A Short Stack of Lies and Half-Truths from the Wall Street Journal
By: BJ Lawson
I’m grateful that Dr. Tom DiLorenzo, professor of economics at Loyola College, took the time to write a rebuttal to an inexplicably ignorant hit-piece recently published in the Wall Street Journal entitled “A Short Banking History of the United States.”
The author of this article, Mr. John Steele Gordon, makes a number of spurious claims in an attempt to discredit the economic philosophy of sound money controlled by the people, and defend Alexander Hamilton’s loyalty to banking interests in the drive to create a private central bank to own our money supply.
Beneath Mr. Gordon’s flowery rhetoric, however, is a profound ignorance of a fundamental problem in our money and banking system: fractional reserve lending. As I noted in an article last August, this ignorance in the mainstream media is nothing new, and par for the course:
http://blog.lawsonforcongress.com/2007/08/29/what-cnn-doesnt-understand-fractional-reserve-banking/
What’s wrong with fractional reserve lending? This article from June outlines the details:
http://blog.lawsonforcongress.com/2008/06/04/whats-the-problem-with-banks/
Once you understand the root of the problem, namely that banks are given a monopoly on the ability to create money out of nothing based solely out of someone’s promise to pay it back with interest, the tragic absurdity of our current situation becomes clear:
http://blog.lawsonforcongress.com/2008/07/11/may-you-live-in-interesting-times/
I’m especially grateful, though, for Dr. DiLorenzo’s rebuttal that puts Mr. Gordon’s revisionist history in the proper context:
The system of financial regulatory dictatorship that Gordon praises, and which is about to be forced down the throats of the American public, has been tried before in other countries. During one of its own periodic financial crises, Italian government officials complained bitterly, as Gordon does, of regulation that has been “disorganic” and “case by case, as the need arises.” The Italian regime altered its regulatory system so that it could pursue “certain fixed objectives,” just as Gordon argues for a “unified and coherent regulatory system.” This highly centralized or even dictatorial regulatory system, the Italians argued, would supposedly “introduce order in the economic field” and achieve the goal of “unity of aim” with regard to government regulation of industry.
All of the words in quotation marks in the preceding paragraph, except for the last ones, are the words of Benito Mussolini. The “unity of aim” phrase was from Mussolini apologist/propagandist Fausto Pitigliani. There is, after all, a very keen similarity between Hamiltonian mercantilism — or an economy directed and controlled by government, supposedly “in the public interest” but in reality for the benefit of a privileged few — and the economic fascism of Italy (and Germany) of the 1920s and ’30s.
I encourage you to read the rest of Dr. DiLorenzo’s article, and to evaluate the credentials of those who praise our Federal Reserve and banking system carefully — including my opponent. As with many corporate interests in Washington, the fox has been left guarding the henhouse.
Once you’ve read the explanations of how banking works, you’ll really enjoy the below cartoon (from Sinfest) that beautifully explains the bailout in action:
Ladies and gentlemen, we’ve been jacked.
October 31st, 2008 at 12:21 am
Haha I love the cartoon. And a special thanks to Dr. Tom DiLorenzo for his rebuttal!
-David Carlson
http://www.davidcarlsonpolitics.com
October 31st, 2008 at 7:24 am
That cartoon is one of the most succinct explanations of the recent banking crisis that I’ve seen. Of course, it leaves out the role of the Federal Reserve and the inflation of the money, but it’s a great start.
-jcr
October 31st, 2008 at 1:57 pm
The honest truth is that our banking system and money itself is a complete mystery to most Americans - myself included up until about a year ago. Although I have done a good bit of reading on the monetary issue, it is still a very confusing subject full of overlapping jargon and complex systems.
I think that criticism of fractional reserve banking is certainly fair when it is practiced under a central bank on the basis of a purely “paper” currency. If I was to loan out money to others, and charge interest, by writing checks for money that I did not have, I would be charged with fraud. Even if I had $10 in the bank, I would still be committing fraud by writing checks for $100 and exchanging them with you for the promise of repayment plus interest.
Yet this is precisely what banks do every day. They make loans to individuals using money they do not have. Well, how do they make the loans? They simply create the new money on the spot by typing on the computer and updating the size of your account.
The unfairness is that 1) the government essentially mandates that we can only use Federal Reserve Notes as currency and 2) the government mandates that only institutions which are part of the Federal Reserve banking cartel can create this commodity. Such is not the case with gold. Gold is not valuable because the government says so, and no one has an exclusive legal right (or physical ability) to conjure gold out of nothing. Hence, fractional reserve banking - where only a portion of your liabilities are backed by reserves of currency - is immoral primarily because it rests upon a legal monopoly given to and benefiting the banks of the Federal Reserve system.
On the other hand, I’m inclined to believe that fractional reserve banking - in a true free market monetary system (free banking system) - would not be immoral or even necessarily dangerous. In such a system, the currency would most likely be gold, silver, or even potentially shares of a basket of commodities… whatever consumers and producers conclude, in aggregate, is the most stable/flexible/desirable basis for a medium of exchange in trade. Banks, then, would provide the services of 1) storing money 2) providing bank notes (paper or electronic) to facilitate economic transactions and 3) issuing loans.
Currently, you can go to a bank and exchange a Federal Reserve note for just another Federal Reserve note. Under a free market system, no one would accept such a currency that had no intrinsic value (unless it is an extremely well-established social norm/tradition - like pacific island cultures that used round stones with holes in the middle as money), instead they would demand something of actual value in return that they could then trade with others. Banks would have vaults of gold (or other commodities perhaps), but to facilitate transactions they would issue private notes which are essential mini-contractual obligations to exchange the note for real currency on demand.
These notes, like Federal Reserve notes, would be used in trade. People would only accept them, however, if they believed the bank was sound, and that the probability that the notes would be redeemed on demand was certain. This would provide an incentive for banks to behave more cautiously and to show the public proof of their soundness. This contrasts with our current system in which default FDIC insurance discourages consumers from caring about the financial status of their bank.
At the same time, such a system would allow banks to engage in fractional reserve banking. By issuing loans in their own private bank notes, they would be able to create more notes (contracts guaranteeing the exchange of the note for real currency) than actual currency in their reserves. The question is, would this be immoral? I don’t think so.
First, under a free market system, anyone would be free to establish such a bank and issue notes. Membership in a central banking cartel would not be enforced by law - the system would be completely voluntary. Banks may exist which use 100% reserve ratios, and if you did not trust using a fractional reserve bank’s notes, you could turn to alternatives. Secondly, the entire system would be on the basis of contract. No one would be living under the pretense that the notes are actual money, as we do today. Although banks would be issuing contracts that they know, under certain conditions, they would not be able to deliver on (assume a huge bank run, or theft of the reserves), such contracts are made every day by businesses who know that, under rare or extreme circumstances, they will not be able to fulfill (hurricane, theft, etc).
If a bank issues notes and is aware of a substantial risk that it will be unable to perform the contract, or should have been aware of that fact, or if it issues them knowing for certain that they will not fulfill it - the role of the government is to punish them for fraud. Even still, it would against the bank’s own interest to create too many notes since the danger of insolvency in a free market would not be accompanied by the subtle guarantee of a government bailout as it is today.
In conclusion, as supply and demand for money changes (in both actual form and in contractual note form), only a free market monetary system would be able to react appropriately. Like all commodities such as lamps, canned soup, or iron ore, money must be left to the free market.
I realize this is quite a lengthy post, but I think that the subject is absolutely fascinating. Thank you B.J. for providing a place for discussion of these important and often-ignored issues.
October 31st, 2008 at 2:59 pm
BJ was on the Glenn Beck Radio Show this morning:
http://libertymaven.com/2008/10/31/ron-paul-jr-bj-lawson-on-glenn-beck-radio/2920/
October 31st, 2008 at 6:03 pm
Paul — great thoughts. We had a similar discussion on the validity of fractional reserve banking in the comments below:
http://blog.lawsonforcongress.com/2008/06/04/whats-the-problem-with-banks/#comments
Even in a free market for money and banking, and even without the moral hazard of “deposit insurance”, there’s another reason that I don’t like the fractional reserve lending.
Lending in excess of reserves and artificially increasing the supply of paper/receipt money has a detrimental effect on other users of the same money — it confiscates purchasing power of others through inflation.
Following the Golden Rule (no pun intended), is it right for inflation to confiscate purchasing power of others using that same money?
October 31st, 2008 at 8:54 pm
Love the comic.
November 1st, 2008 at 5:13 pm
Thanks, BJ. I enjoyed reading through that discussion - I doubt there are many Congressional candidate’s websites were so much interesting commentary can be found.
There certainly is a potential danger in inflating a currency, but I think that banks would realize that if they provide a bank note which has an unstable value or which devalues over time, people would be more reluctant to use it.
I don’t think that the supply of a bank’s notes would fluctuate much in practice, as banks would likely settle on a ratio and would probably not alter it much from there.
Also, doesn’t the discovery of gold confiscate the purchasing power of gold? The same goes with any other commodity. I think the morality argument applies more with the current system since it is a policy decision to debase the value of the currency. Even still, it is certainly debatable that it would also be immoral in a “free banking” system.
November 3rd, 2008 at 8:01 am
Paul - As you note, it takes effort to bring commodity money into circulation. So the purchasing power of commodity money discounts that effort, although it can change over time.
The problem with paper currency (or even receipt money fractionally backed by a commodity) is that it can be brought into circulation (as in the case of fractional reserve lending) without any effort, so you’re dependent on the morality of the actors involved — everyone must exhibit restraint. We have banking regulations that put brakes on the process of unrestrained credit creation, although as noted, many brakes were taken off over the past decade with deregulation.
Finally, the most important distinction is not commodity money versus fiat money. The most important distinction between money as an asset, and money as debt. What’s the difference, you ask? How the money gets put into circulation. Money as an asset gets spent into circulation, or created in circulation as evidence of wealth (like commodity money). Money as debt gets lent into circulation (such as through fractional reserve banking), and creates an obligation to be paid back… typically with additional interest:
http://blog.lawsonforcongress.com/2008/09/18/honesty/
November 3rd, 2008 at 6:01 pm
Regarding fractional reserve lending. After spending lots of time reading about how banking systems work (including lots of really dry stuff like international settlement systems) I’ve come to the conclusion that fractional reserve practices fill critically important and likely delicate roles in highly interconnected and critical global systems and that leading the charge to change those rules would be tilting at windmills. This is not the sort of problem where we should write a new system, reinstall and reboot.
We should instead address one of the major flaws of the system, the accumulation of debt in excess of the money supply (think of it as an in-memory patch).
Perhaps this issue could be solved with by tasking the Treasury with issuing into circulation of non-debt dollars in a quantity equal to the interest paid for each reporting period (quarterly I’d suppose).
I’m not convinced that the ‘boom and bust’ cycle is solely the result of Fed control of the monetary system (seems to me that complex social factors probably also play in important role; consider the development of CDOs and MBSs), or that it is /necessarily/ a bad thing. Booms encourage and enable new ideas (lots of money available results in funding of wild and harebrained ideas that just might work but that wouldn’t be able to pay off in an environment of higher interest rates one would expect in a completely stable economy), and busts weed out marginal or weak practices (the harebrained ideas). The cycle (provided it describes mild recessions rather than Great Depressions) may help to prevent stagnation.
What is bad is that in conjunction with the current practice of creating only principle rather than principle+interest the system can be managed to (or perhaps must) cause an accumulation of debt obligation toward the entities permitted to practice fractional reserve lending.
Perhaps we can greatly improve the system simply by causing to exist each quarter all the money required to pay off the interest on loans. This would begin the injection of credit money into the system with minimal impact on business.