Mises Canada Daily
The Fraud in Fractional Reserve Banking
Nov 26, 2014 08:00 am by Frank Hollenbeck posted in Banking, Economics, credit expansion, Fractional Reserve Banking, fraud, Inflation
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.
Is Scott Sumner “the NGDP Guy”?
Nov 25, 2014 06:46 pm by Robert P. Murphy posted in Economics, Federal Reserve, Sumner
In a recent post at EconLog, leading Market Monetarist Scott Sumner complained that he had been pigeonholed:
I was recently reading a new book on monetary policy alternatives, edited by Larry White. One thing I noticed was that when my name came up it was always in the context of NGDP targeting. Yes, I am a big fan of NGDP targeting. But I don’t really see myself as “the NGDP guy.”…It’s a very conventional idea, not radical at all. There are many proponents of the policy.
I see myself as the “monetary misdiagnosis guy.” I’m the one that claims almost the entire profession has it wrong, and Milton Friedman had it right….Monetary policy has been tight since 2008. There should be no debate about whether the Fed should end its extraordinarily accommodative policy, as there has been…no such policy. These views distinguish me from almost all other economists on both sides of the spectrum.
Well, on the first part about Sumner complaining that he has been identified as “the NGDP guy,” maybe it’s comments like this that gave him that rep?
Future generations of economists will look back on our era with disbelief….The Fed continued to blunder into errors costing hundreds of billions of dollars…partly because they weren’t willing to spend a few thousand dollars setting up and subsidizing prediction markets to gather real time investor forecasts.
The biggest problem by far was the lack of an NGDP futures market. TIPS spreads are fine, but in a world of 2% inflation targeting much of the variation in inflation represents supply shocks, such as unstable commodity prices. Interest rates are almost useless as a measure of the stance of monetary policy, and the money supply is only marginally better. We need real time data on the single most important macroeconomic variable in the universe, expected US NGDP growth, which also happens to be the best indicator of the stance of US monetary policy.
Or try this one, where Sumner’s talking about the central bank:
There is only one force in the economic universe powerful enough to cause trillions in asset values to suddenly disappear, for no apparent reason. To cause nominal incomes to plunge further and further below trend, causing massive job loses. The center of the black hole sees itself as a force for good, helping to solve the problems it is actually creating. Others see it as a potential source of help, which is not acting forcefully enough. Both are wrong. It’s the center of the black hole. It’s pulling down the things we see disappear over the event horizon. But we can’t see it, and hence most of us don’t understand the problem. It’s the only force capable of determining NGDP growth over time. It’s the force that several decades ago decreed that henceforth NGDP will grow at about 5%, not 11% or 3%. It said “let there be 2% inflation.” And the force saw the 2% inflation, and saw that it was good. Only one force in the universe could pick a 2% inflation rate out of thin air, and make it happen. Is it God? No, it’s much more powerful than that. And since mid-2008 the force has decided that 1.4% annual NGDP growth is good enough. Which means ever more asset values and ever more jobs will disappear over the event horizon.
Since Sumner has called expected U.S. NGDP growth “the most important macroeconomic variable in the universe,” control over which makes the Fed “much more powerful” than God Himself, you can see why some of us tended to think of him as “the NGDP guy.”
Yet beyond the wise-aleck response, my substantive reply to Sumner is that the metric by which he can employ his claim of misdiagnosis is through NGDP growth. For example, Sumner likes to bring up Milton Friedman and interest rates. But the problem here is that Friedman could rightfully contrast the two in the Great Depression, where monetary aggregates like M1 and M2 collapsed, which is why nominal interest rates fell.
Yet in our time, all of the monetary aggregates are rising, so the standard Friedmanite warning (about judging monetary policy looking merely at interest rates) doesn’t neatly carry over.
Let’s push this a bit further. When Sumner complains (as he does on a very regular basis such that he has “trademarked” the phrase) about his colleagues “reasoning from a price change,” he will bring up the high nominal interest rates during the Weimar hyperinflation, or during the late 1970s, to show the dangers in looking at nominal interest rates and then judging the stance of monetary policy. Just as extremely “loose money” can go hand-in-hand with high nominal interest rates, so too (Sumner argues) “tight money” can go hand-in-hand with low nominal interest rates. Sumner’s rhetorical point here is that just because the Fed has had a virtually zero-interest-rate policy in effect for five years and counting, we shouldn’t buy into the conventional wisdom that the Fed has been loose.
The problem with this line of argument is that we can easily adjust for price inflation to gauge the “real” interest rate. In the following diagram, I took the effective federal funds rate and subtracted the 12-month change in the Consumer Price Index:
As the chart shows, if we look at my crude measure of the “real federal funds rate,” we see that it has been quite low since 2009. Indeed, since the CPI has continually risen, while the Fed’s nominal policy interest rates have been virtually zero, the “real” federal funds rate has obviously been negative. Going back to 1960, the only other times we saw such “easy money” were the late 1970s and the height of the recent housing bubble. So it looks like the Austrian story makes a lot of sense, doesn’t it?
The Path to the Perfect Reserve Currency
Nov 25, 2014 04:21 pm by Patrick Barron posted in Banking, Economics, Politics, Regulation
Much has been written lately, including by me, about the coming rejection of the dollar as the primary reserve currency of the world’s most important central banks. My prediction is based upon two things: one, that the Federal Reserve is controlled by inflationist politicians whose main goal is to monetize the federal government’s vast annual budget deficits; and, two, that the rest of the world is getting fed up with holding ever more fiat dollars of decreasing purchasing power. In the first instance, as long as the Fed can get away with printing dollars that ultimately are used to purchase federal government debt, there is no reason for it to cease federal debt monetization or for the federal government itself to balance its budget by reducing the welfare/warfare state. In the second instance, it is in the self interest of the rest of the world to find an alternative to being robbed by loss of the dollar’s purchasing power. In short, if the Fed does not stop debasing the dollar, its status as a reserve currency will continue to erode. If the Fed wants the dollar to remain the world’s reserve currency of choice, it must raise interest rates rather than print more money and the government must slash its spending to avoid imposing higher taxes. If it chooses neither of these, or in such small increments as to make little difference, then I fear the dollar is doomed as the world’s primary reserve currency.
The Definition of the Best Reserve Currency
Central banks hold reserves in order to facilitate international trade. Individuals and companies within a monopolized currency area (either an individual nation or some region, such as the euro zone) must exchange their local currency for some other nation’s currency in order to import goods and services. Likewise, individuals and companies within a monopolized currency area must convert foreign currency to local currency in order to pay their local suppliers for producing goods and services that are sold abroad and for which they were paid in foreign currency. They do this through the central bank. Alternatively, individuals and companies may decide to conduct these exchanges in a third currency, one that is accepted in most of the world. Since the end of World War II the US dollar has performed this role, meaning that the world is willing to hold dollars (or dollar denominated assets, such as US Treasury bonds), that circulate outside the borders of the US. Thusly was developed over time the eurodollar and the petrodollar markets, for example.
But simply saying that the world has preferred to hold US dollars does not explain why it preferred to do so. We have lost sight of the fact that there were real reasons for the eurodollar and petrodollar markets, which transcended some mystical faith in the dollar and the US. The world simply had recognized that the dollar was the most marketable currency to hold, I believe mainly for both geopolitical (think a VERY strong military) and economic (think the most free) reasons. But now those reasons are evaporating, creating an opening for some other, better currency.
Definition of the perfect reserve currency
The market wants a currency which retains its purchasing power and can be exchanged readily for the most varied real goods, services, and assets. As long as nations issue fiat currencies, only a nation with a large internal market will find that its currency is accepted as one of many reserve currencies. If no one else will accept that currency, it always will be accepted in the monopolized currency zone of the central bank that issued it. For example, it is possible that the eurodollar and petrodollar markets could end, forcing holders of US dollars to exchange them for goods and services in the one part of the world that MUST accept dollars–the US. Holders of dollars know that they can exchange their holdings for American assets, products, and services. The American market is huge, offering lots of choice; whereas, a smaller market, such as Singapore or Russia, would have fewer assets, goods, and services for exchange against the Singapore dollar or the Russian ruble. Much has been written of late that Russia, whose economy is one tenth the size of the US, wants to end what it calls the dollar’s “special privilege”. But there is a natural limit on the demand by central banks to hold Russian rubles, because Russia exports mainly commodities and few goods or services. Furthermore, property rights in Russian companies and other assets are not seen by the market to be as secure as those in Western countries. China’s yuan might fare better than the ruble, because China exports many more goods to the West than Russia; thus, holders of yuan would have somewhat more confidence that they could find readily marketable goods in exchange for yuan.
Gold backing adds to a currency’s marketability
But there is one step that small market countries or those with questionable dedication to defending property rights could take that would enable them to make their currencies attractive to hold nonetheless. They could tie their currencies to gold. Gold backing provides two important assurances to potential holders. One, gold cannot be inflated at the stroke of a key on a central bank computer; therefore, the currency could not be debased and would retain its purchasing power. And, two, gold is acceptable intrinsically anywhere in the world. The holder of a gold backed currency can look beyond ultimately exchanging his currency in the issuer’s monopolized currency zone; he can exchange the currency for gold and spend it on real assets, goods, and services anywhere in the world.
Guaranteed gold redemption provides even greater currency marketability
But the risk to a holder of gold backed currency has not yet been completely removed. Two further hurdles need to be crossed. One, the holder needs to know that the issuer of the gold backed currency is not secretly issuing currency that is not backed by the commodity, what Mises calls “fiduciary media”. At the Bretton Woods Conference in 1944 the US promised to maintain a dollar to gold ounce ratio of thirty-five to one. The International Monetary Fund was established at the same Bretton Woods Conference and charged with ensuring that the US honored the agreement, but it failed to do so. The US issued so much unbacked (fiduciary) media that the Fed suffered a run on its gold reserves as the US’s trading partners scrambled to redeem US dollars for gold at the promised price. Therefore, an issuer of a gold backed currency needs to open its books to periodic and random independent audits.
But even independent audits are not completely sufficient. Complete confidence in a currency requires that the holder be able to take possession of the actual specie without incurring undue cost. For example, the gold might be held in a remote or possibly dangerous location, such as Moscow or Tehran. Worse yet, the currency issuer might refuse to redeem its currency for specie upon demand even though it had honored its promise not to issue fiduciary media. For example, holders of rubles might not be allowed to take possession of the physical gold in Moscow, even though independent auditors had established that the ruble had not been debased by the Russian central bank. This risk could be mitigated by the currency issuer establishing gold redemption centers in many, convenient places around the world. These redemption centers would promise to surrender specie upon demand for any issuer willing to contract with it to do so and by the currency issuer moving sufficient specie there to reassure the market.
Sound money conveys no special privilege on the issuer
Sound money–i.e., money that is backed one hundred percent by specie and for which provisions have been made for safe and dependable redemption–actually conveys no special privilege upon the issuer but, rather, an obligation. The “special privilege” that critics of the dollar have expressed refers to the Fed’s ability to debase its currency. Were it not allowed to do so, the Fed would become simply another market participant producing a good or service desired by the market. In a sound money environment, If the market discovered that the Fed had debased the dollar, demand to hold dollars would quickly erode. The market’s demand to hold dollars would fall and its demand to hold other, sounder currencies would rise. Once found to be issuing fraudulent, fiduciary media–i.e., media not backed one hundred percent by specie–international demand to hold dollars might never return, because the Fed’s reputation for honesty had been destroyed. I fear that the dollar’s reputation has been destroyed. It is no secret that base money in the US has risen tremendously, from $569 billion in March 2000 to $4,083 billion in September 2014. In that time the Fed’s inventory of gold has remained the same at 261.5 million ounces. This abuse of the market has opened the door for others. If any country could convince the market that its currency was sound, by following the principles outlined above, international demand to hold that currency would rise, supplanting the dollar as the world’s primary reserve currency. Furthermore, it would be doing all international market participants a favor. Remember, providing a sound currency conveys an obligation to the issuer to honor its promises; it does not convey a privilege to cheat the market by printing unbacked currency.
The benefits that accrue to issuers of sound money are all ancillary. For example, the British pound represented more than the fact that it was backed by specie redeemable upon demand. The convertible British pound was representative of a nation that honored the rule of law, fair dealing, honesty, and prudence. British law was exported to the world, as was its form of government, because the world recognized that these institutions were part and parcel of its financial and economic success. British bankers, lawyers, and businessmen gained in statue and real wealth because they upheld these values. The redeemable British pound was a daily verification of trust in everything British. In other words, Britain led by example, and the example was the British pound.
But we’re not at the perfect reserve currency yet!
So far we have assumed that only central banks can issue money that would be accepted by international traders as a reserve currency. But there still is one risk to holders even of fully redeemable, gold backed currency–the risk of sovereign suspension of gold redemption by all (or most) of the major central banks. This is exactly what happened at the start of World War I. Regardless of the reason for suspension of gold redemption, a central bank would be protected from court action by its national government. National governments hold the monopoly of coercive force within their sovereign area, so holders of the currency could be denied redemption there, although they might have access to partial redemption of gold held at remote locations. However, a private issuer of a redeemable gold backed currency would have no such protection and national governments would have little incentive to provide it. Courts in many countries could attach the assets of the currency issuer and even bring criminal charges of fraud against the principals, a risk that central bank bureaucrats need not face. Therefore, the ultimate reserve currency is one that is issued by private institutions, such as international banks.
The world needs honest money founded in law to which men everywhere can seek justice in the protection of their trade, property, and wealth. Honest, sound money is representative of an entire society’s dedication to the rule of law, fair dealing, prudence, and reliability. There is no secret to sound money, only dedication to providing its ready and convenient redemption. The nation that adopts these principles will thrive.