Nationalize Money, Not Banks

We Don’t Have To Be In Financial Crisis
Herman Daly
Emeritus Professor, University of Maryland School of Public Policy

If our present banking system, in addition to fraudulent and corrupt, also seems “screwy” to you, it should. Why should money, a public utility (serving the public as medium of exchange, store of value, and unit of account), be largely the by-product of private lending and borrowing? Is that really an improvement over being a by-product of private gold mining, as it was under the gold standard? The best way to sabotage a system is hobble it by tying together two of its separate parts, creating an unnecessary and obstructive connection. Why should the public pay interest to the private banking sector to provide a medium of exchange that the government can provide at little or no cost? Why should seigniorage (profit to the issuer of fiat money) go largely to the private sector rather than entirely to the government (the commonwealth)?

Is there not a better away? Yes, there is. We need not go back to the gold standard. Keep fiat money, but move from fractional reserve banking to a system of 100% reserve requirements. The change need not be abrupt—we could gradually raise the reserve requirement to 100%. Already the Fed has the authority to change reserve requirements but seldom uses it. This would put control of the money supply and seigniorage entirely with the government rather than largely with private banks. Banks would no longer be able to live the alchemist’s dream by creating money out of nothing and lending it at interest. All quasi-bank financial institutions should be brought under this rule, regulated as commercial banks subject to 100% reserve requirements.

Banks cannot create money under 100% reserves (the reserve deposit multiplier would be unity), and banks would earn their profit by financial intermediation only, lending savers’ money for them (charging a loan rate higher than the rate paid to savings or “time-account” depositors) and charging for checking, safekeeping, and other services. With 100% reserves every dollar loaned to a borrower would be a dollar previously saved by a depositor (and not available to the depositor during the period of the loan), thereby re-establishing the classical balance between abstinence and investment. With credit limited by saving (abstinence from consumption) there will be less lending and borrowing and it will be done more carefully—no more easy credit to finance the leveraged purchase of “assets” that are nothing but bets on dodgy debts.

To make up for the decline and eventual elimination of bank- created, interest-bearing money, the government can pay some of its expenses by issuing more non interest-bearing fiat money.

However, it can only do this up to a strict limit imposed by inflation. If the government issues more money than the public voluntarily wants to hold, the public will trade it for goods, driving the price level up. As soon as the price index begins to rise the government must print less. Thus a policy of maintaining a constant price index would govern the internal value of the dollar. The external value of the dollar could be left to freely fluctuating exchange rates.

Alternatively, if we instituted John M. Keynes’ international clearing union, the external value of the dollar, along with that of all other currencies, could be set relative to the “bancor,” a common denominator accounting unit used by the payments union. The bancor would serve as an international reserve currency for settling trade imbalances—a kind of “gold substitute”.

The United States opposed Keynes’ plan at Bretton Woods precisely because under it the dollar would not function as the world’s reserve currency, and the US would lose the enormous international subsidy that results from all countries having to hold large transaction balances in dollars.

The payments union would settle trade balances multilaterally. Each country would have a net trade balance with the rest of the world (with the payments union) in bancor units. Any country running a persistent deficit would be charged a penalty, and if continued would have its currency devalued relative to the bancor. But persistent surplus countries would also be charged a penalty, and if the surplus persisted their currency would suffer an appreciation relative to the bancor.

Keynes’ goal was balanced trade, and both surplus and deficit nations would be expected to take measures to bring their trade into balance. With trade in near balance there would be little need for a world reserve currency, and what need there was could be met by the bancor. Freely fluctuating exchange rates would also in theory keep trade balanced and reduce or eliminate the need for a world reserve currency. Which system would be better is a complicated issue not pursued here. In either case the IMF could be abolished since there would be little need for financing trade imbalances (the IMF’s main purpose) in a regime whose goal is to eliminate trade imbalances.

Returning to domestic institutions, the Treasury would replace the Fed (which is owned by and operated in the interests of the commercial banks). The interest rate would no longer be a target policy variable, but rather left to market forces. The target variables of the Treasury would be the money supply and the price index. The treasury would print and spend into circulation for public purposes as much money as the public voluntarily wants to hold. When the price index begins to rise it must cease printing money and finance any additional public expenditures by taxing or borrowing from the public (not from itself). The policy of maintaining a constant price index effectively gives the fiat currency the “backing” of the basket of commodities in the price index.

In the 1920s the leading academic economists, Frank Knight of Chicago and Irving Fisher of Yale, along with others including underground economist and Nobel Laureate in Chemistry, Frederick Soddy, strongly advocated a policy of 100% reserves for commercial banks. Why did this suggestion for financial reform disappear from discussion? The best answer I have received is that the great depression and subsequent Keynesian emphasis on growth swept it aside because limiting bank lending to actual savings was too restrictive on growth, which became the big panacea. Also there is the obvious vested interest of commercial banks in retaining the privilege of creating money and lending it at interest.

Now suppose for a moment that aggregate growth has begun to increase environmental and social costs faster than production benefits, thus becoming uneconomic growth. There is much evidence that this is the case. Then a financial constraint on growth (balancing investment with abstinence) would be much needed, and 100% reserves would be a good way to accomplish it. If, however, growth remains the summum bonum of the economy, then we will inevitably borrow against our hoped for larger future income to finance the investments needed to produce it.

Financing investment by saving would require less present consumption, which many will deem to be an unacceptable drag on growth. But real growth has encountered the biophysical and social limits of a “full world.” Financial growth is being stimulated ever more in the hope that it will pull real growth behind it, but it is in fact pushing uneconomic growth- — growth of ”illth.” Since illth is negative wealth it can hardly redeem the growing debt that is financing it.

The original 100% reserve proponents mentioned above were in favor of aggregate growth, but wanted it to be steady growth in wealth, not speculative boom and bust cycles. Soddy was especially cautious about uncontrolled physical growth, but his main concern was with the symbolic financial system and its disconnect from the real system that it was supposed to symbolize. The result was confusion between wealth and debt. One need not advocate a steady-state economy to favor 100% reserves, but if one does favor a steady state the attractions of 100% reserves are increased.

How would the 100% reserve system serve the steady-state economy?

• First, as just mentioned it would restrict borrowing for new investment to existing savings, greatly reducing speculative growth ventures—for example the leveraging of stock purchases with huge amounts of borrowed money (created by banks ex nihilo rather than saved out of past earnings) would be severely limited. Down payment on houses would be much higher, and consumer credit would be greatly diminished. Credit cards would become debit cards. Long term lending would have to be financed by long term time deposits, or by carefully sequenced rolling over of shorter term deposits. Growth economists will scream, but a steady-state economy does not aim to grow, for the very good reason that growth has become uneconomic.

• Second, the money supply no longer has to grow in order for people to pay back the principal plus the interest required by the loan responsible for the money’s very existence in the first place. The repayment of old loans with interest continually threatens to diminish the money supply unless new loans compensate. With 100% reserves money becomes neutral with respect to growth rather than biasing the system toward growth by requiring more loans just to keep the money supply from shrinking.

• Third, the financial sector will no longer be able to capture such a large share of the nation’s profits (around 40%!), freeing some smart people for more productive, less parasitic, activity. 

• Fourth, the money supply would no longer expand during a boom, when banks like to loan lots of money, and contract during a recession, when banks try to collect outstanding debts, thereby reinforcing the cyclical tendency of the economy.

• Fifth, with 100% reserves there is no danger of a run on a bank leading to a cascading collapse of the credit pyramid, and the FDIC could be abolished, along with its consequent moral hazard. The danger of collapse of the whole payment system due to the failure of one or two “too big to fail” banks would be eliminated. Congress then could not be frightened into giving huge bailouts to some banks to avoid the “contagion” of failure, because the money supply is no longer controlled by the private banks. Any given bank could fail by making imprudent loans, but its failure, even if a large bank, would not disrupt the public utility function of money. The club that the banks used to beat Congress into giving bailouts would have been taken away.

• Sixth, the explicit policy of a constant price index would reduce fears of inflation and the resultant quest to accumulate more as a protection against inflation. Also it in effect provides a multi-commodity backing to our fiat money.

Keynes bancor scheme or a regime of fluctuating exchange rates would automatically balance international trade accounts, eliminating large surpluses and deficits. Thus, there would no longer be any need for the International Monetary Fund and the austerity its “conditionality” imposes on weaker economies.

To dismiss such sound policies as “extreme” in the face of the repeatedly demonstrated failure and fraud of our current financial system is quite absurd. The idea is not to nationalize banks, but to nationalize money, which is a natural public utility in the first place. The fact that this idea is hardly discussed today, in spite of its distinguished intellectual ancestry and common sense, is testimony to the power of vested interests over good ideas. It is also testimony to the veto power that our growth fetish exercises over the thinking of economists today.

Eminent Domain/Repossessed Properties as Collateral for China's Investments in the US

Rebuttal To Snopes
By A. True Ott, PhD, ND

re: SNOPES - China Eminent Domain Collateral False


A REBUTTAL TO DAVID AND BARBARA MIKKELSON (Snopes.com) BASED ON TRUTH AND LOGIC

The website Snopes.com is run by David and Barbara Mikkelson, a couple with a gift for debunking false stories and dis-information circulating around cyber-space. For the most part, they perform a valuable service and have earned a reputation as being an authoritative and conclusive final verdict on controversial subjects. Like all writers, however, they are only human. They can, and do, make mistakes. (* see below--jef)

With all due respect, David and Barbara, you have missed wide left of the target on this particular subject.

I do not know or listen to Mr. Hal Turner. It may well be that he has taken liberties and stretched otherwise true stories to their breaking points in the past. For your information, however, in this particular instance, Turner's recent story corroborates my own sources. While the specific term "eminent domain" may be perhaps a bit of a stretch -- the basic story-line is absolutely true.

In your research as posted in the link above, you obviously came across the Bloomberg article that stated "Chinese officials have expressed concern" that China's massive investments in America are "safe, as a pre-requisite for additional purchases of U.S. Securities." Clearly, you believe the Bloomberg story to be accurate, but then skewer Mr. Turner for basically saying the same thing. I submit this is not logical and smacks more of a witch hunt than ethical hoax-busting and truth searching.

According to authors Bill Geitz (The China Threat) and Peter Navarro (The Coming China Wars), the Chinese PLA have been investing large sums of money into America in the form of political donations (the Clintons received millions), private and public mortgage companies, and U.S. Government debentures for decades. The floodgate of Chinese profits from goods produced largely by their massive prison-labor work-force have been strategically re-invested into the debt-based economy of America. Now, according to Navarro, et.al. the entire U.S. Economy hinges on the whims and will of the Chinese military leadership.

China has basically bought America with cheap trinkets, just as the British purchased Manhattan from the local Indians centuries ago with baubles, bangles and beads.

The cruel, hard facts are that following the conclusion of the Beijing Olympics, China stopped purchasing U.S.-dollar based securities. They quit buying oil and gas futures, causing the price of gasoline to tumble. They quit purchasing Treasury Bills and Bonds -- and quit funding Fannie and Freddie mortgages. This sudden constriction of liquidity was the prime factor behind the market panic last fall, and resulted in Bush's "emergency stimulus" package then, and President Obama's "stimulus" package now.

The cruel, hard fact is that the only way that the Obama administration can stop the current economic bloodbath is to coax China into again investing their Home Depot and Walmart profits back into America's debt machine, (which are then leveraged at 10 times their face value in "The Feds" fractional reserve, debt-driven system). Just as the Bloomberg article correctly exposes, China is not willing to do this, unless and until WRITTEN GUARANTEES THAT THEIR INVESTMENTS ARE SECURE ARE SIGNED AND DULY EXECUTED.

David and Barbara, please tell us: What do you think these "guarantees" involve, and what makes you so blindly confident that Hillary did not grant them??

What the Bloomberg article fails to mention is that the Chinese PLA military leaders filed a lawsuit in the World Court at the Hague, Netherlands last summer. The suit petitioned the World Court to grant the PLA the right to USE CHINESE MILITARY POLICE (i.e. Chinese troops) ON U.S. SOIL in order to "repossess real estate assets secured by PLA's mortgage funding" in the United States upon default of the contracts. The Chinese leadership did not, and do not, trust local sheriff departments to perform the task and preserve their trillions of invested dollars/yen. The World Court opined that only the U.S. government could legally grant such a request.

Given her past acceptances of PLA influence peddling, there is no doubt whatsoever in my mind, that Hillary Clinton not only gave the PLA military leaders just such a signed document, but sealed it with a kiss as well.

Whether it is called "eminent domain" or "mortgage repo authorization" -- the desired effect is the same. Foreign troops have now been given the legal authority to operate as constables on American soil. Treason by any other name, is still an odorous offense.

David and Barbara, aka SNOPES --- just because CNN or Reuters doesn't report the story, it doesn't mean it isn't vitally important information for all Americans to understand and act upon.

Respectfully,

A. True Ott, PhD, ND

(Now, I don't know how accurate the above information is. If even a fraction of it is true, it's pretty scary. I found an inaccuracy with Snopes last year regarding their assertion that the unemployment rate used by the media (the U3, currently 8.1%) was statistically accurate and included everyone who was unemployed. The U3 is a telephone survey administered to the same number of people around the country (1000) as all telephone surveys you see in magazines and newspapers. The U6, incomplete but still far more accurate and compelling than the U3, I argued, was the more accurate rate. And of course, I'm correct because the data is right there on the Bureau of Labor and Standards website. So, my point is that Snopes is not always correct because no one is infallible; and that makes the above story kind of scary.--jef)

American Dream "American nightmare"

The Triumph of the Bankers

by George F. Smith on May 25, 2011

 

In spite of its success in bestowing wealth on some men while funding an unnecessary war, [1] the National Banking System proved unsatisfactory to financial leaders. Even with laws discouraging or restricting redemption, crises still occurred, and banks had to contract and deflate to survive. They were unable to inflate their way out of recession because they lacked a centralized lender who could provide them emergency funding.

In addition, people, especially those who kept their savings outside the banking system, generally saw the notes that circulated as mere substitutes for the real thing, which financier Jay Cooke disparaged as a “musty [relic] of a bygone age,” a sentiment no doubt shared by a certain Scottish adventurer of the early 18^th Century. [2] Even if the system had a centralized lender, it would still be subject to market retribution because it could not arbitrarily create gold or silver coin. Money was still the most marketable commodity, rather than tickets or digits a centralized lender could issue at will, as the Fed does today. [3]

Another problem the national banks faced was the growing competition of private and state banks, neither of which had the national system’s high capital requirements. After 1873, total bank deposits were shifting in favor of non-national banks, as were clearings outside of New York. Furthermore, in 1887, St. Louis and Chicago bumped New York from its monopoly position as the base of the National Banking System’s inverted pyramid, and the two newcomers gained an alarming share of the percentage of total deposits of all three cities from 1880 to 1912. [4]

For bankers and government alike, the ideal monetary situation would seem to be a permanent state of specie suspension; even better would be a world in which everyone thought of money as only paper or deposits redeemable in paper, with specie relegated to the status of a collector’s item. The ideal in banking would be a government-enforced banking cartel that would ensure a uniform rate of monetary inflation to prevent currency drains and bank runs. With this power, it could inflate its way out of recessions and bail out the big commercial banks as an emergency lender. And for its part, the government would have a reliable market for its debt in peacetime and war.

To bring this about, the big bankers leveraged the rising tide of Progressive ideology. They began by hiring agents to promote the idea that banking crises were the result of inadequate regulation and an “inelastic” currency. As Rothbard has written, they formed an alliance with trained economists and other opinion-molders, many of whom already favored bureaucratic control of business from their exposure to Bismarckian statism while acquiring their doctorates in Germany. In the U.S., the National Civic Federation, founded in 1900, became the chief forum for promoting the “the new ideals of civic cooperation and social efficiency” for the purpose of “correcting” the rampant individualism of American society.

The academics were eager to use the state to license membership into their own professional organizations and thereby restrict competition and raise members’ incomes. They also saw themselves acquiring lucrative grants and filling vital government posts in running the bureaucracies. The public already had a deep distrust of Wall Street’s enormous concentration of wealth, and the task facing J. P. Morgan and other banking elites was to get opinion-molders to convince everyone that the big bankers needed public-spirited bureaucrats to rein in their power. [5]

Their push for a central bank, initiated by Morgan and Rockefeller forces, began following Republican William McKinley’s defeat of Democrat William Jennings Bryan in 1896 and ended with passage of the Federal Reserve Act in 1913. Bryan expunged the laissez-faire heritage of his party with his opposition to sound money and his proposal for a bold inflation of silver, an inflation that circumvented the banking system. In his famous “Cross of Gold” speech, Bryan said his party was “opposing the national bank currency” and stood “against the encroachments of aggregated wealth.” McKinley campaign manager Mark Hannahad no trouble raising a record amount of money from the Morgan-Rockefeller alliance to defeat Bryan.

Though the McKinley victory secured the gold standard, gold served mostly as a camouflage behind which the elite bankers could set up a system of inflation they controlled. [6]

A Banker’s Dream Comes True

When the next fractional-reserve breakdown occurred in 1907, Thomas Woodrow Wilson, then president of Princeton, endeared himself to the banking movement by declaring that “all this trouble could be averted if we appointed a committee of six or seven public-spirited men like J. P. Morgan to handle the affairs of our country.” [7] Colonel Edward Mandell House, a close Morgan associate who served as shadow president when Wilson was elected to the White House, became the “unseen guardian angel of the [banking] bill” that emerged in 1913. [8] Originally drafted at a secret meeting of banking elites at Morgan’s hunting lodge on Jekyll Island, Georgia in November, 1910, the Glass-Owen Bill, as it was finally called, overwhelmingly passed the House and Senate on December 22, 1913 and was signed into law by Wilson the following day. [9] The Fed began operations in November, 1914, with Morgan men occupying key positions.

The new law gave the bankers what they wanted: a monopoly of the note issue. Commercial banks could only issue demand deposits redeemable in Fed notes or nominally in gold. National banks were compelled to join the System but had the legal option of becoming state banks, which were not required to join, though many state banks chose to do so in 1917 when federal regulations were relaxed. [10] Critically, gold coin and bullion were moved further away from the public when member banks shipped their gold to the Fed in exchange for reserves. [11]

The inflationary potential of the system is revealed by its structure: The Fed inflated by pyramiding on its gold, member banks by pyramiding on its reserves at the Fed, and nonmembers by pyramiding on its deposits at member banks. Furthermore, after a few years the Fed began withdrawing fully-backed U.S. Treasury gold certificates from circulation and substituting Federal Reserve Notes instead. With Fed notes requiring only 40 percent backing of gold certificates, more gold was available on which to pyramid reserves. Also, with the advent of the Fed, reserve requirements for demand deposits were cut approximately in half, moving from a 21.1 percent average under the National Banking System to 11.6 percent, then lower still to 9.8 percent in June, 1917, after the U.S. had joined the war. Reserve requirements for time deposits dropped from the same 21.1 percent average to 5 percent, then 3 percent in 1917. Commercial banks developed a policy of shifting borrowers into time deposits to inflate even further. [12]

Thus, the country now had a government-privileged central bank called the Federal Reserve. By hoarding gold as its pyramidal base, the Fed was weaning the public from the use of gold coins, which would make them easier to confiscate later on. Through the Fed, member banks would be inflating at a uniform rate to avoid trouble with redemption demands.

Did this new system bring the big bankers in line? Did the Federal Reserve Act provide “a circulating medium absolutely safe,” as the Report of the Comptroller of the Currency of 1914 stated? How accurate was the report’s claim that:

Under the operation of this law such financial and commercial crises, or "panics," as this country experienced in 1873, in 1893, and again in 1907, with their attendant misfortunes and prostrations, seem to be mathematically impossible. [13]

Imagine, no more crises. Did the people running the banking cartel, almost all of whom were Morgan men, create a better world for most Americans?

They indeed have if you believe wars, depressions, massive debt, depreciating helicopter money, and unaccountable government constitute improvements in our quality of life.

References:

1. See Thomas J. DiLorenzo, The Real Lincoln: A New Look at Abraham Lincoln, His Agenda, and an Unnecessary War, Prima Publishing, Roseville, CA, 2002

2. Murray N. Rothbard, The Mystery of Banking, Mises Institute, Auburn, AL, 2008, p. 230

3. Carl Menger, Principles of Economics, Mises Institute, Auburn, AL, 2007, pp. 257-260; Ludwig von Mises, The Theory of Money and Credit, The Foundation for Economic Education, Inc., Irvington-on-Hudson, New York, 1971, pp. 30-33.

4. Murray N. Rothbard, “The Federal Reserve as a Cartelization Device,” from Money in Crisis: The Federal Reserve, the Economy, and Monetary Reform, edited by Barry N. Siegel, San Francisco, CA: Pacific Institute for Public Policy Analysis, 1984, pp. 91-93

5. Murray N. Rothbard, The Case Against the Fed, Mises Institute, Auburn, AL, 1994, pp. 84-90

6. Murray N. Rothbard, A History of Money and Banking in the United States: The Colonial Era to World War II, Mises Institute, Auburn, AL, 2002, p. 189

7. G. Edward Griffin, The Creature from Jekyll Island: A Second Look at the Federal Reserve, Fourth Edition, American Media, Westlake Village, CA, 2002, p. 448

8. Ibid, p. 459

9. Ibid., p. 468

10. Rothbard, Money in Crisis, p. 112

11. The Case Against the Fed, p. 119

12. Mystery, pp. 238-239

13. Annual Report of the Comptroller of the Currency, December 7, 1914, Vol. 1, p. 10

Fractional Reserve Banking

by Murray N. Rothbard

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, 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.