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FIRST ACCESS to Nadeem Walayat’s Analysis and Trend Forecasts

Fractional Reserve Banking System Basis of Bankster Fraud

Stock-Markets / Credit Crisis 2009 Oct 10, 2009 - 02:52 PM GMT

By: Gary_North

Stock-Markets

Diamond Rated - Best Financial Markets Analysis ArticleThe heart of the modern monetary system is fractional reserve banking. This system is based on fraud. At the very heart of the modern economy is fraud – fraud on a gigantic scale.

What is the nature of this fraud? Counterfeiting. Banks are government-licensed institutions that issue bogus IOUs. Because these IOUs function as money, they are counterfeit money. This is the heart, mind, and soul of all modern banking.


There is only one textbook in money and banking that states explicitly that all fractional reserve banking rests on fraud: Murray Rothbard's The Mystery of Banking. It is not used in any university. It never has been. It was published in 1983. It went out of print almost immediately. It is on-line here.

Rothbard takes the reader through the traditional T-account exercise that is common to all upper-division textbooks in money and banking. Unlike all the others, his book shows how the process of making deposits and lending the money involves counterfeiting whenever the depositor has the legal right to withdraw his money on demand.

This is not the same as a life insurance contract in which you can borrow against your built-up reserves. The company treats the policy-holder as it would treat another borrower. It raises money to make the loan.

The withdraw-on-demand banking process has the same effect as counterfeiting gold and silver coins by adding base metals (pp. 48–51). It has the same effect as issuing paper money that has no backing in gold or silver (pp. 51–55). It has the same effect as issuing warehouse receipts for goods stored for which there are no goods stored (pp. 88–90).

The banking system issues multiple IOUs to depositors and borrowers, yet these IOUs are based on the same initial deposits. Traditional textbooks describe this process, but they refuse to identify the process as counterfeiting. They also refuse to mention that this process of monetary inflation is the sole basis of all booms and busts: the business cycle. This was Ludwig von Mises' insight as far back as 1912 in his book, The Theory of Money and Credit.

Rothbard makes it clear why fractional reserve banking is fraudulent. This is why no professor assigns his book to his classes.

The irresistible temptation now emerges for the goldsmith 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 (pp. 96–97).

Modern economists do not acknowledge that fractional reserve banking is a gigantic system of counterfeiting. They do not apply the same analysis to fractional reserve banking that they would apply to counterfeiting if they discussed counterfeiting. They rarely discuss counterfeiting. This is because they know that bright students can make the analytical connection. The students will be tempted to conclude what is in fact the case, namely, that fractional reserve banking is a form of counterfeiting.

BORROWED SHORT AND LENT LONG

The banker offers a deal to holders of currency. (Prior to 1914 in Europe and prior to 1933 in the United States, the public held gold coins.) Here is the offer.

If you will deposit your money in my bank, I will lend it out at interest. I will share some of this interest with you by guaranteeing you a fixed rate of return.

So far, so good. But then comes the kicker. Furthermore, I will pay you your money on demand during banking hours. Any time you want your currency back, just come to the bank and take it out – no questions asked (unless you try to take out $10,000 or more).

The banker knows what the economics professor knows: almost no one can think through the implications of this promise. Both the banker and the professor of money and banking strive to keep people in the dark. They promote the mystery of banking.

What are a few implications? Here is one. When the bank lends money to a borrower at a fixed rate of return, it lends for a specific period of time (commercial loans) or else no deadline (credit card loans). It cannot get this money back on demand. Yet it owes money on demand.

The depositor can demand immediate payment. Yet the money is gone. The bank has therefore issued two IOUs to the same deposit. The depositor can pull out his money at any time. The borrower, who has the money sitting in his account, can do the same thing.

How is this possible? Because the government or the central bank allows the bank to set aside a small percentage of reserves on the deposit. The bank does not have to keep 100% of the on-demand money in reserve.

With a 10% reserve requirement, if a bank gets a $100 deposit and sends $10 to the central bank as a reserve, it can legally lend $90. When the borrower spends this $90, the receiving bank sets aside $9 and lends $81. The initial $100 deposit leads to $900 in new money, if banks lend all of the money they are legally allowed to lend.

If the banker had added the following statement, there would be no fraud. There would be no counterfeiting.

You will not be able to get your money back on demand until the contract runs out for the borrower. As he repays interest, you will get your share. If he refuses to repay, I will pay you your principal based on bank reserves. But, of course, if the bank goes bankrupt, you will not be repaid.

This offer would make it clear to the depositor that there is no such thing as a free lunch. He cannot get the return of his money until the bank gets it back from the borrower. The same deposit still serves as money: for the borrower, not for the depositor.

The banker makes the offer of payment on demand because he knows that few depositors will demand their money most of the time. Those who do demand their money can be paid out of the money deposited by today's depositors. Is this a Ponzi scheme? In part, yes. It is a Ponzi scheme that can go on much longer, because the bank possesses the power to create money.

The bank has borrowed short – "withdraw the money on demand" – and has lent long: "pay the money back on time." This is fraudulent.

CONTRACTS OVER TIME

All contracts have a time component. A contract is a promise to perform an action in the future.

What about an exchange that is instantaneous? In the most radical form, a seller of money holds out a wad of currency. A seller of a good holds out the good. Each of them takes hold of both items, using different hands. On the count of three, each person releases the item he is offering to the other. Each person hopes the other will turn lose of the item on three.

Yet even here, there is a time component. Each participant promises to let loose on the count of three. If there were no agreement – either formal or implied – there would be no exchange.

A contract that promises to do the impossible is fraudulent. If it is part of a series of identical contracts, only a few of which can be consummated on the same day, then all of the payment-on-demand contracts are fraudulent. The creditor cannot distinguish his claim from all the others, other than by "first come, first served." That principle encourages bank runs.

Whenever a prospective depositor goes down to the bank to make a deposit, he should sing to himself the song that every fractional reserve bank has as its anthem regarding its depositors, who are its creditors. The banker silently sings to every depositor:

Well, that'll be the day, when you say goodbye.
Yes, that'll be the day, when you make me cry.
You say you're gonna leave, you know it's a lie.
'Cause that'll be the day when I die.

This is the chorus. But those of us from the late 1950's remember what followed.

Well, you give me all your lovin' and your turtle dovin'
All your hugs and kisses and your money too.
Well, you know you love me baby
Until you tell me, maybe
That some day, well, I'll be through.

Fractional reserve banking may be a mystery, but Buddy Holly has provided the key to understanding the system.

Bankers woo depositors with promises of everlasting commitment. The proof of this everlasting commitment is the promise of withdrawal on demand. Then they take the depositors' money to woo borrowers with promises of what would otherwise have been below-market interest rates. Why below market? Because depositors have been lured into parting with their money by means of a promise – a promise that cannot be fulfilled because of the time discrepancy between borrowing short (depositors' accounts) and lending long (borrowers' accounts).

The basis of this monetary philandery is the discrepancy between the rival promises of time.

To understand modern banking, think of a full-time philanderer with one mid-town apartment, four mistresses, and three keys. We can call this a 25% reserve requirement. Three mistresses live in the suburbs. His favorite lives in mid-town. One key is for him; one is for the mid-town girl; and one is for the other three mistresses. This key is kept on reserve at the desk downstairs. He assumes that out-of-towners will not all show up on the same day at the same time.

This plan works until a rumor gets out about the nature of the arrangement. Then all three out-of-towners show up to make sure they have a key.

INFLATION AND BAD INFORMATION

Counterfeiters increase the money supply. This is inflationary. They defraud holders of the non-counterfeit currency. How? By lowering the market price of the currency already in circulation. The slogan is: "More money chasing the same amount of goods."

But, as Mises showed, there is more to it than this. The added money, when lent to producers, leads to a transfer of wealth to the producers. They start bidding for production goods: land (including raw materials), labor, and capital (land plus labor over time). The can make higher bids. They supply goods and services to match expected demand. This creates an economic boom. But when the counterfeiters stop counterfeiting, expected demand does not appear. This creates a bust.

Counterfeit money distorts information. How? Because prices convey information. Prices should convey accurate information. When decision-makers have accurate information, they can find ways to lower the transaction costs of their decisions. They can search out better ways to cut expenses. They can become more efficient.

When prices convey inaccurate information, individuals find that they make more mistakes. They make decisions in terms of information that is misleading. This is why prices should be based on decentralized decisions in which individuals making the decisions are responsible for the outcome of their actions. This is the defense of free-market capitalism. But, when it comes to banks, the economists refuse to follow the logic of this principle of individual responsibility and performance. Defenders of central banking and fractional reserve banking are necessarily defenders of inaccurate information.

CENTRAL BANKING

A central bank provides emergency money to commercial banks. This reduces the threat of bank runs. Central banks intervene to save large banks. This is why no large American bank went bust in the Great Depression, while over 6,000 small banks did.

Central banks are the enforcing arm of the fractional reserve banking system. Central banks determine which banks survive and which do not in a national bank run. Their job is to protect the largest commercial banks. This is a form of central planning by a government-licensed monopolistic agency.

When central planners substitute their judgment for individual decision-makers, we see a centralization of power over the market. The terms of exchange are not being set by individual participants who are responsible for their actions. The terms of exchange are being set by a distant committee. They are immune from negative feedback for their own decisions.

This arrangement is guaranteed to reduce the accuracy of information that is conveyed by prices. Furthermore, when the intervention in question relates to the control of the money supply, we can be certain that the information conveyed by the decision of the committee will be less accurate than the information conveyed by individual decision-makers.

Fractional reserve banking creates blindness. Central banking extends this blindness.

Any economy that relies on fractional reserve banking is flying partially blind. This blindness becomes permanent when a central bank protects large commercial banks that are regarded as too big to fail.

CONCLUSION

Fractional reserve banking is inherently fraudulent. It inflates the money supply. It creates the boom-bust cycle. Through central banking, it transfers planning authority to bureaucrats with only an indirect stake in the outcome of their decisions.

It is the basis of the modern economy. The booms and busts get worse. The dollar depreciates. Central planning increases. Information becomes more distorted.

This will end badly. Worse, it may start over again.

    Gary North [send him mail ] is the author of Mises on Money . Visit http://www.garynorth.com . He is also the author of a free 20-volume series, An Economic Commentary on the Bible .

    http://www.lewrockwell.com

    © 2009 Copyright Gary North / LewRockwell.com - All Rights Reserved
    Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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