REAL FINANCIAL REFORM

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.

A Quick Lesson In Understanding the Fed

My students at the University of Iowa must understand how the Fed operates. We study books and articles by great Austrian economists, such as The Mystery of Banking by Murray N. Rothbard. Even though Professor Rothbard presents his subject in about as clear and concise terms as one can imagine, it takes some serious application of one’s time and energy to comprehend all that the Fed does and how it does it. It then takes even more time and energy to comprehend the Fed’s impact on the economy to arrive at a conclusion that is greatly at odds with mainstream economists. Mainstream economists revere the Fed as the “All-wise, All-knowing Great Oz” that stabilizes the economy, prevents depressions, ensures full employment, etc. And, they have formulas and econometric models to prove it! By contrast we Rothbardian Austrians conclude that the Fed causes the boom/bust business cycle by expanding the money supply and encouraging malinvestment that must later be liquidated. This is known as the Austrian theory of the business cycle. After studying the Fed’s operation, students dive into the study of this equally serious and time-consuming subject.

The Fed as a Monopoly Counterfeiter

Well, I have come up with a much simpler way to understand what the Fed does and its impact on the economy. There are no books to read or equations to memorize. Simply think of the Fed as a counterfeiter, but a very special kind of counterfeiter. Real counterfeiters operate in secrecy, knowing that their paper money amounts to theft and that their discovery would result in jail time. Printing money does not create a resource; it merely redistributes it. But, curiously, the Fed does the same thing and, except for us Austrians, engenders great respect from both the citizens and the government. Unlike a real counterfeiter, the Fed operates in the light of day. It has nothing to fear, because it has a legal monopoly on its counterfeiting activities. This makes all the difference and makes it easy to explain its operation.

The Police Power of the State Protects the Fed…for a Price

The Fed is the only entity that is allowed to manufacture money in America. The full police power of the federal government ensures its monopoly. The federal government forces everyone in America to use the Fed’s product—the dollar—for all monetary transactions. Even if we agree with one another to use some more desirable money, such as the yuan or the Euro, we are prevented from doings so under penalty of law. Furthermore, if we refuse to accept the dollar to satisfy a debt, the debtor is released from his obligation ever to pay us! This state-enforced monetary regime is known as “legal tender law”.

Holding the monopoly of money production in America makes the Fed a very popular entity, to say the least. As a semi-independent agency, the Fed can print money in just about any amount it wishes and can give it to just about anyone it wishes. But it gives most of its money production to the government itself, and it is not hard to understand why. A symbiotic relationship exists between the Fed and the federal government. Each gives the other something that it cannot have on its own. As already mentioned, the Fed gets protection from the federal government for its monopoly counterfeiting operation. Without this protection Gresham’s law would operate to drive the Fed’s fiat currency out of circulation; i.e., no one would want to use a currency that lacks intrinsic value.

But the Fed has the full coercive power of the federal government to force the dollar upon us, because the federal government gets an equally important benefit. It gets as much newly manufactured money as it requires, without going to the people via taxation or honest borrowing. When the government must appeal to the people for the money it wishes to spend, its insatiable appetite for spending meets the reality of the marketplace. There is only so much that the government can tax and/or borrow before the people either revolt or are driven to destitution and have nothing more to give up. But when the federal government can “sell” its debt to the Fed and receive as many dollars as it desires…and its desire is unlimited…it need not appeal to the people at all!

“Shill” Economists Provide Theoretical Cover

The economics profession should be solidly against this well-known scam, as Dr. Mark Thornton, Senior Fellow at the Ludwig von Mises Institute, calls it. But Dr. Thornton has discovered why so many economists and academic publishers support this legalized theft—they are on the payroll, literally! As Dr. Thornton explained at this year’s Rothbard Memorial Lecture, held in March at the Mises Institute, both get lucrative grants to produce and publish monetary studies for the Fed, and their Keynesian outlook provides amply scope for research into the arcania of fiat money. To quote Dr. Thornton, “…government money dominates the whole process.” Like the priestly class who supported the divine right of kings in days of old, academics and publishers receive support and public recognition from the state in return for providing theoretical justification for the state’s parasitic activities. As the bought-and-paid-for shills of the Fed itself, this group provides the third leg of support for this grand-theft-auto of a system.

So don’t be impressed with all the theater of complicated sounding Fed programs that authorize the Fed to buy this asset or that asset or lend to this bank or that insurance company. These are simply the huckster’s sales pitches for disguising the Fed’s real operation—manufacturing money for the federal government in exchange for the government’s protection of its counterfeiting operation. This evil, destructive relationship is the most ingenious method ever devised for fleecing the people of their wealth and, eventually, destroying our society.

My Letter to the Wall Street Journal re: China Revalues the Yuan

Re: China's Yuan Rises to Highest Level Against the Dollar in Modern Era

Dear Sirs:
I cannot impress strongly enough upon your readers my recommendation that they read Murray N. Rothbard's The Mystery of Banking. Rothbard explains in capsulized form the means by which our central bank, the Fed, has created the conditions for a much higher price level in America (what most people wrongly call "inflation"). There is no way to stop this process now, because the Fed is intent upon reflating the economy, which is short-hand for destroying the purchasing power of the dollar by printing massive amounts of money. Why will it do this? Because it is the only way the government itself can repay its debts, at least in dollar terms. China now understands this. It has moved from confidence in the dollar to loss of confidence in the dollar. Therefore, it will reduce its dollar holdings by repatriating them to the US. Other nations will follow. This will increase our DOMESTIC money supply and push prices much higher. Do not believe that anyone is the cause of this other than our own government. We are about to reap the wages of a half century of money inflation.

Patrick Barron

My Letter to National Review--Abolish the FDIC

From: patrickbarron@msn.com
To: letters@nationalreview.com
Subject: Abolish the FDIC
Date: Thu, 3 Jun 2010 11:05:44 -0400

Re: Shadow Bailouts by Kevin D. Williamson

Dear Sirs:
In his May 17 essay titled "Shadow Bailouts" Kevin D. Williamson has exposed the real purpose of the Dodd bill--to socialize credit via the institutionalization of bailouts as a normal government practice. As a consequence moral hazard will reign unrestrained. The resulting chaos will reinforce government's claim that only it can prevent the complete breakdown of the nation's credit system. For this explanation Mr. Williamson deserves our hearty thanks. However, although Mr. Williamson may see clearly into the future, it is his view of the past with which I take a very small and polite issue. To quote from his essay...


"We don't mind bailing out ma-and-pa depositors when a bank goes feet-up, because keeping those depositors guaranteed adds greatly to the stability of the banking system and the economy, encouraging savings and capital formation, and does so at a remarkably low cost to the nation."


Well, we should mind bailing out ma-and-pa depositors, because that is the foundation upon which government is taking over the entire banking system. If there are natural laws of government, one of them must surely be that no government program remains small. Like a cancer it expands until it consumes the host body. The depression-era FDIC is a case in point. At one time only small depositors were guaranteed. But now we find that this guarantee, via the logic of a natural law of government, must be extended to Wall Street millionaires. A more clear-eyed assessment of the FDIC and its purported guarantee would reveal that it is not an insurance program at all. The only way a deposit can be guaranteed is for the banker to hold standard money in sufficient quantity to honor all deposits one hundred percent. Once the deposit has been lent, there can be no guarantee, for to do so would be to guarantee that all loans would be repaid in full with interest. This is impossible. A free and honest banking system would carefully delineate between a deposit, for which the bank retained one hundred percent standard money, and an investment, which would be lent to worthy borrowers chosen by the banker. The investments would be repaid either by the maturing loans or by the banker's capital itself. When loan losses exceed the banker's capital, the bank fails and the investors become general creditors.

Now, some may say that this is terrible, and it is. But in a free market, incompetent bankers would be driven from the market and would never regain their positions. Would you continue to employ a plumber or a roofer who can't fix a leak? It happens, but their incompetence becomes known rather quickly and they are driven from the market. The same with bankers. Incompetent bankers with low capital reserves would find few customers and would be driven from the market. Bankers with better judgement and larger capital accounts would survive.

Banking is a competitive, market-driven business like any other. Our problem is not that the FDIC has been expanded too far but that it was enacted in the first place.

Patrick Barron
20 McMullan Farm Lane
West Chester, PA 19382
Phone: 610-793-3605
www.patrickbarron.blogspot.com

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.