What? CNN Doesn’t Understand Fractional Reserve Banking?
By: BJ Lawson
This might not surprise you, but after reading this CNN/Money article entitled, “Panic on Wall Street: A brief history of fear”, I’ve come to the conclusion that CNN doesn’t understand how our banking system works. Here are some interesting quotes that portray unfortunate financiers as innocent bystanders victimized by panic and circumstances outside of their control:
If the Panic of 1873 has one timeless lesson, it’s the physical inability of everyone to escape from trouble at the same moment. Jay Cooke, the railroad financier, had been stiffed by international lenders, and his bank (which then fronted the intersection of Wall and Broad) was suspending payments…
Which brings us to the Great Panic of ‘07, the drama - and trauma - that changed everything… The directors of the Knickerbocker Trust thought they were being secretive when they met in a private dining room to discuss whether they should open their doors the next day, given its president’s connection to a speculative copper scheme. They weren’t secretive enough. According to Wall Street lore, they carelessly left the door ajar, and their conversation floated to the ears of a bystander and then, it seemed, to all 18,000 of its depositors… Soon they were lining up at Knickerbocker’s palatial new headquarters at 34th Street and Fifth Avenue. For several days Knickerbocker tried to buy time (one trick was for tellers to count and recount the cash very slowly).
Of course, while the bankers take their hits, the depositors at these insolvent institutions are big losers as well. What’s amusing about this “history” is that Jerry Useem, the Contributing Editor, never even questions the underlying reason that bank panics and credit crunches occur. Could it be that banks lending more money than they have on deposit for lending isn’t really a good idea? Isn’t our entire banking system technically insolvent, since every $1 of central bank deposits is magically transformed into $10 in loans (assuming a typical 10% “reserve ratio”)?
Particularly telling is the portrayal of Andrew Jackson’s struggle against central banking:
Andrew Jackson rid the nation of a central bank in 1836, which helped produce the Panic of 1837. An unforeseen effect of his policies - a host of barely regulated banks flooding the nation with paper money - produced bad results as well as some innovations: Reserve requirements could be met, for instance, by adding a layer of gold coins over a much bigger pile of tenpenny (or subprime) nails.
In short, while Andrew Jackson was able to remove the central bank, he wasn’t able to eliminate unsound fractional reserve banking. When one such unsound bank in Massachusetts collapsed, it was discovered that its bank note circulation of $500,000 was backed by exactly $86.48. Why is this obvious absurdity, and the banks’ protection from criminal prosecution if they suspended payments, not called into question?
Instead, Jerry’s underlying message is a not-so-subtle “thanks” to our Federal Reserve, whose ability to “inject liquidity” creates the moral hazard that ensures panics involving the financial system will recur over, and over, and over again. And every time a panic happens, we go through the same cycle: bailout those immediately affected at taxpayer expense, look for a scapegoat, wave the flag of justice with high-profile criminal prosecutions, and overreach with new legislative and regulatory “solutions” that ignore the underlying problem and further distort the market. You think getting a mortgage is tough now, just wait until you see what the regulators have in store for you over the next couple of years.
If you’d like a more accurate history of the U.S. banking system, The Creature from Jekyll Island by G. Edward Griffin is a good place to start. Here’s a quote regarding the period described in the CNN article just for comparison:
“The period between the Civil War and the enactment of the Federal Reserve System was one of great economic volatility and no small measure of chaos. The National Banking Acts of 1863-65 established a system of federally chartered banks which were given significant privilege and power over the monetary system. They were granted a monopoly in the issue of bank notes, and the government agreed to accept these notes for the payment of taxes and duties. They were allowed to back this money up to ninety percent with government bonds instead of gold. And they were guaranteed that every bank in the system would have to accept the notes of every other bank at face value, regardless of how shaky their position. The net effect was that the banking system of the United States after the Civil War, far from being free and unregulated as some historians have claimed, was literally a halfway house to central banking. (Emphasis mine)
“The notion of being able to generate prosperity by simply creating more money has always fascinated politicians and businessmen, but at no time in our history was it more in vogue than in the second half of the nineteenth century. The nation had gone mad with the Midas complex, a compulsion to turn everything into money through the magic of banking. Personal checks gradually had become accepted in commerce just as readily as bank notes, and the banks obliged their customers by entering into their passbooks just as many little numbers as they cared to “borrow”. As Groseclose observed, “The manna of cheap money became the universal cry, and as with the Israelites, the easier the manna was acquired, the louder became the complaint, the less willing the people to struggle for it”.
“The prevailing philosophy of the time was aptly expressed by Jay Cooke, the famous financier who had marketed the huge Civil War loans of the federal government and who now was raising $100 million for the Northern Pacific Railroad. Cooke had published a pamphlet which was aptly summarized by its own title: How Our National Debt May Be a National Blessing. The Debt is Public Wealth, Political Union, Protection of Industry, Secure Basis for National Currency. “Why,” asked Cooke, “should this Grand and Glorious country be stunted and dwarfed — its activities chilled and its very life blood curdled by those miserable ‘hard coin’ theories — the musty theories of a bygone age.” As it turned out, however, the chilling and curdling came, not from the musty hard-coin theories of the past, but from the glittering easy-money theories of the present. The Northern Pacific went bankrupt and, as the mountain of imaginary money invested in it collapsed back into nothing, Cooke’s giant investment firm disappeared along with it, triggering the panic of 1873 as it went…
“Altogether, there were four major contractions of the money supply during this period: the so-called panics of 1873, 1884, 1893, and 1907. Each of them was characterized by inadequate bank reserves and suspension of specie payment. Congress reacted, not by requiring an increase in reserves which would have improved the safety margin, but by allowing a decrease. In June of 1874, legislation was passed which permitted the banks to back their notes entirely with government bonds. That, of course, meant more fiat money for Congress, but it also meant that bank notes no longer had any specie backing at all, not even ten per cent. This released over $20 million from bank reserves which then could be used as the basis for pyramiding even more checkbook money into the economy.
“It has become accepted mythology that these panics were caused by seasonal demands for farm loans at harvest time. To supply those funds, the county banks had to draw down their cash reserves which generally were deposited in the larger city banks. This thinned out the reserves held in the cities, and the whole system become more vulnerable. Actually that part of the legend true, but apparently no one is expected to ask questions about the rest of the story. Several of them come to mind. Why wasn’t there a panic every Autumn instead of just every eleven years or so? Why didn’t all banks — country or city — maintain adequate reserves to cover their depositor demands? And why didn’t they do this is in all seasons of the year? The myth falls apart under the weight of these questions.
“The truth is that, if it hadn’t been seasonal demand by agriculture, the money magicians simply would have found another scapegoat. It would have been “immobile” reserves, lack of “elasticity” in the money supply, “imbalance” in international payments, or some other technocratic smoke screen to cover the real problem which was — and has always been — fractional-reserve banking itself. The bottom line was that, in spite of an elaborate scheme to pool the minuscule reserves of the country banks into larger regional banks where they could be rushed from town to town like a keg of coins on the old frontier, it still didn’t work. The loaves and fishes stubbornly refused to multiply.
(from The Creature From Jekyll Island, pp 407-409)
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Actually, our functioning reserve requirements are much, much less right now. One, the larger banks all created SIV’s (remember them from Enron), which acted as short-term money markets making income on, securitized mortgages - which started losing money last year, and had to be brought back on banks balances sheets this year because they were created by the bank’s commerical paper. They were never included in reserve requirements. Secondly, and what will be the larger problems, all the banks, especially the banks owning investment houses sold many derivatives, which are also kept off book, and not included in reserve requirements. The most dangerous of these is the CDS, or Credit Default Swaps. Bear had 60 trillion notional, AIG sold 562 million, and there were more that a trillions dollars of CDS contracts that would have triggered on Fanny and Freddy bonds.