Fractional Reserve Banking
by
Murray
N. Rothbard
We have
already described one part of the contemporary flight from sound,
free market money to statized and inflated money: the abolition
of the gold standard by Franklin Roosevelt in 1933, and the substitution
of fiat paper tickets by the Federal Reserve as our "monetary standard."
Another crucial part of this process was the federal cartelization
of the nation's banks through the creation of the Federal Reserve
System in 1913.
Banking is a particularly arcane part of the economic system; one
of the problems is that the word "bank" covers many different activities,
with very different implications. During the Renaissance era, the
Medicis in Italy and the Fuggers in Germany, were "bankers"; their
banking, however, was not only private but also began at least as
a legitimate, non-inflationary, and highly productive activity.
Essentially, these were "merchant-bankers," who started as prominent
merchants. In the course of their trade, the merchants began to
extend credit to their customers, and in the case of these great
banking families, the credit or "banking" part of their operations
eventually overshadowed their mercantile activities. These firms
lent money out of their own profits and savings, and earned interest
from the loans. Hence, they were channels for the productive investment
of their own savings.
To the extent that banks lend their own savings, or mobilize the
savings of others, their activities are productive and unexceptionable.
Even in our current commercial banking system, if I buy a $10,000
CD ("certificate of deposit") redeemable in six months, earning
a certain fixed interest return, I am taking my savings and lending
it to a bank, which in turn lends it out at a higher interest rate,
the differential being the bank's earnings for the function of channeling
savings into the hands of credit-worthy or productive borrowers.
There is no problem with this process.
The same is even true of the great "investment banking" houses,
which developed as industrial capitalism flowered in the nineteenth
century. Investment bankers would take their own capital, or capital
invested or loaned by others, to underwrite corporations gathering
capital by selling securities to stockholders and creditors. The
problem with the investment bankers is that one of their major fields
of investment was the underwriting of government bonds, which plunged
them hip-deep into politics, giving them a powerful incentive for
pressuring and manipulating governments, so that taxes would be
levied to pay off their and their clients' government bonds. Hence,
the powerful and baleful political influence of investment bankers
in the nineteenth and twentieth centuries: in particular, the Rothschilds
in Western Europe, and Jay Cooke and the House of Morgan in the
United States.
By the late nineteenth century, the Morgans took the lead in trying
to pressure the U.S. government to cartelize industries they were
interested in – first railroads and then manufacturing: to
protect these industries from the winds of free competition, and
to use the power of government to enable these industries to restrict
production and raise prices.
In particular, the investment bankers acted as a ginger group to
work for the cartelization of commercial banks. To some extent,
commercial bankers lend out their own capital and money acquired
by CDs. But most commercial banking is "deposit banking" based on
a gigantic scam: the idea, which most depositors believe, that their
money is down at the bank, ready to be redeemed in cash at any time.
If Jim has a checking account of $1,000 at a local bank, Jim knows
that this is a "demand deposit," that is, that the bank pledges
to pay him $1,000 in cash, on demand, anytime he wishes to "get
his money out." Naturally, the Jims of this world are convinced
that their money is safely there, in the bank, for them to take
out at any time. Hence, they think of their checking account as
equivalent to a warehouse receipt. If they put a chair in a warehouse
before going on a trip, they expect to get the chair back whenever
they present the receipt. Unfortunately, while banks depend on the
warehouse analogy, the depositors are systematically deluded. Their
money ain't there.
An honest warehouse makes sure that the goods entrusted to its care
are there, in its storeroom or vault. But banks operate very differently,
at least since the days of such deposit banks as the Banks of Amsterdam
and Hamburg in the seventeenth century, which indeed acted as warehouses
and backed all of their receipts fully by the assets deposited,
e.g., gold and silver. This honest deposit or "giro" banking is
called "100 percent reserve" banking. Ever since, banks have habitually
created warehouse receipts (originally bank notes and now deposits)
out of thin air. Essentially, they are counterfeiters of fake warehouse-receipts
to cash or standard money, which circulate as if they were genuine,
fullybacked notes or checking accounts. Banks make money by literally
creating money out of thin air, nowadays exclusively deposits rather
than bank notes. This sort of swindling or counterfeiting is dignified
by the term "fractional-reserve banking," which means that bank
deposits are backed by only a small fraction of the cash they promise
to have at hand and redeem. (Right now, in the United States, this
minimum fraction is fixed by the Federal Reserve System at 10 percent.)
Fractional Reserve Banking
Let's see how the fractional reserve process works, in the absence
of a central bank. I set up a Rothbard Bank, and invest $1,000 of
cash (whether gold or government paper does not matter here). Then
I "lend out" $10,000 to someone, either for consumer spending or
to invest in his business. How can I "lend out" far more than I
have? Ahh, that's the magic of the "fraction" in the fractional
reserve. I simply open up a checking account of $10,000 which I
am happy to lend to Mr. Jones. Why does Jones borrow from me? Well,
for one thing, I can charge a lower rate of interest than savers
would. I don't have to save up the money myself, but simply can
counterfeit it out of thin air. (In the nineteenth century, I would
have been able to issue bank notes, but the Federal Reserve now
monopolizes note issues.) Since demand deposits at the Rothbard
Bank function as equivalent to cash, the nation's money supply has
just, by magic, increased by $10,000. The inflationary, counterfeiting
process is under way.
The nineteenth-century English economist Thomas Tooke correctly
stated that "free trade in banking is tantamount to free trade in
swindling." But under freedom, and without government support, there
are some severe hitches in this counterfeiting process, or in what
has been termed "free banking." First: why should anyone trust me?
Why should anyone accept the checking deposits of the Rothbard Bank?
But second, even if I were trusted, and I were able to con my way
into the trust of the gullible, there is another severe problem,
caused by the fact that the banking system is competitive, with
free entry into the field. After all, the Rothbard Bank is limited
in its clientele. After Jones borrows checking deposits from me,
he is going to spend it. Why else pay money for a loan? Sooner or
later, the money he spends, whether for a vacation, or for expanding
his business, will be spent on the goods or services of clients
of some other bank, say the Rockwell Bank. The Rockwell Bank is
not particularly interested in holding checking accounts on my bank;
it wants reserves so that it can pyramid its own counterfeiting
on top of cash reserves. And so if, to make the case simple, the
Rockwell Bank gets a $10,000 check on the Rothbard Bank, it is going
to demand cash so that it can do some inflationary counterfeit-pyramiding
of its own. But, I, of course, can't pay the $10,000, so I'm finished.
Bankrupt. Found out. By rights, I should be in jail as an embezzler,
but at least my phoney checking deposits and I are out of the game,
and out of the money supply.
Hence, under free competition, and without government support and
enforcement, there will only be limited scope for fractional-reserve
counterfeiting. Banks could form cartels to prop each other up,
but generally cartels on the market don't work well without government
enforcement, without the government cracking down on competitors
who insist on busting the cartel, in this case, forcing competing
banks to pay up.
Central Banking
Hence the drive by the bankers themselves to get the government
to cartelize their industry by means of a central bank. Central
Banking began with the Bank of England in the 1690s, spread to the
rest of the Western world in the eighteenth and nineteenth centuries,
and finally was imposed upon the United States by banking cartelists
via the Federal Reserve System of 1913. Particularly enthusiastic
about the Central Bank were the investment bankers, such as the
Morgans, who pioneered the cartel idea, and who by this time had
expanded into commercial banking.
In modern central banking, the Central Bank is granted the monopoly
of the issue of bank notes (originally written or printed warehouse
receipts as opposed to the intangible receipts of bank deposits),
which are now identical to the government's paper money and therefore
the monetary "standard" in the country. People want to use physical
cash as well as bank deposits. If, therefore, I wish to redeem $1,000
in cash from my checking bank, the bank has to go to the Federal
Reserve, and draw down its own checking account with the Fed, "buying"
$1,000 of Federal Reserve Notes (the cash in the United States today)
from the Fed. The Fed, in other words, acts as a bankers' bank.
Banks keep checking deposits at the Fed and these deposits constitute
their reserves, on which they can and do pyramid ten times the amount
in checkbook money.
Here's how the counterfeiting process works in today's world. Let's
say that the Federal Reserve, as usual, decides that it wants to
expand (i.e., inflate) the money supply. The Federal Reserve decides
to go into the market (called the "open market") and purchase an
asset. It doesn't really matter what asset it buys; the important
point is that it writes out a check. The Fed could, if it wanted
to, buy any asset it wished, including corporate stocks, buildings,
or foreign currency. In practice, it almost always buys U.S. government
securities.
Let's assume that the Fed buys $10,000,000 of U.S. Treasury bills
from some "approved" government bond dealer (a small group), say
Shearson, Lehman on Wall Street. The Fed writes out a check for
$10,000,000, which it gives to Shearson, Lehman in exchange for
$10,000,000 in U.S. securities. Where does the Fed get the $10,000,000
to pay Shearson, Lehman? It creates the money out of thin air. Shearson,
Lehman can do only one thing with the check: deposit it in its checking
account at a commercial bank, say Chase Manhattan. The "money supply"
of the country has already increased by $10,000,000; no one else's
checking account has decreased at all. There has been a net increase
of $10,000,000.
But this is only the beginning of the inflationary, counterfeiting
process. For Chase Manhattan is delighted to get a check on the
Fed, and rushes down to deposit it in its own checking account at
the Fed, which now increases by $10,000,000. But this checking account
constitutes the "reserves" of the banks, which have now increased
across the nation by $10,000,000. But this means that Chase Manhattan
can create deposits based on these reserves, and that, as checks
and reserves seep out to other banks (much as the Rothbard Bank
deposits did), each one can add its inflationary mite, until the
banking system as a whole has increased its demand deposits by $100,000,000,
ten times the original purchase of assets by the Fed. The banking
system is allowed to keep reserves amounting to 10 percent of its
deposits, which means that the "money multiplier" – the amount
of deposits the banks can expand on top of reserves – is 10.
A purchase of assets of $10 million by the Fed has generated very
quickly a tenfold, $100,000,000 increase in the money supply of
the banking system as a whole.
Interestingly, all economists agree on the mechanics of this process
even though they of course disagree sharply on the moral or economic
evaluation of that process. But unfortunately, the general public,
not inducted into the mysteries of banking, still persists in thinking
that their money remains "in the bank."
Thus, the Federal Reserve and other central banking systems act
as giant government creators and enforcers of a banking cartel;
the Fed bails out banks in trouble, and it centralizes and coordinates
the banking system so that all the banks, whether the Chase Manhattan,
or the Rothbard or Rockwell banks, can inflate together. Under free
banking, one bank expanding beyond its fellows was in danger of
imminent bankruptcy. Now, under the Fed, all banks can expand together
and proportionately.
"Deposit Insurance"
But even with the backing of the Fed, fractional reserve banking
proved shaky, and so the New Deal, in 1933, added the lie of "bank
deposit insurance," using the benign word "insurance" to mask an
arrant hoax. When the savings and loan system went down the tubes
in the late 1980s, the "deposit insurance" of the federal FSLIC
[Federal Savings and Loan Insurance Corporation] was unmasked as
sheer fraud. The "insurance" was simply the smoke-and-mirrors term
for the unbacked name of the federal government. The poor taxpayers
finally bailed out the S&Ls, but now we are left with the formerly
sainted FDIC [Federal Deposit Insurance Corporation], for commercial
banks, which is now increasingly seen to be shaky, since the FDIC
itself has less than one percent of the huge number of deposits
it "insures."
The very idea of "deposit insurance" is a swindle; how does one
insure an institution (fractional reserve banking) that is inherently
insolvent, and which will fall apart whenever the public finally
understands the swindle? Suppose that, tomorrow, the American public
suddenly became aware of the banking swindle, and went to the banks
tomorrow morning, and, in unison, demanded cash. What would happen?
The banks would be instantly insolvent, since they could only muster
10 percent of the cash they owe their befuddled customers. Neither
would the enormous tax increase needed to bail everyone out be at
all palatable. No: the only thing the Fed could do, and this would
be in their power, would be to print enough money to pay off all
the bank depositors. Unfortunately, in the present state of the
banking system, the result would be an immediate plunge into the
horrors of hyperinflation.
Let us suppose that total insured bank deposits are $1,600 billion.
Technically, in the case of a run on the banks, the Fed could exercise
emergency powers and print $1,600 billion in cash to give to the
FDIC to pay off the bank depositors. The problem is that, emboldened
at this massive bailout, the depositors would promptly redeposit
the new $1,600 billion into the banks, increasing the total bank
reserves by $1,600 billion, thus permitting an immediate expansion
of the money supply by the banks by tenfold, increasing the total
stock of bank money by $16 trillion. Runaway inflation and total
destruction of the currency would quickly follow.
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