Fractional Reserve Banking and the Business Cycle

Last week I explained that it is possible to return to a sound monetary system, which probably means a gold standard, although a good case can be made that a free market may choose some other commodity such as silver. That choice would be a market choice, not a political choice.

I wish to delve a little deeper into another monetary reform that should be instituted concomitantly with a gold standard—a legal prohibition against fractional reserve banking. I must admit to the reader that not all Austrian School economists would agree with my proposal, but I have solid reasons for advocating such a prohibition.

There are two main problems with our current fiat monetary system. First of all, fiat monies are subject to inflation and deflation. Now in Austrian School parlance the terms "inflation" and "deflation" refer only to the size of the money supply; whereas, the public refers to these terms as indications of a general rise or fall in prices. The mainstream press and mainstream economists rue rising prices or falling prices—they favor "stable" prices. But they fail to understand that the violent price swings that they find so objectionable are caused by increases and decreases in the money supply, to which they show very little interest. Today we experience an excellent example of this point of view, for the Fed has increased bank reserves—the building blocks, so to speak, of the money supply—with no apparent concern about future price increases that must follow the inevitable expansion of the money supply. But Austrians understand that both inflation and deflation are monetary phenomenon; therefore, it is critically important that an economy be anchored to a stable money supply that is not subject to political manipulation.

Gold serves this purpose magnificently. It is both inflation and deflation proof. Its supply cannot be increased except very slowly and at great cost—thusly, inoculating the economy against inflation. Furthermore, all the gold that has ever been mined—except that quantity lost to fire or at the bottom of the sea--still circulates in the world, so it is deflation proof as well.

The second main problem with our current fiat monetary system is that it serves as the catalyst of the boom/bust business cycle. It is not enough to end the destabilizing affects of inflation and deflation. We also must end these wealth destroying boom/bust business cycles. Anchoring the monetary system to gold will not prevent them, for the world experienced these wealth-destroying cycles during the centuries when all the world’s currencies were anchored to gold. True, prices were stable, actually falling very gradually in line with improvements in productivity. But there still were periodic booms and busts. So, there must be some other problem that needs resolution.

Austrian economists who have studied economic history discovered that these pernicious cycles began with the advent of the modern banking system, specifically the advent of fractional reserve banking. Historically, banking began as a warehousing service for money (usually gold) for which service the bank received a small fee. The bank would issue receipts for the gold deposited in its care. Over time these receipts were traded in lieu of the cumbersome process of retrieving one’s gold from the bank, exchanging it for a good or service, and re-depositing the gold back into the same or competing bank. These receipts were not money themselves. They were money substitutes. The real money was always the gold itself.

Eventually bankers realized that at any one time only a few depositors actually demanded to reclaim their gold. So these bankers began to issue false warehouse receipts to borrowers, who agreed to repay the gold with interest. Thusly, the ratio of gold to warehouse receipts no longer bore a one-to-one relationship with gold on deposit but only a "fractional" one. Thusly was born the "fractional reserve" banking system.

But notice that the banker created the warehouse receipt that he issued to the borrower in a fraudulent manner. The bank’s depositors did not know that their gold had been lent and now would be claimed by more than one person. When this revelation became widespread, the depositors would rush to the bank to withdraw their gold—creating a "bank run". Therefore, bank runs were completely avoidable by honest bankers who maintained a one-to-one relationship of gold to deposits.

To recap our discussion so far, under a gold standard, money IS gold. The paper certificates one carries in one’s wallet or the ledger entry of the balance of one’s account at a bank are NOT money. These things are money substitutes. A holder may redeem these substitutes for gold, which the issuer of the certificates or demand deposit must safe keep for the holder.

It is impossible for a non-fraudulent bank to pay interest on a demand account backed by gold, because gold does not earn interest as it sits in a vault. In fact we have seen that the owner of the demand account must pay some small fee to the bank for the bank’s safe keeping services. THIS PROVES THAT IT IS IMPOSSIBLE FOR THE BANK TO BOTH HONOR ITS PLEDGE TO REDEEM ITS CERTIFICATES FOR GOLD AND LEND THAT SAME QUANTITY OF GOLD TO SOMEONE ELSE WHO WOULD PAY INTEREST.

The only non-fraudulent method of lending gold is to transfer its ownership, temporarily, to a borrower. The bank would make it clear that opening a savings account, in which the depositor earns interest, removes the depositor’s ownership of his gold for some period of time. He must wait for the borrower to return the gold to the bank before he can reclaim his property. At that time the bank places the gold back into its vaults and the depositor may draw upon his account once again.

A fractional reserve bank, on the other hand, is inherently insolvent, because it cannot honor all of the claims of its demand depositors. A 100% gold reserve bank can. Plus it can still offer financial intermediation services, as long as the depositor transfers his gold claim from a demand deposit account to an interest bearing account. Now the bank owns the gold until it finds a borrower—then it transfers ownership of the gold to the borrower for some specified period of time. For this service the banker charges the borrower an interest rate high enough to cover the interest expense paid to the depositor, plus his operating expenses, plus a provision to the loan loss reserve. The depositor, who earns interest, must understand that in the case of a loan loss the banker’s capital account (which includes a loan loss reserve portion) will be the source of his redemption at the maturity of his time deposit. This is the only real protection afforded savings depositors; thusly, the more highly capitalized banks will gain customers, as they should.

In an honest banking system such as the one I describe, no demand depositor would ever lose his money; that is, his REAL money—gold. He could lose all or a portion of his money, money that he entrusts to the banker in the banker’s role as financial intermediary, that he places in a savings account.

Now let us return to how fractional reserve banking causes the boom/bust business cycle. Since a fractional reserve bank does not have to pay interest to its depositor, who has agreed to allow the banker to find worthy borrowers of his money, his cost of funds are lower than those of honest bankers who do not engage in fractional reserve banking. The fractional reserve banker attempts to gain market share by lowering the rate he charges for loans. This sets off the Austrian business cycle whereby investment is encouraged in longer term production cycles that cannot be sustained or completed because no new real savings serves as its basis. The depositors of the fractional reserve bank have not altered their spending patterns; that is, they have not saved more. The depositors of the honest bank have altered their spending patterns; they have lengthened their time preference, in Austrian lingo, by saving more and consuming less. Their actions do not set off the Austrian business cycle, because the funds they lend are representative of real assets that have been released from lower order production (consumer goods) to higher order production (producer goods). Therefore, the economy’s legal protectors--government--must prohibit fractional reserve banking.

Wait a minute, shout the critics, the government should have nothing to do with the banking system! I agree. And the government will have nothing to do with the banking system. It merely protects it in the same way that it protects any citizen from thieves and/or fraud. For fractional reserve banking IS fraud. The U.S. Constitution authorizes the federal government to ensure that only sound money circulates within our borders, as do the laws of most other countries. The Constitution authorizes the federal government to define the dollar in terms of the weight of gold. Thusly, a one hundred percent gold reserve dollar, which we must remember is strictly a money substitute, must be backed by its full, legal reserve requirement, whatever weight of gold that is set by law. Therefore, any dollar—money substitute--that is not backed one hundred percent by its required amount of gold is fraudulent. It is not a dollar. It is a half of a dollar or a quarter of a dollar or as little as one-twentieth of a dollar. It circulates as a lie, proclaiming on its face to be something that it is not. Government was formed to protect our property, in addition to our life and liberty. Therefore, it is not an intrusion of government into monetary affairs to require it to prosecute fraudulent bankers who engage in fractional reserve banking.

For those who advocate free banking, meaning that fractional reserve bankers could disclose their actions and that the public could choose to accept their money substitutes or not, I can only say that this circle cannot be squared. For these bankers would have to disclose on the face of their money substitutes that their dollar was not really a dollar…that it is something less. So, how can the dollar claim to be something that it discloses that it is not? This cognitive dissonance cannot be logically reconciled.

It should be clear why banks support a central bank, especially one that has the power to print fiat money. If the banker makes too many bad loans, his capital account is threatened. Rather than declare bankruptcy and liquidate the bank, paying off all demand depositors in full, if sufficient assets exist, and the savings depositors their pro-rata share of any left over assets, these bankers lobbied for a "lender of last resort". Now a central bank does not have to be a fiat money bank. It, too, can be an honest bank, holding gold in proportion to its demand deposits. But such a central bank can, itself, go bankrupt, if it lends gold to banks that cannot repay. This was the case of the Bank of Austria at the start of the Great Depression. It ran out of gold, could not redeem its demand deposits, and had to declare itself bankrupt. Thusly, around the world the banks and the government slowly destroyed the gold standard, so that the central bank could not, in a technical sense only, go bankrupt. A fiat money central bank can always print certificates. But by now the reader should understand that these certificates are not MONEY; that is, they are not substitutes for gold. They are counterfeit. The central bank merely is papering over the insolvency of itself and the banking system, which was caused by fractional reserve banking and exposed in the boom/bust business cycle.

It is fruitless for governments to cling to fractional reserve, fiat money by proclaiming that their regulators will prevent malinvestment with prohibitions against exotic financial instruments and more vigorous enforcement. These are but the symptoms of malinvestment set in motion by fractional reserve banking and perpetuated and exacerbated by the injection of even more fiat money by central banks. The solution is clear—abolish the Fed; enforce a one hundred percent gold reserve monetary standard; and prosecute fractional reserve banking as fraudulent.

CAN WE RETURN TO SOUND MONEY?

No one alive today has ever experienced sound money; that is, money backed by a commodity of lasting value, such as gold or silver. So it is not surprising that even many who understand the concept and advantages of sound money have many serious questions about the possibility of reinstating a gold standard. Their questions usually occur in this order: Is fiat money so ingrained in our economy and our way of life that re-conversion is not possible? What are the obstacles? Would the U.S. be able to reconvert on its own or would most of the world have to join us? What would a transition entail?

If it really isn’t possible to reconvert and/or the obstacles and transition costs are too great, lets just forget the whole thing and concentrate our efforts on getting reformist politicians and bureaucrats in positions of power. In other words, get better men to rule in a benign dictatorship. Regrettably this really is not an option. Our current fiat money system will fail. No such system has ever met the test of time. All…let me repeat that…ALL such fiat money experiments have failed. Once men realize that they hold the power to create and spend money in unlimited amounts, no appeal to the better angels of their nature will prevent them from abusing their commissions. So, our only option is to reconvert.

Fortunately, fiat money is not so ingrained in our economy that it cannot be replaced by a gold standard. The main obstacle to doing so is not some mechanical barrier. Although such a transition would be easier the more countries that agreed to participate in a coordinated re-conversion, the U.S. could go it alone. And, finally, there are several intellectually solid transition strategies from which to choose.

There is no question that many American institutions cannot survive in their present form under a sound money environment. It is these beneficiaries of our fiat money system that present the most serious obstacle to re-conversion. I refer, of course, to government itself. A fiat money system enables government to expand its power by stealing the product of the people’s effort without overt taxation or honest borrowing. Such is the situation today. Our government--with the cooperation of our central bank, the supposedly independent Federal Reserve—spends money created out of thin air and intervenes to drive down the rate of interest. So far this strategy appears to work, and this is a shame. For the inevitable rise in prices and the interest rate will be delayed, perhaps for more than a year. Then the government’s apologists will blame price rises on everyone but themselves—greedy oil companies, greedy oil sheiks, greedy merchants, etc. If you think that the people will not be so foolish as to believe such nonsense, this is exactly the message that the government has so successfully spread as the cause of our current financial crisis. Therefore, you can imagine the tremendous propaganda effort from our government to discredit efforts to end their gravy train. Our response should acknowledge the source—such cries of panic are to be expected and should be ignored.

So, we have determined that there really is no choice but to re-convert to sound money, and we have discounted the objections from government itself, the primary beneficiary of our fiat money system. Can we go it alone or do we have to get the cooperation of our major trading partners? Professor George Reisman has addressed this issue (and more) in great detail in his magnum opus Capitalism and many other venues. He concludes that an internationally coordinated re-conversion would prevent the likely rise and subsequent fall in prices in the U.S., a one-time cycle caused initially by "outside gold" flowing into the U.S. and inflating the U.S. money supply to be followed by a later fall in U.S. prices as our sound money regime takes hold. If the European Central Bank, the Bank of Japan, the Bank of England, and the Bank of China coordinated re-conversion with us, there would be no such "outside" gold to initiate the cycle. But, even if these countries demurred in our re-conversion effort, Reisman explains that the U.S. would be the eventual winner, because the cycle would end and the dollar would gain against all other currencies as time progressed. Furthermore, the U.S. would not suffer the frequent boom/bust business cycles caused by our current, manipulated fiat money system.

Finally, how would we do it? There are several scenarios. Some economists claim that all the U.S. has to do is repeal its legal tender laws (laws that prohibit any other money from circulating within the U.S. other than our fiat dollar). A free money environment would allow the wonders of competition to work. The best monies would drive poor ones from the marketplace, a reverse of Gresham’s Law. Good money would drive out bad in the same way that any superior good drives lesser ones from the market. Whether only those currencies backed 100% by gold would circulate or if some lesser currencies also would circulate would be at the discretion of the real rulers of the marketplace—the consumer.

Most other scenarios give some role to government, at least for the transitional period. The U.S. confiscated the gold of the U.S. citizenry in 1934, forcing them to surrender their gold in exchange for depreciating federal reserve notes. So government, in effect, stole the nation’s gold and still holds vast quantities of it in its vaults. This gold would be returned to the people in proportion to their money holdings via some mechanism, of which there are many worthy ones. Then the U.S. dollar would be fully convertible to gold at some market determined parity price, such parity price then established by law as the legally enforced price of the dollar. Any dollar holder could redeem his dollars for gold at the parity price. At this point the U.S. dollar would become, in essence, a warehouse receipt for gold. The U.S. would be on the gold standard.

The sooner the U.S. re-converts to the gold standard, the sooner the U.S. economy will recover and, more importantly, the sooner the liberties of the people will be restored. No longer will the government be able to hide the true cost of its spending and blame others for the inevitable deleterious consequences. It must either tax the people or suffer higher interest rates. Then the people can decide whether such spending is warranted, because they will see first hand that they must pay the cost of such spending. Of course, it has always been the case that the people must pay for government spending, but now this fact will be immediately discernable and subject to the people’s control. That is the America in which I want to live. How about you?

A House Divided: Will Fiat Money or the Free Market End Up on the Ash-heap of History?

On June 8, 1982 Ronald Reagan addressed the Members of the British Parliament at the Palace of Westminster in London.

(Read his full address: http://www.reagansheritage.org/html/reagan06_08_82.shtml)

Barely a year as America’s president and presumptive leader of the free world, Reagan had taken office when the West seemed to be in retreat in the face of aggressive Soviet communism. But Reagan saw the inherent weakness in the Soviet position—its economic system. Pointing out various facts about the Soviet economy—for example, that the three percent of agricultural land allowed for private use accounted for one-fourth of Soviet agricultural production—he said, "What we see here is a political structure that no longer corresponds to its economic base, a society where productive forces are hampered by political ones." Reagan referred, of course, to the Soviet’s centrally planned, command economy.

Later in the speech he predicted the demise of the Soviet Union itself, brought about by the failure of its repressive economic system to meet even the simplest needs of the people. Its repressive economic system--that Reagan, in another speech, said actually was the absence of economics--simply was incompatible with man’s very nature. No threat of gulags could make it work. We who lived through those dangerous times were stunned by the following prediction:

"What I am describing now is a plan and a hope for the long term -- the march of freedom and democracy which will leave Marxism-Leninism on the ash-heap of history, as it has left other tyrannies which stifle the freedom and muzzle the self-expression of the people"

Communism on the "Ash-heap of history"! Yes, it had lasted many decades. Yes, it appeared to be as powerful and aggressive as ever. Yes, its people showed no sign of revolt. Yet here was our president predicting its end based upon the fact that its "productive factors are hampered by political ones."

Dare we predict the same thing today regarding our fractional-reserve fiat money banking system, forced upon us by a central bank and manipulated for political purposes rather than safeguarded to ensure our freedom? Is this system, so out of synch with our basically free enterprise economy, doomed to the ash-heap of history, too? Yes. Like Lincoln’s "house divided" we see that the U.S. economy is divided. The means of production are in private hands, yet our money is in government hands. This dichotomy cannot last. Our economy cannot survive half free and half controlled by political factors; it must become all one or all the other. We cannot expect the free half of our economy to survive and flourish as long as our money, which is at least one-half of every transaction, is as unfree as was the worthless ruble of the Soviet Union.

It is our fiat money system that allows our political leaders to "stimulate" voters and "bailout" special interests with the collusion of our supposedly independent central bank. Each monetary expansion to accomplish their unconstitutional actions hampers the free side of our economy all the more. How is it possible for businessmen to plan when the political authorities constantly undermine money’s value? They cannot. The more government expands the money supply the more resources it commandeers for its boondoggle, wasteful, unproductive ventures that sap the ability of private business to secure the resources necessary for true progress.

This is the great un-reconciled and irreconcilable divide within our economic system today. It is the same everywhere—in Europe, Japan, and China. Either our fiat money system will be relegated to the ash-heap of history or our free enterprise system will fail. There really is only one choice, for if we loose our free enterprise system we will suffer the same fate as did the Soviet Union. Even now we see our government moving in steps in the wrong direction. It has demanded veto power over General Motors’ restructuring plans, following GM’s acceptance of government bailout funds. Influential advisors, such as Nobel Laureate Paul Krugman, are demanding that the government nationalize the country’s largest banks. These are ominous signs indeed. But with the fatal consequences of politically run command economies so recently in our memories, why are we even considering such actions? Give us liberty! End the Fed!

Truman's Steel-Mill Seizure

Fifty-seven years ago today, on April 8th, 1952, President Truman ordered his Secretary of Commerce to seize the nation’s steel mills, ostensibly due to a strike that threatened national security. The nation was fighting a "police action" in Korea at the time and the war was not going well. The United Steel Workers went on strike and America’s steel industry came to a halt. This was President Truman’s very vague justification for his seizure. The industry took the president to court and won, but the case was decided on such narrow grounds that no general precedence was established. This is the story that most historians understand.

But a larger story exists. It is the story of unintended adverse consequences that stem from a trail of government interventions that are not found in the Constitution. This is a common theme that reverberates to an even greater extent today, for today we are witnessing an interventionist government that seems to know no legal bounds to its exercise of power for the most specious of reasons.

The real story and the real lesson is that when property rights have once been violated, there is no end to the trouble that ensues and no real satisfactory answer that will end the controversy. When the principle of the sanctity of property has been violated, we are reduced to the pure exercise of power rather than the rule of law to determine right and wrong.

The early twentieth century saw the rise of militant labor unions. Now there is nothing wrong with men organizing to form a union of workers for the purpose of offering their labor en mass to employers. But the law should not require any employer to recognize or negotiate with such a union.

As it says in the famous passage from the Declaration of Independence, which was borrowed form the 17th century philosopher John Locke: "All men are endowed by their Creator with life, liberty, and the pursuit of happiness." An 1850 book by Frederic Bastiat, titled The Law, gives the clearest and simplest explanation of this phrase. Bastiat contends that we own ourselves and the definition of "ourselves" must extend to include our property, for without property we cannot survive and, therefore, will be reduced to slavery.

But the Orwellian-named "Progressive Movement" weakened the sanctity of both self-ownership and property ownership. Included in its poisonous philosophy was the idea that labor unions had a right to force workers to become members and to force employers to contract for labor exclusively through the union. The Depression era "National Labor Relations Act" of 1934 (Wagner Act) created a means for sympathetic politicians and courts to defend unions’ forceful occupations of factories with violence to the owners and non-union workers. This law exacerbated union violence and labor unrest during the Great Depression.

The act ignored the fact that labor and capital have harmonies of interest and will tend to resolve differences peacefully as long as property rights are not violated. This means that men may offer their services individually or via a union and that the owners may employ labor either individually, through a union, or through some combination of both. The competitive market place ensures that owners pay the workers according to the value of the skill they bring to the work place. This same market ensures that the owners are not forced to deal with a legally protected and uncompetitive labor force. But the Wagner Act intervened in this basically peaceful and fruitful process.

The Wagner Act had been passed during the Depression by a Democratic Congress and signed into law by a Democratic president-FDR. After the war, a Republican Congress sought an end to labor violence and unrest, but instead of simply repealing the Wagner Act and taking measures to restore the rule of law to its rightful place as protector of property rights—which includes the right NOT to belong to a labor union plus the right NOT to negotiate with one—the Republicans passed the "Labor Management Relations Act" of 1947 (Taft-Hartley) over the veto of another Democratic president-Harry S. Truman. Taft-Hartley gave Congress the power to force workers to continue on the job AFTER their contract had expired. In other words, the union would not be allowed to strike as long as Taft-Hartley had been invoked. Labor rightly saw this as slave labor and called it so.

This is the state of things even today. Whereas the market would tend to resolve labor disputes in a peaceful manner, due to the inherent harmony of interests between labor and capital, conflicting laws perpetuate and aggravate labor strife. It seems to be a law of nature that one bad law generates a second bad law that generates a third bad law…on infinitum. Without first the Wagner Act, that attempted to side with unions, and then Taft-Hartley, that attempted to deal harshly with unions, there would have been less labor strife overall and possibly no labor strife during the Korean War that spurred HST to seize the mills. What is so complicated about protecting life, liberty, and property?

Stealing a Nation

Bloomberg News reported earlier this week that it had calculated the total spending promised by the Obama administration to date as equaling the nation’s gross national product for one entire year—around $13 trillion. The public has grown inured to daily reports of massive spending programs and the administration’s fear mongering that the world will come to an end—or rather the cushy jobs of its friends on Wall Street will come to an end—unless our government spends and inflates on a scale that has never before been attempted. Ah, all the more reason to admire us, their propagandists proclaim, for the boldness of our actions in the face of such a calamity.

Yes, a calamity is approaching. It is the calamity brought about by reckless spending of the nation’s wealth in pursuit of the unattainable. There is no way that the trillions of dollars of malinvestment of the last few years can be pulled back out of the sinkhole. The money is gone. There is no way to get it back. What the Obama administration is doing is trying to make everyone pay for this massive loss when the proper, legal, ethical policy should be to ensure that those involved accept their losses like men (which may include many reading this essay plus the author himself).

It is redundant of me to point out to readers of my essays that none of the Obama administration’s plans would be possible without the ability of the Federal Reserve Bank to inflate the money supply and steal from us via reducing the purchasing power of the dollar. Without a central bank the government would be required to adopt some combination of taxes and borrowing to launch any bailout and stimulus plans. The nation might accept some small measures, but it would never accept measures that would require it to toil for one full year as a slave of the government.

This is the great evil that a central bank makes possible—the theft of a nation’s wealth. Gone forever is the pretense that the central bank is an independent agency that guards our money from the predation of plundering politicians aligned with powerful interest groups. The citizens of the United States should demand an end to the Fed and an end to this administration’s plans to steal our wealth.

Hold no illusions. The administration’s plans to rescue the American economy will not work. Our government cannot turn back the clock and pretend as if millions of homes had not been built at a loss rather than a profit. The damage has been done and now the insane pretensions of megalomaniacs must stop before even more damage is done—damage that even the great American people cannot repair in a generation. Criminals who claim no more right to their actions than that they won an election and/or were appointed to a government job are plundering our nation. They are our servants and not our masters. They certainly are not entitled by any law to rob us of all our wealth and destroy our liberties in the futile attempt to hold back the tide or paper over losses borne by their friends on Wall Street. This plunder, this theft, this illegality must stop!

A Drop in the Price of Oil Is a Good Thing

Unless one were a speculator in oil betting that its cost would rise, the fall of the price of any commodity is a blessing to mankind. The fall in the price of oil will help spur the economic recovery by lowering our cost of living; that is, our gasoline bills will be lower, providing funds for other necessities or enabling us to pay of debt or increase savings. Furthermore, oil is a vital component of American industry, so its reduced price will help business recover, too. This is the normal way that economies heal themselves, not from gigantic governmental spending programs, bailouts of failed industries or running the central bank’s money printing presses at full tilt.