What’s the Problem with Banks?
By: BJ Lawson
I’ve been struggling with a blog post to outline my concerns with our economy in light of the challenges in the housing and credit markets. Two excellent books, Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash and Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, are timely additions to the dialog that explore the financial market’s “innovations” behind our current boom/bust cycle. However, as great as these books are at explaining the immediate cause of our difficulties, neither of them get to the root of the problem that has plagued our financial system, and economy, for generations.
Beyond the headlines of “writedowns” and management turnovers, the problems in today’s financial industry ultimately stem from its unstable, and many would say immoral, foundation. That foundation is “fractional reserve banking”.
What, exactly, is fractional reserve banking? Quite simply, it’s where banks lend more money than their depositors have given them for that purpose. Perhaps the best way to explain it is to talk about how “honest” banking would work, and then highlight the differences.
Broadly speaking, banks serve two customer needs: safeguarding wealth for the depositor’s peace of mind and convenience, and matching up savers who want to lend money with borrowers who want to borrow money. Those purposes are completely separate, and should not be confused. However, the temptation to confuse them in pursuit of greater profit has always led the banking industry to a precarious state.
In the world of “honest banking”, banks recognize two types of deposits, demand deposits and time deposits:
- Demand deposits, as the name implies, are available “on demand” and reflect the bank serving the customer’s first need: safeguarding wealth for peace of mind and convenience. Since the bank is offering this service, the customer should expect to pay for the safety and convenience offered by a demand deposit (or typical checking account). The customer expects that her money is always available, and effectively “in the vault”.
- Time deposits, in contrast, are not available on demand. They are savings that the depositor is looking to invest, and use to earn income. The simplest example of a time deposit is a Certificate of Deposit, or CD. CDs pay an interest rate, and the funds in a CD are returned with interest after a certain period of time. With a CD, the money is not available for immediate withdrawal. In fact, the customer expects that the money is not “in the vault” — she can’t access the funds until the CD matures since the money is literally “out working”, and being used to create value by another customer who borrowed it through a loan.
From the descriptions above, you can imagine that a bank’s income would come from two sources: fees for offering demand deposits, and the difference between interest paid to savers (who lend the bank money) and received from borrowers (who borrow money from the bank). That’s pretty much the way banking should work. Unfortunately, however, it doesn’t.
You see, unscrupulous bankers throughout history realized that they could increase their profits by loaning out their demand deposits as well as their time deposits. You can easily see the temptation — as long as most customers don’t ask for all their money out of their checking accounts, what’s the harm in loaning out some of that demand deposit money and earning interest for the bank? No one will know the difference, and it’s a profitable risk to take.
Even better, once merchants began accepting checks or receipts from this banker instead of the underlying “money” (whatever it was) itself, the banker began to realize that he could create even more loans. Who will know, if the community accepts the bank’s receipts as money? Suddenly the bank is no longer just in the business of storing money, and matching lenders and borrowers. Now the bank is in the business of falsely creating new money when a customer takes out a loan.
The problem is that eventually, inevitably, the bank’s customers get suspicious — perhaps in the face of rising prices, as new money floods the local economy. The customers realize that the bank has more receipts, or checks, outstanding than it can possibly cover. Once the bank’s customers lose confidence, they all show up and demand their money. The bank, of course, doesn’t have enough money to honor all the claims, so the depositors are left in the lurch. This “run on the bank” reveals the deception, and exposes the fractional reserve bank as an inherently bankrupt institution.
From a social perspective, what are the consequences of the banking industry creating new money (at essentially zero cost), only to loan it to you with interest? When the bank creates “money”, is it actually creating value? The answer is no — the banking industry is not creating value when it creates new money to fulfill a loan. In fact, the bank’s new money is taking value from everyone else by reducing the purchasing power of everyone’s savings, investments, and earnings.
You’d think that after generations of repeating the same pattern of booms, busts, and bank failures, we’d put control, and the rule of law, firmly on the side of the customers whose assets form the basis of society’s prosperity. You’d think that fractional reserve banking would be illegal, and those who fraudulently make multiple loans against the same money, or loan out money that already has another claim against it, would be liable for civil or criminal prosecution. In fact, even the Bible warns against this practice, termed “multiple indebtedness”:
If you ever take your neighbor’s garment as a pledge, you shall return it to him before the sun goes down. For that is his only covering, it is his garment for his skin. What will he sleep in? And it will be that when he cries to Me, I will hear, for I am gracious (Exodus 22:26-27)
This verse is talking about the prohibition of interest in loans to poor fellow believers, also known as usury. In this case, the borrower is so poor that his cloak is his collateral. While this is not a business loan, it’s still important, and acceptable, that the borrower offer collateral — even something as humble as his cloak. The fact that this impoverished borrower physically gives the cloak to the lender during the day is protection against the borrower being corrupt at heart — the borrower cannot make the rounds of moneylenders, securing loans out of sympathy from each, and pledging his coat multiple times as collateral. Since only one lender can hold the cloak, there can be only one loan made against it.
As a matter of common sense, and as a matter of morality, it’s wrong (and typically prohibited) to secure multiple loans with the same piece of collateral.
So how does the concept of multiple indebtedness relate to banks? In the same way that the poor man should not defraud lenders by taking out multiple loans on the same piece of collateral, banks should not defraud their customers by creating multiple loans against the same money, or loaning out money that already has another claim against it.
In a nutshell, that’s the problem with our financial system. If a pawnbroker were to make loans against family heirlooms with counterfeit paper currency photocopied in his office, he would be arrested. But when the bank gives you a mortgage against your house, and creates a new deposit in your checking account that’s only partially backed by depositors’ money, the bank has created new money just as certainly as the pawnbroker with counterfeit bills.
For an entertaining description of fractional reserve banking and its interaction with paper money, watch this video:
While this video does an excellent job of showing the problems with our current system, there’s still much discussion to be had on proposed solutions. But we need to begin an honest discussion as we look towards the future.
On a more humorous note, here’s a great video on the Northern Rock bank failure in Great Britain:
Next, we’ll explore how the Federal Reserve and our government attempt to keep this fragile system intact.
June 4th, 2008 at 5:54 pm
Well, I finally understand the principle behind fractional reserve banking. Is is possible to do fractional reserve banking with the gold standard?
Sure there are ups and downs with fractional reserve banking, but is it really possible to grow at fast rates without it? I guess I still don’t understand the whole picture.
June 4th, 2008 at 10:31 pm
Jeffrey — Yes, fractional reserve banking where banks lend out in excess of their deposits can and does occur regardless of the underlying “money”. Paper money, gold, or silver — all are susceptible to “credit expansion” if merchants accept checks and receipts for the underlying money instead of the money itself. I just embedded a video that talks about the relationship between money and banking in more detail — it’s worth a watch.
The question of growth is a good one. How much growth is considered “fast”? What’s the “right” rate of growth? The problem is that our Federal Reserve’s ability to set interest rates essentially controls the growth of the money supply, and as a result we get boom/bust cycles instead of steady organic growth.
Like most Americans, I’m concerned with sustainability. Our current system has one overriding consequence that makes it unsustainable: inflation, and debasement of the currency. Inflation isn’t just rising prices, it’s “falling money” that confiscates purchasing power and encourages people to embrace short-term gains to “beat inflation”. As a result, we’re living in the world of “no money down”, “easy credit”, and “Fast Money” instead of investing and saving to build wealth over time.
Growth should be a virtuous cycle where people work to assemble raw materials into things of greater value, creating wealth and accumulating capital in the process. There are many factors that influence the rate of overall growth, but it’s important to note that artificially stimulating growth by manipulating money and credit is at the heart of the boom/bust cycles and wealth confiscation through inflation that are eviscerating our working poor and middle class.
Here’s a more vivid analogy: fractional reserve banking, especially when coupled with a fiat currency, is the economic equivalent of amphetamines. Yes, credit expansion and growing the money supply can accelerate growth. The euphoria will be followed by a crash, however, as credit contraction is amplified by the same leveraged process that first expanded it. Furthermore, recovery demands increasing doses of the “drug”. The consequences of our getting hooked on easy money from banks for economic growth are similar to the physiological consequences for the amphetamines addict. Didn’t turn out too well for Elvis, either.
There is a natural rate of growth in any economy given its level of resources (natural, human, and capital), incentives, protection of property, and freedom from corruption and theft. Abruptly growing (and then shrinking) the money supply interferes with that equilibrium and has destructive consequences.
June 5th, 2008 at 1:28 pm
BJ,
Interesting. How would you manage the money supply then? Just increase it by three or four percent every year, as Milton Friedmann proposed?
Thanks,
James
June 5th, 2008 at 2:57 pm
James — Another great question. How about replacing the word “money” with another commodity, say milk, and asking again: “How would you manage the milk supply then? Just increase it by three or four percent every year…”
Why do we think the money supply needs to be “managed”? Well, because we have given our central bank a monopoly over our money supply. When Milton Friedman proposed his monetarist solution, he was working within the constraints of a central bank monopoly that exercises complete control over the money supply. His monetarist “solution” may be theoretically preferable to the discretion of a group of central bankers joined at the hip with politicians looking to get re-elected. But one drawback of Friedman’s solution is that it’s extremely difficult to measure and predict the money supply, its growth, and how growth will intersect with the psychology of the markets.
Given that most folks think monopolies are “bad”, why should we allow a private central bank to exercise monopolistic control over the most important commodity in our economy: the money supply itself? Why can’t Americans have monetary choice, and choose to swap between Federal Reserve Notes, gold, or silver (i.e., Constitutional money) without incurring tax liability?
My point is that we need to question the appropriateness of our unconstitutional central bank having a monopoly over our money, much as we would question the existence of a milk monopoly that proposed to regulate the milk supply “for the good of the people.” Money is a commodity with a price (i.e., interest rates) that depends on supply and demand. Without the Fed’s intervention, and in a free system with monetary choice, the market for money will fluctuate, but will be much more stable. When money is in high demand and savings are low, interest rates will go up - thus stimulating saving. When money is in low demand, and savings are high, interest rates will go down - thus stimulating borrowing.
The Federal Reserve, however, fixes interest rates and thus the price of money, which gives false signals to the market. As a result, our system creates recurrent booms and busts to the detriment of all Americans. This is getting into the next post, but you’ll really enjoy the book, “What Has the Government Done with our Money” by Murray Rothbard, downloadable here:
http://mises.org/money.asp
BJ
June 5th, 2008 at 11:32 pm
James,
As it happens, there is a role for the federal government in the monetary system, authorized by the Constitution. The Congress (not the executive) is empowered to “coin money, and regulate the value thereof”. This is the authority for the US Mint to strike coins. What you have in your pocket today are not coins, they are slugs. Coins are made of a valuable metal, like gold or silver, and are units of a guaranteed weight.
We’ve returned from fiat currency to honest money twice in the history of this country. Once, when we had the catastrophic failure of the Continental dollar (which is why the Constitution prohibits fiat money), and once in an orderly fashion, when we retired Lincoln’s illegal greenbacks with which the Union financed the Civil War.
The way to retire a fiat currency is quite straightforward. First, you stop inflating the fiat money. Second, you determine a par value for the fiat money in gold or another legal commodity, and finally, you redeem the fiat notes for the promised coinage over time.
The biggest problem we have with the Federal Reserve’s manipulation of the fiat money supply is that the purpose of the Fed is, and has always been, to increase the wealth of its owners. The Fed is owned by its member banks, which in turn are owned by their shareholders. When a bank in the USA makes a loan, they’re not lending out their depositors’ money, they’re borrowing money from the fed, tacking on a higher interest rate, and making their profit on the difference.
The upshot of this is that the banks win by lending out as much money as they can, and there’s no limit to the amount they can borrow, since money from the fed is created out of thin air by simply changing a number in a computer. Every time a bank makes a loan, the fed is inflating the currency by the amount of that loan.
-jcr
June 6th, 2008 at 12:14 pm
It is possible to do inflate through Fractional Reserve Banking under the Gold Standard, in fact that’s how it was done most of the 19th century, and it’s what caused all the bank runs during that period.
A Gold standard will produce stability only if banks are allowed to fail, just like any other business, because they are just like any other business; they exist to make profit. So, banks must feel the effect of the risk of Fractional Reserve Banking when the depositors come to claim their coin. If the government props them up as it did during the 19th century, there is no risk and it creates incentive to inflate at will. Therefore, the inflation problem will persist.
If (WHEN!) we move back to a Gold Standard, Banks should be required to keep 100% Reserves when chartered, redeeming notes for coin on demand.
-Joe
June 6th, 2008 at 6:41 pm
Joe,
I don’t agree that banks should be required to keep 100% reserves. I think that it would be quite sufficient to let the market reward those banks that do business carefully, and destroy those that don’t. Let the banks advertise how prudent they are, or that they have deposit insurance from well-reputed private insurers, and of course once they make a claim in an advertisement it had better be true or they’ll be liable for fraud.
-jcr
June 7th, 2008 at 8:52 am
JCR — When banks choose to take a position on the “slippery slope” of fractional reserve banking, they are immediately vulnerable to bank runs. In the absence of a central bank to “provide liquidity” (i.e., print money), and transfer the cost of bank failures to the general public through inflation, such banks *will* ultimately fail and depositors’ money *will* be lost. Our federal deposit insurance is a not truly insurance, and again simply depends on the government’s ability to print money in the event of a significant failure.
When an inevitable bank failure occurs in your scenario, should the bank’s owners be liable for prosecution? Or should the customers just learn the hard way that there is no substitute for honest banking?
June 7th, 2008 at 12:29 pm
“When an inevitable bank failure occurs in your scenario, should the bank’s owners be liable for prosecution? ”
That would depend on whether they had committed fraud. If they’re up front about what they’re doing, then fractional reserve banking isn’t necessarily a crime. Also, I didn’t advocate that the government should be in the bank insurance business. That’s a job for the private insurance industry.
-jcr
June 7th, 2008 at 12:33 pm
This just in.. Ron Paul’s book, “Pillars of Prosperity. Free Markets, Honest Money, Private Property” is available in PDF form online at the Von Mises Institute.
http://www.mises.org/books/prosperity.pdf
-jcr
June 7th, 2008 at 10:25 pm
hi BJ…Rothbard has written an excellent book on exactly this topic…its called “the mystery of banking” and is available free on mises.org…the book is written in typical Rothbard style…where the most complex ideas are explained in amazingly simple terms…
hope this helps!
June 8th, 2008 at 9:28 pm
JCR, the market would indeed reward the prudent bankers, you have a point there. With FRB there will be inflation though (but at least it wouldn’t be for the extravagance of Big Govt.). The point remains though, without 100% reserves, and with FRB the banks will eventually fail, and as BJ said people will lose all or most of their money.
So either competing banks will have to foot the bill and redeem the failed banks notes, or the people who entrusted their funds with the bankrupt bank will share the same fate.
I don’t know what the solution is: a law requiring 100% reserves as was tried by Andrew Jackson, or the free market solution of having stronger banks redeem the failing(inflationary) banks’ notes.
Joe
June 10th, 2008 at 4:53 pm
Check out this chart from the St. Louis Fed:
http://research.stlouisfed.org/fred2/data/BOGNONBR_Max_630_378.png
Our banking system in aggregate has NEGATIVE non-borrowed reserves. Banks essentially don’t have the organic reserves themselves required by law, and are relying on the Federal Reserve to fund their reserve requirements.
The financial as a whole is insolvent.
June 10th, 2008 at 4:54 pm
Check out this chart from the St. Louis Fed:
http://research.stlouisfed.org/fred2/data/BOGNONBR_Max_630_378.png
Our banking system in aggregate has NEGATIVE non-borrowed reserves. Banks essentially don’t have the organic reserves themselves required by law, and are relying on the Federal Reserve to fund their reserve requirements.
The financial system as a whole is insolvent.
June 10th, 2008 at 11:04 pm
BJ, it is great to see your knowledge and understanding of the current monetary system and the practice of fractional reserve banking (FRB) the current banks utilize and speak about it. You’ve explained and articulated it very well.
Certainly this is usury and most Americans do not realize the destruction this fraud perpetuates. Of course FRB is only part of the problem. BJ hit it on the nail when he said, “Given that most folks think monopolies are “bad”, why should we allow a private central bank to exercise monopolistic control over the most important commodity in our economy: the money supply itself?”
Regarding the Gold Standard, I’m not completely convinced this is the best option. History would show gold has never been a stable commodity itself. Though I have not studied or read much about Ludwig von Mises ideas regarding monetary policy, I have read the book Louis Even wrote entitled, In This Age of Plenty, published by the Michael Journal in Canada (http://www.michaeljournal.org/plenty.htm) which is based on the principles of the Scottish Engineer, C.H. Douglas’s book, Social Credit. (http://douglassocialcredit.com/resources/resources/social_credit_by_ch_douglas.pdf).
I would highly recommend a review of those two books, which essentially illustrate the points BJ made and more but also offer an alternative monetary system putting money back at the service of man and not its master. I believe a great step in the right direction is the legislation proposed by the American Monetary Institute (http://www.monetary.org), The American Monetary Act (http://www.monetary.org/amacolorpamphlet.pdf). Such legislation would change the monetary system bringing prosperity and real freedom back to Americans. The institute provides a wealth of information and Stephen Zarlenga has written a quite extensive and lengthy book (736 pages) titled, The Lost Science of Money, an interesting read (I”m not finished though).
We should all keep in mind, this crude economic system persists throughout the world, not just America and in other parts of the world this has created a situation in which people suffer and starve to death.
An economic system that mass-produces poor, homeless, starving people; every Christian must make it his duty to fight and replace it.
I’ll end this post with one final comment from F.R. Burch’s book, Money and Its True Function:
“As long as Christ confined His teachings to the realm of morality and righteousness, He was undisturbed; it was not till He assailed the established economic system and cast out the profiteers and overthrew the tables of the money changers, that He was doomed. The following day, He was questioned, betrayed on the second, tried on the third, and on the fourth, crucified.”
June 13th, 2008 at 1:15 am
[...] What’s the Problem with Banks? [...]
June 16th, 2008 at 9:36 pm
In a wealth-based economy, the ‘money supply’ will expand as people create anything of value, because those valuable things are ‘monetized’ as they enter into the economy. In a debt-based (Keynesian) system, debt becomes money. The bank does not loan money per se. Instead, it creates a debt claim on real property (the collateral) and monetizes that debt. The bank lends CREDIT at interest. Because the amount of ‘money’ created cannot exceed the principal plus the interest on the ‘loan’, default and foreclosure is a necessary consequence. For example, I want to buy your house for 100K. I don’t have 100 K so I go to the bank and they create 100K out of nothing. But my loan is at interest. All they create is the principal, so the only way I can pay off my debt is by getting someone else’s princpal. Someone, somewhere will go into default as soon as the bank stops creating this ‘money.’ So this rash of foreclosures is not an unintended consequence. It is part of the design and is fully intended by the bankers. They did it in the 30’s to harvest farms, and they are doing it again with residences. The intent is a complete feudal system, as Jefferson warned against, where we “wake up homeless on the continent our forefathers conquered.”
Read “God, the Devil, and Legal Tender” at http://www.rogershermansociety.com/rushdoony.htm
August 30th, 2008 at 3:45 pm
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October 28th, 2008 at 1:34 am
[...] How did we get to the point where we accept “money” that is a token of debt instead of wealth? How did we get to the point where we accept a monopoly on money that is lent into circulation based upon the borrower’s promise to pay it back with interest? [...]