Thursday, August 18, 2011

Is Ron Paul Crazy? Part IV

After a nearly 15 month hiatus I am finally ready to conclude my series on Ron Paul. I felt the break was necessary so I could take the time to fully understand Austrian Business Cycle Theory.

Parts I - III dealt with the gold standard, fractional-reserve, and central banking. I will now conclude the analysis of Ron Paul's policies by laying out Austrian Business Cycle Theory. This is important as it is relevant to current affairs, more specifically, the recent rise in food and oil prices.

Austrian Business Cycle Theory tells us that any increase in credit money will lead to a boom that must be followed by a bust as the credit money is contracted, so long as the credit money is invested in capital goods. The increase in credit money, or inflation, leads to many investments during the boom that are later revealed to be malinvestments during the bust. The theory is clear; if we wish to avoid the bust, we must not allow the boom.

Credit, absent Fractional Reserve Banking

In a free market the money supply is made up of specie and notes. If gold is the standard money then the money supply would be equal to the amount of gold specie (coin, bars, etc) in circulation plus the amount of bank notes that are redeemable in gold. The total money supply can never be more than the amount of gold that has been mined and being used as money, ie a medium of exchange. Assume that there exists 100oz of gold that has been mined.

M = Money Supply (100oz)

The holders of this money can either store the money themselves (US, for undesposited specie) or deposit the money in a bank (DS, deposited specie). Drawing upon my Part II discussion of the two different types of banking we know that these deposits can either be in the form of demand deposits (DS, checking accounts) or time deposits (T, savings accounts). For convenience banks will often issue notes (N, or claims, cash) to the deposited specie. We can then say:

 M = US+DS+T
 N = DS + T


M = US + N
N = M - US

It is clear that the amount of Bank Notes must always be equal to the Money Supply minus the amount of Undeposited Specie. If this were not true then banks are issuing bank notes to claims to specie that they do not own. For the rest of this post I will refer to these faulty claims as Bank Credit (BC). More on that later...

We also know that in a free market, absent fractional reserve banking, the supply of loanable funds (C, credit) must come from previous savings (e.g. I can't loan you $1000 if I have not already earned and saved it). To contribute to this pool and individual can either; a) allow someone else to manage their investment by depositing money into a savings account, b) lend to someone directly using my specie, c) lend to someone directly using my bank notes. For those that prefer algebra;

SC = Specie Loans
NC = Bank Note Loans

C = T + SC + NC

T = M - US - DS

C = (M-US-DS) + SC + NC

C = M + (SC-US) + (NC-DS)

It now becomes important to distinguish between specie being lent (SC, Specie Loans) and specie being held for personal use (SP, Specie Personal). The same is true for bank notes; Bank notes being lent (NC, Bank Note Loans) and notes being retained by the depositor (NP, Bank Note Personal).

US = SC + SP
DS = NC + NP


SC = US - SP
NC = DS - NP

and (from above)

C = M + (SC - S) + (NC - D)


C = M + (S - SP - S) + (D - NP - D)
C = M - SP - NP

But in word form, the supply of Credit (C) is limited by the total Money Supply (M) minus the total amount of Undeposited Specie (SP) and Bank Notes (NP) retained for personal use. Remembering that a Bank Note is just a claim to a deposited amount of money (ie. gold) this is expression is simplified to the truism that the amount of credit is limited by the amount people are willing to save and lend. This expression is true for an individual and in aggregate. The preceding analysis may seem a bit overkill to prove such an obvious fact but it is necessary to do so to show what happens when fractional reserve banking becomes involved.

Credit, with Fractional Reserve Banking

I have already discussed that under Fractional Reserve Banking (FRB) a bank is allowed to keep only a certain percentage of deposits on hand. For example if a bank has 1000oz of gold in demand deposits (DS) and the reserve is 10% (R%) it can legally loan out (assuming $1 = 1oz) $900 (FRN, fractional reserve notes). There now exists claims to 1900oz when only 1000oz are deposited. Back to the algebra;

N = DS + T

Assuming  T=0

$1900 * 1oz/$ = 1000oz +0
1900oz Does Not Equal (DNE) 1000oz

Under FRB the amount of notes looks like this:

FRN = (100%- R%) * DS
N(FRB) = FRN + DS + T
N(FRB) = (200% - R%) * DS + T

And under FRB the "Money" Supply increases to:

M(FRB) = US + N(FRB)
M(FRB) = US + (200% - R%) * DS + T

Therefore the Credit Supply increases:

C(FRB) = M(FRB) - SP - NP
C(FRB) = US + (200% - R%) * DS + T - SP - NP

Comparing C(FRB) to C:

C(FRB) = US + (200% - R%) * DS +T - SP - NP
C = US + DS + T - SP - NP

The above analysis shows that with FRB the amount of credit is no longer limited by individuals willingness to save and lend. The credit supply is instantaneously increased by whatever the reserve requirement is and savings is no longer required. The invention of electronic banking and "on-demand" savings accounts increases the supply still further because they are also artificially expanded by the reserve requirement.

Economic Effects

Categorically an individual only has options to using his present money. He can either buy consumer goods, increase his cash balance (hoard), or invest in capital goods. Paying off debt means that he previously did one of the three and is now choosing to increase his cash balance (ie. pay down debt).

If the receivers of the Bank Credit use this money to buy consumer goods then you will have an increase in prices in those goods because you will have more money chasing the same amount of goods, other things being equal. This, however, will not trigger the boom-bust cycle. The same is also true for increasing cash balances, except present prices will remain unchanged.

The boom-bust cycle begins when FRN's are put towards investing in capital goods either through T(FRN) or NC(FRN). This artificial increase in credit represents a fictitious increase in the savings pool. This investment, what Ludwig von Mises termed malinvestment, is unsustainable because the investors are using money to buy goods and at the same time the depositor is using the same money to buy goods. At some point, when the bills come due, somebody will be out of luck when they find that the money they were using to purchase goods does not exist at all. In order to satisfy liabilities banks will begin to call in their FRNs and C(FRN) will begin to contract towards C. This is the moment when the bust begins and is usually followed by bank-runs as depositors quickly begin to demand redemption of their specie.

The economic consequences of the boom-bust cycle, thanks to fractional reserve banking, are disastrous and painful. There will be massive lay-offs and people will often have to leave their homes and friends to find a new job. Real capital goods, thought to be put towards profitable investment, are now revealed to have been wasted and, in some cases, gone forever. It is important to keep in mind, however, that any government intervention (unemployment insurance, bailouts, regulation) will only increase the amount of time required for the necessary adjustments. Furthermore, if the central bank chooses to re-inflate the credit markets another boom-bust cycle will begin with the potential to destroy the currency all together.

Psychological Effects

The consequences are not only economic but psychological as well. The artificial increase in money and credit removes natural checks on human activity that in order to consume one must first produce and that in order to invest one must first produce and defer consumption. Fractional Reserve Banking enables people to consume without producing and invest without producing nor deferring consumption. Consuming for the present begins to dominate whereas saving and investing for the future tends to fade.

Is FRB Evil?

The crucial question to ask is this, "is fractional reserve banking fraud?" The question is important because attackers of the free-market (and even some "supporters") have blamed the boom-bust cycle on free-market capitalism run amok.

The free-market is defined as a society in which all exchange is voluntary. There are no violations of property rights. Therefore crimes like murder, rape, fraud, theft can not occur. A proper legal system wishing to adhere to these principles then must properly define and outlaw these violations of property, or involuntary exchange. The above should make quite clear that Fractional Reserve Banking is indeed fraud.

Some libertarians will argue that two parties could voluntarily agree to engage in FRB. But this ignores the third-party, the recipient of fractional reserve notes. Indeed, the same could be said of two parties that wish to voluntarily agree to murder someone. Of course they could agree to, but does the victim agree to this? Of course not, otherwise it would not be murder. Just as murder is not allowed in the free market, neither is fractional reserve banking.


Anyone who blames the boom-bust cycle on the free-market and does not mention fractional reserve banking is either naive, ignorant, or deceptive. They are naive to the extent that they not been exposed to Austrian Business Cycle Theory. If they have been exposed but out of ideological reason refuse to understand or accept it, they are ignorant. The far more serious offender is the person who not only understands the causes and consequences of fractional reserve banking but purposefully hides the truth to benefit themselves.

Others are quick to blame the business cycle on greed. Yet this explanation only begs the question. What is that allows people to act on this greed? The answer should be quite clear; fractional reserve banking.

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