[R-G] [BillTottenWeblog] Fractional Reserve Banking

[Bill Totten]

by Murray N Rothbard

The Freeman (October 1995)


We have already described one part of the contemporary flight from sound,
free market money to statized and inflated money: the abolition of the
gold standard by Franklin Roosevelt in 1933, and the substitution of fiat
paper tickets by the Federal Reserve as our "monetary standard". Another
crucial part of this process was the federal cartelization of the nation's
banks through the creation of the Federal Reserve System in 1913.

Banking is a particularly arcane part of the economic system; one of the
problems is that the word "bank" covers many different activities, with
very different implications. During the Renaissance era, the Medicis in
Italy and the Fuggers in Germany, were "bankers"; their banking, however,
was not only private but also began at least as a legitimate,
non-inflationary, and highly productive activity. Essentially, these were
"merchant bankers", who started as prominent merchants. In the course of
their trade, the merchants began to extend credit to their customers, and
in the case of these great banking families, the credit or "banking" part
of their operations eventually overshadowed their mercantile activities.
These firms lent money out of their own profits and savings, and earned
interest from the loans. Hence, they were channels for the productive
investment of their own savings.

To the extent that banks lend their own savings, or mobilize the savings
of others, their activities are productive and unexceptionable. Even in
our current commercial banking system, if I buy a $10,000 CD ("certificate
of deposit") redeemable in six months, earning a certain fixed interest
return, I am taking my savings and lending it to a bank, which in turn
lends it out at a higher interest rate, the differential being the bank's
earnings for the function of channeling savings into the hands of
credit-worthy or productive borrowers. There is no problem with this
process.

The same is even true of the great "investment banking" houses, which
developed as industrial capitalism flowered in the nineteenth century.
Investment bankers would take their own capital, or capital invested or
loaned by others, to underwrite corporations gathering capital by selling
securities to stockholders and creditors. The problem with the investment
bankers is that one of their major fields of investment was the
underwriting of government bonds, which plunged them hip-deep into
politics, giving them a powerful incentive for pressuring and manipulating
governments, so that taxes would be levied to pay off their and their
clients' government bonds. Hence, the powerful and baleful political
influence of investment bankers in the nineteenth and twentieth centuries:
in particular, the Rothschilds in Western Europe, and Jay Cooke and the
House of Morgan in the United States.

By the late nineteenth century, the Morgans took the lead in trying to
pressure the US government to cartelize industries they were interested in
- first railroads and then manufacturing: to protect these industries from
the winds of free competition, and to use the power of government to
enable these industries to restrict production and raise prices.

In particular, the investment bankers acted as a ginger group to work for
the cartelization of commercial banks. To some extent, commercial bankers
lend out their own capital and money acquired by CDs. But most commercial
banking is "deposit banking" based on a gigantic scam: the idea, which
most depositors believe, that their money is down at the bank, ready to be
redeemed in cash at any time. If Jim has a checking account of $1,000 at a
local bank, Jim knows that this is a "demand deposit", that is, that the
bank pledges to pay him $1,000 in cash, on demand, anytime he wishes to
"get his money out". Naturally, the Jims of this world are convinced that
their money is safely there, in the bank, for them to take out at any
time. Hence, they think of their checking account as equivalent to a
warehouse receipt. If they put a chair in a warehouse before going on a
trip, they expect to get the chair back whenever they present the receipt.
Unfortunately, while banks depend on the warehouse analogy, the depositors
are systematically deluded. Their money ain't there.

An honest warehouse makes sure that the goods entrusted to its care are
there, in its storeroom or vault. But banks operate very differently, at
least since the days of such deposit banks as the Banks of Amsterdam and
Hamburg in the seventeenth century, which indeed acted as warehouses and
backed all of their receipts fully by the assets deposited, for example,
gold and silver. This honest deposit or "giro" banking is called "100
percent reserve" banking. Ever since, banks have habitually created
warehouse receipts (originally bank notes and now deposits) out of thin
air. Essentially, they are counterfeiters of fake warehouse-receipts to
cash or standard money, which circulate as if they were genuine,
fullybacked notes or checking accounts. Banks make money by literally
creating money out of thin air, nowadays exclusively deposits rather than
bank notes. This sort of swindling or counterfeiting is dignified by the
term "fractional-reserve banking", which means that bank deposits are
backed by only a small fraction of the cash they promise to have at hand
and redeem. (Right now, in the United States, this minimum fraction is
fixed by the Federal Reserve System at ten percent.)


Fractional Reserve Banking

Let's see how the fractional reserve process works, in the absence of a
central bank. I set up a Rothbard Bank, and invest $1,000 of cash (whether
gold or government paper does not matter here). Then I "lend out" $10,000
to someone, either for consumer spending or to invest in his business. How
can I "lend out" far more than I have? Ahh, that's the magic of the
"fraction" in the fractional reserve. I simply open up a checking account
of $10,000 which I am happy to lend to Mr Jones. Why does Jones borrow
from me? Well, for one thing, I can charge a lower rate of interest than
savers would. I don't have to save up the money myself, but simply can
counterfeit it out of thin air. (In the nineteenth century, I would have
been able to issue bank notes, but the Federal Reserve now monopolizes
note issues.) Since demand deposits at the Rothbard Bank function as
equivalent to cash, the nation's money supply has just, by magic,
increased by $10,000. The inflationary, counterfeiting process is under
way.

The nineteenth-century English economist Thomas Tooke correctly stated
that "free trade in banking is tantamount to free trade in swindling". But
under freedom, and without government support, there are some severe
hitches in this counterfeiting process, or in what has been termed "free
banking". First: why should anyone trust me? Why should anyone accept the
checking deposits of the Rothbard Bank? But second, even if I were
trusted, and I were able to con my way into the trust of the gullible,
there is another severe problem, caused by the fact that the banking
system is competitive, with free entry into the field. After all, the
Rothbard Bank is limited in its clientele. After Jones borrows checking
deposits from me, he is going to spend it. Why else pay money for a loan?
Sooner or later, the money he spends, whether for a vacation, or for
expanding his business, will be spent on the goods or services of clients
of some other bank, say the Rockwell Bank. The Rockwell Bank is not
particularly interested in holding checking accounts on my bank; it wants
reserves so that it can pyramid its own counterfeiting on top of cash
reserves. And so if, to make the case simple, the Rockwell Bank gets a
$10,000 check on the Rothbard Bank, it is going to demand cash so that it
can do some inflationary counterfeit-pyramiding of its own. But, I, of
course, can't pay the $10,000, so I'm finished. Bankrupt. Found out. By
rights, I should be in jail as an embezzler, but at least my phoney
checking deposits and I are out of the game, and out of the money supply.

Hence, under free competition, and without government support and
enforcement, there will only be limited scope for fractional-reserve
counterfeiting. Banks could form cartels to prop each other up, but
generally cartels on the market don't work well without government
enforcement, without the government cracking down on competitors who
insist on busting the cartel, in this case, forcing competing banks to pay
up.


Central Banking

Hence the drive by the bankers themselves to get the government to
cartelize their industry by means of a central bank. Central Banking began
with the Bank of England in the 1690s, spread to the rest of the Western
world in the eighteenth and nineteenth centuries, and finally was imposed
upon the United States by banking cartelists via the Federal Reserve
System of 1913. Particularly enthusiastic about the Central Bank were the
investment bankers, such as the Morgans, who pioneered the cartel idea,
and who by this time had expanded into commercial banking.

In modern central banking, the Central Bank is granted the monopoly of the
issue of bank notes (originally written or printed warehouse receipts as
opposed to the intangible receipts of bank deposits), which are now
identical to the government's paper money and therefore the monetary
"standard" in the country. People want to use physical cash as well as
bank deposits. If, therefore, I wish to redeem $1,000 in cash from my
checking bank, the bank has to go to the Federal Reserve, and draw down
its own checking account with the Fed, "buying" $1,000 of Federal Reserve
Notes (the cash in the United States today) from the Fed. The Fed, in
other words, acts as a bankers' bank. Banks keep checking deposits at the
Fed and these deposits constitute their reserves, on which they can and do
pyramid ten times the amount in checkbook money.

Here's how the counterfeiting process works in today's world. Let's say
that the Federal Reserve, as usual, decides that it wants to expand (that
is, inflate) the money supply. The Federal Reserve decides to go into the
market (called the "open market") and purchase an asset. It doesn't really
matter what asset it buys; the important point is that it writes out a
check. The Fed could, if it wanted to, buy any asset it wished, including
corporate stocks, buildings, or foreign currency. In practice, it almost
always buys US government securities.

Let's assume that the Fed buys $10,000,000 of US Treasury bills from some
"approved" government bond dealer (a small group), say Shearson, Lehman on
Wall Street. The Fed writes out a check for $10,000,000, which it gives to
Shearson, Lehman in exchange for $10,000,000 in US securities. Where does
the Fed get the $10,000,000 to pay Shearson, Lehman? It creates the money
out of thin air. Shearson, Lehman can do only one thing with the check:
deposit it in its checking account at a commercial bank, say Chase
Manhattan. The "money supply" of the country has already increased by
$10,000,000; no one else's checking account has decreased at all. There
has been a net increase of $10,000,000.

But this is only the beginning of the inflationary, counterfeiting
process. For Chase Manhattan is delighted to get a check on the Fed, and
rushes down to deposit it in its own checking account at the Fed, which
now increases by $10,000,000. But this checking account constitutes the
"reserves" of the banks, which have now increased across the nation by
$10,000,000. But this means that Chase Manhattan can create deposits based
on these reserves, and that, as checks and reserves seep out to other
banks (much as the Rothbard Bank deposits did), each one can add its
inflationary mite, until the banking system as a whole has increased its
demand deposits by $100,000,000, ten times the original purchase of assets
by the Fed. The banking system is allowed to keep reserves amounting to
ten percent of its deposits, which means that the "money multiplier" - the
amount of deposits the banks can expand on top of reserves - is ten. A
purchase of assets of $10 million by the Fed has generated very quickly a
tenfold, $100,000,000 increase in the money supply of the banking system
as a whole.

Interestingly, all economists agree on the mechanics of this process even
though they of course disagree sharply on the moral or economic evaluation
of that process. But unfortunately, the general public, not inducted into
the mysteries of banking, still persists in thinking that their money
remains "in the bank".

Thus, the Federal Reserve and other central banking systems act as giant
government creators and enforcers of a banking cartel; the Fed bails out
banks in trouble, and it centralizes and coordinates the banking system so
that all the banks, whether the Chase Manhattan, or the Rothbard or
Rockwell banks, can inflate together. Under free banking, one bank
expanding beyond its fellows was in danger of imminent bankruptcy. Now,
under the Fed, all banks can expand together and proportionately.


"Deposit Insurance"

But even with the backing of the Fed, fractional reserve banking proved
shaky, and so the New Deal, in 1933, added the lie of "bank deposit
insurance", using the benign word "insurance" to mask an arrant hoax. When
the savings and loan system went down the tubes in the late 1980s, the
"deposit insurance" of the federal FSLIC [Federal Savings and Loan
Insurance Corporation] was unmasked as sheer fraud. The "insurance" was
simply the smoke-and-mirrors term for the unbacked name of the federal
government. The poor taxpayers finally bailed out the S&Ls, but now we are
left with the formerly sainted FDIC [Federal Deposit Insurance
Corporation], for commercial banks, which is now increasingly seen to be
shaky, since the FDIC itself has less than one percent of the huge number
of deposits it "insures".

The very idea of "deposit insurance" is a swindle; how does one insure an
institution (fractional reserve banking) that is inherently insolvent, and
which will fall apart whenever the public finally understands the swindle?
Suppose that, tomorrow, the American public suddenly became aware of the
banking swindle, and went to the banks tomorrow morning, and, in unison,
demanded cash. What would happen? The banks would be instantly insolvent,
since they could only muster ten percent of the cash they owe their
befuddled customers. Neither would the enormous tax increase needed to
bail everyone out be at all palatable. No: the only thing the Fed could
do, and this would be in their power, would be to print enough money to
pay off all the bank depositors. Unfortunately, in the present state of
the banking system, the result would be an immediate plunge into the
horrors of hyperinflation.

Let us suppose that total insured bank deposits are $1,600 billion.
Technically, in the case of a run on the banks, the Fed could exercise
emergency powers and print $1,600 billion in cash to give to the FDIC to
pay off the bank depositors. The problem is that, emboldened at this
massive bailout, the depositors would promptly redeposit the new $1,600
billion into the banks, increasing the total bank reserves by $1,600
billion, thus permitting an immediate expansion of the money supply by the
banks by tenfold, increasing the total stock of bank money by $16
trillion. Runaway inflation and total destruction of the currency would
quickly follow.

_____

This article originally appeared in the October 1995 issue of The Freeman
and is reprinted with permission: http://www.fee.org/vnews.php?sec=iolmisc

Murray N Rothbard (1926-1995), the founder of modern libertarianism and
the dean of the Austrian School of economics, was the author of The Ethics
of Liberty (1982) and For a New Liberty (1973) and many other books and
articles. He was also academic vice president of the Ludwig von Mises
Institute and the Center for Libertarian Studies, and the editor - with
Lew Rockwell - of The Rothbard-Rockwell Report.

Murray Rothbard Archives:
http://www.lewrockwell.com/rothbard/rothbard-arch.html

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