Case Against the Fed and Fractional Reserve Lending

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Reserve Lending (FRL) is fraudulent. Indeed, FRL in conjunction
with micro-mismanagement of interest rates by the Fed is the root
cause of the financial crisis we are in.

many do not see FRL for the fraudulent scheme that it is. Here
are the most common defenses against the allegation of fraud.

Arguments Used To Defend FRL

  1. FRL is not fraud because the lending is backed by assets.

  2. FRL is not fraud because it is allowed by law.

  3. Eliminating FRL would require unwarranted “regulation.”

  4. No one is harmed by FRL.

  5. People have a legal right to make agreements with banks allowing
    their money to be lent with no reserves


1R. To those
who claim credit extended by fractional reserve lending is not
fraudulent because it’s backed by assets, I ask: “What assets?”
The answer of course is ….

  • Fannie
    Mae and Freddie Mac debt that would be worthless were it not
    for taxpayer bailouts.
  • Asset-backed
    commercial paper that has ceased to trade.
  • Toggle
    bonds and other such nonsense where debt is paid back with more
  • Loans
    to hedge funds for speculation in credit default swaps and commodities.
  • Commercial
    real estate boondoggles including scores of condo towers now
    sitting empty.
  • A whole
    array of other silly loans that should never have been made.

Close analysis
shows the “backed by assets” claim only holds true as long as
asset prices are rising. When asset prices are falling as they
are now, the true state of the non-existent backing is plain to

Credit extended
via FRL is backed by nothing more than thin air and promises.
Those promises are currently worth pennies on the dollar, and
the entire global banking system is insolvent as a result.

2R. Some
claim that fractional reserve lending cannot be fraud because
it is legal. However, just because something is legal does not
make it right. For example: Slavery was once legal. It certainly
never was right. Government decree cannot make slavery right,
but it can and did make it legal. By the same token, government
decree alone cannot change the fact that fractional reserve lending
is fraudulent. Proof of fraudulence will be offered in the rebuttal
to point number 4.

3R. Some
claim that FRL cannot be eliminated because that would require
regulation and such regulation would in and of itself be against
free market principles. The fact of the matter is that a free
market would quickly shut down any bank lending out more money
than it had in the vault. No one would possibly trust such a bank.
It is only government decree (regulation) that allows banks to
get away with such obvious fraud.

people are confused by what “libertarian” means. Libertarian does
not mean anarchy. There are laws against murder, theft, fraud,
and slavery that no libertarian I know would argue against.

for any society to function, there must be certain laws (regulations)
in place. Here are the basic tenants of valid laws.

  • Protection
    of property rights
  • Protection
    of civil rights
  • Freedom
    of religion
  • Equal
    protection under the law regardless of race, creed, color, sex,
    nationality, wealth, etc.

4R. Proponents
of FRL claim no one is harmed by it. In practice, everyone is
harmed by it. Here is how it starts. Those with first access to
money accumulate assets and those with later access to money bid
up those assets. Consider housing. GSE creation of credit out
of thin air is a perfect example of what happens. By the time
credit was available to those of lower economic status, the bubble
was already formed and ripe for a collapse. Even the non-participants
were harmed. How so? Via rising property taxes and rising prices
of goods and services without the benefit of rising wages.

even those with first access to money (the banks and wealthy)
ultimately did not fare well because they were greedy. When the
bubble popped (as all debt bubbles eventually do) the only winners
were the few who made timely bets on the demise of the bubble.

FRL is the
enabler for credit bubbles. Given enough time, credit bubbles
are guaranteed to implode in deflationary fashion. History is
replete with examples. The South Seas bubble, the John Law Mississippi
bubble, and tulip mania are prime examples.

5R. People
have no such right to agree to commit fraud. Here are more things
people have no right to do: Shout fire in a movie theatre, conspire
to steal someone’s money, agree to start a toxic waste dump in
a location where it would poison every water source in the neighborhood.
There is an infinite number of things two people cannot agree
to do. The right of people to do things ends when it affects the
property rights of everyone else. And as noted in 4R, everyone
is affected by fraudulent agreements that allow more credit to
be extended than there is money in the bank.


authorized sweeps in 1994.

Sweeps allow
Demand Deposits Accounts (checking accounts) to be systematically
“swept” from checking accounts into savings accounts unbeknown
to the checking account holder.

accounts have zero reserves.

So… In
actual practice there is almost no money backing up checking accounts,
none (beyond what banks THINK they need historically). You can
thank Greenspan for this.

This is
not “Laissez Faire” economics or libertarianism. This is blatant
fraud, something that those blaming libertarianism need to understand.

Such a construct
would never flourish in a free market. It takes a regulator like
Greenspan to allow it.

for Scapegoats

of placing the blame on fractional reserve lending and the biggest
regulator of all (the Fed), many claim there is not enough regulation
and the Fed needs still more powers.

Please consider
Nonsense From Henry Kaufman & Company
for a discussion
of the so-called libertarian Fed, Fannie Mae and Freddie Mac,
Rating Agency Madness, and the Glass-Steagall Scapegoat.

Fed Uncertainty

minds should also consider the Fed
Uncertainty Principle

Principle Corollary Number Two: The government/quasi-government
body most responsible for creating this mess (the Fed), will attempt
a big power grab, purportedly to fix whatever problems it creates.
The bigger the mess it creates, the more power it will attempt
to grab. Over time this leads to dangerously concentrated power
into the hands of those who have already proven they do not know
what they are doing.
Why We Can’t
Reinflate The Bubble

Ron Paul
explains Why
We Can’t Reinflate The Bubble



We have
to come to the realization that there is a sea change in what’s
happening. This is an end of an era and that we can’t re-inflate
the bubble, just as we devised a new system of Bretton Woods
in '44 which was doomed to fail. It failed in '71 and then we
came up with the dollar reserve standard which was a paper standard;
it was doomed to fail and we have to recognize that it has failed.
And if we think we can re-inflate the bubble by artificially
creating credit out of thin air and calling it capital; believe
me, we don’t have a prayer of solving these problems. We have
a total misunderstanding of what credit is vs. capital. Capital
can’t come from the thin air creation by the Federal Reserve
System; capital has to come from savings. We have to work hard,
produce, live within our means and what is left over is called
capital. This whole idea that we can re-capitalize markets by
merely turning on the printing presses and increasing credit
is a total fallacy; so the sooner we wake up to realize that
a new system has to be devised, the better.

now I think the Central Bankers of the world realize exactly
what I’m talking about and they’re planning, but they’re planning
another system that goes one step further to internationalize
regulations, internationalize the printing press. Give up on
the dollar standard, but we have to be very much aware that
that system will be no more viable. We have to have a system
which encourages people to work and to save. What do we do now?
We’re telling consumers to spend and continue the old process;
it won’t work.

All We Are
Sayin’ Is Give Free Markets a Chance

Paul Kasriel,
Director of Economic Research at the Northern Trust weighs in
with All
We Are Sayin’ Is Give Free Markets a Chance

the economic and financial market “challenges” of
the past year, some pundits and politicians are concluding that
these challenges are the result of the failure of free markets.
I would respond that we cannot determine whether free markets
have failed unless we have had free markets. I do not think we

One of
the most important markets in an economy is the market for credit.
We do not have free markets in credit in the U.S. or anywhere
else that I know of. The price of short-term credit is fixed
by central banks. It would only be by accident that a central
bank would fix the price of short-term credit at a level that
would obtain if a free market in credit were allowed. It is
beyond me why most economists would view with horror some government
agency fixing the price of say, copper, but view the fixing
of the price of short-term credit by central banks as nothing
to be alarmed at.

is at least one group of economists that realizes the economic
mischief caused by central banks — economists who belong
to the Austrian school. (For information about Austrian economics,
click on this link to the Ludwig
von Mises Institute
or this link to Leithner
and Company
, a private investment firm located not in Austria,
but in Australia. I
am not endorsing the political views or the investment advice
of either of these entities, but I am endorsing their approach
to economic analysis.) By holding a key short-term interest
rate below or above the unobservable free market equilibrium
level of this rate, the central bank creates credit, much as
does a counterfeiter, or destroys credit, which leads to distortions
in the economy and financial markets.

the central bank starts out by preventing the short-term interest
rate from rising to its equilibrium level. This leads to central
bank credit creation. In turn, this encourages investments which
are profitable only so long as the central bank prevents the
interest rate structure from rising to its free-market equilibrium
level. All of this manifests itself in the form of higher prices
— higher prices of goods/services and/or the higher prices
of assets. At some point, the central bank can no longer tolerate
what it has wrought, and raises the level of the short-term
interest rate above its free-market equilibrium. This precipitates
a decline in asset prices, an economic recession and, later,
a decline in goods/services prices (or a
slowing in their rate of increase). It was recognized by Austrian
economists during the sharp run-up in U.S. stock prices in the
late 1990s and the subsequent housing boom that the Greenspan-led
Fed was especially egregious in keeping the federal funds rate
far below its equilibrium level too long. We are now experiencing
the economic and financial market fallout from Greenspan’s interference
with the free market.

In free
markets, risk-takers get rewarded if they are correct in the
risks they take, but are punished if they are incorrect. Here,
too, Greenspan intervened in the free markets. When it turned
out some risk-takers had erred, Greenspan cushioned their losses
by slashing the federal funds rate and creating central bank
(counterfeit) credit. This central bank intervention in free
markets encouraged risk-takers to take on even more risk inasmuch
as their upside rewards would seem to be unlimited but their
downside punishment would be limited.

of Property Rights Is The Key Issue

The central
point in a free market–based banking system is to avoid violations
of property rights. However, the current system of 100% fractionally
reserved banks allows money to be created out of thin air robbing
savers, by making those savings worthless over time. A pernicious
effect of this system of permanent inflation is that it creates
malinvestment and large boom-bust cycles that destroy wealth.

The Fed
is a failed institution. Fannie Mae is a failed institution. Freddie
Mac is a failed institution and fractional reserve lending is
a fraud.

The correct
policy decision is to abolish all of them, not to add layer after
layer after layer of regulators watching over other regulators,
who in turn watch over still other regulators, where some “god-like”
super-regulator at the top supposedly has infinite wisdom and
knows exactly how to regulate.

7, 2009

Mike "Mish"
Shedlock is a registered investment advisor representative for SitkaPacific
Capital Management
. Sitka Pacific is an asset management firm
whose goal is strong performance and low volatility, regardless
of market direction.

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