Fractional Reserve Banking: A Century Old Fraud

“Monetary System requires deliverance, not a reprieve”

Robert K. Landis

Critics of Fractional Reserve and related Fiat Paper Monetary System may refer it to by the term, ‘Debt Based Monetary System’ or ‘Credit Based Monetary System’. They also refer to money created in parallel with debt as ‘Debt Money’ or ‘Endogenous Money’ reflecting the fact that money is created either to facilitate the needs of individuals, business or governments further in indebting themselves to banks. The credit has been termed as endogenous money because the money supply is flexible, expanding in parallel with the demand for debt and stalling and contracting when the demand for debt declines. It’s also connoted as a perverse and a dysfunctional way of expanding the monetary base of any economy.

To avoid mainstream hysteria amongst the general populace, the term ‘Debt’ has been replaced with the term ‘Credit’ and is only practically distinguishable after the money is created. Most mainstream economists rarely discuss about debt being referred to as credit or vise-versa and hardly bother with the original money as it is to their staunch believe that the origin of money or the volume of their insurance don’t really matter in the long run as propounded by another theory, ‘Money Neutrality’. But the whole idea behind not considering alternatives to fractional reserve banking doesn’t augur well with me, It could be perhaps the mainstream economists and banking moguls are too reluctant to change the system which so set up eludes from the very premise of trickling down effect, or the people are so conditioned that they may never question themselves.

In August 2004, four years before the Global Financial Crisis of September 2008 and the ongoing financial crisis in Europe and elsewhere, Austrian commentator Robert K. Landis stated the following:

“No, the die is cast: we shall have the catastrophe. Our fiat monetary system got a reprieve in the 1980’s, not a deliverance, all that has happened since, with the fantastic mis-pricing of credit the Greenspan Fed has engineered, and the massive global malinvestment this has endangered, is that the dimension of the unravelling has become direr.”

Before we delve into further arguments, let’s first learn what exactly Fractional-reserve banking Implies: -

It is a widespread banking practice in which only a fraction of bank’s demand deposit are kept in reserve and available for immediate withdrawal, whilst the remaining deposits are immediately lent out to borrowers ( and so is never actually available for immediate withdrawal by the legitimate depositors).The bank in effect lends out most or even all of the funds it receives in demand deposits, whilst at the same time guaranteeing that all deposits are available for immediate withdrawal upon demand. The practice of Fractional Reserve Banking expands credit and so does money well beyond what it would be in a stable money system. So how does it work?

Let’s say government for-sees a credit crunch in the economy and to alleviate any signs of early on recession it borrows money from a central bank or a reserve bank as against promissory notes, promising to return the money back to central bank with due interest but the time period may not be specified. Voila and like magic we have an expanded money supply, but wait, the promissory notes or the money never existed in the first place. Only 3% of money supply is fiat and the rest 97% is electronic. The government does expand the money supply but without any sovereign instrument backing it; not only does it lead to devaluation of currency effectively decreasing your real income implying rise in the domestic prices. Case in point: Value a rupee in 1966 (7.5 rupees = 1 dollar); Inflation can never be stopped and more so is interesting how the government pays back money to the central bank. It never does. Money borrowed, itself is non-existent, the promissory notes only exist theoretically but practically they too are non-existent. The borrowed money (debt) can never be repaid. Debt in case of an individual to bank or government to its central bank, can never be repaid. What more interesting is so the whole of money supply is just the principle amount but banking is done on the premise of interest, so logically next pertinent question is, how to repay the loan with interest? We cannot. There is nothing to show for interest.

According to Murray Rothbard of Ludwig von Mises, fractional reserve banking should be considered as an embezzlement, but it is legal now. The bank is technically insolvent, because it cannot pay debt as and when they fall due-the deposit being due instantaneously at any time, however, unless the customers(depositors) demand too much money at once-or too many loans fail-it can continue running without the customers ever noticing that their money was gone. If the bank’s customers lose confidence in the chances if the bank’s repayment, they van decide, en masse to cash the deposits in. The loss of confidence, if it spreads from a few to a large number of bank depositors is called a bank run. Unless the central bank intervenes or the bank comes to its rescue, a bank run is always fatal, because by the very nature of the Fractional Reserve banking, the bank cannot honour all of its contracts.

To put forward historical perspective, under the leadership of Andrew Jackson, the 7th president of United States of America, USA was the only economy that was debt ridden from 1835–1913 until the tabulation of Federal Reserve Act which then succeeded the Central Bank.

“If there were no debt in our money system, there wouldn’t be any money” — Marriner Eccles, Governor of the Federal Reserve (September 30th 1941, House Committee Hearing on Banking and Currency)

Fast-forward to 21st century, there is now a growing a voice of dissent against the fractional reserve banking. Positive money in the UK is such a movement which aims to outstrip private bankers of the banking mechanism called ‘Quantitative Easing’ which is employed to bolster the money supply by having interest rates in the negative in the short-run, and tending to 0% in the long-run.

In the wake of the Great Recession of 2008, with the resurfacing of the ‘Chicago Plan’ of 1933 titled ‘Chicago Plan Revisited’ proposed by Jaromir Benes and Michael, endorsing the original ‘Chicago Plan’ — two economists at the IMF — Switzerland will hold a referendum — popularly known as ‘Vollgeld’ (Full money initiative) — to consider ending the practice of fractional reserve banking. The father of the original Chicago Plan, Irwin Fischer had reiterated the following benefits of non-fraction reserve banking:

· Greater control of a major source of business cycle fluctuations, including the unpredictable expansion and contraction of banks’ credit and, consequently, the supply of banks’ created money.

· The complete elimination of bank runs.

· A dramatic reduction — if not complete elimination — of net government debt.

· A dramatic reduction in private debt since money creation is no longer tied to debt creation.

Iceland the only country where private bankers are cuffed, upped the ante by publishing a report commissioned by the prime minister entitled, “Monetary Reform: A better monetary reform for Iceland” which studied in depth the feasibility of the end of fractional reserve banking. According to the author ­of the paper, Frosti Sigurjonsson:

“[The report] proposes a radical structural solution to the problems we face. The feasibility of and merits of that specific solution need to be debated. But whatever the precise policies pursued, they must be grounded in the philosophy which the report proposes — the money creation is too important to be left to bankers alone.”

Iceland being smaller nation than Switzerland can contain the ramification if the suggestions of the report were to be implemented, but if the practice of fractional reserve banking were to come to an end in Switzerland, there will be a spill-over effect affecting the way money is being created.

After 171 years, Andrew Jackson might turn in his grave in hopes of his dream of public instead of private money to be fulfilled again.