8. Fractional Reserve Banking

CHAPTER EIGHT

FRACTIONAL RESERVE BANKING

If you ever take your neighbor’s garment as a pledge, you shall return it to him before the sun goes down. For that is his only covering, it is his garment for his skin. What will he sleep in? And it will be that when he crieth to Me, I will hear; for I am gracious. (Exodus 22:26–27)

The context of this verse is the general prohibition of interest taken from a poor fellow believer. He has been reduced to such abject poverty that he asks the neighbor for a loan so small that his coat can serve as collateral. He has nothing else of value that can serve as collateral. This is not a business loan.

But think about the purpose of collateral. If I give you a loan, I want some security that I will get something from you if you refuse to repay it or are unable to repay it. Perhaps I loan you money against an automobile you own. If you default on the loan, I can repossess the automobile and sell it. Maybe I can get my money back this way.

Also, I know that you don’t want to lose that automobile. You will work hard to earn enough money to repay me. I know that the pain you will experience by losing your collateral spurs you on to greater efforts. I don’t have to take physical possession of the property, if I have taken possession of legal title which entitles me to take physical possession, should you default on the loan.

But what about a poor man who has no collateral besides his cloak? I want to get him to pay off the loan. Still, the cloak is useless to me personally. I would want to use it at night, when it gets cold, but I can’t. I have to return it to him every evening. So, it is useless to me. Or is it?

Obviously, it is useful to him. He gets cold at night, so he comes to get it. It is a lot of trouble for him (and a bit humiliating) to have to come to my place every evening to get back his cloak. He wants to get out of debt as soon as possible. So, it does serve as an incentive for him to repay, which also means that it is an asset to me.

There is another aspect of this sort of collateral which most people never think of. What if the borrower is corrupt in his heart? What if he went out and borrowed money from a dozen people, with the cloak as collateral? He promised each lender: “Look, if I default, you may have my cloak. I want my cloak, so I surely won’t default.” But if he has borrowed against the cloak twelve times over, he may be perfectly willing to default on that cloak. Let the lenders decide who gets the collateral.

The corrupt debtor shouts, “Tough luck, suckers. Sort it out among yourselves. The money is gone. All I have left is the cloak. I’ll be cold without it, but I had fun with the money. It was worth it!”

What the Bible teaches is that it is immoral to secure multiple loans with the same piece of collateral. To reduce the possibility of someone indebting himself several times over, the Bible allows the lender to take physical possession of the collateral daily. Since only one lender can do this per day, the debtor is not able to indebt himself many times over on the basis of one piece of collateral.

Just because a piece of collateral is physically useless to the lender does not mean that it is economically useless to him. It may be very useful to him economically, first, to motivate the debtor to repay the loan, and second, to prohibit the borrower from indebting himself several times over.

Multiple Indebtedness

In chapter 3 I discussed the creation of a warehouse receipt for storing gold or silver. A person brings in ten ounces of gold to the warehouse for safekeeping, and the warehouse issues a receipt for ten ounces of gold. The owner pays a fee for storing the money, but he presumably increases the safety of his holdings. The warehouse specializes in protecting money metals from burglars. The depositor pays for this specialized service. It is somewhat like a safety deposit box in a bank, except that the warehouse issues a receipt.

The receipt may begin to function as money. If people trust the warehouse, they will accept a receipt for all or part of this gold in payment for goods and services. Why not? A piece of paper authorizing the bearer to collect a specified amount of gold is just about the same as the actual ounce of gold. Besides, the gold is safer in storage, and paper is a lot more convenient than pieces of metal.

But a problem threatens the system. What if the warehouse owner recognizes that people in the community trust him? They know that he has a lot of guards watching everything, and that he has always been scrupulously honest. He then betrays this trust. He issues warehouse receipts for gold for which there is no gold in reserve.

He then loans these receipts to borrowers. The receipts serve as money. People accept them in exchange for goods and services. These warehouse receipts are considered “as good as gold.” Why not? They are always exchangeable for gold upon demand. Just take the piece of paper to the warehouse, and get your gold. No problem!

But now there is a problem. There are more receipts for gold than gold in reserve to pay all the potential bearers on demand. These “demand deposits” are now vulnerable to that most feared of financial events, a bank run. Depositors who have receipts come down and demand repayment. But there isn’t enough gold in reserve to meet the total demand.

The warehouse has placed itself in a similar position as the poor man who immorally secures loans from a dozen lenders on the basis of one piece of collateral. The warehouse owner has become a banker. He makes loans, for which borrowers agree to pay him interest in the future, along with a return of the principal. But the money, once loaned out, is gone until the day that repayment comes. The warehouse is vulnerable to a run on the deposits. The warehouse owes gold to the depositors. It is indebted to them. The deposits are legal liabilities to the bank. The bank has become indebted many times over. It has in reserve only a fraction of the assets promised to depositors.

There is a name used by economists to describe such banking practices: fractional reserve banking. Banks do not have 100 percent of all their liabilities on hand as assets against those liabilities. In short, their reserves are only a fraction of their liabilities (deposits). They have loaned out the money long term, but their clients (depositors, lenders to them) can demand their money short term. Thus, the time factor intervenes. This is the weak point of all modern banking.

The Creation of Money

Remember, I said that the warehouse receipt circulated as if it were gold. Therefore, if gold serves as money in that society, the pieces of paper will also serve as money.

When these pieces of paper are pure money-metal substitutes, nothing changes. Physical gold is taken out of circulation and put into a warehouse. A piece of paper (a warehouse receipt) substitutes for the physical gold. No new money has come into circulation. No money has been taken out of circulation. Nothing fundamental changes, except for convenience.

But if the warehouse owner writes up a warehouse receipt for gold when there is no new gold on deposit, then he has increased the money supply in the community. No one has come to the warehouse and deposited gold (taken it out of the day-to-day economy). So, the warehouse receipt is inescapably inflationary. It is an addition of money into the economy. (I am defining “inflation” as “an increase in the money supply,” the way dictionaries and economists defined it 50 years ago. The result is rising prices, or else prices will not fall as far as they would otherwise have fallen.)

Here is what normally would happen. The warehouse receipt circulates as if it were gold. If the warehouse owner is very cautious, and issues only a few extra receipts, probably nobody will find out. He will collect a little interest from borrowers, and everyone will be happy. Prices may rise only a little, or perhaps not at all.

But other warehouse owners hear about their competitor. So, he’s lending out money, is he? Well, two can play that game. So, they begin to issue their warehouse receipts to borrowers. They too get in on the banking game. The money supply now starts to increase.

Prices start to rise as denominated in gold. But gold’s price doesn’t rise, for all the receipts are “as good as gold” and therefore identical to gold, supposedly. So, those who hold gold get hurt. They see the price of other goods rising, but stodgy old gold stays the same. So, they do the rational thing: they start buying goods before the price of these goods gets any higher. They go down to the store and start buying goods with warehouse receipts. All of a sudden, the store owners see a lot of paper receipts. Where did all these receipts come from? Maybe it would be smart to cash in these receipts and demand delivery of gold. Something funny is going on.

They go to the warehouses and start demanding gold. All of a sudden, the run on the warehouse begins. The warehouse receipts begin to fall in value compared to gold. Other people rush down to get their gold (which is now rising in value compared to the warehouse receipts they are holding). The bank collapses. Or else it is forced to delay repayment to receipt owners.

It is similar to the wicked cloak owner who has indebted himself many times over, and then leaves his creditors standing out in the cold.

The Shrinking of Money

A few days before the bank run, business had been booming. Everyone seemed to have lots of money to spend. It was terrific for businessmen.

A few days after the bank run, reality sets in. Many depositors can’t get their money. People who have borrowed from the banks because business was so great discover that their investments have gone sour. They had begun building new factories, but now there is no more demand for the goods produced by these factories. They had been lured into making the investment (borrowing the money) because the economy seemed to be booming, and interest rates were nice and low.

The reason interest rates were so low is that the banks were counterfeiting money and lending it out. They didn’t have to pay depositors any interest, and they were taking in interest. It was so easy.

The day of economic judgment arrives. Businesses go bankrupt. Others lay off employees. Everyone has to adjust to the new conditions of supply and demand. The inflation is over; deflation has come. Some bank notes (warehouse receipts) are worthless. They aren’t money any more. People who held them have lost their money. They stop spending as much as before.

Does this sound familiar? It should. It’s called a depression. And there is one cause, and only one cause, of depressions: prior inflations. The good days looked so good; the bad days look so bad. People were lied to. The counterfeit warehouse receipts were promissory notes, and these promises were lies. The reality of the post-lying era is like a hangover after a night of reveling. But it is reality. The drunk, like the businessman, should be thankful for it. They seldom are.

Look, depressions are hard to explain. Why should virtually every businessman in the country—even in the world (1930s)—all make the same mistakes at about the same time. Sure, businessmen make mistakes. Some buy when they ought to be selling. But never forget: there’s always another businessman who sold to the one who was buying. Why don’t their mistakes offset?

The answer is the money system. All businessmen are tied to money and interest rates. If we want to explain why almost all of them think a boom is going to continue when a bust is about to occur, we need to look at money and interest rates. The businessmen make the same mistakes because interest rates are giving them incorrect signals.

Borrowing rates are low because bankers are creating counterfeit money—legal counterfeit money—and loaning it out. Then inflation hits, the economy booms, and then craters when the bankers slow down the printing of money in self-defense against bank runs: too many receipts for too few reserves. Money shrinks (or even just slows down), and the depression hits.

We’ve seen it before: the boom of 1964–69 turned into the bust of 1969–71. The boom of 1972–74 turned into the bust of 1975–76. The boom of 1977–79 turned into the bust of 1980–82. It will happen again. It always does.

That’s the curse of counterfeit money.

Pure Counterfeit Money

The modern banking system has gone a long way in the last fifty years. All over the world, nations abandoned the gold standard. The citizens are no longer given legal access to true warehouse receipts (gold-backed money). They can’t take their paper receipts to a bank or the national treasury and demand a fixed, predictable quantity of gold (or silver) on demand.

Now the bankers don’t have to worry about a “bank run” against gold. Neither do the politicians. The result has been mass inflation all over the world. You could buy a three-bedroom home in 1913 for under $3,000.

Today, the game is played differently. Let’s see how it works. Say that you take in $100 cash and deposit it in your bank. The central bank (in the United States, the Federal Reserve System) requires banks to keep varying percentages of money on reserve at the Fed itself, in non-interest-paying accounts. A 10 percent reserve makes it easy to compute, though for many accounts it’s under 5 percent.

The bank takes your $100 and issues you a receipt (bank deposit slip) for $100. It then takes $10 and wires it to the regional Federal Reserve bank. Then it loans out the remaining $90.

The guy who borrows the $90 deposits it into his account. Presumably, he then writes a check for the $90. The person who gets his check deposits it. His banker takes 10 percent, or $9, and wires it to the regional Federal Reserve Bank. Then he loans out the remaining $81. The borrower writes a check to someone who deposits it in his bank. His banker takes 10 percent, or $8.10, wires it to the Federal Reserve Bank, and loans out $72.90.

And so it goes, from bank to bank, merrily multiplying. In theory, the original $100 cash deposit (or check) creates an additional $800 in loaned money, plus your original $100.

And you wonder why we have inflation?

Isn’t legalized counterfeiting wonderful? Something for nothing. We’ll all be rich soon. Millionaires. But bread will cost $40 a loaf.

Then we’ll have a depression. The politicians will blame businessmen. The bankers will blame anyone. Everyone will blame capitalism. But capitalism wasn’t the cause of the boom or the collapse; fractional reserve banking was: too many warehouse receipts with too little money in reserve.

Conclusion

Banking as a purely lender and borrower operation is a wonderful institution. But pure banking is not inflationary. If I loan you $100, I can’t use that $100 while you’re using it. I don’t have a “demand deposit.” When your banker takes in your deposit, he can’t loan it out. It sits in his vault until the borrower spends it. Once it’s spent, it isn’t his anymore. He has to wait until his business starts paying him money before he can repay the loan. The same $100 goes through the economy without multiplying.

Not so in a fractional reserve banking system. I have the right to spend the money I deposited at any time, even though 90 percent of it (or more) was loaned out already. Where does the banker get the money to honor my check? From some depositor who deposited his paycheck today.

It’s just like the fellow who owns that warehouse. He issues lots of extra warehouse receipts to money (gold) because he knows that very few depositors will come down on any day and demand their gold. If someone does, probably this will be offset by some other depositor who is depositing gold in the warehouse. It all looks so easy, until the run occurs.

Fractional reserve banking violates the Biblical principle against multiple indebtedness. When bankers violate this law (with the consent of the State), it leads to inflation and economic booms, followed by deflation and economic depressions. Fractional reserve banking is a form of fraud, as surely as a borrower who uses one piece of collateral to get a dozen loans is fraudulent. But at least “cloak banking” isn’t inflationary. Fractional reserve banking is. A single piece of collateral (deposit) is used by the banking system as a whole to create multiple liabilities against the banks as a system.

Summary

Here is how the system produces evil:

1. Using a single piece of collateral to borrow money and therefore to create multiple indebtedness is prohibited by the Bible.

2. A lawful warehouse receipt must have whatever is promised on reserve for immediate delivery.

3. A warehouse receipt to any item which serves the community as money must also be fully backed with the weight and fineness promised on the receipt.

4. The issuing of unbacked warehouse receipts to a money commodity is a form of counterfeiting.

5. Counterfeiting is an addition of new money into the economy.

6. The addition of new money into an economy is inflationary.

7. The new money creates an illusion of prosperity: economic boom.

8. The boom leads to further borrowing by businessmen.

9. Interest rates stay low temporarily because counterfeiters are creating new money to loan.

10. Prices rise.

11. People get suspicious of the warehouse receipts.

12. A run on the warehouse occurs.

13. The public loses confidence in the warehouse receipts and the boom.

14. The money supply shrinks.

15. The boom turns into a bust: deflationary depression.

16. The depression brings everyone to economic reality.

17. People hate painful reality.

18. The government is tempted to create new money, or have the banks do it for them, to stimulate a new boom.

19. Capitalism doesn’t cause depressions; fraudulent banking and government inflation cause booms, then depressions.