"How the Fiat Money is Being Defended" -- where Corn Farmer's wife, acting as a fractional reserve banker, surreptitiously removes currently not needed 83 000 gold dollars from her husband's strong box and lends it to her brother, an Alcohol Distiller, for six months to earn 3 000 gold dollars in interest -- and let us place that example in the context of the fractional reserve banking as it existed under still honest money regime and still free banking system circa 1900 (when only gold coin were legal tender for all debts, and no central bank existed in the United States).
It's October 1900. Upon selling his entire crop, Corn Farmer deposits his proceeds of 100 000 dollars in gold coins in Corn Bank rather than in his strong box, and Alcohol Distiller asks Corn Bank rather than Corn Farmer's wife for a loan.
In exchange for his deposit, Corn Farmer receives 100 000 dollars worth of receipts, also known as banknotes, in standardized dollar denominations (5, 10, 20 and 50) each promising on its face that Corn Bank will redeem it for (5, 10, 20 or 50) gold dollars on demand.
Because in the foreseeable future Corn Farmer is likely to present for redemption in gold no more than one-sixth of the total face value of his banknotes, Corn Bank sets aside that one-sixth in reserve (a fractional reserve) in its vault, and lends the remaining five-sixths (83 000 dollars) to Alcohol Distiller.
Unlike Corn Farmer's wife, who knew for a fact that her husband would not need those 83 000 gold dollars for six months, Corn Bank plays it safe and lends those dollars to Alcohol Distiller just for three months at 2 basis points per diem.
(Taken as random sample, withdrawals of demand deposits are statistically predictable, down to seasonal and regional variations.)
Alcohol Distiller spends the borrowed 83 000 dollars right away by purchasing a trainload of potatoes for processing into alcohol, and Potato Farmer deposits his proceeds of 83 000 dollars in Potato Bank.
When Corn Bank lent 83 000 dollars to Alcohol Distiller it did not give him 83 000 dollars in gold coins. Instead it gave him 83 000 dollars worth of banknotes in various dollar denominations, each of them containing a statement that Corn Bank will pay so many dollars for each note in gold coins on demand.
Such banknotes are being used in daily trade as convenient substitutes for gold coins (Ludwig von Mises will correctly call them "fiduciary media", for they are not money, they only represent money), and every bank accepts them for deposit , subject to collection (US Treasury accepts them too but discounts them just like any other commercial paper even though they are printed by the Comptroller of the Currency against a deposit of Treasury bonds). Large sums in gold, not to mention silver, are too heavy to carry around. 83 000 dollars in gold coins weigh 139 kilograms or 306 avoirdupois pounds (372 troy pounds).
"Here we have it!" - maintain the Austrian gentlemen and other adherents of the theory that fractional reserve banking creates new money out of thin air. "Corn Bank has only 100 000 gold dollars in its vault, but it injected into circulation 183 000 dollars worth of its fiduciary media representing those 100 000 gold dollars. Corn Bank has just increased overall money supply by 83 000 dollars by extending a loan to Alcohol Distiller in the form of 83 000 dollars in banknotes, notwithstanding that 100 000 dollars in banknotes given to Corn Farmer are still outstanding. This is fractional reserve banking! This is not full (100%) reserve banking! Corn Bank has just created out of thin air 83 000 dollars that did not exist before!"
Do Austrian gentlemen score a point here?
Not really, and we don't have to leave their bailiwick to defeat their contention, we can use their own reasoning.
What if Corn Banker would have asked Corn Farmer to come to the bank right away, and then presented him with the following business proposition:
"We have a client who wants to borrow 83 000 dollars for three months and who is willing to pay 2 basis points per diem. If you would give me permission to use your 83 000 dollars we could split the interest."
"Will my money be as safe in your client's hands as it is in your bank?" - Corn Farmer would ask.
"Yes. Our client has a valid unimpeachable contract on hand."
"Then you have my permission."
"Keep 17 000 dollars in our banknotes" - Corn Banker would then say - "and return 83 000 dollars in banknotes to us. We will give you a Certificate of Deposit for the same sum payable after three months in gold coins with interest of 1 basis point per diem, which will add up to a total of 83 750 dollars."
Question: Under these new circumstances, when Corn Bank will then re-issue to Alcohol Distiller the banknotes returned by Corn Farmer, will that loan increase the overall money supply by 83 000 dollars?
Of course not! Corn Bank will have 100 000 dollars in gold reserves for 17 000 in banknotes kept by Corn Farmer and 83 000 in banknotes kept by Alcohol Distiller. All Austrian gentlemen will agree this is full 100% reserve banking.
Then what is it exactly, in the name of bread and butter, that converts this full 100% reserve banking, which most evidently does not increase the overall money supply, into fractional reserve banking, which is alleged by so many to create additional money out of thin air?
The only difference between full reserve banking and fractional reserve banking is depositor's permission for bank's loan and depositor's sharing in the interest the loan is going to earn.
Let us restate this point in a language everyone will understand:
In full 100% reserve banking, depositor grants permission to his banker to lend depositor's gold coins to a third party in exchange for sharing in the interest proceeds.
In fractional reserve banking, the banker lends depositor's gold coins to a third party just the same but without depositor's permission in order to keep all the interest proceeds to himself.
Why then -- we ask -- are the Austrian gentlemen maintaining that fractional reserve banking increases the money supply?
Is it because they look at it from the bank accounting perspective? They see two overlapping sets of outstanding "fiduciary media" representing a claim to one and the same reserve in gold coins.
But why so obvious an accounting principle could possibly be wrong?
It is wrong because only one set of those outstanding "fiduciary media" actually represents a claim to the existing gold reserve. The one that is presented for redemption first! A cake that has just been eaten by Alcohol Distiller can never be eaten again by Corn Farmer. Corn Farmer will have to wait until Alcohol Distiller will bring a new cake to Corn Bank for him.
The myth that fractional reserve banking creates new money out of thin air can be maintained only for so long as only one set of the duplicate "fiduciary media" is actually presented for redemption in gold. The holder of the other overlapping set of "fiduciary media" merely deludes himself that he has money in the bank. All that he has is a debt in the bank which is only as good as the bank's ability to repay it. It can never be as good as gold. No one's paper can ever be as good as his gold.
And so, while Corn Farmer is deluding himself that he has 100 000 gold dollars in the bank because he has 100 000 dollars worth of banknotes redeemable in gold coins on demand, Potato Bank promptly presents to Corn Bank 83 000 dollars worth of its banknotes and demands gold coins, all 139 kilos. Corn Bank complies, and from that moment on, Corn Bank has no more money to lend. It holds on to 17 000 dollar fractional reserve for anticipated partial withdrawals by Corn Farmer, and holds its breath until Alcohol Distiller repays his loan of 83 000 dollars with interest of 1500 dollars, or until somebody else will make a new deposit of gold.
If by chance Corn Farmer would have presented all 100 000 dollars in banknotes for redemption in gold dollars while 83 000 dollars worth of potatoes were still in the process of being fermented into alcohol, he would have stumbled upon a "situation". Corn Farmer would be told that he could get 17 000 dollars in gold coins right away and 83 000 dollars as soon thereafter as the potato alcohol is produced and delivered.
Being a reasonable man, Corn Farmer would quickly agree to wait in exchange for a written promise that his banknotes will be redeemed in gold with interest of 1 basis point for each day of waiting, which in effect, would exchange his banknotes into a certificate of deposit.
By making this sensible arrangement, Corn Farmer would give up what he did not have in exchange for what he could have. Would he in the process also reduce the overall money supply by 83 000 dollars?
Of course not, notwithstanding that otherwise brilliant scholars think he would.
People who maintain that fractional reserve banking increases overall money supply out of thin air are simply unable to comprehend that it is not possible to have a cake and eat it too. When there are two sets of banknotes representing the same reserve in gold coins, only one set is valid - the one that is redeemed first.
And so, having exchanged mere promises to produce real dollars for the real dollars, Potato Bank finds itself in the position to enter the market with 69 000 dollars to lend. The remaining one-sixth of Potato Farmer's deposit (14 000 dollars) must be kept in reserve to cover his anticipated withdrawals.
Alcohol distiller promptly borrows 69 000 dollars from Potato Bank for 90 days at 2 basis point per diem and spends it right away by purchasing a trainload of rye to be processed into alcohol. Rye Farmer then deposits his proceeds of 69 000 dollars in Rye Bank.
Unlike Corn Bank, Potato Bank is not a national bank operating under federal charter with authority to issue banknotes. It is a state chartered bank, and authority to issue banknotes has been specifically denied to all state chartered banks by Congressional legislation ever since the Civil War . For this reason, Potato Bank grants its loan to Alcohol Distiller not in the form of a pile of banknotes, but in the form of a checking account.
And so, Alcohol Distiller gives Rye Farmer a check drawn upon Potato Bank directing it to pay to the order of Rye Farmer the sum of 69 000 dollars. Rye Farmer endorses and deposits that check to his account at Rye Bank, and Rye Bank promptly presents it for payment in gold coins to Potato Bank. Potato Bank complies, and from that moment on, Potato Bank has no more money to lend. It holds on to 14 000 dollar fractional reserve for anticipated partial withdrawals by Potato Farmer, and holds its breath until Alcohol Distiller repays his loan of 69000 dollars with interest of 1240 dollars, or until somebody else will make a new deposit of gold.
Now it's Rye Bank's turn to enter the market with 57 500 dollars to lend. The remaining one-sixth of Rye Farmer's deposit (11 500 dollars) must be kept in reserve to cover his anticipated withdrawals.
Alcohol Distiller obtains his next 90 days loan from Rye Bank in the form of a checking account of 57 500 dollars at 2 basis points per diem, and draws the check for the entire amount payable to Sugarcane Farmer, who deposits it to his account at Sugarcane Bank, which then promptly presents it for payment in gold coins to Rye Bank.
Once 57 500 dollars in gold leave its vault, Rye Bank has no more money to lend. It holds on to 11 500 gold dollars reserve for anticipated partial withdrawals by Rye Farmer, and holds its breath until Alcohol Distiller repays his loan of 57500 dollars with interest of 1035 dollars, or until somebody else will make a new deposit of gold.
In due course, Sugarcane Bank will open a checking account for Alcohol Distiller in the amount of 48 000 dollars for 90 days, while setting aside the remaining 9500 dollars for expected withdrawals of Sugarcane Farmer.
But before Alcohol Distiller will write a check for 48 000 dollars, let us stop the camera so to speak, and let us analyze the existing situation.
Whatever happened to 100 000 dollars in gold coins which Corn Farmer originally deposited at Corn Bank?
17 000 sits in Corn Bank vault as a fractional reserve
14 000 sits in Potato Bank vault as a fractional reserve
11 500 sits in Rye Bank vault as a fractional reserve
57 500 sits in Sugarcane Bank vault still as a full reserve
Where are the additional dollars the fractional reserve banks have allegedly created out of thin air and added to the overall money supply in the form of deposits?
They are nowhere to be found for they were never created.
Instead of creating new money out of thin air, each fractional reserve loan transfers a part of the existing deposit of gold coins to the borrower, and then downgrades the corresponding part of the original demand deposit into time deposit without informing depositor and without paying any interest due.
According to the theory that fractional reserve banking inflates money supply by creating new deposits out of thin air, the overall amount of dollars created by fractional reserve loans cascading from the original 100 000 should eventually add up to 600 000. Where are all these new "dollars"? All we can see is a pyramid of debts that taken to its utmost arithmetic limit may add up to as much as 500 000 dollars (600 000 minus the original 100 000) and produce as much as 10 800 dollars in interest at 2 basis points per diem over 90 days. But we can see no new money anywhere. Money supply remains unchanged.
Suppose Corn Farmer's wife removed 83 thousand dollars in gold coins from her husband's strongbox little by little, few kilos at a time, to a safe deposit box she opened for that purpose, and once the full amount was there, she gave Alcohol Distiller the key to that box in order to pass the loan proceeds to him.
Question: Was the overall money supply increased by 83 thousand dollars when Corn Farmer's wife gave the key to her safe deposit box to Alcohol Distiller?
If the answer is Yes, then what is the new "money"? A brass key?!
And if the answer is No, then why is a check or a pile of promissory notes different than a brass key?! Both of them are being used essentially to one and the same end: to transfer gold coins which constitute the real payment.
(Nothing else is recognized as legal tender under honest money regime.)
Perhaps the myth that a deposit account increases the existing money supply is believed by so many is that checks and banknotes are being used daily in a multitude of transactions. If we can buy goods and services with checks and banknotes, then the checks and banknotes are as good a money as silver and gold, are they not?
What these simple souls cannot see is that every single check and banknote must be exchanged into gold in order to constitute a valid payment. Those who neglects to attend to this formality are sometimes rudely awakened to the reality that the banknotes they are holding as money are not money at all.
For as long as their checks and banknotes are being honored in payments for their purchases, most Jacks and Jennies will think of their checks and banknotes as real money. It will take insolvency of their bank to make them realize that without redemption in silver and gold their checks and banknotes can only be given to their children to play with.
The more people use checks and banknotes in daily commerce the higher the percentage of their gold deposits can safely be used by the bankers for loans, because the use of checks and banknotes reduces demand for gold coins.
If the local market area would have only one bank, most of the daily transactions could clear without gold or silver, and more silver and gold could be used for loans. But this would not allow for increase of money supply either, it would merely allow for reduction of the local fractional reserve requirement.
A one bank situation is attainable also in large towns by a clearinghouse agreement between the existing banks, where all the transactions of the day of every bank in town are reduced to a net balance which every bank must settle in gold before the sun sets upon it. But this again does not allow for increase of the money supply either. It merely allows to mobilize the existing money supply more broadly.
Without central bank and fiat money it is plainly impossible to defeat gold discipline and actually increase the available money supply at will.
If it would be possible to increase money supply within fractional reserve banking system, central banks would have never been created.
The problem should be seen in global perspective, because the fact that one country does not have central bank is not a guarantee against invasion of the bankers from another country which has one. For example, American boom and bust cycles were caused by predatory interventions of the English banks whose ample gold funds were made available by replacing gold with the sterling bill in international shipping, monopolized by the British shipping firms and London bankers. Being unaware of the predatory interventions of the English banks, the Austrian gentlemen had to attribute those booms and busts to something, and the only explanation they could come up with was that fractional reserve banking was increasing money supply and thus was causing those booms and busts.
It is the sheer presence of more than one bank that imposes gold discipline on fractional reserve banking. The banknotes issued today by Corn Bank to make a loan of 83 000 dollars to Alcohol Distiller, which appear to some as the increase of money supply, are withdrawn tomorrow when Potato Bank presents them to Corn Bank for redemption in gold coins.
Banknotes are injected into circulation in lieu of gold coins held in the issuing bank's vault. When they are presented for redemption, they return to the issuing bank's vault while gold coins are reintroduced into circulation. Increase in money supply would require both gold and banknotes and /or checks to circulate at the same time. And that would be like having a cake and eating it too. It simply cannot be done.
The same principle applies to every deposit of gold. The only reason bank can inject depositors gold coins into circulation, is that depositors keep their banknotes under their mattresses and do not present them for redemption, thus in effect taking them out of circulation.
The myth of "creating new money out of thin air" by way of the fractional reserve loans is a hocus-pocus maintained by the fiat banking establishment for purposes of distraction and deception.
Why would the fiat banking establishment be interested in maintaining the false belief that new loans increase money supply by a multiplier of the fractional reserve?
Because being accused of "creating new money out of thin air" is incomparably less damaging to bankers reputation than being accused of... "converting other people's property".
"Conversion... may be consummated without any intent to keep and without any wrongful taking, where the initial possession by the converter was entirely lawful. Conversion may include misuse or abuse of property. It may reach use in an unauthorized manner or to an unauthorized extent of property placed in one's custody for limited use. Money rightfully taken into one's custody may be converted without any intent to keep or embezzle it merely by commingling it with the custodian's own, if he was under a duty to keep it separate and intact." Morissette vs United States, 342 US 246 (1952).
caselaw.lp.findlaw.com
The English Larceny Law of 1916, does equate conversion with stealing:
"...a person may be guilty of stealing any such thing notwithstanding that he has lawful possession thereof, if, being a bailee or part owner thereof, he fraudulently converts the same to his own use or the use of any person other than the owner..." Ibidem. (The legal status of a bank is that of a bailee.)
"Creating money out of thin air" implies extraordinary intelligence and skills bordering on supernatural powers. It brings to mind the concept of philosopher's stone sought by alchemists in medieval times.
But "converting other people's property" in the regular course of business is nothing short of racketeering. All it brings to mind is... the RICO statute.
This is the reason why the fiat banking establishment is supporting universities, news media, publications, research institutions, even Nobel Prizes to cultivate the myth that fractional reserve banking increases money supply out of thin air.
The truth is, it does not! It cannot!
"It's a strange, strange world we live in, Master Jacques!"
Again, if the fractional reserve banking could create new money out of thin air, there would be no need for Federal Reserve and its counterfeiting.
It's not the fractional reserve banking, it's the fiat money counterfeiting that injects new money into circulation and thereby increases money supply.
If you were a banker, would you be happier if your profession were likened to that of a wizard and an alchemist, or to that of a thief and a counterfeiter?
To make the long story short: Why issuing a duplicate set of banknotes or creating a duplicate checking account for the very same deposit of gold does not increase the overall money supply?
Because neither banknotes nor checks are money sensu stricto; they are merely the instruments to move the real money. To be used as money, the check "money" or the banknote "money" must be first exchanged into gold money. And if there is more check "money" or banknote "money" than gold money, only a part of check "money" or banknote "money" can be exchanged for gold. The excess part may not be exchanged, therefore it can never become real money. Until exchanged into gold, deposit "money" is a delusion money, created solely to provide reassurance to Jacks and Jennies of this world so they would not withdraw their deposits of gold.
Deposits "created out of thin air" to extend loans to Alcohol Distiller by Corn Bank, Potato Bank and Rye Bank could not be used as money until they were exchanged into real money (gold coins). Therefore they never increased the overall money supply even by one penny. Anyone who maintains they did is respectfully requested to demonstrate where exactly this additional money is located and how can it be used parallel (not interchangeably) with the real money.
Again and again, fractional reserve banking cannot create new money out of thin air. It actually enforces gold discipline.
The first step on the road to creating new money out of thin air is the central bank, then comes coercion of the public to accept a "money" that is professed to be "as good as gold", and then comes a naked fiat central bank note that proclaims on its face: This Note is Legal Tender for All Debt, Public and Private.
Under fully developed fiat money system administered by a central bank, fractional reserve banking becomes redundant, and it is used by a central bank only as a useful administrative device; under fiat, there is no need to maintain money supply discipline, anyone with a credit card can create new money.
When such fiat money system is abolished overnight -- as proposed in The Alternative Future -- fractional reserve banking is not abolished automatically, and there is no need to eliminate it. As a practical matter, it could not be done even if we wanted to.
All that needs to be done is to reform it so it can be used to mobilize all available savings for credit and capital formation, without fleecing savers and without causing instability to the financial markets. The only valid complaints against fractional reserve banking were precisely those, fleecing savers and causing financial instability.
What reform we have in mind?
A general rule that every bank must be owned by its depositors!
When every bank that is not presently a credit union or a mutual bank is required to undergo a formal dissolution and re-incorporation as a mutual bank, most of the problems associated with the banks as we know them will disappear.
By virtue of this simple reform, all the banks will be defanged once for all, and all the banking regulations will be rendered redundant.
You take people's money on deposit, you give them their share of profits and their share of corporate control. This is the only banking regulation you need.
5 January 2004
J. N. Tlaga
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