Deadly Duo: Fiat Money and Fractional Reserve Banking

The government propaganda machine is in full swing. It denounces bankers for making bad loans. It proposes more numerous and more onerous regulations in addition to increasing the bureaucracy to implement them. The message is that the free enterprise banking system itself is to blame, that without government regulation there is nothing to prevent bankers from looting their depositors’ money in order to line their own pockets. Bankers make loans that they KNOW will not be repaid and cannot be repaid, all the while paying themselves enormous salaries and bonuses. When the house of cards comes crashing down, the bankers give the bill to the government and the taxpayers.

All the above is a lie.

The fact is that this current crisis, as with all previous crises in the past one hundred years, was caused by government interference in the financial markets. Specifically it is government’s creation of fiat money-- money backed by no commodity; that is, nothing of intrinsic value—that is primarily responsible for our economic problems. This money has two sources—the Fed’s printing press and bank credit expansion. This “deadly duo” touches off the boom/bust business cycle. This business cycle is not something inherent in capitalism. A commodity based money and a legal prohibition against bank credit expansion will end these vicious, wealth destroying and, ultimately, liberty destroying economic crises.

Money is as much a moral as an economic good. Real money is part and parcel of the market economy. It originates as a widely accepted commodity that comes to be used, through the market process, as indirect exchange. As such, its value increases beyond demand for its intrinsic use to include a new demand as something to be exchanged later for some other good. Thusly, real money facilitates the exchange of “something for something”. This is its moral component. But fiat money—that is, money manufactured by the government and backed by nothing—always enters the monetary system as a counterfeit “something for nothing”. There are two corrupt sources of this counterfeit evil.

The first evil source is Federal Reserve monetization of the government’s debt, meaning that the Fed buys government bonds with money that it creates out of thin air. Government itself benefits directly, when, for example, it pays bureaucratic salaries, buys goods and services, and when it rewards its constituents, such as political contributors and voters, through earmarked targeted spending. The first recipients of this new money can purchase goods at the current lower price. Subsequent recipients pay higher prices, because the supply of money increased and pushed up the price level.

Furthermore, this money creates even more money via the “fractional reserve” banking system. Recipients of government spending deposit the checks into their bank accounts; then their banks deposit the checks with the Fed. Bank reserves increase, and banks are allowed to pyramid around ten times the amount of the new and excessive reserves into new loans. These new loans are matched, dollar for dollar, with an increase in the money supply, because banks lend money by crediting the borrower’s checking account. The borrowers spend the money, of course—that is why they borrowed it in the first place. Thusly, bank credit expansion creates new money based upon DEBT. We shall see shortly how fragile this system can be.

Thus far, bank credit expansion has triggered a boom. New projects are started, because the increased quantity of money lowers the interest rate, making long term projects—those for which the cost of funds is most important—now appear to be feasible. Factories expand, mines open, etc., all of which may take years before bearing any real fruit. The problem is that the consumer has not changed his spending habits. He has NOT decided to save more. He purchases immediate, consumer-type goods in the same relationship to his savings as before. In fact the boom may prompt him actually to increase his consumption-to-savings ratio. Therefore, there is no new capital for the successful and profitable completion of these longer-term projects, so these “malinvestments” must be abandoned. Since the projects are abandoned, they never generate revenue for paying off their bank loans. As loans default, the money supply drops, because a large component of the malinvestment was funded by loan generation--when the loans fail, the money disappears.

Now the banks are in trouble. Their capital is reduced dollar for dollar by the loan defaults. It is foolish to ask them to resume lending, because their capital-to-asset ratio is so low. They must build capital before they can begin lending again. But this is not the worst consequence of building the money supply out of debt. The reduction of the money supply reduces overall spending in the economy. This impacts even businesses that did not expand and that previously were healthy and profitable. Their revenue decreases too, driving them to unprofitability. The total amount of goods and services in the economy cannot be sold with this lower volume of spending UNLESS PRICES DROP. Therefore, it is crucial that government do nothing to prevent prices, including the price of labor, from falling. Only a lower price level can bring the economy’s supply of goods and services into equilibrium with less money. As Professor George Reisman of Pepperdine University has explained, falling prices are the antidote to deflation (where “deflation” is defined as a fall in the supply of money).

Perversely, the government recently raised the minimum wage and gave Fannie Mae and Freddie Mac its UNLIMITED guarantee!

Government’s current attempts to prop up prices are doomed to failure. Supply can clear only at lower prices. The malinvestment, especially in housing, must be allowed to liquidate on as good terms as current owners, mostly developers, can get. There is an excessive supply of housing in the economy in relation to other necessary goods. Reports of government efforts to “revive housing” are indications that government is thwarting the necessary correction via its many bailout programs. A more encouraging report would be that the price of housing is falling precipitously. This would be welcome news to all seeking housing—don’t we all love a sale?

We are doomed to repeat these boom and bust cycles, probably with even greater intensity due to government’s foolish interventions, as long as government can print money out of thin air and banks can create even more money out of debt. No regulations can prevent this cycle. In fact some government agencies, such as Fannie Mae and Freddie Mac, are trying to rekindle the boom while other government agencies, such as bank regulators, claim that they can so regulate bank lending to prevent any future malinvestment. This is impossible. The problem lies in the very nature of the monetary system, which sends false signals to bankers and bank regulators alike, inducing them to fuel another unsustainable boom. Money is lent on the cheap to precipitate projects for which no real new capital exists. This money built on debt will vanish as it has in the past, wiping out the hopes and dreams of tens of millions. The lower quantity of money means that total spending will be inadequate to clear the production side of the economy at current, boom-induced high prices. Yet, even though lower prices are the only cure, government and organized labor fight this cure tooth and nail.

The answer lies in driving a stake through the heart of this deadly duo. First of all, return to commodity money, most likely gold. Gold money can be neither created nor destroyed. Once brought into circulation, gold money remains in circulation. Total spending remains the same; only prices change—usually downward, based upon productivity gains—very gradually over time. Next, prohibit banks from engaging in fractional reserve banking. All money must be backed one hundred percent by gold. Loans must be based upon the transfer of gold from saver to borrower via a professional banking system, which exacts a small profit for its intermediation services.

There is no role for government in this system beyond insuring that banks do not engage in fraud by lending out more money than they have gold on deposit. Government should not insure deposits or regulate lending in any way. There is no role for a central bank in this system either. This is laissez faire banking based upon market generated money. This is freedom. This is the cure.