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, fully-backed 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, 1, 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
un-backed 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.
Murray N. Rothbard (1926-1995) was the S.J. Hall
Distinguished Professor of Economics at the University of Nevada, Las
Vegas, and Academic Vice President of the Ludwig von Mises Institute.
This is the second in Professor Rothbard's series of articles on
money. Part 3 will appear in the November issue of The Freeman.
Reprinted with permission from The
Freeman, a publication of the Foundation for Economic Education, Inc.,
October 1995, Vol. 45, No. 10.
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