The Mystery Of Banking

by Murray N. Rothbard

  Where did the money come from? It came—and this is the most important single thing to know about modern banking—it came out of thin air. Commercial banks—that is, fractional reserve banks—create money out of thin air. Essentially they do it in the same way as counterfeiters. Counterfeiters, too, create money out of thin air by printing something masquerading as money or as a warehouse receipt for money. In this way, they fraudulently extract resources from the public, from the people who have genuinely earned their money. In the same way, fractional reserve banks counterfeit warehouse receipts for money, which then circulate as equivalent to money among the public. There is one exception to the equivalence: The law fails to treat the receipts as counterfeit.

  Another way of looking at the essential and inherent unsoundness of fractional reserve banking is to note a crucial rule of sound financial management—one that is observed everywhere except in the banking business. Namely, that the time structure of the firm’s assets should be no longer than the time structure of its liabilities. In short, suppose that a firm has a note of $1 million due to creditors next January 1, and $5 million due the following January 1. If it knows what is good for it, it will arrange to have assets of the same amount falling due on these dates or a bit earlier. That is, it will have $1 million coming due to it before or on January 1, and $5 million by the year following. Its time structure of assets is no longer, and preferably a bit shorter, than its liabilities coming due. But deposit banks do not and cannot observe this rule. On the contrary, its liabilities—its warehouse receipts—are due instantly, on demand, while its outstanding loans to debtors are inevitably available only after some time period, short or long as the case may be. A bank’s assets are always “longer” than its liabilities, which are instantaneous. Put another way, a bank is always inherently bankrupt, and would actually become so if its depositors all woke up to the fact that the money they believe to be available on demand is actually not there.12

  One attempted justification of fractional reserve banking, often employed by the late Professor Walter E. Spahr, maintains that the banker operates somewhat like a bridge builder. The builder of a bridge estimates approximately how many people will be using it from day to day; he doesn’t attempt the absurd task of building a bridge big enough to accommodate every resident of the area should he or she wish to travel on the bridge at the same time. But if the bridge builder may act on estimates of the small fraction of citizens who will use the bridge at any one time, why may not a banker likewise estimate what percentage of his deposits will be redeemed at any one time, and keep no more than the required fraction? The problem with this analogy is that citizens in no sense have a legal claim to be able to cross the bridge at any given time. But holders of warehouse receipts to money emphatically do have such a claim, even in modern banking law, to their own property any time they choose to redeem it. But the legal claims issued by the bank must then be fraudulent, since the bank could not possibly meet them all.13

  It should be clear that for the purpose of analyzing fractional reserve banking, it doesn’t make any difference what is considered money or cash in the society, whether it be gold, tobacco, or even government fiat paper money. The technique of pyramiding by the banks remains the same. Thus, suppose that now gold has been outlawed, and cash or legal tender money consists of dollars printed by the central government. The process of pyramiding remains the same, except that the base of the pyramid is paper dollars instead of gold coin.14

  Our Rothbard Bank which receives $50,000 of government paper money on deposit, then proceeds to pyramid $80,000 on top of it by issuing fake warehouse receipts.

  FIGURE 7.3 — FRACTIONAL RESERVE BANKING (PAPER)

  Just as in the gold case, the total money supply has increased from $50,000 to $130,000, consisting precisely in the issue of new warehouse receipts, and in the credit expanded by the fractional reserve bank.

  Just as in the case of outright counterfeiting, the new money—this time in the form of new warehouse receipts—does not shower upon everyone alike. The new money is injected at some particular point in the economic system—in this case, the Rothbard Bank issues it and it is immediately loaned to Smith—and the new money then ripples out into the economy. Smith, let us say, uses the $80,000 of new money to buy more equipment, the equipment manufacturer buys raw materials and pays more for labor, and so on. As the new money pours into the system and ripples outward, demand curves for particular goods or services are increased along the way, and prices are increased as well. The more extensive the spread of bank credit, and the more new money is pumped out, the greater will be its effect in raising prices. Once again, the early receivers from the new money benefit at the expense of the late receivers—and still more, of those who never receive the new money at all. The earliest receivers—the bank and Smith—benefit most, and, like a hidden tax or tribute, the late receivers are fraudulently despoiled of their rightful resources.

  Thus, fractional reserve banking, like government fiat paper or technical counterfeiting, is inflationary, and aids some at the expense of others. But there are even more problems here. Because unlike government paper and unlike counterfeiting (unless the counterfeit is detected), the bank credit is subject to contraction as well as expansion. In the case of bank credit, what comes up, can later come down, and generally does. The expansion of bank credit makes the banks shaky and leaves them open, in various ways, to a contraction of their credit.

  Thus, let us consider the Rothbard Bank again. Suppose that the loan to Smith of $80,000 was for a two-year period. At the end of the two years, Smith is supposed to return the $80,000 plus interest. But when Smith pays the $80,000 (forgetting about the interest payment to keep things simple), he will very likely pay in Rothbard Bank warehouse receipts, which are then canceled. The repayment of the $80,000 loan means that $80,000 in fake warehouse receipts has been canceled, and the money supply has now contracted back to the original $50,000. After the repayment, the balance sheet of the Rothbard Bank will be as follows:

  FIGURE 7.4 — REPAYMENT OF BANK LOANS

  We are back to the pre-expansion figures of our original example (Figure 7.1).

  But if the money supply contracts, this means that there is deflationary pressure on prices, and prices will contract, in a similar kind of ripple effect as in the preceding expansion. Ordinarily, of course, the Rothbard Bank, or any other fractional reserve bank, will not passively sit back and see its loans and credit contract. Why should it, when the bank makes its money by inflationary lending? But, the important point is that fractional reserve banks are sitting ducks, and are always subject to contraction. When the banks’ state of inherent bankruptcy is discovered, for example, people will tend to cash in their deposits, and the contractionary, deflationary pressure could be severe. If banks have to contract suddenly, they will put pressure on their borrowers, try to call in or will refuse to renew their loans, and the deflationary pressure will bring about a recession—the successor to the inflationary boom.

  Note the contrast between fractional reserve banking and the pure gold coin standard. Under the pure gold standard, there is virtually no way that the money supply can actually decline, since gold is a highly durable commodity. Nor will it be likely that government fiat paper will decline in circulation; the only rare example would be a budget surplus where the government burned the paper money returning to it in taxes. But fractional reserve bank credit expansion is always shaky, for the more extensive its inflationary creation of new money, the more likely it will be to suffer contraction and subsequent deflation. We already see here the outlines of the basic model of the famous and seemingly mysterious business cycle, which has plagued the Western world since the middle or late eighteenth century. For every business cycle is marked, and even ignited, by inflationary expansions of bank credit. The basic model of the business cycle then becomes evident: bank credit expansion raises prices and causes a seeming boom situation, but a boom based on a hidden fraudulent tax on the la
te receivers of money. The greater the inflation, the more the banks will be sitting ducks, and the more likely will there be a subsequent credit contraction touching off liquidation of credit and investments, bankruptcies, and deflationary price declines. This is only a crude outline of the business cycle, but its relevance to the modern world of the business cycle should already be evident.

  Establishing oneself as a fractional reserve bank, however, is not as easy as it seems, despite the law unfortunately looking the other way at systemic fraud. For the Rothbard Bank, or any other bank, to have its warehouse receipts functioning in lieu of gold or government paper requires a long initial buildup of trust on the part of the public. The Rothbard Bank must first build up a reputation over the decades as a bank of safety, probity, and honesty, and as always ready and able to redeem its liabilities on demand. This cannot be achieved overnight.

  4. BANK NOTES AND DEPOSITS

  Through the centuries, there have been two basic forms of money warehouse receipts. The first, the most obvious, is the written receipt, a piece of paper on which the deposit bank promises to pay to the bearer a certain amount of cash in gold or silver (or in government paper money). This written form of warehouse receipt is called the bank note. Thus, in the United States before the Civil War, hundreds if not thousands of banks issued their own notes, some in response to gold deposited, others in the course of extending fractional reserve loans. At any rate, if someone comes into the possession (either by depositing gold or by selling a product in exchange) of, say, a $100 note from the Bank of New Haven, it will function as part of the money supply so long as people accept the $100 note as a substitute, a surrogate, for the gold. If someone uses the $100 note of the Bank of New Haven to buy a product sold by another person who is a customer of the Bank of Hartford, the latter will go to his bank and exchange the $100 New Haven note for a similar note from the Bank of Hartford.

  The bank note has always been the basic form of warehouse receipt used by the mass of the public. Later, however, there emerged another form of warehouse receipt used by large merchants and other sophisticated depositors. Instead of a tangible receipt, the bank simply opened a deposit account on its books. Thus, if Jones deposited $10,000 in a bank, he received, if he wished, not tangible bank notes, but an open book account or deposit account for $10,000 on the bank’s books. The bank’s demand debt to Jones was not in the form of a piece of paper but of an intangible book account which could be redeemed at any time in cash. Confusingly, these open book accounts came to be called demand deposits, even though the tangible bank note was just as much a demand deposit from an economic or a legal point of view. When used in exchange, instead of being transferred physically as in the case of a bank note, the depositor, Jones, would write out an order, directing the bank to transfer his book account to, say, Brown. Thus, suppose that Jones has a deposit account of $10,000 at the Rothbard Bank.

  Suppose now that Jones buys a hi-fi set from Brown for $3,000. Jones writes out an order to the bank, directing it to transfer $3,000 from his open book account to that of Brown. The order will appear somewhat as follows:

  Rothbard Bank

  Pay to the order of John Brown $3,000

  Three thousand and 00/000

  (signed)

  Robert Jones

  This written instrument is, of course, called a check. Note that the check itself is not functioning as a money surrogate here. The check is simply a written order transferring the demand deposit from one person to another. The demand deposit, not the check, functions as money, for the former is a warehouse receipt (albeit unwritten) for money or cash.

  The Rothbard Bank’s balance sheet is now as follows:

  FIGURE 7.5 — TRANSFERRING DEMAND DEPOSITS

  Note that from this purchase of a hi-fi set, nothing has changed in the total money supply in the country. The bank was and still is pursuing a 100 percent reserve policy; all of its demand liabilities are still covered or backed 100 percent by cash in its vaults. There is no fraud and no inflation.

  Economically, then, the demand deposit and the tangible bank note are simply different technological forms of the same thing: a demand receipt for cash at the money warehouse. Their economic consequences are the same and there is no reason for the legal system to treat them differently. Each form will tend to have its own technological advantages and disadvantages on the market. The bank note is simpler and more tangible, and doesn’t require quite the same degree of sophistication or trust by the holders of the receipt. It also involves less work for the bank, since it doesn’t have to change the names on its books; all it needs to know is that a certain quantity of bank notes is out in circulation. If Jones buys a hi-fi set from Brown, the bank note changes hands without anyone having to report the change at the bank, since the bank is liable to the note-holder in any case. For small transactions—purchase of a newspaper or ham sandwich—it is difficult to visualize having to write out a check in payment. On the other hand, demand deposits have the advantage of allowing one to write out checks for exact amounts. If, for example, the hi-fi set costs some nonrounded amount, such as $3,168.57, it may well be easier to simply write out the check than trying to find notes and coins for the exact amount—since notes will generally be in fixed denominations ($1, $5, $10, etc.).15 Also, it will often be more convenient to use demand deposits for large transactions, when amassing cash can be cumbersome and inconvenient. Moreover, there is far greater danger of loss from theft or accident when carrying cash than when having a certain known amount on a bank’s books.

  All of these factors will tend, on the free market, to limit the use of bank deposits to large users and for large transactions.16 As late as World War I, the general public in the Western world rarely used bank deposits. Most transactions were effected in cash, and workers received cash rather than bank checks for wages and salaries. It was only after World War II, under the impetus of decades of special support and privilege by government, that checking accounts became nearly universal.

  A bank can issue fraudulent and inflationary warehouse receipts just as easily in the form of open book deposits as it can in bank notes. To return to our earlier example, the Rothbard Bank, instead of printing fraudulent, uncovered bank notes worth $80,000 and lending them to Smith, can simply open up a new or larger book account for smith, and credit him with $80,000, thereby, at the stroke of a pen and as if by magic, increasing the money supply in the country by $80,000.

  In the real world, as fractional reserve banking was allowed to develop, the rigid separation between deposit banking and loan banking was no longer maintained in what came to be known as commercial banks.17 The bank accepted deposits, loaned out its equity and the money it borrowed, and also created notes or deposits out of thin air which it loaned out to its own borrowers. On the balance sheet, all these items and activities were jumbled together. Part of a bank’s activity was the legitimate and productive lending of saved or borrowed funds; but most of it was the fraudulent and inflationary creation of a fraudulent warehouse receipt, and hence a money surrogate out of thin air, to be loaned out at interest.

  Let us take a hypothetical mixed bank, and see how its balance sheet might look, so that we can analyze the various items.

  FIGURE 7.6 — MIXED LOAN AND DEPOSIT BANK

  Our hypothetical Jones Bank has a stockholders’ equity of $200,000, warehouse receipts of $1.8 million distributed as $1 million of bank notes and $800,000 of demand deposits, cash in the vault of $300,000, and IOUs outstanding from borrowers of $1.7 million. Total assets, and total equity and liabilities, each equal $2 million.

  We are now equipped to analyze the balance sheet of the bank from the point of view of economic and monetary importance. The crucial point is that the Jones Bank has demand liabilities, instantly payable on presentation of the note or deposit, totaling $1.8 million, whereas cash in the vault ready to meet these obligations is only $300,000.18 The Jones Bank is engaging in fractional reserve banking, with the fraction being
>
  $300,000/$1,800,000

  or 1/6. Or, looking at it another way, we can say that the invested stockholder equity of $200,000 is invested in loans, while the other $1.5 million of assets have been loaned out by the creation of fraudulent warehouse receipts for money.

  The Jones Bank could increase its equity by a certain amount, or borrow money by issuing bonds, and then invest them in extra loans, but these legitimate loan operations would not affect the 1/6 fraction, or the amount of fraudulent warehouse receipts outstanding. Suppose, for example, that stockholders invest another $500,000 in the Jones Bank, and that this cash is then loaned to various borrowers. The balance sheet of the Jones Bank would now appear as shown in Figure 7.7.

  Thus, while the Jones Bank has extended its credit, and its new extension of $500,000 of assets and liabilities is legitimate, productive and noninflationary, its inflationary issue of $1,500,000 continues in place, as does its fractional reserve of 1/6.

  A requirement that banks act as any other warehouse, and that they keep their demand liabilities fully covered, that is, that they engage only in 100 percent banking, would quickly and completely put an end to the fraud as well as the inflationary impetus of modern banking. Banks could no longer add to the money supply, since they would no longer be engaged in what is tantamount to counterfeiting. But suppose that we don’t have a legal requirement for 100 percent banking. How inflationary would be a system of free and unrestricted banking, with no government intervention? Is it true, as is generally believed, that a system of free banking would lead to an orgy of unrestricted money creation and inflation?