Monday, April 27, 2009

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.


  1. This is an excellent post and enlightening info.

    Here is the big question: living in the US of A, what can I do with this information to make the banking system better? How does one person effect change?

    I already don't use any US banks, or credit cards, I try to use Digital Gold as much as possible.

    What can the everyday Joe do to advance sound money is his everyday life? Should he close his bank account? What are the alternatives if this occurs? Should he hold gold in his house?

    Each day I read excellent articles on banking, how this or that is bad but I never get solutions. You are preaching to the choir here......No one tells me an alternative that I can use today. I get a lot of theories and thoughts but then I suspect the person who wrote the piece just goes back to buying his groceries with a plastic card and direct depositing his checks into a no interest local checking account. If you don't work each day for a solution, if you just preach, you advancing the problem.

    Do you walk the walk? Give me everyday solutions not theory.

    Mark Herpel

  2. Our elected representatives in the U.S. Congress possess neither the understanding of history or economic theory to think these matters through. And, even if they did, they will not sacrifice the campaign contributions they receive from bank executives and their PACs to establish sound banking as you propose.

    The second Great Depression is here, and only a handful of economists have recognized its cause: credit-fueled speculation in the property and stock markets. The absence of effective oversight of the financial markets allowed for massive fraud to occur, throwing even more accelerant on an already glowing fire.

    I have no idea what it will take to get politicans to act in the common interest rather than in the vested interests of those who pay to have them elected and re-elected again and again. A constitutional amendment setting term limits would help as a necessary first step!

  3. There is one huge problem with the above proposal: the total amount of gold in the world is a minute fraction of the total amount of money that people and businesses need to do business.