The Fraud in Fractional Reserve Banking
Politics / Central Banks Nov 26, 2014 - 02:13 PM GMTBy: Frank_Hollenbeck
Suppose you bring a fur coat to a dry cleaner, and discover that the owner allowed his wife to wear it before cleaning it (which is also the subject of an episode from Seinfeld). Or, suppose you gave your car keys to a hotel valet and, when attempting to pick up the car later, were told your automobile was lent to teenagers who took it for a joy ride while you slept at the hotel. You would not be too happy, and for good reason. When you surrendered your clothes or your car keys it was a bailment. You retained ownership and gave the clothes or car keys for safekeeping. In no shape or form, did you surrender ownership of the items or lend out your property.
Suppose you lived in the 18th century and had 100 ounces of gold. It’s heavy and you do not live in a safe neighborhood, so you decide to bring it to a goldsmith for safekeeping. In exchange for this gold, the goldsmith gives you ten tickets where each is clearly marked as claims against 10 ounces. Now, gold is heavy and burdensome to carry, so in a short period of time, those claims will start circulating in place of gold. This is the creation of near monies. This doesn’t mean you have given up your ownership claims on gold, but have used a simpler way of transferring ownership of this gold.
Of course, now the gold just sits in the vault, and no one usually comes to get some of it or even check that it is still there. Quickly the goldsmith realizes there is an easy, fraudulent, way to get rich: just lend out the gold to someone else by creating another 10 tickets. Since the tickets are rarely redeemed, the goldsmith figures he can run this scam for a very long time. Of course, it is not his gold, but since it is in his vault, he can act as though it is his money to use. This is fractional reserve banking with a voluntary reserve requirement of 50%. Today, modern US banks have a reserve requirement of between 0% and 10%. This is also how the banking system can create money out of thin air, or basically counterfeit money, and steal the purchasing power from others without actually having to produce real goods and services.
Now the goldsmith, or what we will now call a bank, is limited in the amount of fraud or counterfeiting it can commit. Imagine a bank has 100 ounces of gold but outstanding claims on 200 ounces of gold. The bank has to keep a certain amount of gold in its vaults since depositors on occasion will exchange tickets for gold. Another constraint is that depositors, if they get suspicious that there are more claims than available gold, may run to the bank demanding to redeem their “on demand” claims into gold. This run, really reflects the totally fraudulent nature of banking. Banking holidays, implemented in the 30’s, or capital controls, implemented in Cyprus recently, are actions to benefit the fraudster (the banks) instead of the victim (the depositors). The world has been turned on its head.
Suppose you are the goldsmith and your rich uncle promises to lend you as much gold as you need if you happen to run out – what could be considered a central bank’s lender of last resort function. Are you likely to commit more or less fraud? Suppose this rich uncle tells you that if things go bad, he will make sure everyone get their gold back (deposit insurance). Again, are you likely to commit more or less fraud? And since you have no skin in the game, are you likely to take even more risks, for higher returns, in your lending activities?
Austrian economists typically have a hard time explaining why fractional reserve banking is fraud. The standard response from the average Joe is “everyone knows that the bank loans out your money.” Or, they will say “all banks in the U.S. include a clause in the depositors’ contract that specifically says that the relationship between the depositor and the bank is exclusively one of creditor and debtor”. Suppose the bank takes your money and loses it all. How does the bank satisfy your expectation that the money is there on demand to pay your rent and electricity bills? It’s simple. They take the money from someone else. If the bank had told you it is lost and unfortunate, there would be no fraud. The fraud occurs the minute the bank takes someone else’s money. The victim of the fraud is the other depositor. The bank runs a Ponzi scheme (a fraudulent activity) that can continue for a very, very long time, but is no less a Ponzi scheme and should be treated as such. Although, you and the bank may be well aware of what is going on, it still should be treated as fraud. The fact that you are aware, or even unaware, of the Ponzi scheme does not diminish the fraud. Government deposit insurance just shifts the ultimate cost of the fraud to other depositors, taxpayers or anyone using currency to conduct transactions.
Why is counterfeiting illegal? The counterfeiter is happy since he gets real goods and services, and the store owner is happy since he made a sale and can also get more real goods and services if he spends the money quickly before prices go up. So where is the problem? The transaction has been beneficial to both. It is illegal because of third party effects. The counterfeiter takes from the economic pie but does not contribute to the economic pie. He has basically stolen real goods and services by reducing the purchasing power of the money in everyone else’s wallets. When the fractional reserve banking system creates money out of thin air, it is also a form of counterfeiting, and has undesirable third party effects. Economists know that it is the rapid expansion of money and credit, unjustified by the growth of slow moving savings, that have created the booms and busts of the last two centuries, and the hardships that have gone along with them.
Eliminate fractional reserve banking and you eliminate most booms and busts. Unable to create money out of thin air, banking would now just be another sector without the ability to sink the entire world economy.
We need to start a serious discussion about ending fractional reserve banking and central banking at the same time. Our current banking system is not free market capitalism. Banking in its current form should be outlawed because it is both fraud and theft. We have a duty to our children to leave them with an economic system that is not constantly swinging from booms to busts. A system that is stable filled with opportunities that only a true capitalist system can provide.
Frank Hollenbeck teaches finance and economics at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and as an Associate Director of a Swiss private bank. See Frank Hollenbeck's article archives.
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