Fractional Reserve Banking

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We have
already described one part of the contemporary flight from sound,
free market money to statized and inflated money: the abolition
of the gold standard by Franklin Roosevelt in 1933, and the substitution
of fiat paper tickets by the Federal Reserve as our “monetary
standard.” Another crucial part of this process was the federal
cartelization of the nation’s banks through the creation of the
Federal Reserve System in 1913.

Banking is a particularly arcane part of the economic system;
one of the problems is that the word “bank” covers many different
activities, with very different implications. During the Renaissance
era, the Medicis in Italy and the Fuggers in Germany, were “bankers”;
their banking, however, was not only private but also began at
least as a legitimate, non-inflationary, and highly productive
activity. Essentially, these were “merchant-bankers,” who started
as prominent merchants. In the course of their trade, the merchants
began to extend credit to their customers, and in the case of
these great banking families, the credit or “banking” part of
their operations eventually overshadowed their mercantile activities.
These firms lent money out of their own profits and savings, and
earned interest from the loans. Hence, they were channels for
the productive investment of their own savings.

To the extent that banks lend their own savings, or mobilize the
savings of others, their activities are productive and unexceptionable.
Even in our current commercial banking system, if I buy a $10,000
CD (“certificate of deposit”) redeemable in six months, earning
a certain fixed interest return, I am taking my savings and lending
it to a bank, which in turn lends it out at a higher interest
rate, the differential being the bank’s earnings for the function
of channeling savings into the hands of credit-worthy or productive
borrowers. There is no problem with this process.

The same is even true of the great “investment banking” houses,
which developed as industrial capitalism flowered in the nineteenth
century. Investment bankers would take their own capital, or capital
invested or loaned by others, to underwrite corporations gathering
capital by selling securities to stockholders and creditors. The
problem with the investment bankers is that one of their major
fields of investment was the underwriting of government bonds,
which plunged them hip-deep into politics, giving them a powerful
incentive for pressuring and manipulating governments, so that
taxes would be levied to pay off their and their clients’ government
bonds. Hence, the powerful and baleful political influence of
investment bankers in the nineteenth and twentieth centuries:
in particular, the Rothschilds in Western Europe, and Jay Cooke
and the House of Morgan in the United States.

By the
late nineteenth century, the Morgans took the lead in trying to
pressure the U.S. government to cartelize industries they were
interested in – first railroads and then manufacturing: to
protect these industries from the winds of free competition, and
to use the power of government to enable these industries to restrict
production and raise prices.

In particular,
the investment bankers acted as a ginger group to work for the
cartelization of commercial banks. To some extent, commercial
bankers lend out their own capital and money acquired by CDs.
But most commercial banking is “deposit banking” based on a gigantic
scam: the idea, which most depositors believe, that their money
is down at the bank, ready to be redeemed in cash at any time.
If Jim has a checking account of $1,000 at a local bank, Jim knows
that this is a “demand deposit,” that is, that the bank pledges
to pay him $1,000 in cash, on demand, anytime he wishes to “get
his money out.” Naturally, the Jims of this world are convinced
that their money is safely there, in the bank, for them to take
out at any time. Hence, they think of their checking account as
equivalent to a warehouse receipt. If they put a chair in a warehouse
before going on a trip, they expect to get the chair back whenever
they present the receipt. Unfortunately, while banks depend on
the warehouse analogy, the depositors are systematically deluded.
Their money ain’t there.

honest warehouse makes sure that the goods entrusted to its care
are there, in its storeroom or vault. But banks operate very differently,
at least since the days of such deposit banks as the Banks of
Amsterdam and Hamburg in the seventeenth century, which indeed
acted as warehouses and backed all of their receipts fully by
the assets deposited, e.g., gold and silver. This honest deposit
or “giro” banking is called “100 percent reserve” banking. Ever
since, banks have habitually created warehouse receipts (originally
bank notes and now deposits) out of thin air. Essentially, they
are counterfeiters of fake warehouse-receipts to cash or standard
money, which circulate as if they were genuine, fully backed notes
or checking accounts. Banks make money by literally creating money
out of thin air, nowadays exclusively deposits rather than bank
notes. This sort of swindling or counterfeiting is dignified by
the term “fractional-reserve banking,” which means that bank deposits
are backed by only a small fraction of the cash they promise to
have at hand and redeem. (Right now, in the United States, this
minimum fraction is fixed by the Federal Reserve System at 10

Fractional Reserve Banking

Let’s see how the fractional reserve process works, in the absence
of a central bank. I set up a Rothbard Bank, and invest $1,000
of cash (whether gold or government paper does not matter here).
Then I “lend out” $10,000 to someone, either for consumer spending
or to invest in his business. How can I “lend out” far more than
I have? Ahh, that’s the magic of the “fraction” in the fractional
reserve. I simply open up a checking account of $10,000 which
I am happy to lend to Mr. Jones. Why does Jones borrow from me?
Well, for one thing, I can charge a lower rate of interest than
savers would. I don’t have to save up the money myself, but simply
can counterfeit it out of thin air. (In the nineteenth century,
I would have been able to issue bank notes, but the Federal Reserve
now monopolizes note issues.) Since demand deposits at the Rothbard
Bank function as equivalent to cash, the nation’s money supply
has just, by magic, increased by $10,000. The inflationary, counterfeiting
process is under way.

The nineteenth-century
English economist Thomas Tooke correctly stated that “free trade
in banking is tantamount to free trade in swindling.” But under
freedom, and without government support, there are some severe
hitches in this counterfeiting process, or in what has been termed
“free banking.” First: why should anyone trust me? Why should
anyone accept the checking deposits of the Rothbard Bank? But
second, even if I were trusted, and I were able to con my way
into the trust of the gullible, there is another severe problem,
caused by the fact that the banking system is competitive, with
free entry into the field. After all, the Rothbard Bank is limited
in its clientele. After Jones borrows checking deposits from me,
he is going to spend it. Why else pay money for a loan? Sooner
or later, the money he spends, whether for a vacation, or for
expanding his business, will be spent on the goods or services
of clients of some other bank, say the Rockwell Bank. The Rockwell
Bank is not particularly interested in holding checking accounts
on my bank; it wants reserves so that it can pyramid its own counterfeiting
on top of cash reserves. And so if, to make the case simple, the
Rockwell Bank gets a $10,000 check on the Rothbard Bank, it is
going to demand cash so that it can do some inflationary counterfeit-pyramiding
of its own. But, I, of course, can’t pay the $10,000, so I’m finished.
Bankrupt. Found out. By rights, I should be in jail as an embezzler,
but at least my phoney checking deposits and I are out of the
game, and out of the money supply.

Hence, under free competition, and without government support
and enforcement, there will only be limited scope for fractional-reserve
counterfeiting. Banks could form cartels to prop each other up,
but generally cartels on the market don’t work well without government
enforcement, without the government cracking down on competitors
who insist on busting the cartel; in this case, forcing competing
banks to pay up.

Central Banking

Hence the drive by the bankers themselves to get the government
to cartelize their industry by means of a central bank. Central
Banking began with the Bank of England in the 1690s, spread to
the rest of the Western world in the eighteenth and nineteenth
centuries, and finally was imposed upon the United States by banking
cartelists via the Federal Reserve System of 1913. Particularly
enthusiastic about the Central Bank were the investment bankers,
such as the Morgans, who pioneered the cartel idea, and who by
this time had expanded into commercial banking.

In modern central banking, the Central Bank is granted the monopoly
of the issue of bank notes (originally written or printed warehouse
receipts as opposed to the intangible receipts of bank deposits),
which are now identical to the government’s paper money and therefore
the monetary “standard” in the country. People want to use physical
cash as well as bank deposits. If, therefore, I wish to redeem
$1,000 in cash from my checking bank, the bank has to go to the
Federal Reserve, and draw down its own checking account with the
Fed, “buying” $1,000 of Federal Reserve Notes (the cash in the
United States today) from the Fed. The Fed, in other words, acts
as a bankers’ bank. Banks keep checking deposits at the Fed and
these deposits constitute their reserves, on which they can and
do pyramid ten times the amount in checkbook money.

how the counterfeiting process works in today’s world. Let’s say
that the Federal Reserve, as usual, decides that it wants to expand
(i.e., inflate) the money supply. The Federal Reserve decides
to go into the market (called the “open market”) and purchase
an asset. It doesn’t really matter what asset it buys; the important
point is that it writes out a check. The Fed could, if it wanted
to, buy any asset it wished, including corporate stocks, buildings,
or foreign currency. In practice, it almost always buys U.S. government

Let’s assume that the Fed buys $10,000,000 of U.S. Treasury bills
from some “approved” government bond dealer (a small group), say
Shearson, Lehman on Wall Street. The Fed writes out a check for
$10,000,000, which it gives to Shearson, Lehman in exchange for
$10,000,000 in U.S. securities. Where does the Fed get the $10,000,000
to pay Shearson, Lehman? It creates the money out of thin air.
Shearson, Lehman can do only one thing with the check: deposit
it in its checking account at a commercial bank, say Chase Manhattan.
The “money supply” of the country has already increased by $10,000,000;
no one else’s checking account has decreased at all. There has
been a net increase of $10,000,000.

But this is only the beginning of the inflationary, counterfeiting
process. For Chase Manhattan is delighted to get a check on the
Fed, and rushes down to deposit it in its own checking account
at the Fed, which now increases by $10,000,000. But this checking
account constitutes the “reserves” of the banks, which have now
increased across the nation by $10,000,000. But this means that
Chase Manhattan can create deposits based on these reserves, and
that, as checks and reserves seep out to other banks (much as
the Rothbard Bank deposits did), each one can add its inflationary
mite, until the banking system as a whole has increased its demand
deposits by $100,000,000, ten times the original purchase of assets
by the Fed. The banking system is allowed to keep reserves amounting
to 10 percent of its deposits, which means that the “money multiplier”
– the amount of deposits the banks can expand on top of reserves
– is 10. A purchase of assets of $10 million by the Fed has
generated very quickly a tenfold, $100,000,000 increase in the
money supply of the banking system as a whole.

all economists agree on the mechanics of this process even though
they of course disagree sharply on the moral or economic evaluation
of that process. But unfortunately, the general public, not inducted
into the mysteries of banking, still persists in thinking that
their money remains “in the bank.”

the Federal Reserve and other central banking systems act as giant
government creators and enforcers of a banking cartel; the Fed
bails out banks in trouble, and it centralizes and coordinates
the banking system so that all the banks, whether the Chase Manhattan,
or the Rothbard or Rockwell banks, can inflate together. Under
free banking, one bank expanding beyond its fellows was in danger
of imminent bankruptcy. Now, under the Fed, all banks can expand
together and proportionately.

“Deposit Insurance”

But even with the backing of the Fed, fractional reserve banking
proved shaky, and so the New Deal, in 1933, added the lie of “bank
deposit insurance,” using the benign word “insurance” to mask
an arrant hoax. When the savings and loan system went down the
tubes in the late 1980s, the “deposit insurance” of the federal
FSLIC [Federal Savings and Loan Insurance Corporation] was unmasked
as sheer fraud. The “insurance” was simply the smoke-and-mirrors
term for the unbacked name of the federal government. The poor
taxpayers finally bailed out the S&Ls, but now we are left
with the formerly sainted FDIC [Federal Deposit Insurance Corporation],
for commercial banks, which is now increasingly seen to be shaky,
since the FDIC itself has less than one percent of the huge number
of deposits it “insures.”

very idea of “deposit insurance” is a swindle; how does one insure
an institution (fractional reserve banking) that is inherently
insolvent, and which will fall apart whenever the public finally
understands the swindle? Suppose that, tomorrow, the American
public suddenly became aware of the banking swindle, and went
to the banks tomorrow morning, and, in unison, demanded cash.
What would happen? The banks would be instantly insolvent, since
they could only muster 10 percent of the cash they owe their befuddled
customers. Neither would the enormous tax increase needed to bail
everyone out be at all palatable. No: the only thing the Fed could
do, and this would be in their power, would be to print enough
money to pay off all the bank depositors. Unfortunately, in the
present state of the banking system, the result would be an immediate
plunge into the horrors of hyperinflation.

Let us suppose that total insured bank deposits are $1,600 billion.
Technically, in the case of a run on the banks, the Fed could
exercise emergency powers and print $1,600 billion in cash to
give to the FDIC to pay off the bank depositors. The problem is
that, emboldened at this massive bailout, the depositors would
promptly redeposit the new $1,600 billion into the banks, increasing
the total bank reserves by $1,600 billion, thus permitting an
immediate expansion of the money supply by the banks by tenfold,
increasing the total stock of bank money by $16 trillion. Runaway
inflation and total destruction of the currency would quickly

article originally appeared in the October 1995 issue of The
and is reprinted with permission.

N. Rothbard
(1926–1995) was dean of the Austrian
School, founder of modern libertarianism, and academic vice
president of the Mises Institute.
He was also editor — with Lew Rockwell — of The
Rothbard-Rockwell Report
, and appointed Lew as his
literary executor. See
his books.

© 1995
Foundation for Economic Education

Best of Murray Rothbard

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