Deception in “Free Market” Banking

The free market is constantly blamed for mistakes made by banks, when in reality the economic problems begin when a free market is overridden with excessive and unnecessary government law, intervention, and agencies.

To grasp banking we must first learn and understand fractional reserve banking.

The fractional reserve banking system gives banks the chance to keep only a portion of their deposits in reserve, allowing them to loan or invest the rest. Today U.S. banks are required to keep only 10% of their deposits in reserve. So if you deposit $100 in the bank, legally the bank is only required to hold $10 of it in reserve. This provides cash for “day to day” privileges and allows the bank to invest in securities and loan out funds, among other things.

You may have heard how the “panics” in the 1800s were a failure of the free market. Many of the “panics” were caused from bank runs, meaning that the banks had overextended themselves and their promises and could not provide the money when customers decided to withdraw their holdings. In the 19th century banks kept gold (primarily) in their vaults and issued paper promises, so to speak, guaranteeing people their gold. Banks would print more of the paper money, loan it out or invest it, creating monetary inflation (because the new paper notes were not backed by more gold; rather they were diluting the value of the gold held in the bank’s vault).

In the Panic of 1819, both local banks and the national bank joined in the practice of spreading themselves too thin through fractional reserve lending. When people wanted to withdraw their funds and realized they couldn’t, it led to the bank runs and harsh economic conditions as the economy was forced to contract after the unsustainable monetary inflation.

The inflation caused by the banks led to higher prices domestically and an outflow of gold from the U.S. due to the suddenly more attractive prices from foreign producers, which forced banks to draw back on their commitments. The law in 1819, and for many years following, allowed banks to neglect their depositors’ holdings while still continuing their operations. If they overextended themselves, banks were given a special privilege and protection from government that allowed them to ignore their clients’ rightful and original property, and instead pursue the unsustainable and destructive road of monetary inflation and the creation of artificial credit.

I bring this up because people who support government and central economic intervention will often bring up the “financial panics” in the 1800s to show how disastrous a free market is. But the truth is that the government protections placed on banks helped cause a great majority of the panics. Because of the government protection, banks were able to take unnatural risks that never would have been possible in a free market. Government shielded banks when the fractional reserve process failed. In other words, the government protected the fractional reserve system in order to benefit banks, not the citizens.

Fast-forward to 1907. This was the time of the last “panic” before the Federal Reserve Act was signed into law, creating the central bank, in 1913. Once again this crisis came about because banks were unable to give customers their initial deposits. This caused a whole stream of withdrawals (or attempted withdrawals) by bank customers around the nation. Banks had placed the deposits into income-earning securities and did not have the necessary cash to meet customer demands.

After the Panic of 1907 and the umpteenth failure of fractional reserve lending, the attacks still were not aimed at the fractional reserve system. This system, when protected through law, gave banks the undoubted opportunity to inflate the money supply, overextend themselves in ways that would never be sustainable in a free market economy, and give little regard to the customers’ original property. Instead, economists began calling for a “lender of last resort” to bail out banks if they were caught overstretched in commitments. Many people don’t realize it, but the U.S. financial system has been in bailout mode for nearly a century since this event. In an otherwise relatively free market system, banking started as the largest sour grape of interventionism in the bunch.

What are the alternatives to fractional reserve lending, which has been criticized by free market, sound money supporters since its inception in the U.S.? Interestingly enough, the Romans sorted this out by making a clear legal distinction between “demand deposits” and “time deposits.”

Demand deposits are the deposits and withdrawals you and I make everyday. We expect to get the same amount of money that we initially deposited to the bank. Just as when you give $100 to a friend to hang on to for a week, you are not giving him the right to invest or spend it for his own personal gain at the risk of you completely losing that money.

Time deposits are essentially what we have today with Certificates of Deposit (CDs), where a depositor and a bank enter into an agreement of money guaranteed somewhere down the road (such as 1, 3, or 5 years). Time deposits represent fixed contracts where both parties know what they are getting into and what the terms and risks are.

Under a system similar to the Roman principles, banks would legally be required to hold 100% reserve rates with demand deposits. This guarantees that individual property is protected and not at risk of being permanently inflated or loaned away by the bank. With time deposits, however, the bank and the depositor agree on a certain time frame that the funds would be controlled by the bank, giving the bank the opportunity to invest or loan the money. If a depositor decided to withdraw his funds before the agreed-upon date he would be given a fee of some sort, just as we have with Certificates of Deposits today.

Understanding banking and monetary history in the U.S. is pivotal to understanding how booms, busts, and “panics” are initially created. Harsh economic times have more often than not, whether in the 19th, 20th, or 21st century, been created through government protections and privileges to certain industries, central manipulation of interest rates and credit, and unceasing government intervention in the economy.

People point to the failure of the fractional reserve system that occurred time and time again in the 1800s (through bank runs) and mistakenly shove the blame on the free market, and use it as an excuse to bring even more government intervention into the economy. History shows that when the free market is manipulated from outside forces the worst problems come about.

Today we are led to believe that a bailout-guaranteed, centrally manipulated, and government protected banking system is the most sustainable and sensible option. I have a very hard time believing this, just by looking through our own history. Government somehow fooled the majority into believing that it had absolutely nothing to do with causing “panics,” recessions, or any other rough economic situation you can think of.

It is long overdue that people cease buying into this ridiculous idea of an angelic government that knows the cure for every economic ill. Allowing the government and central bankers to freely mold and manipulate the economy is precisely what caused the many economic collapses over the decades and centuries. Freedom and the protection of private property represent the most solid and sustainable foundation for a prosperous economy.

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