Fractional-Reserve Banking: An Analysis from an Ethical and Economic Standpoint - Part 1: Introduction and History

(This is part 1 of a 8 part series on Fractional-Reserve Banking)

Fractional-Reserve Banking: An Analysis from an Ethnical and Economic Perspective

Our current system of banking, a centralized system of money production and control, is one of mystery and will be discussed for this essay. This system of money creation and its implications will be analyzed for their ethical dexterity and economic effects. The modern system of banking, where a Central Bank controls the entire money supply of a country, must be understood and explored since money is the lifeblood of any economy. However, our monetary system is not well-understood and met with confusion and ignorance rather than curiosity and knowledge. The fractional-reserve system will be the focus of this paper as I examine its history, process, legality, economic and ethical rational and criticisms, and also present a discussion on possible alternatives.

History

The beginnings of fractional-reserve banking go as far back as 8th century China1
(Rothbard 91) but the emergence of standardized practices did not exist till around the seventeenth century. While the practice was not the same everywhere the basic story follows this pattern: Gold and silver coin were the prevailing currency at this time and people would carry their coins around with them and keep their stores somewhere in their home. Goldsmiths would keep their extra gold in vaults at their shops and customers would ask to keep their extra currency in there as well for safe keeping. The Goldsmiths would charge a fine for the service and in return for the deposit of gold would issue deposit receipts to the customers for the amount of gold placed in the vault (typically one note per ounce of gold). As more people began using these “money warehouses” the more people began having deposit receipts. As a result, it was found that by just exchanging deposit receipts for goods and services, instead of the actual gold, transactions could be made easier in the marketplace. The exchange of notes proved much more convenient instead of having to carry around gold, or transfer large amounts of precious metals.

The Goldsmiths realized this trend and decided to take advantage of the situation. Since very few customers actually took their gold out of the vaults and instead used the deposit notes as a medium of exchange, the Goldsmiths were able to issue more notes than actual deposits as loans with interest. Thus the Goldsmiths moved from 100% reserves to fractional-reserves since they could not redeem all the notes from the gold reserves. They justified these actions by calling the extra notes an IOU liability that they would pay back to the depositors’ accounts. However, these money warehouses (becoming the equivalent of modern banks now that they lent out depositors money) still recognized depositors’ right to redeem their gold on demand. It is not hard to see as Murray Rothbard put it, “But the legal claims issued by the bank must then be fraudulent, since the bank could not possibly meet them all” (ibid 99). These practices continued and soon became legalized banking practices and are the base to the modern system that exists here in America and around the world.

Here in America our Central Bank, the Federal Reserve, controls monetary policy and the supply of money in the economy. The Federal Reserve (commonly known as the Fed) conducts monetary policy through tools such as open-market operations and the required reserve ratio. The Federal Reserve controls the operations of commercial banks by changing this reserve ratio, thereby affecting the amount of credit, or new money, that can be created. This process of making new money, of how money is created out of thin air, will be detailed in this next section.
First off, it is important to understand why a Federal Reserve is needed in a fractional-reserve system. Since banks cannot possibly redeem all deposits at the same time (the phenomenon know as a “bank run”) the system is inherently unstable. Recognizing such instability, bankers pushed for, and got, the Federal Government to establish a central bank to act as “lender of last resort”. The purpose of the central bank is one of providing liquidity to banks during times where the banks would have otherwise become insolvent and declared bankruptcy. Having such a power allows banks to continue fractional-reserve practices without the worry of going out of business.

Bailouts and Bull**** - 20/20 special

Youtube Link

John Stossel tells it how it is again. This special starts out by exposing the "consensus" opinion about stimulus packages then deals with other government influenced issues: roads, education, the American Dream, and immigration. Honestly I don't know how people actually think the government can do a better job than the private sector. I think its because people equate it this way: private=profits=evil.... But people fail to see the backward thinking this is.

Profits are not "evil" but actually serve the interest of the people much, much better than the public sector. When profits are the driving force it is the consumer who decides how well the company does. If the company cannot provide a service that suits a consumer their profits will drop and the company will either change for the better, change their business to something profitable, or fail. However, if the government is in charge they are not driven by profits, so they are not driven by the consumer. Instead they rely on tax dollars -- money that is not earned by providing a superior product but instead by forcefully taking money from citizens. What would you prefer? A company that responds to your decision to buy its product or not? Or a company that does not care whether or not its product is what's best for the consumer because it will get money for it regardless?

Contrary to popular belief, services such as roads, health care, and education do not have to be provided by the government. In fact, history shows us that when put in the care of the private sector all of these services are provided better, cheaper, and to more people. Again I think the best way to think about it is to change how we view "profits". To profit from something is not to take advantage of people. Profits are indications that people have chosen the goods or services a particular company offers over other companies. In order to keep profits companies need to keep providing this superior service or they will lose their consumers to competing firms. In a free society there can be no "taking advantage" of consumers because they can choose not to buy from a company that doesn't provide a superior good or service. However, when the government provides something we have no choice -- we have to pay taxes, regardless if we feel the good or service we receive is worth it or not. Now if that isn't "taking advantage" of people I don't know what is.

Unemployment: A Response to my Economics Class

I think this may have to become a daily occurrence because everyday I find something just wrong (substitute Keynesian) about what I'm taught in my Intermediate Economics Class. Today we dealt with Unemployment. I have no problem with the basic assumptions of what makes up the numbers and how such numbers are acquired, but I do have a problem with the "Policy Implications".

One implication was that in order for government to spur "job finding" they could force firms to pay most or even all of unemployment insurance. The absurdity of this statement made me almost gag in class. The theory is that if firms have to pay for unemployment insurance that they will be less likely to fire people. There is such a major flaw in this logic I cannot believe people actual think it plausible.

The goal of a firm is to make profits, not to employ people. Firms need people in order to produce or provide a good or service. Firms hire people based off their qualifications and if the marginal benefit (increased profits) provided by hiring them exceeds the marginal costs (their wage) a firm will hire additional workers. Part of this process involves firing workers whom a firm decides their marginal cost exceeds their marginal benefit. This keeps a firm competitive and thus keeps costs down, and ultimately establishes prices at their lowest possible levels. If a firm is unable to fire workers, or in this case has to pay an extreme price to do so, there is no way they can possibly find the most efficient workers and their costs will ultimately be higher in the long-run, which of course leads to higher prices.

What would logically happen is that firms would become extremely selective in their hiring process and I would assume less people would be hired. A firm would be extremely hesitant to take chances on prospective employees since the cost of firing them would be extreme. I do agree that firms may fire less people, but the amount of people they wouldn't hire would greatly offset such changes.

Such a policy would not spur "job finding" but rather would cause firms to hire less. However, most people (especially politicians) and even economists fail to see the huge logical flaws in such arguments, and in their desire to protect the worker in fact harm them even worse. Once again, the whole theory of "forcing" someone to do something, even in good intentions, never leads to the desired result. Freedom of choice is the only way for equality to become a constant in society.