Most people with a love for liberty have developed a strong dislike for the Federal Reserve System. There is an inherent contradiction between free markets that reward productive achievement with honestly-earned wealth and a central planning apparatus that arbitrarily controls the real cost of investment, how much investment there will be, and ultimately what the fruits of your labor will be worth. In a country that proclaims itself to be the “land of the free,” central banking doesn’t sound good, it doesn’t feel good, and, most importantly, it doesn’t work. However, the Federal Reserve System is merely the catalyst of malinvestment and economic cycles. If we really want solve the problems of economic cycles and invisible wealth transfer, we have to eliminate the root cause: fractional reserve banking.

Thomas Jefferson and Andrew Jackson are often cited as heroes against the evils of banking because they each championed elimination of the national banks that had been established prior to their presidencies. While this put a limit on money creation and credit expansion, it is easy to forget who paid the price for those limits: depositors. During the “free banking” period from 1837-1862, the average lifespan of a bank was about 5 years, and roughly half of the banks failed, largely due to their inability to honor deposits.(1) Bank failures contracted the money supply, keeping the value of money relatively stable. That was great if you had a safe full of gold coins or even U.S. dollars. However, if your life savings was stored in a failed bank, you lost it all. When a bank failed, everyone that did not withdraw their deposited money lost their deposits. Both the wealthy financier and the retiree of modest means were harmed.

Fractional reserve banking allows the bank to lend out money on deposit while keeping the deposited money simultaneously available to the depositor. Thus, the money it actually has is merely “a fraction” of the total deposits. This certainly provides a huge opportunity to the bank, which can make astronomical profits. It also allows a depositor to earn interest on a savings account. It can accelerate economic growth, by providing loans for business investment beyond the real savings rate for a particular economy.

However, the downside of fractional reserve banking is one we are all familiar with. With liquidity in the system equaling as much as 10 times the real savings on deposit, negative consequences are virtually inevitable. First, prices are going to go up. Fiat money retains its value based upon its scarcity. Ron Paul uses an excellent metaphor in his book, The Revolution: A Manifesto, when he asks the rhetorical question, “Or imagine an art auction in which the bidders are given an additional million dollars. Would we not expect bids to go up?” (2)

Second, malinvestment is going to occur. A scarcity of money and credit forces lenders to use higher standards when deciding whether or not to make a loan. They will always lend out to what they believe are the investments that have the best combination of risk and return. The natural tendency for a lender is to limit his risk, while seeking those investments where the return is the highest and most certain. However, as the money supply is increased and there is still money available AFTER the most optimal investments have been made, the remaining money gets invested in ventures that have more risk, or less certain expectation of return, or both. Loans are granted to people or companies that would not have received them without the additional “liquidity” available to lenders. When the money supply is inflated hundreds of billions or even trillions of dollars beyond real savings, you get a bubble. A bubble is a critical mass of malinvestment that causes whole sectors of the economy to become overvalued. Of course, once it becomes obvious that those investments are never going to yield a return, you get the bursting of the bubble, and a recession. During the recession, all of those malinvestments are liquidated, debts are paid down, and general contraction in the economy occurs. This is usually accompanied by higher unemployment.

Throughout history, the practice of fractional reserve banking and the inevitable bank failures that accompany it have motivated calls for a lender of last resort, or a central bank.(3) If you are going to allow fractional reserve banking, you must either resign yourself that bank failures are going to be common from time to time, and that there is no “guaranteed” place to store and safeguard your savings, or that a central bank is necessary to create out of thin air the money needed when banks cannot honor all of their withdrawal requests.

Thus, the central bank perpetuates fractional reserve banking when it would otherwise fail. Moreover, by intervening in the free market by artificially setting interests rates, the central bank actually promotes faster and greater expansion of the money supply. If fractional reserve banking were a chemical reaction, the central bank would be the catalyst, accelerating the process with its infusions of “liquidity” through interest rate manipulation and open market operations.

In order for real economic growth to occur, savers must consume less than they produce. The resulting savings provide capital for growth. The saver must then trade consumption today for a return on investment tomorrow. In the terms of the economist, he must trade present goods for future goods. Fractional reserve banking attempts to do away with this reality. It tells the saver that he does not have to sacrifice present goods at all but can still expect future goods. When you open a savings account that pays interest, you and your banker pretend that your banker can not only safeguard your money for you for free, but can actually pay you for the privilege and still stay in business. He cannot. The only way that he can pay you interest on that deposited money is by investing your money somewhere else. Fractional reserve banking is really a kind of insanity, where you give money to your banker, he lends it out, and you both pretend it is still sitting in the vault at your disposal. It violates a universal law that most 8-year-olds know but most bankers have forgotten: You can’t have your cake and eat it, too.

In order to fully understand these issues, one must understand the nature of money. What is money? It is a store of value and a medium of exchange.(4) It is a practical way for people producing a wide variety of different goods and services to trade those goods and services with each other. It allows the grower of apples to trade with the manufacturer of automobiles without requiring the manufacturer to accept 20,000 apples at once for his automobile.

Economists usually divide money into three categories. The first is commodity money. Commodity money is unique in that it has intrinsic value.(5) While gold is often the example used, I believe grain is a better one to understand this concept. At certain times and places in history, grain has been used as money. It is relatively uniform, easily divisible, somewhat imperishable, and scarce enough that it can function as money. When the automobile manufacturer trades his product for grain, he can store it for years without it spoiling. He can divide it into bushels, one pound sacks, cups, or even tablespoons, allowing him to buy goods and services of varying value. He can use it to trade for furniture for his house, or meat, or his electric service. If all else fails, and there are not sellers available to provide him something he wants in exchange for his grain, he can eat it. Gold and silver are other common examples of commodity money.

Storing the necessary amount of grain to meet all of the needs for money in a modern society is of course inconvenient, and carrying enough grain on your person even to get through the day would be even more so. That is what gives rise to a second type of money, representative money. Our U.S. dollar, when it was redeemable for a fixed amount of gold, was representative money. The defining characteristic of representative money is that, while it has no intrinsic value of its own, it is directly redeemable for commodity money or a hard asset.(6) This makes its value relatively stable, because you can always redeem it for grain, gold, or whatever hard asset the representative money is backed by.

The U.S. dollar of today fits into a third category of money, fiat money. Fiat money neither has intrinsic value itself nor is it redeemable for a hard asset or commodity money. Its value is “bestowed upon it by fiat,” and ultimately depends upon the confidence of those using it that it will be accepted in exchange for goods and services that the holder may want.

It is virtually self-evident that only commodity money is completely safe from inflation while a fractional reserve is permitted. While there is a tendency today to associate inflation and the business cycle completely with fiat money and the Federal Reserve System, the bank failures of the free banking period all occurred while the U.S. was without a central bank and still on the gold standard. Is the only answer for us to carry around bushels full of grain?

No. What is really needed is the legal requirement of a 100% reserve ratio. This means that banks are only allowed to loan out money that is made available to them for that purpose by customers. Banks would not be able to loan out deposited money that is simultaneously available to the depositor.

There is a cost to this proposition that most people will find pretty easy to live with. Savings accounts would no longer pay interest. In fact, bankers would be due a reasonable fee for safekeeping the depositor’s money without exposing it to any risk. A bank customer who wished to earn interest on his money would have to agree to loan the money to the bank for an agreed upon term, during which the money would not be available to the depositor. We make these loans now; they are called Certificates of Deposit (CD’s). There is also a degree of risk in this, in that the bank could make a lot of bad loans. However, history shows that banks are pretty good at evaluating risk when not flooded with cheap, fiat currency.

Wall Street would pay a higher price in that growth and investment would be slower, although much steadier and less likely to be imaginary. Rather than billionaires, many financiers would have to resign themselves to being millionaires. However, they would be comforted by the knowledge that they had earned those millions, instead of having indirectly stolen billions from the poor and middle class through inflation. Perhaps a private charity could be founded to help those millionaires having trouble making ends meet.

In return for these sacrifices (if you can call them that), economic growth would be real. No longer would there be inflationary bubbles, like the 1990’s tech bubble or this decade’s real estate bubble, or the painful recessions that follow them. With every investment relying on real savings rather than fiat “liquidity,” standards would be much higher and malinvestment would be significantly reduced. While malinvestment and business cycles could still occur, they would be infinitesimally milder than the booms and busts we experience now. We would no longer need a Federal Reserve to bail out banks during a run. In fact, a run on the bank would be of little consequence, since the bank would have 100% of the depositors’ money available.

Moreover, without over-expansion of the money supply, the wealth transfer from the poor and middle class to the wealthy would cease. We would have less billionaires, but we would have a much higher standard of living for most people. The gap between rich and poor would begin to close, with most people landing VERY comfortably in the middle. The quality of life for the poor would again begin to improve, as it improved during the nineteenth century. Our steps might take a little longer, but we would no longer take a step back after every two steps forward. After thousands of years of invisible wealth transfer, bankers would no longer inherit the earth. All of this is possible, but reinstituting a gold standard and abolishing the Federal Reserve are not enough. We must finally end the insane practice of fractional reserve banking.

(1) http://en.wikipedia.org/wiki/History_of_central_banking_in_the_United_St...
(2) Paul, Ron The Revolution: A Manifesto Grand Central Publishing New York, NY 2008 pg. 142
(3)De Soto, Jesus Huerta Money, Banking, and Economic Cycles (English Edition) Ludwig Von Mises Institute Auburn, Alabama 2006 pg. 713
(4) Piana, Valentino Money Economics Web Institute (2002) http://www.economicswebinstitute.org/glossary/money.htm
(5) http://en.wikipedia.org/wiki/Commodity_money
(6) http://en.wikipedia.org/wiki/Representative_money

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