Our Dangerous Banking System

Although I enjoyed using the Seinfeld sitcom as a literary device in the previous post to illustrate the internal workings of American banking system, I think a little history is needed to fully reveal how dangerous that banking system is to our general welfare.

According to Murray Rothbard, in The Mystery of Banking, 2nd Edition, banks originated as trusted places where people, for a small fee, kept there valuables in a safe place (this practice continues to this day in the form of safety deposit boxes). This practice of protecting people’s deposited valuables turned to fraud over one-thousand years ago in China when banking merchants first used their deposits to inflate the economy. Customers were given receipts for their deposits of gold and these receipts were treated as substitutes for the gold itself and could therefore be used in commercial exchange. The banks eventually were caught issuing more receipts than they actually held as gold. This attempt to inflate the economy with counterfeit receipts of gold was then considered to be a crime, although it is now hailed as our modern “fractional reserve” banking system.

Venice, the home of Marco Polo, adopted many things from its Chinese trading partners, among which were noodles, silk, and the bad practice of using bank deposits to inflate the economy. In Venice as well as China, however, the issuing of more gold receipts than gold was considered a form of fraud, rather that the heart of a banking system that made national heroes of its leading perpetrators. The wizards of our current Federal Reserve would have been ringleaders in those more innocent times.

The Middle Ages in Europe witnessed the growth of another form of banking which we are also today very familiar with – the loaning of money for interest. But, in the Middle Ages, the banking families that grew rich financing the wars of kings, loaned only their own money – not the money of other people who had intrusted their wealth to them. This type of issuing of credit has a far different effect on the general economy than the modern practice of loaning out other people deposits. When a Rothchild loans $1,000 of his own money to a customer, there is no inflationary effect on the economy. The customer has $1,000 more to take to the market to bid on fabrics and spices, but Rothchild has $1,000 less to make competing bids in that market. The result of loaning your own money out is that the money supply remains the same; there is no inflation, and the costs of the fabrics and spices remain essentially unchanged.

The practice of bankers loaning only their own money ended in England and America in the nineteenth century when courts held consistently that depositors’ deposits were not deposits at all, but rather, were loans from the depositor to the bank, to be used by the bank for its own purpose of making loans to customers. On the surface, this does not seem to be such a bad practice; the additional money that banks are able loan is available for expanding businesses. However, let us take a look at the inflationary effect of banks making loans from its depositors’ accounts.

When customer Richman deposits his $1,000 in the local bank, he receives a deposit slip that proves his checks are worth that sum. He is able to go to the market and write checks just as if he had the $1,000 in his pocket. However, the bank takes his deposit and loans $800 to Poorman (the $200 is held by the bank to satisfy the government’s requirement of a 20% “fractional reserve”). Now, Richman and Poorman each go to the market with what they believe is a pocketful of money, Richman with $1,000 and Poorman with $800. But doing a little addition, we can see that the market has a total money supply from our friends of $1,800 from what began as Richman’s original $1,000. The marketplace has suffered an inflation of an addition $800.

Poorman, however, does not carry around his $800 in cash. He took his loan and immediately deposited in the bank. Now it is safe and all he has to do is carry his checkbook and a deposit slip that proves that he has $800 deposited in the bank. It is as good as carrying around cash. However, now the bank has a total amount on deposit of $1,800, Richman’s $1,000 and Poorman’s $800. Since it can loan out 80% of its total deposits, it is able to loan out an additional $640 (80% of the Poorman’s $800 deposit) to Realpoorman. Realpoorman, in turn, deposits his $640 in the bank and the bank has even more deposits and the inflationary growth of the money supply continues.

This modern banking practice works if you don’t think of the damage done to Richman when he goes to the market and finds that the goods he once purchased for $10 are now costing him $20 because he must now bid for those goods against other people with money – the additional money that the bank has created by issuing credit on his original $1,000 deposit. Richman is a victim of an inflation that diluted the value of his $1,000.

But there is a greater danger to this “fractional reserve” banking system. Just as they can create inflation by issuing credit, banks can also create deflation by reducing the total amount of credit issued. Banks have the power of credit expansion that inflates the economy and they likewise have the power of credit contraction which deflates the economy. When an economy inflates, the good that once sold for $10 has the inflated price of $20; and when an economy deflates, the good that once sold for $20 has a sales price of $10. Merchants who don’t reduce their prices fast enough get caught holding unsold goods. Other merchants who do reduce their prices make sales that are less than their costs. Businesses lose money in what is called a recession.

And merchants aren’t the only victims of the banks’ credit contraction; employees who sell their labor must also reduce their prices (wages) to adapt to the deflating economy, and their failure to do such leads to their inevitable unemployment.

The real problem with “fractional reserve” banking is that the whole economy is dependent upon the psychology of the bankers. When bankers are optimistic, the economy booms, but when they lose confidence in their borrowers, they recall their loans and cause the economy to deflate through credit contraction, causing a spiral of deepening financial depression.