Evan's Easy Economics: #24 The Secret Evils of Fractional Reserve Banking

Fractional Reserve Banking: It's Secretly Evil

During a normal economic cycle, some businesses fail, and some businesses succeed. This is completely normal, and should be expected. It should even be encouraged. When businesses succeed, it simply means that they're providing consumers what they want in a relatively efficient manner, and when a business fails it means that they were unable to do so. The relentless competition in a free-market constantly weeds out inefficient companies that can't give consumers what they want at a reasonable price.

Well then, what are booms and busts? A boom is simply a time when the economy is going along at a fast pace: large and numerous investments are being made, those investments seem to be paying off, a large number of people have jobs, people's standards of living are increasing, etc. A bust is just the opposite: when a large number of investments are not being made, when previous investments do not pay off, a large number of people lose jobs, and standards of living are likely going down.

But, what causes booms? What causes busts? What causes such a huge number of businesses and investments to be successful at the same time but then also fail at the same time? How is it that such a huge number of people who are all venturing out into the world of business all seem to make the exact same mistakes at the same time? Some people simply blame capitalism, others sought an explanation. There is an answer to these questions, and it all begins in the 18^th century with David Hume and David Ricardo. Their answer was expanded on by F.A. Hayek, Murray Rothbard and Ludwig Von Mises, amongst others.

The above mentioned economists (minus Hume and Ricardo) along with Henry Hazlitt, Walter Block and many others, belong to a group of economists known as “the Austrian School of Economics”. Most schools of economic thought don't really provide a clear and encompassing theory as to why booms and busts happen, but the Austrian School of economics provides a very good explanation. In fact, the only school of economics to 'predict' and give a comprehensive explanation to the Great Depression, the failure of socialism, the panic of 1819, the failure of the Bretton-Woods agreement, and the current mess we're in, (amongst other issues) was the Austrian School. Their explanation revolves around inflation and interest rates. (Don't worry, this won't be too hard... just long.)

In order to start a new business, or start a new industry of some sort, a large amount of money is needed. Usually, this money comes from a loan, usually from a bank. In order to repay the loan, the person who receives the money must pay back a certain amount each month (or so), but in addition to the amount of money they received, they must pay back a bit more. This extra amount of money is called interest. It most likely got its name because of the idea that the person lending out the money was taking a huge risk, and it was necessary for the debtor to do what he could to increase the lender’s “interest” in the deal in order to seal the deal. The amount of money that the receiver has to pay is determined by the interest rate.

Let's analyze the interest rate really quick. We always hear about the Federal Reserve lowering and raising the interest rate (in fact, right now, as I write this, the interest rate is, unbelievably, 0%), but what the heck is the interest rate? If you're anything like I was a year or two ago, you have no idea what the heck this “interest rate” means. Don't worry, it's actually pretty easy. The interest rate is simply the price of the money that is to be lent. If the interest rate is higher, then it costs more to borrow money, if it's lower, it costs less. Now that it's 0%, it costs nothing to borrow money.

The interest rate was not always determined by a bunch of people in a building dubbed “the Federal Reserve”; in fact, said institution was created in 1914 when Congress decided it was too lazy to follow the duties given to it by the Constitution. The interest rate used to be set only by supply and demand (it still is, but in a twisted way).

When people saved a lot of money and stored it away in a bank, the bank would be able to lend a lot of money out. This increased the supply of money available to loan, and thus decreased the scarcity of loanable money. With an increase in loanable money, its price would decrease in turn, and that would attract people who would want to start a new business, or some other venture.

The opposite of this is also true: when people decided to spend their money instead of save it in a bank, the amount of loanable money would decrease, leading to scarcity and higher interest rates.

The reverse of these situations are also true. When more people want to borrow money, the supply of loanable money decreases, and thus the interest rates increase. The rates also lower when there are fewer people borrowing money.

This all follows from supply, demand, and scarcity being applied to “loanable money”, and looking at interest rates in this way makes them a lot less confusing. There is a limited amount of money at one time that can be lent out to people, and thus loanable money has a price associated with it. That price is called the interest rate. Just like every other commodity in an economy, supply and demand determined the price of loanable money. Once again, one of the central themes of my "Evan's Easy Economics" resurfaces: money is a commodity just like everything else, and obeys the same laws as all other commodities.

Before we continue, let me make sure that it is understood that there isn't really one single interest rate. This should make sense because different areas of the country have different amounts of money and a wide variety of entrepreneurs looking to borrow money. However the Federal Reserve does have the ability to affect interest rates on a wide scale.

Let's analyze the interest rates even further. As we've seen, one of the major influences of the interest rate is the amount of money that is being saved up. This is important for two reasons: the obvious reason, that there needs to be money saved up to spend, but also because it means that people are saving their money to spend later; people are not consuming in the present. People save money so that they can spend it later. When someone borrows the money, they spend it so that they can produce a business or institution that will serve people. But in order for that business or institution to be made, it takes time. Thus, at the same time that people are saving their money to spend in the future, businessmen are using that saved-up-money to produce an institution that will serve goods or services for consumers in the future.

The interest rate not only determines the price of the money, it also coordinates consumer's spending patterns with producers and investment! So, when the interest rate is low (money is in the bank), consumers are telling businessmen they want to spend money in the future and they aren't spending money now. Businessmen see this and begin ventures to serve that future consumption. Also, just simply twisting this example, when the interest rate is low (money is in the bank), consumers are telling businessmen that they are not spending their money now. This means that they are not consuming resources. This means that the resources the businessmen need will be cheaper!

These seemingly obvious, yet slightly disguised functions of the interest rate are so beautiful in their simplicity! People save money when they want to spend later, and this allows investors to use money cheaply to invest in future spending. When the interest rate is high, it means that it would be a bad idea to start a long-term business venture because, 1- the resources would cost more, 2- consumers are spending their money now instead of later, and 3- the money needed to buy the resources costs more. When the rate is low, it means that long term investments should be undertaken because 1- the resources are cheaper, 2- consumers aren't spending their money now, they plan on spending it later, and 3- The money needed to buy the resources is also cheaper.

If the amount of money helps determine the interest rate, is saving money the only way to lower the interest rate? Well, it obviously should be, but, unfortunately, it is not.

Around the 18^th century, as banks began to partake in fractional reserve banking (discussed earlier), they were able to print more paper money receipts for gold than there was gold – i.e. there would be receipts for 1,500 ounces of gold when there would only be 1,000 ounces of gold specie. This led to an artificial inflation of the money supply, and thus artificial lowering of the interest rates.

We will now show that the immoral act of fractional reserve banking has absolutely devastating consequences.

If the amount of loanable money is increased through fractional reserve banking (inflation), then the interest rate decreases because the increase in supply of money reduces its scarcity and value. But unfortunately, this does not mean that consumers intend to save money for future consumption. In fact, it probably means that consumers are interested in spending now.

The artificial lowering of the interest rates through fractional reserve banking does not in any way reflect the spending patterns of the population. So, because the interest rates are artificially low, the businessmen think that it would be a good time to borrow money and start new businesses. They think that people are saving money and are planning to spend it in the future when their ventures and businesses will finally be opened (well, they probably don't actually think that, they probably are just thinking “sweet, cheap money! Now I can start my own restaurant!”).

So, because the interest rates are low, there is more money to be borrowed. But there are no changes in the spending habits of the populace, and there is no change in the price of the resources!!

As a large number of people borrow money, they go out and start constructing buildings, buying large and expensive machinery, and whatnot. Unfortunately, the entire population of the economy is also spending their money on these and similar or related items at the exact same time (because they weren't saving their money). Because the spending of the masses didn't change, and the new businessmen are spending their new made-out-of-thin-air-money, prices have to increase – the banks might have created more money, but they didn't create any more resources! The scarcity of the resources didn't change, and neither has the total wealth of the society, but the demand for these limited resources did increase. This dramatically and suddenly increases scarcity, and thus, prices – it might not happen right away, but it has to happen.

As the prices go up, the attempts of the businessmen to build up factories, restaurants, and the sort will be in futility, for the amount of money they borrowed from the bank will be worth less than they thought. The inevitable bust must ensue.

The time after the increased money supply but before everyone realizes that prices are going to rise is the boom. When the prices finally rise, and everyone realizes that the new ventures cannot be sustained, we find the bust.

The bust that must happen is even more painful on the gold standard. This is what makes the use of gold such a wonderful thing – it is the only powerful safeguard against inflation. We discussed this earlier, but it's worth repeating. In addition to what we just discussed, there is an added kick to the teeth if the country is on the gold standard. As the banks of a country, say, Britain., inflate the fiat money supply, but not the gold supply, the price of goods increases. As the prices of that country's goods increase, the people of Britain will import from abroad because the goods produced with their currency, the pound, are rising in price. As they buy more and more imports, the foreigners that are exporting will receive more and more pounds. What will they do with these pounds? Well, surely they won't spend them on overpriced British exports – they'll trade the pounds for the gold that they represent. This causes a massive outflow of gold from Britain into other countries that results in massive deflation and economic hard times.

To blame this series of events on the gold standard, instead of on fractional reserve banking and inflation, is similar to blaming an airplane crash on gravity. The real problem wasn't that gold restricted the “flexibility” of the money! To say so is rubbish! The real problem is that some greedy banksters decided to print up money that didn't exist and then lend it out and receive interest on the phony money! Unfortunately, many “great” economists do exactly this. Milton Friedman, in his video series “Free to Choose”, blames the Great Depression not on the fact that banks were printing too much money (as is obviously the case, as we'll see shortly). He blames the Great Depression on the obvious lunacy that the banks were not printing enough money! Paul Krugman makes similar ludicrous claims, along with other Keynesians. Friedman's claims, that there needed to be more monetary expansion, are nothing short of vile! This means, as we've shown above, that he wanted the banks to steal more of the value of everyone's money so that they could continue to make money off of interest earned on their counterfeit money!

This is what caused the Great Depression, along with every other panic, recession, depression, slowdown, or whatever else you want to call busts. The Federal Reserve, through fractional reserve banking, increased the amount of money between 1921 and 1929 from about $45 billion to about $73 billion. This translates to a 61.8% increase in the money supply which could be lent out. The resulting boom was known as the roaring twenties. Alongside of this, a large quantity of dollars was being given to Britain during the twenties. This was done because Britain overinflated their money supply during WWI and was demanding that other countries devalue their currencies so that their overinflated pound wouldn't lead to the export of gold.

The Federal Reserve during the '20s astonishingly agreed. But the fed stopped inflating the dollar in 1929, the business ventures couldn't be sustained, and the bust came. Britain's pound was still overinflated, and thus their gold specie went flowing out of their country, much of it to the United States, and they suffered massive deflation. If the market would have been left alone, the problems likely would have sorted themselves out much quicker than they had, but unfortunately President Hoover and Roosevelt went nuts and thoroughly destroyed all of the benefits of the free market that we've discussed in this paper. The Great Depression was the first U.S. depression where the government intervened in a decisive manner, and it was also the first U.S. depression to last longer than five years.

I’ll just briefly talk about the new deal policies that FDR enacted. (For a more in depth analysis please see “How Capitalism Saved America” by Thomas DiLerenzo and “Economics in One Lesson” by Henry Hazlitt). Many of the policies enacted by FDR were of flawed logic; they simply took money from taxpayers and gave it to other people. There is no way that this could even hope to increase society’s wealth. Other policies included slaughtering animals and burning food for the sole reason of benefiting farmers with higher food prices while people were starving. On top of this, almost all of his new deal policies were aimed at gaining votes for the upcoming election: states that were essential to the Democrats' future elections received the most money. All in all, FDR did nothing but play politics with and in the process lengthen the Great Depression and ruin lives.

The Great Depression, the current mess, and just about every other disaster was created by the creation of money out of thin air. Yet we still rely on the same twits who think that inflation is a good thing to direct our markets.