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Sunday, November 1, 2009

The Case Against the Fed, Murray Rothbard

In The Case Against the Fed (1994), Murray Rothbard makes a strong case that the banking system [ruled by a Central Bank] was intentionally created by banks for their own protection, while the Central Bank concept was sold to the public as giving them protection from the banks.

Similarly, he traces the creation of the Interstate Commerce Commission to the influence of existing business essentially trying to erect additional barriers to entry in industries like railroads.

The use and manipulation of government forces by the Mellons and Carnegies of America has been going on since the late 1800's, and the corporations have achieved many protections from the courts and legislators. But their ability to manipulate public opinion, along with their leverage over government in terms of structure and defining the mission of bureaucracies created to protect the public interest has been demonstrated as well (think gutting of the EPA by the Bush administration).

By far the most world-shaping of these business/government collaborations is the Federal Reserve. Without the Federal Reserve to back up the minimal reserves required of individual banks, there would be much more frequent bank failures, or there would be much less money created by the banks because they would loan less of their deposits out out of risk aversion. Essentially, the banks want to be able to lend out as much of their deposits as they can while maintaining the ability to meet all the demands for cash made by customers.

The fractional reserve banking system we use allows banks to lend money they don't really have. The money appears to be in two places at once: in the bank available to each depositor, and on loan to Joe's Construction, Wal-Mart, and Tom, Dick , and Harry. As George Bailey, the banker[Jimmy Stewart], says in “It's a Wonderful Life” “Your money is in Charlie's addition, and in Marge's new Hair Salon, etc.”. He avoids a run on the bank by his reputation of sincerity and honesty. I like to see a modern-day banker try that!

Then the ridiculous thing happens: the same money is lent out again. I can see why loan portfolio management is a difficult field. Juggling maturities, amounts and rates while watching the distribution of daily cash demands to predict them could give one ulcers, I suspect.

So, the banks have been granted a license to lend out money they don't really have, and charge interest to the borrowers. The more they can lend, the more interest they can collect. Of course this cyclical, money recycling machine, if pushed too far [i.e. extremely low reserve margins] seems like it would put the institution on the bleeding edge of bankruptcy; at least it would only take a small perturbation from estimates to put them in possible trouble. Again, the Fed can step in an lend “support” to any particular troubled bank if it chooses. But it reminds me of the AIG pyramid scheme of insurance with no significant reserves relative to the size of the bets (in this case, guarantees on debts).

Does fractional-reserve banking need to be reined in to provide a more stable economic environment? At the cost of some economic growth, and significant bank profits, I think reserve margins should be increased to more like 50% than 5-10%. Alternatively one could allow banks to use a more aggressive 20% reserve margin, if the banks were willing to share a larger portion of the profits from lending money they don't have with the Federal Government – essentially the Federal Government backs up all of their loans at no cost to them in the current system. Or at least that's how I understand it.

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