The Banks Are Broke

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ANNOUNCER: This is the Lew Rockwell Show.

ROCKWELL: Welcome. And for the first time, we’re delighted today to have a guest, Professor Joe Salerno. Joe is head of the graduate business program and professor of economics at Pace University in New York. He’s a senior fellow at the Mises Institute. He’s editor of our quarterlyJournal of Austrian Economics, and a real expert on money and banking, which seem to me an important subject for these days. We’re seeing bank runs, we’re seeing all, you know, the bailing out of Fannie Mae and Freddie Mac, all the other financial troubles that the country is in.

But I wanted to ask Joe a specific question today.

You know, we know that General Motors is in deep trouble, maybe even is about to go bankrupt. Nobody would say that that would bring down the whole automobile industry. In fact, Toyota and Ford and Honda and Chrysler might even be happy to lose a competitor. Why is it, Joe, that if a big bank goes down, let’s say, Indy Mac had been allowed to go bankrupt as it would have without the Fed stepping in, why does that, indeed, threaten the entire banking industry? Why is the banking industry so unstable in a business-cycle situation like this?

SALERNO: The problem, Lew, is that banks, as they’ve come to evolve today, are what we call fractional-reserve institutions. That is, most of the depositors’ money, money that they can withdraw at any time on demand, is loaned out, approximately 90 percent; that banks really only have instantaneously available for withdrawal about 10 percent of the money that they owe their depositors. Now that money then is loaned out at interest. We see that money. Obviously, we don’t want to keep that money and keep paying interest on it without spending it. So it’s invested in various investment projects and so on. And in the natural course of economic activity, some of these projects can go bankrupt and there are losses.

Now if G.M. invests in something that goes bankrupt, G.M. and its stockholders bear the full loss of that. But if a bank has loaned money to some project or to an individual to invest and has gone bankrupt that person now cannot repay the loan, which means then there would be insufficient funds for the depositors to withdraw.

Now that happens and, in a normal situation, there is federal deposit insurance, and so most people do not pay attention to the sort of normal bankruptcies that occur, the normal losses that a bank might suffer.

But as you pointed out, in a business-cycle situation, when we have a cluster or errors, after the Fed has lowered interest rates and really spurred this false investment, investment that really cannot be completed because sufficient savings do not exist, in that situation, when many people make errors, many people start going bankrupt, many different businesses spread out through many different types of industries, then there begins to be problems with the banks paying off.

And it’s at that point that one or two big banks, IndyMac, and then later on, big financial institutions like Fannie Mae and Freddie Mac, begin to go bankrupt and the Fed has to step in and bail them out.

Now the reason why they do is because if depositors actually went and were able to – or to find that they were unable to withdraw all of their deposits, it would be what we call contagion effect. That only exists in banking. It does not exist in any other industry in the economy. The contagion effect is that others, some other banks, depositors in other financial institutions will suddenly start to worry about their own deposits. So even if these banks in some sense were responsible in their lending policies, they still only have 10 percent of the liabilities that they owe their depositors on hand. So this effect can spread very rapidly and bring down the entire financial banking system and then also the financial system.

ROCKWELL: Well, Joe, I noticed that Jim Cramer, the Mad Money Guy on television, the other night, was laughing at the fact that the FDIC has about $50 billion and that’s, by the way, before what they pay out for IndyMac, which he thought would be $8 to $14 billion . They’re saying this is going to be sufficient to take care of all banking troubles. He was predicting that it was going to need $1.2 trillion to bailout the banks that are going to be in trouble. And then he said, “We’ve got to have massive inflation.” He said, “Let the dollar drop, drop, drop on the international exchange. Let the prices go up, up, up.” We were all going to have to suffer and pay vast taxes, vast inflation to preserve the banking industry. It seems to me a politically dangerous position to be taking. This, of course, is the position of the Republican Party, the Bush administration, the Democrats, Pelosi, Reid, and all the rest of them, Obama and McCain, that the American people should be punished to bail out the bankers.

So I just might ask you what – do you think somebody like Cramer is right? I mean, is it that – are we in that sort of danger? This is, of course, moving away from economic science, but what do you think is going to happen?

SALERNO: Well, I think it’s politically and economically very dangerous what he’s advocating. He’s right about the positive analysis, meaning that he’s correct that the FDIC has no more than one-half a percent of all of the deposits that they insure. And if you include savings accounts along with checking deposits, that’s well over $3, $4 trillion, if you look at M2, for example. So the piddling $50 billion that they have to cover these liabilities in the case of a massive bank run certainly would not suffice. So the next step would be either to allow these banks to fail or to inflate, have the Fed inflate massively.

And by the way, inflation cannot take the place of the wave of a hand in the face of a huge bank run. When we have a bank run, people trust currency; they want their money back. So it would take time to print up this currency and distribute it throughout the country. During that time, what may very well happen is that the Fed and other government agencies would put controls on the amount of deposits that people are able to withdraw from their accounts, and so that we could have a situation that developed in Argentina where there wasn’t sufficient currency to carry on the transactions of the country. This was only in 2000 that this occurred. And in Argentina, some people were actually taking recourse to barter. So it’s an extremely dangerous situation.

The silver lining is sort of what you pointed out at the end there, is that people, I think, have come to see this as a bailout of one small group in the economy that has benefited since the Fed was put in place in 1913, OK? And that’s the bankers and the allied financial firms, Wall Street firms that also benefit.

ROCKWELL: Well, really, for those of us who have – you especially and some of the rest of us, critical of the Federal Reserve, of the inflation that it was founded in order to produce, the business cycles that it brings on, the recessions and depressions, the artificial booms and the busts, now is the time to educate people about it. Now is the time for people to understand, first of all, to understand how they’re being ripped off, why they’re being ripped off, and maybe have a chance of preventing future rip-offs.

What would you tell people to read? If you want to understand what the heck is happening in the economy, what might you read?

SALERNO: There are a few books that I would read. One of which, and probably the first of which is Murray Rothbard’s What Has Government Done to Our Money? – which is a wonderful and very insightful but plainly and clearly written exposition of what money is, where it comes from, and how it’s manipulated and eventually destroyed by governments throughout history.

Another book, on the Fed specifically, is the book by Murray Rothbard –

ROCKWELL: The Case Against the Fed, you’re thinking of?

SALERNO: Yes, that’s the book I’m thinking of, The Case Against the Fed. I think those two books together are sort of good primers on what’s going on today.

You might also want to take a look at various essays that Murray Rothbard has written – Economic Depressions: Their Cause and Cure,* on the cause of business cycles.

So these are things that I would recommend to the reader who wants to learn about the basics of the problems that we’re having.

ROCKWELL: Joe, I couldn’t agree more. And, in fact, if you look at the front page of, down on the left-hand side, you’ll see a link to the Rothbard collection. These books are available there.

I’m also going to mention one other book that Joe was responsible for that he edited and wrote the introduction to, and that’s Rothbard’s History of Money and Banking in the United States: The Colonial Era to World War II. And I would especially recommend his long, fascinating essays on who set up the Fed, why they set it up, who benefited. Of course, if it were taught in our civics classes in the government schools that institutions like the Fed come about because smarter, more public-spirited people than we decide this is good for America. Of course, if you know anything about government, you realize that you’re constantly being ripped off and that institutions like this are set up to further rip you off. And Murray shows how the Rockefellers, the Morgans, the other big banking institutions hired a Harvard economist to write the Federal Reserve Act, and exactly why they wanted this, and all the various interest groups then and now that benefit from this currency system. By the way, that’s not you, the average person.

Joe, do you have any other – what’s your thoughts, if I might just ask you? You know, they’re saying we have a downturn. They don’t want to say “recession.” They certainly don’t want to use the word “depression.” But it looks to me like there’s a serious Western world, really world-wide, long and deep recession here. And maybe, I mean, with all these bailouts, are we risking global hyperinflation as well as a global depression, meaning the worst possible of all economic worlds?

SALERNO: Yes, I think we already see significant signs of what’s been called stagflation and what’s better referred to as inflationary recession with the huge increase for June in the CPI and also in the producer price index, OK, which are both in double digits now.

Now, of course, the government downplays all of this by saying, well, if we take out energy and if we take out food, then we still have inflation under control. They’ve been continuously manipulating these numbers since the early 1990s to make inflation look like it’s less than it really is. But now we see with their own figures that we have inflation at the same time that we have severe signs, or signs of severe recession, and a recession that’s likely to get worse because the financial problems have not been solved, because the credit markets have dried up because businesses are afraid to invest. So I think we have more of both on the horizon. The Fed is going to try to inflate our way out of these problems but the fact that the financial system is so weak, may not be conducive to having inflation solve the problem.

ROCKWELL: Joe, I just want to mention that as we face these problems, as most of us are going to be getting poorer over the next few years because of what the Federal Reserve, the banking system, the federal government in general have done, we need to remember who to blame. We need to educate ourselves.

Joe mentions Murray Rothbard’s What Has Government Done to Our Money?, the Case Against the Fed, Murray’s History of Money and Banking in the United States, all of them available from LRC, again, on the front page under the Rothbard collection. Educate yourselves.

But as Murray always advocated, what’s happening to us, in this particular circumstance as in previous circumstances, is not a result of economic error. It’s not the case that the Congress and the president and the Treasury and the Federal Reserve have made mistakes. We are being ripped off. We have been ripped off. We’re being ripped off.

And I’ll just end up by mentioning – you mentioned about how they finagle the CPI figures. It actually goes back before the ’90s. I remember when the Reagan administration took purchased-housing out of the CPI on the grounds it was going up too fast. Of course, maybe they’d like to put purchased-housing back in now that its going down – (laughing). So maybe we’ll see them do that.

But, Joe, thanks a million for coming on. I hope you’ll come back. And it’s great to hear from an actual expert on money and banking as versus most of the boobs that the media presents to us.

SALERNO: Thank you, Lew. It was my pleasure.

ANNOUNCER: You’ve been listening to the Lew Rockwell Show, produced by, the best-read Libertarian website in the world. Thanks for listening.

ROCKWELL: Well, thanks so much for listening to the Lew Rockwell Show today. Take a look at all the podcasts. There have been hundreds of them. There’s a link on the upper right-hand corner of the LRC front page. Thank you.

*The title of this book was corrected and will differ from the audio.

Podcast date, July 23, 2008