Fractional Reserve Banking Is Inherently Fraudulent

The financial system is based on the idea of fractional reserves. Fractional reserve banking is one big fraud.

There are two different things, both called “fractional reserve banking”. First, fractional reserve banking in the context of a gold standard. Second, fractional reserve banking in the context of a fiat paper monetary system. Both are evil, but there are some key differences.

FRACTIONAL RESERVE BANKING IN A GOLD STANDARD

Consider a fractional reserve bank under a gold standard. Suppose the bank has 1000 ounces of gold on deposit. These are “demand deposits”, which means the customer can withdraw at any time.

With a 10:1 reserve ratio, the bank makes term loans for 900 ounces of gold. These loans typically have a duration of 1 year or more.

The bank has committed fraud. The bank has 1000 ounces of demand deposit obligations, but only 100 ounces of gold in its vault. For the remaining 900 ounces, the bank must wait until the loans are repaid.

When someone gets a fractional reserve loan from a bank, they usually deposit that money in another bank! With a 10:1 reserve ratio, 1000 ounces of physical gold leads to 10000 ounces of demand deposits.

Via fractional reserve banking, the banks create the illusion of more demand deposit gold than there actually is. In effect, the bank has counterfeited money. As long as people don’t get wise to the scam, it continues.

If every customer demands withdrawal at the same time, then the bank cannot meet its obligations.

Fractional reserve banking is fraudulent. Like all frauds, it is inherently unstable. This naturally leads to periodic runs, as depositors get wary of the scam. That isn’t an economic law of nature. That is proof that the gold standard is evil. It’s a consequence of the fractional reserve banking fraud.

Most people are unaware of this fraud. Like any Ponzi scam, the fractional reserve scam continues as long as people are fooled.

Once people suspect there is a risk of insolvency, there is a run, and the fraud is discovered. Every single fractional reserve bank can be ruined at any time by a run. If a newspaper prints a rumor of a fractional reserve bank’s insolvency, that causes a run.

However, the State bails out banks. Politicians may declare a bank holiday. Politicians may declare that banks don’t have an obligation to convert their demand deposit paper to gold. During a bank holiday, banks can delay paying depositors, while they still collect loans due. This is a type of bailout. Small banks fail and depositors lose. Big banks lobby for a bank holiday, an indirect bailout.

Some clever banks put a clause in their deposit contract saying “During a run, we may delay paying you for up to 90 days.” That converts fractional reserve demand deposits into time deposits. However, courts ruled those clauses were invalid. State regulations forced banks to operate under a fractional reserve system.

Fractional reserve banking leads to an upward-sloping yield curve. By fabricating demand deposits, fractional reserve banks increase the supply of demand money. The interest rate for short-term loans is artificially suppressed by the fractional reserve banking scam. Banks borrow short-term and lend long-term, exploiting the yield curve they created.

Limited liability incorporation exacerbates the evils of fractional reserve banking. That enables bank owners and management to declare bankruptcy and default on their obligations to depositors. Before limited liability incorporation, the bank’s owners had to sell personal assets to pay depositors. That limited abuse. The evils of fractional reserve banking got worse in the late 19th century, after limited liability incorporation was legalized.

With gold as money, individuals have a way out. They can hold gold, refusing to participate in the fraud. In 1932-1933, people knew that a default was inevitable. They started holding gold instead of State paper. The media decried “evil gold hoarders”, but they had the rational reaction to the inevitable default. In 1933, President Roosevelt declared that gold ownership was illegal. He defaulted on the dollar, leading to the current system of unbacked paper money.

FRACTIONAL RESERVE BANKING IN A PAPER MONETARY SYSTEM

Fractional reserve banking is different in a paper monetary system. The Federal Reserve and Federal government can print more money, bailout out the banks.

In a paper monetary system, banks still create money when they issue loans. Without the right to redeem paper for gold, there is no limit to inflation.

In a paper monetary system, reserve requirements are irrelevant. Banks can always borrow from the central bank.

Under a gold standard, real interest rates cannot fall below 0%. People would hold gold. In a paper monetary system, real interest rates can be negative. The inflation rate can be greater than the interest rate credited on deposits. Negative real interest rates are a huge wealth transfer to bankers and insiders.

In a paper monetary system, the State guarantees all bank deposits. That comes at a cost, inflation. The number on your bank account is guaranteed, but the real purchasing power is stolen by inflation.

Inflation is a massive wealth transfer, from savers to insiders. Inflation is theft.

Some fools say “Big banks are evil! I’m using a local credit union! That’ll show them!” Big banks don’t need deposits. They can borrow from the Federal Reserve. As long as you use paper money, banksters can easily rob you via inflation.

Similarly, you might say “I’ll keep my savings in cash, and hide it under my mattress!” That is foolish. You still will be robbed via inflation.

In a paper monetary system, you are always robbed by inflation. With gold as money, individuals can opt out of the banking system, by holding gold. With physical gold, you preserve your purchasing power.

Under a gold standard, individuals can hold metal and preserve their purchasing power. With paper money, individuals are forced to invest. If you leave money in a savings account, you get robbed by inflation. To most people, “invest” means the stock market. In the stock market, insiders can easily fleece people.

Huge nominal returns provide the illusion that the stock market is a good investment. However, those returns do not keep pace with true inflation.

State comedians promote fake inflation statistics like the CPI. That helps cover up inflation. By lying, they trick people into believing inflation is low.

That’s the “advantage” of paper money compared to gold. In a paper monetary system, it’s easier for insiders to steal.

There’s a lot of propaganda against sound money. Insiders make a lot of money off a corrupt monetary system.

In a really free market, people would be free to use whatever they wanted as money. In practice, this would mean a return to sound money, gold/silver/copper. Only an idiot would prefer paper money to metal. With paper money, there always is a risk of theft by inflation.

In a really free market, fractional reserve banking would not be a viable business.

Time deposit banking is not fraudulent. For a time deposit bank, customers have term deposits and not demand deposits. The bank must balance the duration of assets and liabilities.

Suppose bank A was a fractional reserve bank. Suppose bank B is a time deposit bank. If bank A offered greater interest rates than bank B, that would only be due to the fractional reserve fraud, and the fact that depositors are risking their savings.

In a really free market, there is no limited liability incorporation. If a bank had a limited liability clause in its deposit contract, depositors should realize they are taking a risk. Without limited liability, owners and management will be personally responsible during the inevitable run.

All the banking crises from 1865-1933 were caused by fractional reserve banking, other regulations, and limited liability incorporation. Via “Problem! Reaction! Solution!” The free market and the gold standard took the blame, instead of the State. The “solution” was to create a central bank and abandon the gold standard. This gave insiders nearly unlimited power to steal via inflation.

The only limit to inflation is the risk of hyperinflation. During hyperinflation, the State paper money becomes nearly completely worthless as the slaves get wise to the scam. With bailouts, inflation, 0% interest rates, and high deficits, insiders are getting dangerously close to hyperinflation.

Fractional reserve banking is inherently fraudulent. It only can exist when supported by the State. Under a gold standard, fractional reserve banks counterfeit demand deposits. With paper money, the State guarantees all bank deposits, at the cost of higher inflation. With paper money, fractional reserve banks have nearly unlimited power to print money via loans, because they can always borrow from the central bank. With gold, you can hold physical and be safe from theft via inflation. With paper money, you are robbed via inflation no matter what you do.

3 Responses to Fractional Reserve Banking Is Inherently Fraudulent

  1. Anonymous Coward August 30, 2012 at 4:12 pm

    Thank you for another excellent post.

    What was the one thing that outraged Jesus the most as judged by his actions? See

    http://www.youtube.com/watch?v=kEtBs6j7QgU

    FSK talks of inflation, but what he says was predicted a long time ago.

    http://www.biblegateway.com/passage/?search=Revelation%206:6&version=NIV

    Revelation 6:6
    “Then I heard what sounded like a voice among the four living creatures, saying, “Two pounds of wheat for a day’s wages, and six pounds of barley for a day’s wages,…”

    Obviously the Bible is predicting inflation. Your day’s wages only covers the cost of living and no more to save or buy luxuries.

    • My points regarding the corrupt nature of fractional reserve banking and paper money have nothing to do with anti-Semitism.

      In the current system, when you borrow money, the bank literally creates new money and lends it to you. The details are somewhat obfuscated with the Federal Reserve and interbank loans, but that’s what actually happens.

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