How an Immoral Banking System Has Made a Financial Collapse Possible

Libertarians have long accused the banking system of engaging in a legalized form of counterfeiting that enriches a privileged few at the expense of millions of ordinary people. Historically, this illegitimate scheme has also caused recurring and significant financial disruptions, but until recently, a complete breakdown involving multiple bank runs was seen as very unlikely. In the last few years, however, the process of creating money out of thin air by the banks has grown to such an extent that a total collapse is now a real possibility. In this article, I’ll present an explanation, in broad economic terms, as to what led to this critical state of affairs and suggest the systemic change that needs to take place.

To begin with, there are two important points to make. The first is that no matter what anyone says, an increase in the money supply never does anything good. When the banking cartel churns out additional pieces of paper with dollar amounts printed on them or adds a few zeros to the number of dollars on a computer screen, it does not create wealth. You cannot build houses made of out of money, eat money as food, or consume it any way. Wealth is only created by producing more goods and services, which requires the investment of scarce resources. The production of money, on the other hand, can only transfer wealth to those who are most closely linked to its creation in some way. And at all times, it destroys the wealth of those not associated with its creation. Money inflation makes ordinary people poorer than they would otherwise be.

The second point is that at all times and in all places, the creation of additional units of money out of thin air is illegitimate and immoral. No matter who does it, it’s counterfeiting. Pure and simple. And the two biggest counterfeiters are the regular banks and the Federal Reserve. The fact that they’re legally permitted to do it makes it no less illegitimate.

Let me justify each of these claims.

Most people know that money inflation devalues the unit of money, which means price inflation. But when prices-in-general are rising, wealth is transferred to people who receive the new money first from everyone else. Why? Because the people who receive it first, including those who’ve borrowed money, can spend it before prices have risen, while everyone else can spend it only after prices have increased. Particularly hard hit are lenders and those on fixed incomes, who are the last to receive the new money.

However, few people recognize (and this includes many economists) that money expansion also hurts the economy by causing bad investments, which leads to the destruction of wealth in general. How so?

Most mainstream economists will claim that consumer spending stimulates growth in the economy. This is nonsense. As Walter Block would say, it’s nonsense on stilts. The truth is just the opposite. Indeed, not spending on consumption – otherwise known as saving – and then investing the saved money in production is what grows the economy. Now, as I stated above, money itself cannot build anything. It’s what money buys or doesn’t buy that counts. And in a world without money printing, it’s clear that by not spending money on consumer items, the demand for consumer goods falls, fewer of those goods are produced and consumed, and this frees up limited resources that can be used to make capital goods – i.e., the machines and equipment used for production purposes. In particular, an increase in saving causes interest rates to fall, which means entrepreneurs can obtain cheap long-term loans to produce high-order capital goods. These are goods which take many years to see results, but which extend the capital structure, making it even more productive, thus enabling a greater amount of consumption in the future. This is very good.

However, when the supply of money is artificially inflated, lenders are awash with cash, and the law of supply and demand means that the interest rate is driven down below the level it would otherwise be. Artificially low rates encourage entrepreneurs to start long-term ventures producing high-order capital goods, which they wouldn’t normally contemplate. At the same time, absent any increase in genuine saving, the extra low interest rates send a message to consumers: max out your lines of credit, and spend, spend, spend. In other words, live for the present without having to worry too much about the future.

Under these circumstances, both consumers and producers use up resources. Everyone can live high on the hog for a while – indeed it leads to a boom – but after some time, this situation inevitably results in a shortage of the factors of production because the resources start running out. In particular, all those additional long-term projects, which exist only because of the artificially low rates, come to a grinding halt. They are now seen as a bad investment and have to be abandoned. This leads to waste, capital destruction, and a recession. Businesses fail, and the average person becomes poorer as a consequence.

The recession is in fact the cure for the boom because it rids the economy of all the malinvestment. Unfortunately, it almost always incentivizes the banking cartel to begin another round of money printing, which lowers rates yet again and begins the cycle anew. All this is obviously very bad.

So, it’s clear that money inflation is bad for most individuals and bad for the economy. But how does it occur?

Most people know that money is created by the Federal Reserve. However, the greatest amount of money creation occurs at the hands of regular banks. Here’s how: When a person deposits, say, $100 into their checking account, they might think it sits at the bank in a vault of some sort. However, the bank takes most of that cash and lends it out. It’s not the bank’s money to lend, of course, but by illicitly using the depositor’s money, the bank can “earn” interest from it. But this also means that after it has been spent by the borrower, it winds up in the checking account of someone else. The original depositor still has a claim to all of his money on demand, even though it’s not actually there, and someone else has a claim to the same amount of money on demand at the same time in another account. In other words, new money has been created out of thin air.[1]

However, it gets worse, because that same money is then lent by the second bank, and then spent by the second borrower, whereupon it ends up in a third checking account. And so on. Each time this happens, the money supply expands. All these banks – in fact the whole banking system — rely on the fact that in normal times, not everyone is likely to ask for all their money back at the same time. Therefore, the banks can get away with keeping only a small reserve on hand. This process is totally legal. But laws can be immoral, and this is a prime example. Because if everyone does ask for their money, most of it isn’t there, even though people believe it is. This is the world of fractional reserve banking, the world of legalized fraud and counterfeiting. And it’s utterly corrupt and immoral.

It’s basically a confidence trick. As long as depositors believe their money is in the bank, everything is great, at least for the bank. But when confidence starts to fail, it can lead to a run on the bank, in which everyone asks for their money now. Of course, the bank cannot pay everyone now because they have only a fraction of the funds on hand, and they cannot unwind their loans fast enough to meet the demand. Some customers might get out intact before the bank collapses, but most people will lose everything. Long ago, bank runs were very common. But in 1933, the government created the Federal Deposit Insurance Corporation (FDIC), and this boosted confidence that everything was just fine. It made people believe that the government would make depositors whole if a bank got into trouble. That led to the idea that banks were very unlikely to fail, and with that confidence, bank runs virtually disappeared . . . until now. More on this later.

So where does the Fed fit into the picture? The Fed also creates money but in a different way. It does so with an accounting trick. It buys bonds from a few privileged dealers and simply enters the money (created out of thin air with a few computer keystrokes) into the dealers’ commercial bank accounts. And what happens with that money? It gets lent and spent through the fractional reserve banking process like any other money. Indeed, for every dollar the Fed issues, it is multiplied by the commercial banking machine many times over, thus adding greatly to the overall money supply.[2] All that easy money lowers interest rates artificially and sets in motion a boom which, in reality, is the misallocation of resources and malinvestment discussed above. The Fed tinkers with interest rates in other ways as well, but the main point here is that money creation by the Fed and the banks causes interest rates to fall and sets in motion a boom, but this ultimately and inevitably leads to a recession.

As a recession looms, businesses fail, they can’t repay their loans, credit contracts, and the banks’ balance sheets start to look a little shaky. But everyone has confidence there won’t be any runs because the FDIC stands ready to fend off any trouble. Moreover, if the chips are really down, the Fed can always act as a lender of last resort. Indeed, what usually happens is that the Fed steps in and begins a whole new round of money printing, which shores up the banks and stimulates more fractional reserve lending, all of which lowers the interest rates, and it’s off to the races again. Each time, however, more money is needed than the time before. It’s like a heroin junky who needs more and more of the drug just to feel normal.

Over the course of the last few decades, so much misallocation of capital has taken place that the Fed has had to engage in ever-increasing rounds of money printing to “cure” each successive recession. The real cure is for the Fed to do nothing and let the excesses work themselves out naturally. But the Fed’s actions have meant that interest rates have bottomed out at a lower level each time to the point where, after the financial crisis of 2008, they dropped to almost zero. The last round of money printing during the covid pandemic was particularly egregious because the Fed was creating literally trillions of dollars. Much of this was spent by the government in a stupid, wasteful, and vain attempt to keep the economy afloat during all the lockdowns.

Now, when interest rates are almost zero, what’s a regular bank to do with all that money sitting in its customers’ checking accounts? In a sane and moral world, it would keep the money safely at the bank and charge the depositors a small fee for that service. Indeed, that’s the only way a bank should be allowed to make money from checking accounts, regardless of the interest rate.[3] But this is neither a sane nor a moral world. Banks make money through fractional reserve lending. And when those short-term loans are not yielding any interest, the only remedy is to start issuing (or start buying) very long-term loans where the interest rate is slightly higher than zero, say 1% or maybe 2%.

However, interest rates can’t stay at an artificially low rate forever. At some point, they have to rise, either because market forces take over, or because the Fed realizes that the prices of goods and services are taking off (as a consequence of its previous misguided money expansion!) and it therefore takes action to slow things down. It does this by raising the rates at which banks can lend to one another and by engaging in quantitative tightening, which is a euphemism for scaling back its money creation. In the latter case, instead of buying bonds, the Fed sells them, which throws money creation into reverse.

After the pandemic, there was an incredible amount of misallocated capital, a shortage of goods and services, and an enormous amount of money in circulation. The Fed thus believed it had to act very aggressively to stop out-of-control price inflation. It therefore took actions, including quantitative tightening, which led to a very rapid rise in interest rates across the board.

Which leads me to the present situation. Now, if you’re a depositor with excess cash in your bank account but it’s earning virtually nothing, and you see that the interest on a money market fund or a short-term Treasury has risen to, say, 4.5%, are you going to keep all your money at your local bank? Probably not. You’re going to withdraw it, along with everyone else, especially if you have a large bank balance which could earn a much higher return elsewhere. And if you’re a business, then with all that easy money that’s been sloshing around, you probably do have a large bank balance. However, if everyone is trying to withdraw huge amounts of money at the same time, the bank better liquidate its loans quickly to meet the demand. It obviously can’t wait for its loans to mature years from now, so it needs to sell them on the secondary market to raise the cash needed to reimburse its depositors.

But here’s the problem: Consider the value of those loans on the bank’s books. The present interest rate on a 10-year Treasury is between 3% and 4%, but who’s going to buy a bank’s $10 million bond yielding 1% or 2% for anything close to $10 million when a potential buyer can get double the return on a brand-new bond. Obviously, a bond yielding only half the current interest rate will sell for much less. The bank might have thought it was being responsible when it bought that nice safe Treasury a couple of years ago, but in fact it was incredibly unwise. Because the problem is not that the borrower – in this case the government – was ever likely to default on the bond. The problem is that the bank should have foreseen that interest rates could rise, and the bond could lose much of its value.

For the banks in general, it’s a triple whammy. Customers are withdrawing their funds to get a greater return elsewhere, but the banks don’t have the money because they keep only a fractional reserve on hand. But if they sell their bonds in an attempt to meet demand, they’ll get much less than the bonds’ par value because of the low coupon rate. Moreover, when many banks are faced with the same predicament, and all are trying to sell their low-interest loans at the same time, this further depresses bond prices because there’s too much supply and not enough demand.

But it gets worse. Because remember, it’s all a big confidence trick. For many years, the really big accounts – i.e., businesses with large deposits that exceed the FDIC limit – have been lulled into a false sense of security that their deposits are safe even though they’re not fully insured. But as news gets around that banks are in jam, they realize they could be faced with large unprotected losses on their deposits. If their confidence erodes further, they’re likely to increase their withdrawals. In which case the most vulnerable banks will endure good old-fashioned runs, and the potential exists that the fear and loss of confidence spreads.

Several banks have already failed. And there will surely be more. So, what’s the government to do? Are they going to let people lose all their money. Maybe not, at least not in nominal terms. As announced recently, they’re going to backstop the losses and make up any difference above the FDIC limit. How will they do this? By creating new money, almost certainly. And how much will the Fed have to print if bank runs become ubiquitous? Trillions.

The government is betting that merely by declaring it will support the banking system in a no-holds-barred fashion, it can keep the confidence trick going, and the Fed won’t have to print all that money.[4] But confidence in the system and in the government is eroding fast. Historically, most people have trusted the institutions. But now, many are waking up to the fact that the institutions, including the banking system, are not worthy of any trust at all, and widespread bank runs could occur.

If that happens, then one of two scenarios is possible. Either the government and the Fed will let the banks fail without taking additional action, and many businesses with large accounts will endure significant losses. In this case, there’ll be deflation, and the ensuing severe recession will wring out most of the malinvestment. However, as the pain intensifies, it will be almost impossible to resist a new round of money printing, in which case price inflation will take off again.

Or they’ll do what they’ve threatened to do, which is rescue the banks and the big depositors from the get-go and turn on the printing presses full blast. If the entire banking system has to be bailed out and all depositors have to be made whole, then hyperinflation is in the cards. Probably not like Germany in the 1920s, in which wheelbarrows of cash are needed to pay for a loaf of bread. But many people, particularly those on fixed incomes, will find life very difficult.

Even if bank runs do not become widespread, it’s clear that many banks are in trouble, and further money printing by the Fed at some point seems inevitable. There is a solution, however, and it’s this: If the government immediately implements a 100% reserve on banks and keeps it there, then any money created by the Fed that is used to “save” the system will simply fill up the banks’ reserves and not expand the money supply significantly. In other words, the 100% reserve will prevent the commercial banks from inflating it many times over through further fractional reserve lending. This won’t cure the existing malinvestment right away, and prices will still be high for a while. But it won’t make price inflation worse, and eventually it will fall. More importantly, it will mean that all credit issued from demand deposits is terminated for good, and the only allowable form of credit going forward will be time loans originating from genuine saving.

Is the government likely to mandate a permanent 100% reserve and finally abolish fractional reserve banking? Probably not, given the opportunism of most politicians and their overall ignorance of the system. But that’s what needs to happen. It’s the fractional reserve system that needs to go because that’s the cause of most of the problems we face now. And before anyone asks, what about the Fed? Yes, that needs to go too, but it was the booms and busts caused by fractional reserve lending that provided the original excuse for the creation of the Fed in 1913. The Fed simply made matters worse. Get rid of fractional reserves, and the justification for the Fed’s existence ceases to exist. We can but hope.

[1] I’ve referred here only to checking accounts, but other kinds of highly liquid accounts can be included in this category. In April 2020, a change to Regulation D lifted the limitation on transfers from savings accounts, such that they now act like demand deposits. Since May 2020, M1 money supply now includes savings accounts to reflect this change.

[2] After the financial crisis of 2008, the Fed started paying interest on reserves held at the Fed, which incentivized banks to hold larger reserves than before. Nevertheless, by far the greater part of the M1 money supply is still fiduciary media — i.e., money that originates from fractional reserve lending. From May 2020 to February 2023, the actual reserve ratio fell from 23.2% to 18.1%. (Calculated as the ratio of reserves held at the Fed + vault cash / demand deposits + other liquid deposits. Source: H6 Release Federal Reserve System.)

[3] The other way in which a bank can earn money legitimately is through time loans. Unlike loans originating from demand deposits, genuine time loans do not violate property rights or create fiduciary media, and they do not expand the money stock, artificially lower interest rates, or cause malinvestment.

[4] As part of its effort to mitigate contagion, the Fed has also said it will lend money to any bank for up to a year using the bank’s bonds, in the amount of their par value, as collateral. The loan still has to be repaid, however, and it remains to be seen whether or not this merely defers the problem. The situation is worse for banks in the Eurodollar market since they are not a part of the Federal Reserve system.

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