Wednesday, March 3, 2010

Is Ron Paul Crazy? Part II

In the previous post I focused my attention to an analysis of the gold standard and how gold came to be used as money. This post will focus on another of Ron Paul's "crazy" policy platforms; End the Fed. Discovering and understanding the nature of the Fed must begin with a discussion of inflation and fractional-reserve banking.

Despite what you hear on the news or read in the Wall St Journal, Economist, or NY Times, inflation is not an increase in the price level. Inflation is an increase in the money supply. While it is true that inflation tends to lead to an overall increase in prices, it does not necessarily have to be so. It is perfectly possible that the price level can decrease after an increase in the money supply.

While most people have heard of the term inflation, few have no idea whatsoever as to to what fractional-reserve banking is. By law, banks are only required to keep a certain percentage of their cash obligations on hand. For example, say the US requires that all banks must keep 25% of the cash on hand that it owes to owners of checking accounts. Now I go to my bank and deposit $1000. Because, by law, the bank only needs to keep 25% of this $1000, $750 (called bank credit) are available to be loaned out by the banker. While my check balance shows that I have $1000 in the bank in reality there is only $250.

Now this math may not seem to add up to most people. That's because it does not. You may also think that it sounds an awful lot like a pyramid, Ponzi, and now Madoff scheme. That's because it is.

Before I tie the Federal Reserve into all of this I will rejoin my discussion on the development of banking and the issue of notes in exchange for gold that I began in my previous post. I spoke of the development of banking in general, but I did not mention the two types of banking; deposit and loan.

Deposit banking is when a person gives the banker his gold for safekeeping or for saving. The banker in turn issues a bank note to the depositor. The bank note declares the weight of gold that is redeemable to the owner of the note when presented to the bank. These deposits are known as demand deposits. In our modern system gold is not used. You merely deposit cash into your bank account and expect to receive that cash back when you ask for it.

Once people acquire what they feel to be an adequate amount of savings they tend to wish to loan the money out. People began to lend their gold in banks and agreed to allow the banker to use gold for investments. In exchange for the use of the gold the banker and lender would agree that at the end of a given time period the banker would return the original amount of gold, plus interest, to the lender. These are known as time deposits.

The important distinction to draw between demand and time deposits is that with the former you expect to receive the money on any day at any time and the latter a certain date at a certain time.

Up until this point banking served as a useful, noncriminal business. As banking became more widespread and banks earned more trust, their customers rarely went to the bank to redeem their gold. The bankers began to notice that there always seemed to be a certain amount of gold sitting in the vault remaining "idol". They came up with a brilliant idea. Why not use these "idol" funds to loan out to other people and business? They started to issue additional bank notes for the gold in their reserves. Thus fractional-reserve banking was born.

Let's assume that a bank has total demand deposits equal to 100oz of gold and 10 customers. To these original customers the bank issues notes redeemable for 1oz of gold each. There are now 100 bank notes in the hands of the customers. We will also assume, for simplification, that all of these customers trade only with one another and only use that bank. It is then very unlikely that the customers will ever actually go to the bank to redeem their gold, they will just exchange the bank notes amongst themselves.

The banker, noticing that he always has 100oz of gold, begins to issue notes to 10 new customers each redeemable for 1oz of gold. Assuming the banker is not too reckless, he only issues 100oz (equivalent to a 50% reserve requirement) worth of notes. Now there are 20 customers holding a total of 200 notes that have a claim to 100oz of gold. But each note states that it is redeemable for 1oz of gold. Basic math tells us that 200notes * 1oz/note = 200oz. Yet the bank only has 100oz! The bank is insolvent.

There are two main ways in which the bankers luck runs out and becomes bankrupt. The first is the bank run. The customers are not stupid. They begin to notice the introduction of new bank notes and begin to question the integrity of the banker. Word spreads that the bank may not have enough gold to meet all of its obligations. People rush to the bank to begin redeeming their gold. The fortunate are the ones that arrive before the vault is empty while the less fortunate are the ones that arrive and the bank is empty. Regardless, all 20 customers have been harmed. The banker is a criminal and has committed fraud.

The second way to reveal the criminal activity of the banker requires no such bank run. All that is needed is for one person to acquire 101 of the 200 circulating notes and go to the bank to redeem them for the gold. Once again the banker's evil act has been revealed. However, in this scenario the individual seeking to redeem the gold is usually another bank. This is due to the fact that the customers of the bank eventually exchange notes to customers of another bank and they may turn in these notes to this new bank. The new bank does not want these notes. It wants gold. So it calls upon the original bank for the gold. The consequences of this will be shown below.

Once the banker's scheme is uncovered he is left with few options. He can admit to his crime and declare bankruptcy and arrange for settlement with his depositors. In the event of a bank run he can also close his doors and refuse to turn over the gold to its rightful owners. Things are different when another bank knocks on his door. Because the other bank is most likely engaging in fractional-reserve banking, the two banks usually form a cartel and agree not to redeem the others gold. Eventually these cartels become so large that they are often deemed "too big to fail".

Today nearly all banks are insolvent. If this were not so then they would not need endless bailouts and they would not be aggressively contracting bank credit (decreasing credit card limits, forcing home foreclosures, etc).

It should now be clear that fractional-reserve banking is fraudulent and therefore evil. Yet for some reason fractional-reserve banking is perfectly legal in the US (and I believe nearly every other nation in the world). Why is that? In the next post I will attempt to explain this.

I also only limited the discussion of  fractional-reserve banking to its fraudulent nature. I did not mention the destructive consequences that the issue of artificial bank credit (the inflation of the money supply) has on the entire economy. These also will be the subject of future posts.


Anonymous said...

Began reading "End the FED" at the airport. Not a 100% convert yet but interesting stuff.

Zach Bush said...

In my opinion there are betters books than "End the Fed" if you really want a better understanding. I suggest "What Has Government Done to Our Money?", "The Case For a 100% Gold Dollar", and "The Case Against the Fed".

All are by Murray Rothbard and can downloaded for free from