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.

Seinfeld, Kramer, and the Federal Reserve

Every American taxpayer should know how his country’s banking system works. While how it operates may appear obscure and even intimidating, it is really so simple that all you have to do is watch one particular episode of the Seinfeld sitcom reruns to master its dark secrets.

In the episode entitled “The Wigmaster,” the mechanics of our Federal Reserve banking system are perfectly modeled through the mischief of an unscrupulous parking lot manager. Think of the parking lot as your local bank, watch the show carefully, and walk away with the equivalent of a graduate degree in money and banking.

Two Seinfeld buddies, George and Kramer, have decided to “deposit” their cars in Jiffy Park’s long-term parking lot (Kramer actually gets a free t-shirt for making his initial deposit). The manager of Jiffy Park, like your local bank president, agrees to take care of the deposited property, including providing the necessary storage and protection.

Our two heroes walk away satisfied that their properties are safe, apparently unaware of the deceptive use that will be made of their vehicles. The manager of Jiffy Park, like the president of our local bank, is not really in the business of storing and safekeeping people’s property – instead of depositing the deposits, he loans the deposits out to others for his own gain. In the case of Jiffy Park, the cars are borrowed by prostitutes to perform “tricks,” while in the case of our local bank, the deposits are borrowed by business people, homeowners, and other people performing transactions of a more legal nature.

That our bank deposits are loaned to borrowers is not really a secret to most of us, but the more sinister aspects of the banking system become apparent when we realize that, if our deposits have been loaned out to borrowers, they should not be available to be returned to us upon our demand. This, like the case of Jiffy Park, reveals the dark side of loaning out for profit what really belongs to other people.

Kramer chooses to withdraw his deposit (his car), when it is currently being used by a prostitute plying her trade. This is invariably what will happen when people make withdrawals from their bank accounts. In Kramer’s case, Jiffy Park tells him that his property is currently unavailable, but he can have a Mary Kay Cadillac instead. In the case of our bank withdrawals, our money might be on loan, but we can have someone else’s deposited money instead.

Like Kramer, we can go about our business using someone else’s deposits. In Kramer’s case, the excitement of a pink Cadillac is enough to make him forget that his own deposit is unsafe. In the case of our bank deposits, the money of another bank customer is just as good as our own. Everything is fine until Kramer and the owner of the Mary Kay Cadillac want there vehicles at the same time or until there are a large number of simultaneous withdrawals from our bank.

For Jiffy Park, there are other vehicles to tantalize the gullible customer but in the case of our local bank, fooling the customers requires the help of the Federal Reserve. As the “lender of last resort” the Federal Reserve is in the business of providing an endless supply of Mary Kay Cadillac’s to our local bank. If too many customers want there deposits back when they are on loan to others, the Federal Reserve will always produce more deposits that look just like our deposits, keeping the bank from the embarrassment of having to admit that your deposits are not really deposited – they are being used by the bank to make its own profit.

So, as long as the Federal Reserve keeps coming up with pink Cadillacs, what is the harm? The harm is called inflation by credit expansion. Jiffy Park has taken, for example, ten cars and made them look like twenty. Ten drivers deposited ten cars and think they are the sole possessors of the ten cars, but ten prostitutes also think they are the rightful possessors of ten cars. Twenty people think that they have exclusive use of a vehicle, but there really was only ten cars deposited in the lot. Jiffy Park has counterfeited ten additional cars.

In the case of our bank, the amount of money originally deposited is believed to be owned by the depositors, but the borrowers actually believe that they own the money also (there is a “fractional reserve” of the deposited money that the bank cannot loan out but that amount is small and disregarded here for simplicity’s sake). Due to the bank’s ability to loan out deposits, the economy has far more money in it while having the same number of goods to buy with the money – the bank is the source of inflation. In the same way that Jiffy Park inflated the number of cars possessed through its deceptive practices, the banks are allowed, legally, to inflate the economy by loaning out money that they are pretending to keep “on deposit.” Your local bank counterfeits “legal tender.” In boom periods, banks inflate the economy; in periods of pessimism, they reduce the loans and thereby deflate the already inflated economy, causing unemployment.

The Seinfeld episode ends with an innocent Kramer in a police lineup after he and a prostitute made simultaneous claims to a Mary Kay Cadillac. This is where the analogy to our bank ends; unlike Jiffy Park, there can never be a shortage of Mary Kay Cadillacs for our banks, the Federal Reserve can produce an endless number of them. The Ponzi scheme of banks counterfeiting money by undepositing deposits can continue until the American taxpayers learn about their banking system and find out that they are the ones buying all the Mary Kay Cadillacs.

Econ 101. The Auction

The following few short paragraphs provide the reader with one of the essential foundations of economic thought. It will be simple and easy to understand because it will be free from the complications and self-contradicting delusions of so-called experts who are blinded by their psychosexual need to be “stimulating.”

The economy can be accurately modeled as a simple auction, an activity that easily demonstrates the convergence of supply and demand but in terms that can be related more easily to our common experiences. In an auction, a seller offers to supply a good to the highest bidder. Prospective buyers bid against each other until there is only one buyer remaining, who, by making his final bid, sets the price of the good.

The bidding usually begins at a very low price and there are a number of persons bidding against each other for the good. The initial large number of bidders represents the large demand for the good at its initial low price. As the bids become increasing larger, the number of bidders drops, reflecting how the demand for the product goes down as the price of its supply goes up.

If there is more than one seller of the same type of good, the resulting prices will be correspondingly lower, reflecting how the increase supply of the good causes the demand to go down. In the same way that the buyers competed with each other to drive the price up, the sellers must compete with each other and drive the price down. Because the buyers have a large number of alternative sources, they can purchase the good at the price set when there was a large number of bidders in the original auction.

In the end, each seller will be forced to sell at nearly the same price, the so-called “market price” for the good. Economists graph this market price at the convergence of two lines on a “supply and demand” graph, one line representing the supply of the good and the other line, sloping in an opposite direction, representing its demand. Without the art work, it is really just an auction.

Every seller will be able to dispose of his good as long as he is willing to accept the highest bid. This is known as Say’s Law. Alternatively, the seller may exercise his option to not sell the product at the market price. The seller’s choice to not sell can be interpreted in two different ways:

1. Reasonably. The seller has just decided that, in his judgment, the good is more valuable than the money offered for it. Perhaps, it will bring a better price tomorrow.
2. Hysterically. The failure of the good to “clear the market” is a sign of economic stagnation, a recession, or even a depression.

The reasonable interpretation leaves the seller (perhaps a labor seeking employment) with the freedom to sell his product at the price and time of his choosing, eventually finding a better price or lowering his expectations and accepting the current bid.

The hysterical interpretation believes that the seller is a victim of bidders who need stimulation. Invoking the delusional teachings of John Maynard Keynes, a man who didn’t have a real understanding of auctions or other economies, the followers of the hysterical interpretation allow themselves to be the pawns of power-hungry politicians who promise to stimulate the bidders. According to these “Keynesians,” by giving everyone more money, the value of money will go down and the bidders will be willing to bid higher for the unsold good – they will be “stimulated.” Of course, this all depends upon the seller being too stupid to get as stimulated as the bidders and demand more of the devalued money for his good. The economy’s wealth remains the same; there is just more green paper.

Economics is the easiest social science to intellectually comprehend; however, it remains an obscurity because the government needs to make people believe that they can produce wealth by stimulating consumers and fooling producers.