FRACTIONAL RESERVE BANKING - The Mystery of Banking

The carte blanche for deposit banks to issue counterfeit warehouse receipts for gold had many fateful consequences. In the first place, it meant that any deposit of money could now take its place in the balance sheet of the bank. For the duration of the deposit, the gold or silver now became an owned asset of the bank, with redemption due as a supposed debt, albeit instantly on demand. Let us assume we now have a Rothbard Deposit Bank. It opens for business and receives a deposit of $50,000 of gold from Jones, for which Jones receives a warehouse receipt which he may redeem on demand at any time. The balance sheet of the Rothbard Deposit Bank is now as shown in Figure below.

Although the first step has begun on the slippery slope to fraudulent and deeply inflationary banking, the Rothbard Bank has not yet committed fraud or generated inflation. Apart from a general deposit now being considered a debt rather than bailment, nothing exceptionable has happened. Fifty thousand dollars’worth of gold has simply been deposited in a bank, after which the warehouse receipts circulate from hand to hand or from bank to bank as a surrogate for the gold in question. No fraud has been committed and no inflationary impetus has occurred, because the Rothbard Bank is still backing all of its warehouse receipts by gold or cash in its vaults.

A DEPOSIT BANK

A DEPOSIT BANK

The amount of cash kept in the bank’s vaults ready for instant redemption is called its reserves. Hence, this form of honest, non inflationary deposit banking is called “100 percent reserve banking,”because the bank keeps all of its receipts backed fully by gold or cash. The fraction to be considered is

Reserves

and in our example the fraction is

fraction

or 100 percent. Note, too, that regardless of how much gold is deposited in the banks, the total money supply remains precisely the same so long as each bank observes the 100 percent rule. Only the form of the money will change, not its total amount or its significance. Thus, suppose that the total money supply of acountry is $100,000,000 in gold coin and bullion, of which $70,000,000 is deposited in banks, the warehouse receipts being fully backed by gold and used as a substitute for gold in making monetary exchanges. The total money supply of the country (that is, money actually used in making exchanges) would be:

$30,000,000 (gold) + $70,000,000 (warehouse receipts for gold)

The total amount of money would remain the same at $100,000,000; its form would be changed to mainly warehouse receipts for gold rather than gold itself.

The irresistible temptation now emerges for the gold smith or other deposit banker to commit fraud and inflation: to engage, in short, in fractional reserve banking, where total cash reserves are lower, by some fraction, than the warehouse receipts outstanding. It is unlikely that the banker will simply abstract the gold and use it for his own consumption; there is then no likelihood of ever getting the money should depositors ask to redeem it, and this act would run the risk of being considered embezzlement. Instead, the banker will either lend out the gold, or far more likely, will issue fake warehouse receipts for gold and lend them out, eventually getting repaid the principal plus interest. In short, the deposit banker has suddenly become a loan banker; the difference is that he is not taking his own savings or borrowing in order to lend to consumers or investors. Instead he is taking someone else’s money and lending it out at the same time that the depositor thinks his money is still available for him to redeem. Or rather, and even worse, the banker issues fake warehouse receipts and lends them out as if they were real warehouse receipts represented by cash. At the same time, the original depositor thinks that his warehouse receipts are represented by money available at any time he wishes to cash them in. Here we have the system of fractional reserve banking, in which more than one warehouse receipt is backed by the same amount of gold or other cash in the bank’s vaults.

It should be clear that modern fractional reserve banking is a shell game, a Ponzi scheme, a fraud in which fake warehouse receipts are issued and circulate as equivalent to the cash supposedly represented by the receipts.

Let us see how this works in our T-accounts.

The Rothbard Bank, having had $50,000 of gold coin deposited in it, now issues $80,000 of fraudulent warehouse receipts and lends them to Smith, expecting to be repaid the $80,000 plus interest.

FRACTIONAL RESERVE BANKING

FRACTIONAL RESERVE BANKING

The Rothbard Bank has issued $80,000 of fake warehouse receipts which it lends to Smith, thus increasing the total money supply from $50,000 to $130,000. The money supply has increased by the precise amount of the credit—$80,000—expanded by the fractional reserve bank. One hundred percent reserve banking has been replaced by fractional reserves, the fraction being

fractional reserves

or 5/13. Thus, fractional reserve banking is at one and the same time fraudulent and inflationary; it generates an increase in the money supply by issuing fake warehouse receipts for money. Money in circulation has increased by the amount of warehouse receipts issued beyond the supply of gold in the bank.

The form of the money supply in circulation has again shifted, as in the case of 100 percent reserve banking: A greater proportion of warehouse receipts to gold is now in circulation. But something new has now been added: The total amount of money in circulation has now been increased by the new warehouse receipts issued. Gold coin in the amount of $50,000 formerly in circulation has now been replaced by $130,000 of warehouse receipts. The lower the fraction of the reserve, the greater the amount of new money issued, pyramiding on top of a given total of reserves.

Where did the money come from? It came—and this is the most important single thing to know about modern banking—it came out of thin air. Commercial banks—that is, fractional reserve banks—create money out of thin air. Essentially they do it in the same way as counterfeiters. Counterfeiters, too, create money out of thin air by printing something masquerading as money or as a warehouse receipt for money. In this way, they fraudulently extract resources from the public, from the people who have genuinely earned their money. In the same way, fractional reserve banks counterfeit warehouse receipts for money, which then circulate as equivalent to money among the public. There is one exception to the equivalence: The law fails to treat the receipts as counterfeit.

Another way of looking at the essential and inherent unsoundness of fractional reserve banking is to note a crucial rule of sound financial management—one that is observed every where except in the banking business. Namely, that the time structure of the firm’s assets should be no longer than the time structure of its liabilities. In short, suppose that a firm has a note of $1 million due to creditors next January 1, and $5 million due the following January 1. If it knows what is good for it, it will arrange to have assets of the same amount falling due on these dates or a bit earlier.That is, it will have $1 million coming due to it before or on January 1, and $5 million by the year following. Its time structure of assets is no longer, and preferably a bit shorter, than its liabilities coming due. But deposit banks do not and cannot observe this rule. On the contrary, its liabilities—its warehouse receipts—are due instantly, on demand, while its outstanding loans to debtors are inevitably available only after some time period, short or long as the case may be. A bank’s assets are always “longer” than its liabilities, which are instantaneous. Put another way, a bank is always inherently bankrupt, and would actually become so if its depositors all woke up to the fact that the money they believe to be available on demand is actually not there.

One attempted justification of fractional reserve banking,often employed by the late Professor Walter E. Spahr, maintains that the banker operates some what like a bridge builder. Thebuilder of a bridge estimates approximately how many people will be using it from day to day; he doesn’t attempt the absurdt ask of building a bridge big enough to accommodate every resident of the area should he or she wish to travel on the bridge at the same time. But if the bridge builder may act on estimates of the small fraction of citizens who will use the bridge at any one time, why may not a banker likewise estimate what percentage of his deposits will be redeemed at any one time, and keep no more than the required fraction? The problem with this analogy is that citizens in no sense have a legal claim to be able to cross the bridge at any given time. But holders of warehouse receipts to money emphatically do have such a claim, even in modern banking law, to their own property any time they choose to redeem it. But the legal claims issued by the bank must then be fraudulent, since the bank could not possibly meet them all.

It should be clear that for the purpose of analyzing fractional reserve banking, it doesn’t make any difference what is considered money or cash in the society, whether it be gold, tobacco, or even government fiat paper money. The technique of pyramiding by the banks remains the same. Thus, suppose that now gold has been out lawed, and cash or legal tender money consists of dollars printed by the central government. The process of pyramiding remains the same, except that the base of the pyramid is paper dollars instead of gold coin.

Our Rothbard Bank which receives $50,000 of government paper money on deposit, then proceeds to pyramid $80,000 on top of it by issuing fake warehouse receipts.

FRACTIONAL RESERVE BANKING (PAPER)

FRACTIONAL RESERVE BANKING (PAPER)

One attempted justification of fractional reserve banking, often employed by the late Professor Walter E. Spahr, maintains that the banker operates some what like a bridge builder. The builder of a bridge estimates approximately how many people will be using it from day to day; he doesn’t attempt the absurdt ask of building a bridge big enough to accommodate every resident of the area should he or she wish to travel on the bridge at the same time. But if the bridge builder may act on estimates of the small fraction of citizens who will use the bridge at any one time, why may not a banker likewise estimate what percentage of his deposits will be redeemed at any one time, and keep no more than the required fraction? The problem with this analogy is that citizens in no sense have a legal claim to be able to cross the bridge at any given time. But holders of warehouse receipts to money emphatically do have such a claim, even in modern banking law, to their own property any time they choose to redeem it. But the legal claims issued by the bank must then be fraudulent, since the bank could not possibly meet them all.

It should be clear that for the purpose of analyzing fractional reserve banking, it doesn’t make any difference what is considered money or cash in the society, whether it be gold, tobacco, or even government fiat paper money. The technique of pyramiding by the banks remains the same. Thus, suppose that now gold has been out lawed, and cash or legal tender money consists of dollars printed by the central government. The process of pyramiding remains the same, except that the base of the pyramid is paper dollars instead of gold coin.

Our Rothbard Bank which receives $50,000 of government paper money on deposit, then proceeds to pyramid $80,000 on top of it by issuing fake warehouse receipts.

Just as in the gold case, the total money supply has increased from $50,000 to $130,000, consisting precisely in the issue of new warehouse receipts, and in the credit expanded by the fractional reserve bank.

Just as in the case of outright counterfeiting, the new money—this time in the form of new warehouse receipts—does not shower upon everyone alike. The new money is injected at some particular point in the economic system—in this case, the Rothbard Bank issues it and it is immediately loaned to Smith and the new money then ripples out into the economy. Smith, let us say, uses the $80,000 of new money to buy more equipment, the equipment manufacturer buys raw materials and pays more for labor, and so on. As the new money pours into the system and ripples outward, demand curves for particular goods or services are increased along the way, and prices are increased as well. The more extensive the spread of bank credit, and the more new money is pumped out, the greater will be its effect in raising prices. Once again, the early receivers from the new money benefit at the expense of the late receivers—and still more, of those who never receive the new money at all. The earliest receivers the bank and Smith—benefit most, and, like a hidden tax or tribute, the late receivers are fraudulently despoiled of their rightful resources.

Thus, fractional reserve banking, like government fiat paper or technical counterfeiting, is inflationary, and aids some at the expense of others. But there are even more problems here. Because unlike government paper and unlike counterfeiting (unless the counterfeit is detected), the bank credit is subject to contraction as well as expansion. In the case of bank credit, what comes up, can later come down, and generally does. The expansion of bank credit makes the banks shaky and leaves them open, in various ways, to a contraction of their credit.

Thus, let us consider the Rothbard Bank again. Suppose that the loan to Smith of $80,000 was for a two-year period. At the end of the two years, Smith is supposed to return the $80,000 plus interest. But when Smith pays the $80,000 (forgetting about the interest payment to keep things simple), he will very likely pay in Rothbard Bank warehouse receipts, which are then canceled. The repayment of the $80,000 loan means that $80,000 in fake warehouse receipts has been canceled, and the money supply has now contracted back to the original $50,000. After the repayment,the balance sheet of the Rothbard Bank will be as follows:

REPAYMENT OF BANK LOANS

REPAYMENT OF BANK LOANS

We are back to the pre-expansion figures of our original example (Figure above).

But if the money supply contracts, this means that there is deflationary pressure on prices, and prices will contract, in a similar kind of ripple effect as in the preceding expansion. Ordinarily,of course, the Rothbard Bank, or any other fractional reserve bank, will not passively sit back and see its loans and credit contract.Why should it, when the bank makes its money by inflationary lending? But, the important point is that fractional reserve banks are sitting ducks, and are always subject to contraction.When the banks’ state of inherent bankruptcy is discovered, for example, people will tend to cash in their deposits, and the contractionary, deflationary pressure could be severe. If banks have to contract suddenly, they will put pressure on their borrowers, try to call in or will refuse to renew their loans, and the deflationary pressure will bring about a recession—the successor to the inflationary boom.

Note the contrast between fractional reserve banking and the pure gold coin standard. Under the pure gold standard, there is virtually no way that the money supply can actually decline, since gold is a highly durable commodity. Nor will it be likely that government fiat paper will decline in circulation; the only rare example would be a budget surplus where the government burned the paper money returning to it in taxes. But fractional reserve bank credit expansion is always shaky, for the more extensive its inflationary creation of new money, the more likely it will be to suffer contraction and subsequent deflation. We already see here the outlines of the basic model of the famous and seemingly mysterious business cycle, which has plagued the Western world since the middle or late eighteenth century. For every business cycle is marked, and even ignited, by inflationary expansions of bank credit. The basic model of the business cycle then becomes evident:bank credit expansion raises prices and causes a seeming boom situation, but a boom based on a hidden fraudulent tax on the late receivers of money. The greater the inflation, the more the banks will be sitting ducks, and the more likely will there bea subsequent credit contraction touching off liquidation of credit and investments, bankruptcies, and deflationary price declines. This is only a crude outline of the business cycle, but its relevance to the modern world of the business cycle should already be evident.

Establishing oneself as a fractional reserve bank, however, is not as easy as it seems, despite the law unfortunately looking the other way at systemic fraud. For the Rothbard Bank, or any other bank, to have its warehouse receipts functioning in lieu of gold or government paper requires a long initial buildup of trust on the part of the public. The Rothbard Bank must first build up a reputation over the decades as a bank of safety, probity, and honesty, and as always ready and able to redeem its liabilities on demand. This cannot be achieved over night.


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