Wednesday, 17 September 2008


With headlines like these below coming from the States, it's obvious that in the November elections the big issue will be "the economy, stupid." It doesn't look good, does it:

•AIG Plunges After Cut in Credit Rating Jeopardizes Effort to Raise Capital

•Overnight Interest Rate Doubles as Banks Hoard Cash on Failure Speculation

•Federal Reserve Adds $50 Billion to Money Market, Sending Funds Rate Lower

•Barclays Discussing Purchase of Lehman Assets, May Seek Broker-Dealer Unit

•Wall Street Convulsions May Further Erode U.S. Growth, Put Pressure on Fed

•Goldman Profit Slumps 70%, Biggest Drop Since Company Went Public in 1999

•Consumer Prices in U.S. Fall First Time in Almost Two Years as Fuel Drops

Yet if "it's the economy, stupid," it's clear that both US candidates are stupid when it comes to the economy.  The collapse of US markets has hit traders, bankers and politicians alike like a hurricane, and to all of them the crisis has all the hallmarks of a natural disaster.  But it's not.  It's entirely man-made -- yet despite all the primary causes emanating from government agencies, chief amongst them the counterfeit capital created by the US Federal Reserve, all the two leading candidates have to say is to waffle on about "fundamentals" about which they're both fundamentally ignorant, and to try and outdo each other in plans to further "regulate" financial markets.

Obama plans "an overhaul of Wall Street regulations, saying the subprime housing crisis and other problems stemmed in part from lack of transparency and accountability in the financial system."  McCain meanwhile promises to "reform the way Wall Street does business, and put an end to the greed that has driven our markets into chaos. We'll put an end to running Wall Street like a casino."

Of the two, McCain sounds the more economically illiterate -- but it's no more than a matter of degree -- but no less illiterate than the Bank of America CEO, who's more than happy to pick up Merrill Lynch for a song, despite being completely unable in the interviews I've heard to explain the process by which Merrill Lynch et al came to this parlous state.

Ignorance, ignorance everywhere ... yet the reason for the crisis is not difficult to identify.

The immediate reason for this economic depression, as Mark Thornton points out at the Mises Blog, "is the bust in the housing market."  But this shouldn't have come as any surprise to rational observers, any more than the tulip bubble of the seventeenth century or the South Seas Bubble of the eighteenth century would have been a surprise to rational observers of the time. 

While mainstream economists wring their hands now in dismay, Austrian economists were reporting on the housing bubble and its causes throughout the boom. As Thornton notes,

Beginning in early 2003, Frank Shostak, Christopher Meyer, Lew Rockwell, Robert Blumen, Jeff Scott, and others, including this author, were writing and lecturing about the housing bubble. We identified the cause of the bubble as the Federal Reserve and its inevitable consequences of a bust in the housing market and the overall economy.

Unfortunately, mainstream observers weren't listening. 

They weren't listening when the Federal Reserve created this latest bubble.  They weren't listening while Alan Greenspan was putting the rocket fuel of counterfeit capital into the economy.  They weren't listening when Bear Sterns was bailed out (with yet more counterfeit capital).  They weren't listening when Fannie Mae and Freddie Mac were created -- and then nationalised.  They weren't listening when the FDIC itself was created and expanded, which helped create the "moral hazard" of removing risk from those who risk your savings.  They weren't listening when the "conventional wisdom" of fractional reserve banking, which needs al these smoke and mirrors of government intervention to prop it up, was pointed out to be another Emperor's New Clothes just waiting to be exposed.  As banker Christopher Meyer points out about the fractional reserve system on which the whole banking system is now based, "there is always a bubble in the making in a world of fractional reserve."  No amount of further regulation can fix that -- what's necessary is the much wider understanding that the single greatest factor in causing booms and busts is the expansion and contraction of the money supplySee.

* * * * *

NB: I can't help but mention a local commentator yesterday about whom I'd had high hopes but who's proved himself, unfortunately, to be almost as bad as all the rest.  Trying to summarise the economic situation on National Radio's 'Panel' yesterday, Bernard Hickey said economic booms were "created by greed," and busts are always "characterised by fear" -- and since both are irrational, government regulators are necessary to stabilise the markets... 

Never has such an irrational argument for regulation been made by someone so seemingly obvlivious to all the evidence before their eyes.


  1. Maybe worth noting that AIG is already hugely regulated. Therefore govt could not let that go without seriously losing face.

  2. When you mentioned the "local commentator yesterday [on the panel] about whom I'd had high hopes but who's proved himself, unfortunately, to be almost as bad as all the rest" I had natually assumed you meant me!

    Woo hoo! This is the closest to a compliment I've had from Pete!

  3. The problem is not fractional reserve banking. Under a free-banking system banks should be permitted to lend out more than they have covered by reserves. It is up to the depositor to decide whether the reserves are sufficient or not and choose his bank accordingly.


  4. Oh really? What you are supporting is the idea that Banks be allowed to commit fraud. Next thing you'll be supporting the passing of bad cheques (which is exactly the same behaviour as fractional reserve banking).

    In a free banking system a fraud remains a fraud. It would be regarded (properly) as a criminal act for which the perpetrators would be severely punished.


  5. It's not fraud if they reveal their policy. If I invest my money in a company that loans out my deposits with my full knowledge, where is the fraud?

    Obviously I would expect to earn a higher return on a company that invests my money, where I am effectively providing credit, than a company that simply holds my money in a vault, but the issue of fraud doesn't come into it.


  6. The fraud exists because they loan out the same claim on money more than once. Fractional reserve banking necessarily has the result that multiple people have claim to the same money. Further, the increase in money in circulation generated by this means has the effect of reducing the value of savings and reducing the purchasing power of everyone else's money. It contributes to the boom bust cycle as it is one of the drivers behind unsustainable malinvestment.

    Fractional reserve banking is exactly like passing bad cheques- a fraudulent activity.


  7. My deposit is not money (i.e. a means of exchange) if I am not automatically able to redeem it. It's credit.

    Therefore, the separate claims on my deposit are differentiated by time and therefore do not affect the purchasing power of money.


  8. Ah. So, according to your approach, it's OK to put $30 in the bank and then issue thousands and thousands of dollars of bad cheques against that account. It's all OK so long as you tell people your cheque writing policy is a fractional reserve one (assuming they asked or that they understood). It's OK so long as they don't try to cash the cheques!



    A funny thing about fraud. It all seems very profitable and OK until you get found out!


    The crime in fractional reserve banking lies in the fact that the bank is distributing rights to the same asset to multiple people. The bank can't honour its obligations to all of them. It relies on the probability that they won't all be exercising their rights simultaneously. Of course, once they do, then the fraud is revealed and many, many, many are injured.

    Another problem, often overlooked, is the dilution of the spending power of all money in circulation, and the erosion of the value of savings, caused by the practice of fractional reserve banking. That destruction of wealth is fraudulent. It affects parties not directly involved with your bank regardless of what they do.


    BTW, that the Mongrel Mob tell the public that they are into crime does not make the commissioning of crime (by their members) harmless or moral.


  9. Well, the exaggerated example you use is perfect for showing that such a thing would never happen. You have to imagine a world where there were no government guarantees, loans, bail-outs, indemnities, insurance, welfare checks or any other forms of government support whatsoever. Now who in their right mind would put £30 in the bank knowing that the bank would create new senior claims for “thousands and thousands of dollars” against their £30? Answer: no one. Or at least, it would require an extremely high rate of return to attract anyone.

    But to be clear, in a genuine free banking market, there would be a whole range of account services offering different levels of fractional reserve, so there would be reserve ratio levels at which you would put your $30 in. At one end of the scale you would have demand deposits with zero reserve ratio. Effectively, banks providing these accounts would be simply vaults that would pay zero interest and would charge fees for a money-holding service. However there would also be a whole range of accounts offering different fractional reserves, where people invest in progressively riskier pools of cash (as the reserve ratio decreases) where the fund is invested as debt or any other type of instrument. Obviously the banks (or funds, or whatever they might be called), would be likely to reduce the callability of such deposits the lower the reserve ratio, so the “rights to the same asset” are not in fact rights to the same asset since your right to call your deposit would be contingent on time and/or the repayment of debt. In short, there are simply contingent rights to the asset with different rankings of seniority.

    Your mistake in considering this as inflating the money supply is that such funds are not actually money! Money is the medium of a means of exchange. If I can’t call my funds then I don’t have money. What I have is an asset which is convertible into money at some future date, but it isn’t money.

    So, yes, the answer is that it is quite OK to put $30 in a bank which then issues thousands and thousands of dollars against that account … except that no one would ever do it to that extreme if the government guarantees were taken away. However if your bank did go to that extreme and you didn’t like it, you could simply shift your money to another bank with less risk and greater levels of callability.

    Calling such practices “immoral” is as nonsensical as calling derivative contracts immoral.


  10. Oops. Typo in the above. It should say: "At one end of the scale you would have demand deposits with 100% reserve ratio", not "zero reserve ratio".


  11. Gidday Sturminator

    The fraud occurs not by the act of the depositor putting his money in the bank but by the bank inflating the quantity of money in circulation. That inflation is a necessary attribute of fractional reserve banking. It is the act of crating money from nothing that eventually drives prices higher than they would otherwise be. Fractional reserve bank inflation reduces the spending power of savings, dissipating the pool of real savings. That is, wealth is stolen from everyone, silently, coercively and without consent. It is consumed. The fraud affects people who are not even involved in transactions with the fractional reserve bank and who do not consent to have their wealth robbed in this insidious manner. Hence in a free economy fractional reserve banking would not be tolerated. Its practitioners would be recognised as runing a type of Ponzi scheme- a pyramid. They would be ruthlessly punished (as they should be).



  12. LGM

    As I said, in a free economy with no government monopoly over the money supply and no government guarantees for deposit accounts, fractional reserve banking would NOT inflate the amount of money in circulation.

    As I said, in a free economy the market would very likely dictate that a fractional reserve would only be used for *saving deposits*, not demand deposits. Savings accounts - with their principle characteristic being that they cannot be immediately drawn down - are no different in principle from the investment fund or pension fund you invest your money in. They are not money that can be used as a medium of exchange, they are assets that can be converted into money at some future date, hence their existence implies nothing for the money supply.

    In relation to *demand deposits*, which do constitute money: as I said, it is extremely unlikely that demand deposits would have anything other than a 100% reserve ratio in the absence of government supports. But even if a bank did provide deposit accounts with less than 100% reserves, and was upfront about what they were doing, then so what? In a free market there would be alternative currencies and alternative banks anyway, so if one bank's currency were debased you could always switch to another.

    And bottom line, even if the market determined through supply and demand that an 80% reserve ratio for demand deposits were optimal, so what? Do you really want to crimimalise people for their free choices?


  13. Yes, I understand. I read what you asserted. It is incorrect.

    Returning to the bad cheque example. Consider what occurs when recipients of the fractional reserve cheques choose to endorse them to over to other people instead of cashing them in. Before long you have a considerable number of dud cheques around the show, all being used to purchase goods and services in competition with other means of exchange- such as that currency which has full asset backing (in this example we are treating the $30 cash deposit and cash in general as asset, as specie and the cheques as currency instruments and means of exchange). Meanwhile the holder of the cheque book continues to keep writing more and more of those dud cheques as and when he feels the need to spend. Note that he produces nothing of value above and beyond the original $30. He consumes it and more. It is the more you should be concerned about. His activity is inflationary. He has created "money" out of nothing. What he does accomplish is to increase the amount of "money" in circulation. That eventually causes a bidding up of the price of goods and services, hence destroying value of ALL currency. You can't avoid the effect. Inflation causes prices rises. As the amount of "money" increases in quantity all holders/users/savers of "money" lose purchasing power. The cheque writer benefits by being able to obtain goods and services way more than his actual asset, the $30. Everyone else is defrauded to the extent of the value of goods and services he obtains over and above $30 (in reality and over the long term they lose to a multiple of that amount). If he writes cheques to the value of $600 (not an unusual multiple of the deposit these days), then he is able to obtain $570 more goods and services than he should. ALL OTHER parties in the economy lose since their "money" is devalued by his activity. Prices are bid up (law of supply and demand, more money in circulation results in higher prices). As stated previously, everyone else's wealth is dissapated without their consent. They have their wealth stolen silently and certainly. That is the fraud.

    Returning now from the bad cheque analogy to fractional reserve banking. It should be understood that the class of deposits claimed as fractional reserves for the bank's "investments" (loans, mortgages, instruments, etc) is imaterial. Whether the fractional backing is demand deposit or savings deposit makes little difference to the overall effect of the scheme. It is inflationary. That is where the fraud lies. Its results include dissipation of wealth and obstruction of accumulation of capital.

    The activity of fractional reserve banking provides an excellent example of Gresham's Law. Bad money drives out the good. In effect it is like allowing wooden counters to be accepted as equivalent to gold coins! In the end there are going to be a lot of wooden counters...

    In the end people who commit fraud and steal from others are criminals. They criminalise themselves.



  14. 1. If any bank issued currency at <100% reserve then prices would only be bid up as measured in that currency. That would not stop you purchasing goods in any other acceptable currency, in which prices would be unchanged. For instance, it may be that prices are marked in gold units, with an exchange value for the currencies of each private bank. All that would happen if a bank switched to <100% reserve ratio is that the currency of that bank would devalue in terms of gold units. Prices in gold units would remain unchanged.

    A better example than the "bad cheque" analogy is two banks, one that issues coins with 100% gold content, the other with 80% gold content. The prices of goods in 80% gold coins will simply be 100/80 times the prices of goods in 100% gold coins. As long as the fact that one bank's coins have only 80% gold content is publicly disclosed there is no fraud.

    2. "Whether the fractional backing is demand deposit or savings deposit makes little difference to the overall effect of the scheme."

    It is crucial because (a) your argument can only apply to demand deposits because only demand deposits are true money and (b) in a true free market people would want 100% backing for any demand deposits anyway.

    You can read up any of the articles on the definition of the money supply on They will all tell you that savings deposits should not be counted as "money" to the extent that such accounts cannot be immediately drawn. This should be obvious if you thinnk about a long-term investment in a pension fund, which clearly is not money (as it can't drawn until you are over 60), and so clearly not inflationary if the pension fund invests in mortgage lending or whatever.

    The point is that the reserve ratio of any fund ina free market would be intimately linked to the callability of its funds. For true demand accounts, depositors in a free market are not likely to accept any reserve ratio less than 100%. For investment accounts, it doesn't matter anyway because those accounts are not true money.


  15. Good Morning Sturminator!

    1/. Bidding up of prices takes time to occur. Inflation occurs at the instant the bank does it. The benefits accrue to the creator of the unbacked "money" immediately it is used to purchase goods and services at the prices then prevailing. The cost accrues to everyone else gradually over time.

    The burden of incresed prices and dissapated wealth falls upon others over a period of time. Eventually, as the market adjusts to the presence of the new "money" in circulation, the prices of goods and services climb. It is then the loses as experienced. They are experienced silently and by people who were not even party to the original transaction. The damage persists and multiplies right through the economy. Real savings and wealth are consumed without the permission of the owners. It is a particularly odious fraud.

    2/. Both types of deposit are "money". The value of both types is diminished by inflation.

    What you are considering is a depositor demanding his money immediately and whether the bank can supply it. This is really an issue of terms and conditions agreed between the bank and the depositor. What those terms may or may not be is not the problem at the heart of the fractional reserve fraud. The essential atribute of that activity is the issuance of "money" or instrument of exchange or transaction which is unbacked by reserve. That is inflation and that is the fraud.



    BTW I certainly do enjoy reading the Von Mises Institute material. Not all of it is correct. Still, it's one of the most interesting and stimulating sites on the web. The leading economist on that site, Prof Reisman, is less than impressed with fractional reserve banking. He discussed it in several essays and also in his book. Well worth consideration.

  16. Actually if you read Reisman closely you will see that he is agnostic on whether fractional reserve banking should be barred in law.

    However, like me, he recognises the point that if you took away all of the government supports, depositors would demand 100% reserves anyway.

    He also recognises, like me, the argument that people would switch to different banks or demand gold and silver currency if one bank were inflating its currency by holding <100% reserves.

    Ultimately he concludes that the holding of <100% reserves would be "virtually impossible" in a true free market. Nowhere does he say it needs to be banned.

  17. Sturminator

    As I wrote, he is less than impressed. He certainly isn't a supporter. He's very critical.

    As far as fractional reserve banking is concerned, it's a fraudulent activity which adds nothing good to the economy. The analogy of writing bad cheques is apt. That is, it's a type of theft.



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