is rarely pointed out by the austrian school itself or by their detractors.

  • Dan Wilkinson

    Sorry – the sentence above should have read:

    “It would however leave some flexibility in the hands of the state to increase the money supply carefully in line with production thereby retaining stable prices over time with[OUT] the need for the kind of zero sum results…”

  • Frederic

    quoting McLaughlin:

    “You may have heard the old saying “There is no such thing as a free lunch.” That applies very well to the situation you are discussing. Just because you don’t have monthly fees deducted from your account doesn’t mean that nobody pays the expenses related to your accounts.

    The bank incurs expenses for every service they offer.
    The way the system is set up now, the burden of the bank fees is borne by borrowers. The banks collect the fees in the form of interest from customers.”

    end quote

    Thanks for the patronizing comment in which you want to teach me how banks work. I know how they work and I disagree with the part where you say “, the burden of the bank fees is borne by borrowers” We’re all savers & borrowers at certain times and even I was more than happy to borrow for real-estate investments that made me profit from leverage in good times. I never thought my bank was charging fees “on my back” The system of full reserve banking that you want to promote simply makes no sense. Your bank merely becomes a pawn-shop of some sort.
    Fractional Reserve Banking is not really responsible for today’s crisis. It’s the whole mix of re-packaging and slicing of loans to remove them from bank’s balance sheets, together with cascading derivatives on nobody who knows how many layers all coupled together with IFRS book-keeping norms (that originally meant well but backfired) that went out of control. And I didn’t even speak of rating companies being paid by the very companies they were supposed to be rating. This all was an explosive disaster waiting to happen and Warren Buffet rightly talked about ‘weapons of financial mass destruction’ way before the subprime crisis struck.

  • Hi Frederick,

    Thanks for losing the rhetoric about Sharia law taking over the entire western world. It is much easier to discuss without the emotional baggage.

    My apologies if you felt I was being patronizing, but the quote still holds. Free is not free. Someone pays for it. The fact that depositors don’t pay the related fees absolutely means that they are borne by others. It can’t be any other way. A system where checking account fees are paid by checking account holders and loan costs are paid by borrowers is no less of a rational system than checking account costs being borne by borrowers. It is actually more fair and rational. That is, however, a very minor issue and more of a distraction from the key points.

    I have to agree that fractional reserve banking is not the core cause for the crisis. That honor lies with the Federal Reserve Bank and its manipulation the money supply and interest rates. Obviously there are more contributing factors, such as ones you mention, but without the Fed’s manipulation, there would not have been the inflationary bubble. The role that the fractional reserve system plays is in greatly magnifying the effects by inflationary credit creation.

    The creation of money by banks granting of credit is a very understandable and straight forward process. It multiplies by many times the creation of reserves by the Fed. Because of the leverage, a $200 billion creation of money out of nothing by the Fed can be multiplied into $2 trillion, with a T, of new money created from nothing in a relatively short period of time.

    The problem is that the inflationary credit process is inevitably reversed when it becomes obvious to everyone that the economic conditions are a house of cards, a bubble market. Businesses and individuals default and go bankrupt, mortgages foreclose and loans become uncollectible. Those inherent deflationary pressures are what hurt so bad, but they are absolutely guaranteed by the fractional reserve system now in place, in conjunction with the Fed.

    As I said in one of my other comments, if a depositor wrote a check on an account with no money in it and refused to cover it, he would go to jail. The other side of the coin is that if that depositor wants his money and the banker refuses to provide it, he should go to jail also.

    If a bank always had depositors’ money on hand, bank runs would never, ever happen. Bank failures would be extremely few and far between. A bank run results only from the realization of the depositors that the bank embezzled their money, and does not have it to give back to depositors. In that case, the first ones there get the goods. Once the small amount of reserves on hand are gone, the rest of the depositors are cheated out of their money as the bank goes bankrupt. That is the problem we face. The only way for the fed to help is to create more counterfeit money, and even then, the system melts down.

    There is something inherently wrong with that system. To me, the arguments against fractional reserve banking are overwhelming. What the system should look like in its place should be determined by the market. The banks that serve the customers with the best model would be the ones that perform the best. But it is not too much to ask that bankers be held to the same level of accountability as their depositors.

    If my analysis is wrong, please tell me where. I am truly willing to learn.

  • Dirk

    If money is not created as productive capacity increases, then deflation occurs.

    When deflation occurs, money has more purchasing power tomorrow than it does today. So the incentive is to sit on it, and economic activity slows.

    This would be great if we really are running out of oil, land, water, and breathable air. I believe this is the great debate of our time- will technology be able to obviate current natural resource limits (solar for oil, skyscrapers for land, reservoirs and desalinization for water, etc.) or is Lester Brown right about needing to cut population and ration resources?

    I’m in the “let’s grow, because there are billions of people living in poverty and my empathy for poor people doesn’t stop at the border” camp- so we need more money. Look up “deflation” on wikipedia if you think I’m making the correlation between deflation and reduced economic activity up.

  • Hi Dirk,

    There are a few steps further in the cause –effect relationships that are important.

    If money is not created as productive capacity increases, then deflation occurs. When deflation occurs, the purchasing power of money increases. When the purchasing power of money increases, the prices of goods decrease. When the prices of goods decrease, the quantity demanded increases. When the quantity demanded increases, more items are sold. When more items are sold, the economy goes forward. The end result is a productive economy with lower prices

    We are not talking about rapid deflation, which is just as damaging as rapid inflation. In the normal course of events, the productivity increases at a relatively slow pace. A slow paced deflation can be taken into account in prices for final goods, but also for factors of production, so the end result can still be profits for producers during a slow, steady deflation.

    An important concept that has very good theoretical support, whether monetarists choose to accept it or not, is that any quantity of money is the right quantity. The real economy will function the same. The only affect of increasing the quantity of money from out of nothing is a redistribution of wealth from the producers to the money counterfeiters.

  • Rebecca

    we the students of rison high school do practice banking! :)

    (Future Bankers of America)

    sincerely, A girl.

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