Saturday, July 17, 2010


So Congress has finally passed its much-anticipated reform of the financial system. Like all modern pieces of legislation, it supposedly fixes a problem created by the free market but it actually is a problem that government itself caused. Its main tenets are pure demagoguery and would have the public believe that bankers are brainless. For instance, it proclaims that lenders must do sufficient due diligence to satisfy regulators that the borrower can pay back the loan. Wow! Now, who in the banking industry would ever have thought of that?

There is not sufficient space in an essay of this kind to explain all the easily identifiable adverse consequences let alone the likely unintended adverse consequences of this horrible legislation. Instead I will explain what real financial reform would look like. Now if you show this essay to most politicians or government bureaucrats, make sure they are sitting down, because my reform relies entirely upon the free market. Government’s role is restricted solely to the defense of property rights.

End Fractional Reserve Banking

Fractional reserve banking is the underlying problem. By allowing banks to hold fractional reserves, rather than requiring 100% reserves, more than one person has claim upon the same asset. Since the claims are identical--both owners hold dollars that must be honored “for all debts public and private”, according to our legal tender laws--eventually the market recognizes that there are not enough resources to complete the entrepreneurial projects that were started by the initial and sustained injection of new fiduciary media. This is the nickel explanation of the boom/bust business cycle. So, number one, the government must prohibit and prosecute the fraud of fractional reserve banking. This means that the only way the money supply can grow is by way of the entrepreneurial production of more standard money; i.e., gold or silver.

Deposit Banks and Loan Banks

A common confusion that emanates from our current fractional reserve banking system, especially with the Fed as lender of last resort and the FDIC as guarantor of bank deposits, is how banks would be able to loan money at all if required to maintain 100% reserves on one’s deposit. How can they lend out the money without committing fraud? Murray N. Rothbard offers the simplest explanation in The Mystery of Banking. Divide banking into deposit banks and loan banks. Only deposit banks must maintain 100% reserves.

Here’s how I explain it to my students at the University of Iowa. Suppose that over the summer each one of them earns money and places it in the deposit bank. Since the deposit bank must keep 100% reserves, there is no way that the bank can earn money to cover its operating expenses except by charging fees for its services. After a few weeks the student has built up a balance in his deposit account that exceeds his immediate spending needs. In other words, he has accumulated enough that he can SAVE in order to spend at some later time. Therefore, he writes a check against his deposit account and gives it to a loan banker. The deposit will carry a maturity date, exactly like today’s certificates of deposit. Next the loan banker will seek worthy borrowers for our student’s money. If the student wanted to give the banker his money for a short period of time, say three months, the banker would seek borrowers who wished to finance inventory accumulation or accounts receivable financing, for example, which liquidate fairly quickly. If the student felt that he could invest his savings for a much longer period of time in order to earn a higher rate of interest, he might buy a five-year certificate of deposit. Then the banker would find borrowing needs that correspond to this time frame, perhaps financing the construction of a factory. The interest rate is the mechanism that regulates the loan market. If depositors are short term oriented, businessmen cannot finance long term projects. If the depositors are more long term oriented, then these projects may become financially sound. In Austrian economics we call the depositor’s relative orientation to the shorter or longer term as his “time preference”.

The Impossibility of a Boom/Bust Business Cycle

Notice that no matter what the depositor’s time preference he gives up his ability to spend for some defined period of time. His standard money has been moved from his deposit bank to the loan bank for further transfer to a borrower. Eventually the borrower pays back the loan and the loan bank has funds to honor the depositor’s matured time deposit. At no time was more than one person claiming the right to spend the money; therefore, there is no way that two people can claim the same physical asset. No projects will be started for which there are inadequate resources for their completion. A boom/bust business cycle is impossible under such circumstances.

The Role of the Loan Banker’s Capital Account

Notice that the depositor understands perfectly that his savings is at risk. If he did not wish to risk his savings, he could hold standard money certificates (paper claims upon real money—gold or silver—held in the banker’s vault), a book entry on the deposit banker’s records—a checking account--, or the physical gold or silver itself. As long as the government prosecutes fractional reserve banking as fraud, there is no risk that the depositor will lose his money, because he holds an audited claim upon the physical money itself. But what about the saver who deposits his money with the loan banker? What guarantee does he have that he will get his money back, with interest, when the time deposit matures? This is where the banker’s capital account and, just as importantly, his reputation for probity enter the picture.

The higher the percentage of the loan banker’s capital account to his loans outstanding, the safer are his depositors’ funds. The safest loan bank would be one in which the banker’s capital account EXCEEDS his deposit obligations. Let us assume that Mr. Rockefeller capitalizes his new loan bank with $10 million and will accept savings deposits up to only $5 million. Let us assume that Mr. Rockefeller invests his $10 million in very safe short term Treasury bills. He accepts $5 million from savers and finds borrowers who will pay enough to cover Mr. Rockefeller’s interest expense to his depositors, his operating expenses, and a small provision for future loan losses. The excess of his interest revenue, obtained from his borrowers, over these three expense categories is his profit. One can see that, even if he lost all $5 million of his depositors’ money, his capital account will cover the loss by a factor of two! As time goes by and the market realizes that Mr. Rockefeller is a good banker, who suffers very few loan losses, they will be willing to accept that the capital account may be a smaller percentage of the loans outstanding. Mr. Rockefeller may accept (and the public will decide to deposit) MORE than his capital account can cover. This is NOT fractional reserve banking, since there still is only one claim upon each dollar. But let us say that Mr. Rockefeller now takes deposits up to $20 million. Now he can suffer a loss of half of his loans and still be able to meet his depositors’ claims out of his $10 million capital account.

One can see that the interest rate offered by Mr. Rockefeller and accepted by his depositors will be influenced by how safe is Mr. Rockefeller’s bank, as exemplified by his capital account and his history of sound lending. The market will have room for many lenders, each with varying percentages of capital to loans and different histories of banking success. Poorly capitalized loan banks with bad loan histories will fail to attract depositors and will be taken over by better bankers. Since there is nothing to trigger the destructive boom/bust business cycle, bad loans will be very few and loan banking will be safer than our current FDIC insured system, in which moral hazard has been institutionalized by bailouts of failed Go-Go, risky bankers.

This is not to say that a bank could not suffer loan losses in excess of its capital account, but there would be no systematic reason for widespread bank failures, as is the case now with inflationary fractional reserve banking. The unprofitable bank would attempt to liquidate before running its capital account dry; therefore, it probably would still meet its depositors’ matured time deposit claims. In other words, loan bankers might go out of business but most likely they would pay off their depositors out of what remained of their capital accounts before closing their doors. They would act out of simple self-interest to preserve as much of their capital as possible.

The only role for government in such a free market banking system is to ensure that deposit banks do not violate their requirement to keep 100% reserves. Government would have no role whatsoever in regulating or examining the loan banks. The army of regulators armed with thousands of pages of regulations would not be needed…the free market would regulate banking the same way it regulates the availability and price of any other product. The era of the boom/bust business cycle would be a thing of the past. The only barrier to this simple, common sense, free market system is the hubris of government that it can regulate banking better than the unhampered forces of the free market.

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