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.

The True Economic Recovery Plan

…the only means to shorten the period of bad business is to avoid any attempts to delay or to check the fall in prices and wage rates.

Ludwig von Mises, Human Action (1963, p. 570)

This post borrows liberally from the thoughts of famous economist, Ludwig von Mises. Mises had extensively studied the cycles of business booms and crashes and had an acute understanding of their causes and cures. His voice from the past can give us great comfort in our current time of financial crisis. It can also help us avoid the mistake of government “stimulation.” Mises foresaw the economic collapse of the Soviet Union seventy years before it occurred, having based his insight, not on political and military history, but on an acute understanding of the effects of government intervention in the economy. In relation to our current crisis, he begins by providing us with a very reassuring definition of what a depression is.

...depression is in fact the process of readjustment, of putting production activities anew in agreement with the given state of the market data:

Ludwig von Mises, Human Action (1963, p. 572)

In other words, a depression or recession, such as the one that we are in now, should be looked at as a useful time when, if government intervention can be avoided, the economy can cure itself of its ills and recover to be stronger and more efficient than ever. The free market is a dynamic system that is always repairing itself and moving towards full employment and maximum productivity. The monetary contraction that occurs during a recession is really just a means for wisdom and caution to correct the mistakes that were caused by the excesses of the economy’s preceding boom period. The overly optimistic outlook of an expanding economy led to overinvestment in capital (particularly housing in the current period) and this overinvestment led to bidding wars that brought prices too high. Now, those prices must be brought down to where they belong, even if the government attempts to prevent it.

The recovery and the return to “normalcy” can only begin when prices and wage rates are so low that a sufficient number of people assume that they will not drop still more.

Ludwig von Mises, Human Action (1963, p. 569)

Can we have excessive boom periods and, perhaps with the government’s help, avoid the succeeding recessions? Mises is correct in answering in the negative. Mankind will, in any type of economy, always work to his own advantage and this productive feature of the human character means that people will correct their mistakes of judgment and cure their own excesses. The economy must cool itself down as a way of improving itself, regardless of the government’s attempts to prevent this improvement.

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

Ludwig von Mises, Human Action (1963, p. 572)

Each stimulation package from the Bush and Obama administrations has brought us one step closer to what Mises calls a total catastrophe. Each month that the recession is prolonged will reduce the confidence that the people have in the economy and its monetary system and this lack of confidence will make the inevitable lowering of wages and prices more drastic and severe.

We can take the advice of Ludwig von Mises and allow the recession to run its course and cure itself quickly or we can do what we did in the 1930’s (and what Japan did in the 1990’s) and demand that the government try to prevent the inevitable and, in so doing, allow a short-term recession to turn into a decade-long depression.

There is no use in interfering by means of a new credit expansion with the process of readjustment. This would at best only interrupt, disturb, and prolong the curative process of depression.

Ludwig von Mises, Human Action (1963, p. 578)

The End of Unemployment

It is not the abundance of money but the abundance of other products in general that facilitates sales... Money performs no more than the role of a conduit in this double exchange. When the exchanges have been completed, it will be found that one has paid for products with products.
James Mill

The preceding quote by James Mill is a faithful summary of an economic principle known as Say’s Law. According to Say's Law, any real product on the market will sell if the price is right. This has a powerful implication towards the current economic crisis – in fact, Say’s Law tells us why this “crisis” is not really a crisis at all, but merely a time when, without government interference, the economy is only honing its skills and becoming more efficient.

To see how this is so, let us apply Say’s Law to a particular product on the market that is near and dear to most of our lives – our own labor. By offering to do work, we deliver a product to the market and, according to Say, by simply offering that product we are facilitating its sale – we are creating our own employment.

According to Say’s Law, there is no such thing as a real surplus of employment. Every man who wants to sell his labors should, without government intervention, find a buyer (that is, an employer). In short, what Say is saying is that:

IN A FREE MARKET, THERE IS NO REAL UNEMPLOYMENT.

Then, one must ask, what are the unemployment statistics that are now dominating our front pages? The unemployed represent the amount of the employment product that is stocked on the shelves at the market but, as yet, remain unsold. And, why do products sit too long on the shelves?

THE SELLER IS ASKING TOO MUCH.

Employees, like retail sellers, must realize that if a product is not moving it needs to be put on sale. The sale will invariably help the product “clear the market.” The unemployed person is either asking too much for his services or he is only offering his services in a limited field of application (a third possibility is that he is prohibited by the government to seek his market value by the so-called minimum wage laws).

The bigger question for 7.6% of America’s workers who are now unemployed is: “Is it right that I should have to take a smaller salary than what I am used to, or have to take a job outside my specialty? “ This question is actually what Keynes based his economic fallacies upon. Keynes saw that employee’s offer a product that is “sticky” in that it cannot be adjusted to work in a true marketplace. While the market forces every other commodity to go up and down, employees only want to go up. Employees accept a bull market for their services but will not accept it when it becomes bearish.

Keynesian ideas do not refute Say, however, they merely point out how employees need a little business training – they need to be trained in how to better provide a product for sale in a marketplace.

During period of optimism, credit expands and products such as employment are offered and sold at a price that is the result of the carelessness that comes from over confidence. In times of pessimism, credit contracts and makes corrections to the earlier carelessness. Employees must realize that they were perhaps making too much during the period of expansion and that the recession is “putting their feet back on the ground.” When the contraction is over, money will be less plentiful and they may well realize that the smaller salary that they accepted in a recession offers just as much buying power as the greater one that they held during periods of inflation.

Say’s Law is true and has never been refuted by the snake-oil salesmen that are still trying to sell government intervention under the fallacies of John Maynard Keyes. Unemployment is not being unable to find work; it is simply the unwillingness to satisfy other peoples’ needs at a fair price.

Economic Stimulus as Folly

The only means to shorten the period of bad business [depression] is to avoid any attempts to delay or to check the fall in prices and wage rates.

Ludwig von Mises, Human Action (1949, p. 570)

The trillion dollar economic stimulus package will fail to resolve the current economic crisis and here is why.

Growth in employment, and the economic good times that it brings, occurs during periods of credit expansion. When credit is expanding, banks are creating money by making loans to people who hire other people to serve them. This happens regardless of whether the credit is issued to employers or consumers. Credit expansion occurs when creditors are optimistic about getting their loan money repaid.

Growth of unemployment, on the other hand, occurs during periods of credit contraction. When credit is contracting, banks are reducing the money supply by recalling loans to people who employ other people. Credit contraction occurs when creditors fear that loans will fail and should therefore not be issued.

In terms of credit contraction, it is important to note that creditors not only want a return of the loaned money, but they also want the loaned money to have the same value when repaid as it had when it was loaned out.

The government’s distribution of new money for no other consideration than to “stimulate” the economy tends to dilute the existing money in the economy, including the money that creditors have on loan to their clients.

Most creditors are smart enough to know that if they loan out $100 that will only be worth $90 when it is repaid, they will actually lose real economic value by making the loan. Therefore, the already pessimistic creditor becomes more pessimistic and tends to contract his credit even more.

The more the government threatens to dilute the value of the loaned dollar, the more creditors will keep their money in their pocket and let other people lose their jobs.

So, what is the solution to an economic crisis such as the current one? As von Mises points out in the above quote, the only real solution is to let the economy heal itself. This involves letting some bad investors take their losses while allowing wiser investors to buy back at a new “ground floor” and use their wisdom to create new jobs in an economy where resources are allocated more efficiently.

Left to itself, the economy would actually come out of the recession stronger than ever, but because of government intervention, credit contraction will be prolonged, unemployment levels will remain high, and an economy trying to correct itself will never fully heal.