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The most insidious effects of fractional reserve banking

This article was previously published as an addendum to a longer piece on 19 November 2010.

The most insidious of all of the unintended consequences of both fractional reserve banking and the judicial decisions of Sir William Grant in Carr vs. Carr [1811] and Lord Cottenham in Foley vs. Hill [1848] is the continued shrinkage of the size of the unit of measurement of exchange value.

The unit of money – the pound – is the unit of measurement we each use daily in measuring the value of what we do, what we earn, what we buy and the general course of our individual affairs.  We depend on that unit for measuring and determining our future.  We each rely on it.  Yet, it is an untrustworthy tool for measuring because its size diminishes continually.  Measurements taken at different times will not be measured with the same size of unit.  Therefore, measurements taken at different times cannot be validly compared and formulae derived from such comparisons cannot produce the results predicted.

Imagine what would happen if the unit of measurement of time diminished continually.  Suppose the clock on Big Ben set the official time.  Suppose further that it had a mechanical fault so that it lost half a second a minute.  Every 5 days we would lose an hour.  Every 40 days we would lose 8 hours.  Soon it would be dark at noon and light at midnight.  Time would no longer be synchronized with nature.  Farmers could not rely on the clock to feed their animals.  Nights would get shorter and soon we would find that 8 hours sleep left us still tired.  We wouldn’t be able to get everything done during a normal day’s work and would have to work later and later. What couldn’t be completed today will need to be done tomorrow.  We would have to squeeze more and more into our already busy schedules.  Soon we will always be running out of time and craving more and more of it.  Our levels of stress would increase.  We would know we were not at fault and would seek someone else to blame.

It is no different with money.  Measurements of exchange value taken at different times may use the same numbers of pounds, but those pounds will each represent a different amount of purchasing power.  The budget we planned will no longer suffice.   We find ourselves short of money and crave more.  Soon we can only see the ‘short term’.  Long term planning is no longer an option.  Our levels of stress increase and we seek someone else to blame.  The results are both socially divisive and economically destructive.

Nevertheless, the effects have not always been that obvious.  In our individual experience, one day we suddenly realize that the money we receive as income no longer provides what it did or that our savings are no longer sufficient.  We need more money or we need to reduce our standard of living.

In the 1960’s an average manager earned £4,000 per year.  On that income, he could provide for his family.  He could put his children through private school.  His wife could stay at home and look after the children and she could have help in the home 5 days a week.  He could take his family on a holiday every year.  It wasn’t until he retired that he noticed the change.  By the mid to late 1970’s those who had retired on £2,000 or £3,000 per year discovered they could no longer afford the levels of comfort they had previously enjoyed and many had to alter their retirement plans radically.  The calculations they had previously made did not produce the results predicted.  Someone or something had stolen their purchasing power.  They cannot see who or what did this to them.  They begin to distrust everybody and the seeds of social unrest are sown.  They see themselves as having failed and their self-worth is diminished.

Today, the average manager earns more than £50,000 per year and cannot provide for his family the same standard of living that his predecessor did in the 1960’s earning £4,000 per year.  To achieve a decent standard of living now, his wife will also have to work.  Children cannot receive the same quality of home care.  What will happen in the next 50 years?

Economists use money as one of their principal units of measurement.  Comparisons of such measurements are invalid.  Calculations made using these comparisons are equally invalid comparisons.  Formulae derived from these calculations produce results which cannot possibly be achieved. The predictions of these economists continuously fail to come to pass and the entire field of economics has been brought into disrepute.

To try to improve their results, economists try to ‘index’ the pound but, as we saw in the example of ‘Big Ben’ above, in real life indexing does not work.  Nature does not ‘index’.

This loss or ‘theft’ of purchasing power produced by fractional reserve banking is destroying trust in the capitalist system throughout the world.   Neither labour nor producers will willingly enter into fixed long term contracts without regular reviews of price.  They have each been robbed of purchasing power too often.  As a result, the focus of too much human endeavour has become focused on the short term.

Too many now believe they must earn as much money as possible in the short term.  A culture of ‘greed’ has been fostered.  All of this flows naturally from having allowed the mechanism of money-lending to have been superimposed onto a perfectly valid system for storing and distributing our money.

Who can we blame today?  Is it the fault of the government, the banker or the depositor?  Each has allowed it to happen and each has continue to allow it to happen.  The truth is that we have each found ourselves born and raised within the system as it is.  We have been conditioned to trust it and have each done our best to survive within it.  Like those who for centuries believed and acted as if the world was flat, we have all merely failed adequately to question it.  There is no point in now trying to apportion blame. Those who made the original mistakes are long dead.  What we need to do now is to concentrate our energy on fixing it.

Banks remain a necessity in our economic system.  We live in a mandatory exchange system – a system where exchange is required to survive.  A medium of exchange is required to measure the value and the fairness in each exchange.  Money is that medium of exchange.  Safely to store our money and to distribute efficiently and conveniently is essential today.   Banks can and should continue to provide these services.  However, we can only allow banks to continue to provide these services if we remove the money lending mechanism from the storage function of banking and return it to 100% reserves.  As I have often argued, this can best be done by returning title to their money to depositors.  Then the banks will have a fiduciary responsibility to depositors and cannot lend deposits.

This will stop any further diminution of the size of the unit of measurement of exchange value.  Each of us can then begin to make more accurate measurements of exchange value and that will allow us all to make better decisions.  Nevertheless, we must remember that much of the data already stored in our memories is distorted and inaccurate.  We will each only be beginning the process of correcting our own thinking.   The process will take a long time.  In our own minds, we have each accumulated years of experiences, calculations and decisions – all based on inaccurate information.  We each may well have used our energy pursuing courses we would not otherwise have pursued and much of it will have been wasted.  Patience and understanding will be required.  We are all in the same boat.

Yet, begin we must.  I believe the future of civilization as we know it depends upon our actions now.

7 comments to The most insidious effects of fractional reserve banking

  • Chris Hulme

    Austrians talk at length about the quality of money. However I hear very little about the quantity of money required to run a modern society.
    Over the last three hundred years we have had the industrial revolution and phenomenal growth enabled by cheap credit from the banks and the fractional reserve system.
    If that cheap credit had not existed, would our standard of living have grown as quickly as it has?
    If we return to 100% reserve banking now, do we have enough real savings to allow adequate future growth?
    What happens if different countries have wildly different fractional banking rules, do the risk-takers forge ahead of the more conservative countries?
    Regards, Chris

    • Robert Sadler Robert Sadler

      Hi Chris,

      You seem to be mixing a few things up here. Real savings and whether or not we have 100% reserve banking are not directly linked or dependent on each other. There is a difference between holding cash reserves on hand and making an investment (loan/equity) on the other. Moving from 100% to fractional reserves does not increase the amount of savings/investment capital.

      Also, as Mises and Rothbard said, any amount of money in society is optimal. I contend that as the business cycle is costly (think bankrupcy costs etc.) we would be much wealthier if 100% reserves had been the rule. The government would be smaller also.

  • Toby Baxendale Toby Baxendale

    Chris, private credit in Manchester, the 1st city of the Industrial revolution and for at least the first 1/3rd of the industrial revolution helped build the great commercial enterprises of this country. There were no banks at all in Manchester . The first opened in 1771. Not many trusted it. They used bills of exchange until the 1815 Stamp Act made notes so much more profitable to use at the expense of private credit of bills of exchange . Credit created out of nowhere does not create wealth – it never has done and never will do. Only real entrepreneurs , making goods and services that people want , with savings , over time will wealth be created. Commercial enterprises granting credit to each other was the preferred method of trade across the whole country . Even though the Bills were taxed to a great disadvantage to notes and especially BoE notes, well into the late 1880′s Bills were still some 60% of all commercial transactions – it is just simply a myth that FR banks and credit created out of nothing created prosperity during this period.

  • Paul Marks Paul Marks

    Dear Chris Hulme (if that be your real name).

    If there are not enough real savings then people should be encouraged to SAVE MORE.

    After all there is plenty of physical money (more than even in history) the idea there is not enough physical money for a “modern economy” is nonsense.

    So, I repeat, if people are not saving enough for your desires then offer them a better deal – for example be prepared to pay higher interest rates on your loans.

    Not prepared to do that?

    Then do not talk about there not being “enough money”.

    As for the FRAUD (as an ordinary person would understand the word “fraud” – although the law now sees these things differently) of PRETENDING to have money you do not have (so that you can lend out “money” that no one has really saved)…..

    That scam will not end well.

    As you will see soon enough.

    “But if people save more, what about DEMAND….”

    Oh how silly.

  • All the money in an economy can buy everything in that economy. Print more money and you need more, less require less.
    If an island full everything one needs and also contains, say 100 people with £100 in each individuals pocket and escape impossible then we can easily see that £10,000 is the total cost of everything. Same in the real World. Bankers and Politicians deal in illusions, because they dont ever mention reality, that our children will have to pay for unless a real debt Jubilee occurs. Krugman did look amenable after being eaten alive last week…

  • George Selgin

    The notion that any sort of money unit serves to “measure” value ought to strike anyone conversant with subjective value theory as an especially odd one, and especially so when offered by a proponent of Austrian-school economics.

    Toby’s claim about the FR “myth” is rendered suspect first by his mingling of “FR banking” and “credit created out of thin air” (as I’ve tried to show in a number of places these notions do not necessarily go hand-in-hand) and by his reliance on the peculiar situation in Manchester, to the neglect of experiences elsewhere in Great Britain, and particularly in Scotland. That Lancashire resorted to Bills of Exchange as it did was largely a result of the enfeeblement of English “country” banks by government-imposed restrictions, and by the six-partner rule especially. Manchester found a clever way around it. But that’s no proof of any inherent flaw of FR banking. The true market test can only be had where government doesn’t slant the playing field.

    • Paul Marks Paul Marks

      Either a money lender (whether are called a “bank” or not should be relevant) is lending out REAL SAVINGS (their own, or the savings of others entrusted to them) or they go beyond this.

      If they go beyond this, and engage in credit expansion (i.e. lending that is NOT from real savings) then there will be boom-bust event (as “broad money”, credit, first expands beyond real savings and then crashes down again). What the introduction of Central Banks does is to make the credit-money bubbles larger and more prolonged (and thus cause more damage).

      The boom-bust events are not neutral – the economy does not end up the same after the boom-bust event has played out, than it would have been had no boom-bust event occured. Damage is done – compared to what otherwise would have been the case.

      As for the subjective theory of economic value….

      This is no way implies a belief that reality is subjective. On the contrary, objective reality very much exists.

      Carl Menger, the great defender of the subjective theory of economic value, was not a believer in a subjective theory of reality.

      On the contrary – he was more of a supporter of objective reality than his German “Historical School” foes (the foes so beloved by Richard Ely and the other vile people who founded the American Economics Association).

      It is quite true that even American economists associated (rightly or wrongly) with the defence of the free market had deeply unsound philosophical opinions – for eample the opinions of Frank Knight (who inspired Milton Friedman) are quite dreadful – from an objective reality point of view.

      However, the Austrian School was never dominated by such “Progressive” philosophy. Even Ludwig Von Mises (who, unlike Carl Menger, stresses Kant) interprets Kant in an objective and universal way, totally rejecting a subjective nature of reality view, or one of “historical periods” (and so on).

      Ernst Cassirer’s thought – at least as Mises understood it, is no more “subjective” than Franz Brantino’s thought as understood by Carl Menger.

      There is no denial of objective reality (include the existance of universal laws of logical reasoning that are NOT limited by historical periods, or by “race” or “class”).

      “This is all getting far away from economics” – no actually it is not, but I will simply restate the basic point.

      You can not lend out more than has really be saved – not without CONSEQUENCES.

      You can defy objective reality – but you can not “wish” it out of existance by an act of WILL.

      If you throw yourself off a high cliff do not complain about getting seriously hurt.

      And if you insist on creating a credit money “boom” do not complain about the “bust”.

      “But I want stuff [a house, a factory, whatever] without having to save for it – and without anyone else having to save for it either”.

      That is, basically, what credit bubble “economics” amounts to.

      And objective reality will not be cheated by talk of the subjective theory of value.

      YES – people have different TASTES (which is what the subjective theory of economic value amounts to). Some people want a big house, some people want a factory, some people want hookers and cocaine…..

      But you can not have ANY of these things without saving for them (i.e. choosing not to consume all your income so that you can have what you want more) or convincing someone else to save – and then lend you the money.

      The idea that people can have without they want without saving AND WITHOUT ANYONE ELSE SAVING, is a fallacy.

      And it remains a fallacy – no matter how much complex “scientific” double talk (and academic cant) is used in its defence.

      By the way – I know the above misses out a lot. No discussion of possible differences between consumer goods and investment goods, no detailed examination of the structure of production (and on and on).

      However, unless the BASIC stuff is got right, these is no point in going on to the COMPLEX stuff.

      And “credit expansion” (or “cheap money” – or some other form of words) is NOT a good thing.

      That is basic – very basic.

      If someone does not understand that, he can not be trusted on anything else.

      Such a person is right down there with the early 19th century “Banking School” – talking about credit expansion being O.K. if it is for the “needs of trade” and in the hands of “responsible people” – and on and on.

      Such ideas (and the experiments with them in Chile and other places) discredited Free Banking.

      It led to sayings such as “free trade in banking is free trade in swindleing”.

      But this view is mistaken.

      Free Banking does NOT have to be a vast SCAM. With people dealing in “money” that no one saved – indeed that has no real EXISTANCE.

      Objective reality is just that – REALITY.

      A businessman (whether he is a money lender or a steel manufacturer) must make his plans in the line with objective reality – not behave as if he can defy it by some act of will.

      And NO talking about the subjective nature of economic value (i.e. people haveing different tastes and so on) does NOT change any of this.

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