Case Against the Fed and Fractional Reserve Lending

Fractional Reserve Lending (FRL) is fraudulent. Indeed, FRL in conjunction with micro-mismanagement of interest rates by the Fed is the root cause of the financial crisis we are in.

Unfortunately many do not see FRL for the fraudulent scheme that it is. Here are the most common defenses against the allegation of fraud.

Five Arguments Used To Defend FRL

  1. FRL is not fraud because the lending is backed by assets.
  2. FRL is not fraud because it is allowed by law.
  3. Eliminating FRL would require unwarranted “regulation.”
  4. No one is harmed by FRL.
  5. People have a legal right to make agreements with banks allowing their money to be lent with no reserves

Rebuttal

1R. To those who claim credit extended by fractional reserve lending is not fraudulent because it’s backed by assets, I ask: “What assets?” The answer of course is ….

  • Fannie Mae and Freddie Mac debt that would be worthless were it not for taxpayer bailouts.
  • Asset-backed commercial paper that has ceased to trade.
  • Toggle bonds and other such nonsense where debt is paid back with more debt.
  • Loans to hedge funds for speculation in credit default swaps and commodities.
  • Commercial real estate boondoggles including scores of condo towers now sitting empty.
  • A whole array of other silly loans that should never have been made.

Close analysis shows the “backed by assets” claim only holds true as long as asset prices are rising. When asset prices are falling as they are now, the true state of the non-existent backing is plain to see.

Credit extended via FRL is backed by nothing more than thin air and promises. Those promises are currently worth pennies on the dollar, and the entire global banking system is insolvent as a result.

2R. Some claim that fractional reserve lending cannot be fraud because it is legal. However, just because something is legal does not make it right. For example: Slavery was once legal. It certainly never was right. Government decree cannot make slavery right, but it can and did make it legal. By the same token, government decree alone cannot change the fact that fractional reserve lending is fraudulent. Proof of fraudulence will be offered in the rebuttal to point number 4.

3R. Some claim that FRL cannot be eliminated because that would require regulation and such regulation would in and of itself be against free market principles. The fact of the matter is that a free market would quickly shut down any bank lending out more money than it had in the vault. No one would possibly trust such a bank. It is only government decree (regulation) that allows banks to get away with such obvious fraud.

Furthermore, people are confused by what “libertarian” means. Libertarian does not mean anarchy. There are laws against murder, theft, fraud, and slavery that no libertarian I know would argue against.

Indeed, for any society to function, there must be certain laws (regulations) in place. Here are the basic tenants of valid laws.

  • Protection of property rights
  • Protection of civil rights
  • Freedom of religion
  • Equal protection under the law regardless of race, creed, color, sex, nationality, wealth, etc.

4R. Proponents of FRL claim no one is harmed by it. In practice, everyone is harmed by it. Here is how it starts. Those with first access to money accumulate assets and those with later access to money bid up those assets. Consider housing. GSE creation of credit out of thin air is a perfect example of what happens. By the time credit was available to those of lower economic status, the bubble was already formed and ripe for a collapse. Even the non-participants were harmed. How so? Via rising property taxes and rising prices of goods and services without the benefit of rising wages.

Ironically, even those with first access to money (the banks and wealthy) ultimately did not fare well because they were greedy. When the bubble popped (as all debt bubbles eventually do) the only winners were the few who made timely bets on the demise of the bubble.

FRL is the enabler for credit bubbles. Given enough time, credit bubbles are guaranteed to implode in deflationary fashion. History is replete with examples. The South Seas bubble, the John Law Mississippi bubble, and tulip mania are prime examples.

5R. People have no such right to agree to commit fraud. Here are more things people have no right to do: Shout fire in a movie theatre, conspire to steal someone’s money, agree to start a toxic waste dump in a location where it would poison every water source in the neighborhood. There is an infinite number of things two people cannot agree to do. The right of people to do things ends when it affects the property rights of everyone else. And as noted in 4R, everyone is affected by fraudulent agreements that allow more credit to be extended than there is money in the bank.

Sweeps

Greenspan authorized sweeps in 1994.

Sweeps allow Demand Deposits Accounts (checking accounts) to be systematically “swept” from checking accounts into savings accounts unbeknown to the checking account holder.

Savings accounts have zero reserves.

So… In actual practice there is almost no money backing up checking accounts, none (beyond what banks THINK they need historically). You can thank Greenspan for this.

This is not “Laissez Faire” economics or libertarianism. This is blatant fraud, something that those blaming libertarianism need to understand.

Such a construct would never flourish in a free market. It takes a regulator like Greenspan to allow it.

Search for Scapegoats

Instead of placing the blame on fractional reserve lending and the biggest regulator of all (the Fed), many claim there is not enough regulation and the Fed needs still more powers.

Please consider Anti-Libertarian Nonsense From Henry Kaufman & Company for a discussion of the so-called libertarian Fed, Fannie Mae and Freddie Mac, Rating Agency Madness, and the Glass-Steagall Scapegoat.

Fed Uncertainty Principle

Inquiring minds should also consider the Fed Uncertainty Principle.

Uncertainty Principle Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing. Why We Can’t Reinflate The Bubble

Ron Paul explains Why We Can’t Reinflate The Bubble.

Opening Statement:

Transcript:

We have to come to the realization that there is a sea change in what’s happening. This is an end of an era and that we can’t re-inflate the bubble, just as we devised a new system of Bretton Woods in '44 which was doomed to fail. It failed in '71 and then we came up with the dollar reserve standard which was a paper standard; it was doomed to fail and we have to recognize that it has failed. And if we think we can re-inflate the bubble by artificially creating credit out of thin air and calling it capital; believe me, we don’t have a prayer of solving these problems. We have a total misunderstanding of what credit is vs. capital. Capital can’t come from the thin air creation by the Federal Reserve System; capital has to come from savings. We have to work hard, produce, live within our means and what is left over is called capital. This whole idea that we can re-capitalize markets by merely turning on the printing presses and increasing credit is a total fallacy; so the sooner we wake up to realize that a new system has to be devised, the better.

Right now I think the Central Bankers of the world realize exactly what I’m talking about and they’re planning, but they’re planning another system that goes one step further to internationalize regulations, internationalize the printing press. Give up on the dollar standard, but we have to be very much aware that that system will be no more viable. We have to have a system which encourages people to work and to save. What do we do now? We’re telling consumers to spend and continue the old process; it won’t work. All We Are Sayin’ Is Give Free Markets a Chance

Paul Kasriel, Director of Economic Research at the Northern Trust weighs in with All We Are Sayin’ Is Give Free Markets a Chance.

Given the economic and financial market “challenges” of the past year, some pundits and politicians are concluding that these challenges are the result of the failure of free markets. I would respond that we cannot determine whether free markets have failed unless we have had free markets. I do not think we have.

One of the most important markets in an economy is the market for credit. We do not have free markets in credit in the U.S. or anywhere else that I know of. The price of short-term credit is fixed by central banks. It would only be by accident that a central bank would fix the price of short-term credit at a level that would obtain if a free market in credit were allowed. It is beyond me why most economists would view with horror some government agency fixing the price of say, copper, but view the fixing of the price of short-term credit by central banks as nothing to be alarmed at.

There is at least one group of economists that realizes the economic mischief caused by central banks – economists who belong to the Austrian school. (For information about Austrian economics, click on this link to the Ludwig von Mises Institute or this link to Leithner and Company, a private investment firm located not in Austria, but in Australia. I am not endorsing the political views or the investment advice of either of these entities, but I am endorsing their approach to economic analysis.) By holding a key short-term interest rate below or above the unobservable free market equilibrium level of this rate, the central bank creates credit, much as does a counterfeiter, or destroys credit, which leads to distortions in the economy and financial markets.

Typically, the central bank starts out by preventing the short-term interest rate from rising to its equilibrium level. This leads to central bank credit creation. In turn, this encourages investments which are profitable only so long as the central bank prevents the interest rate structure from rising to its free-market equilibrium level. All of this manifests itself in the form of higher prices – higher prices of goods/services and/or the higher prices of assets. At some point, the central bank can no longer tolerate what it has wrought, and raises the level of the short-term interest rate above its free-market equilibrium. This precipitates a decline in asset prices, an economic recession and, later, a decline in goods/services prices (or a slowing in their rate of increase). It was recognized by Austrian economists during the sharp run-up in U.S. stock prices in the late 1990s and the subsequent housing boom that the Greenspan-led Fed was especially egregious in keeping the federal funds rate far below its equilibrium level too long. We are now experiencing the economic and financial market fallout from Greenspan’s interference with the free market.

In free markets, risk-takers get rewarded if they are correct in the risks they take, but are punished if they are incorrect. Here, too, Greenspan intervened in the free markets. When it turned out some risk-takers had erred, Greenspan cushioned their losses by slashing the federal funds rate and creating central bank (counterfeit) credit. This central bank intervention in free markets encouraged risk-takers to take on even more risk inasmuch as their upside rewards would seem to be unlimited but their downside punishment would be limited. Protection of Property Rights Is The Key Issue

The central point in a free market–based banking system is to avoid violations of property rights. However, the current system of 100% fractionally reserved banks allows money to be created out of thin air robbing savers, by making those savings worthless over time. A pernicious effect of this system of permanent inflation is that it creates malinvestment and large boom-bust cycles that destroy wealth.

The Fed is a failed institution. Fannie Mae is a failed institution. Freddie Mac is a failed institution and fractional reserve lending is a fraud.

The correct policy decision is to abolish all of them, not to add layer after layer after layer of regulators watching over other regulators, who in turn watch over still other regulators, where some “god-like” super-regulator at the top supposedly has infinite wisdom and knows exactly how to regulate.

May 7, 2009

Mike "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.