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Confusing Capitalism with Fractional-Reserve Banking – Article by Frank Hollenbeck

Confusing Capitalism with Fractional-Reserve Banking – Article by Frank Hollenbeck

The New Renaissance Hat
Frank Hollenbeck
August 10, 2014

Today, capitalism is blamed for our current disastrous economic and financial situation and a history of incessant booms and busts. Support for capitalism is eroding worldwide. In a recent global poll, 25 percent (up 2 percent from 2009) of respondents viewed free enterprise as “fatally flawed and needs to be replaced.” The number of Spaniards who hold this view increased from 29 percent in 2009 to 42 percent, the highest amongst those polled. In Indonesia, the percentage went from 17 percent to 32 percent.

Most, if not all, booms and busts originate with excess credit creation from the financial sector. These respondents, incorrectly, assume that this financial system structured on fractural reserve banking is an integral part of capitalism. It isn’t. It is fraud and a violation of property rights, and should be treated as such.

In the past, we had deposit banks and loan banks. If you put your money in a deposit bank, the money was there to pay your rent and food expenses. It was safe. Loan banking was risky. You provided money to a loan bank knowing funds would be tied up for a period of time and that you were taking a risk of never seeing this money again. For this, you received interest to compensate for the risk taken and the value of time preference. Back then, bankers who took a deposit and turned it into a loan took the risk of shortly hanging from the town’s large oak tree.

During the early part of the nineteenth century, the deposit function and loan function were merged into a new entity called a commercial bank. Of course, very quickly these new commercial banks realized they could dip into deposits, essentially committing fraud, as a source of funding for loans. Governments soon realized that such fraudulent activity was a great way to finance government expenditures, and passed laws making this fraud legal. A key interpretation of law in the United Kingdom, Foley v. Hill, set precedence in the financial world for banking laws to follow:

Foley v. Hill and Others, 1848:

Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to an equivalent by paying a similar sum to that deposited with him when he is asked for it. … The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted, having received that money, to repay to the principal, when demanded, a sum equivalent to that paid into his hands. [1]

In other words, when you put your money in a bank it is no longer your money. The bank can do anything it wants with it. It can go to the casino and play roulette. It is not fraud legally, and the only requirement for the bank is to run a Ponzi scheme, giving you the money deposited by someone else if they lost your money and you happen to come back asking for your money. This legalization of fraud is essentially one of the main reasons no one went to jail after the debacle of 2008.

The primary cause of the financial panics during the nineteenth century was this fraudulent nature of fractional reserve banking. It allowed banks to create excessive credit growth which led to boom and bust cycles. If credit, instead, grew as fast as slow moving savings, booms and bust cycles would be a thing of the past.

Critics of the gold standard, (namely, Krugman, et al.), usually point to these cycles as proof that it failed as a monetary system. They are confusing causation with association. The gold standard did not cause these financial panics. The real cause was fractional reserve banking that was grafted onto the gold standard. The gold standard, on the contrary, actually greatly limited the severity of these crises, by limiting the size of the money multiplier.

This is why in the early days of banking in the US, some wildcat bankers would establish themselves in the most inaccessible locations. This was to ensure that few would actually come and convert claims for gold into actual gold since banks had created claims that far exceeded the actual gold in their vaults. And, if by chance a depositor tried to convert his claims into gold, they would be treated as thieves, as though they were stealing the bank’s property by asking for their gold back.

The Federal Reserve System was created following the panics of 1903 and 1907 to counterbalance the negative impact of fractional reserve banking. One hundred years after its creation, the Fed can only be given a failing grade. Money is no longer a store of value, and the world has experienced two of its worst financial crises. Instead of a counterbalance, the central bank has fed and expanded the size of the beast. This was to be expected.

That global poll on capitalism also found that almost half (48 percent) of respondents felt that the problems of capitalism could be resolved with added regulations and reform. Janet Yellen also holds this view, and that regulation, not interest rates, should be the main tool to avoid another costly boom and bust in global finance. This is extremely naïve. We already have more compliance officers in banks than loan officers. Recent banking legislation, Dodd-Frank, and the Vickers and Liikanen reports will probably make the situation even worse. Banks will always be able to use new technologies and new financial instruments to stay one step ahead of the regulators. We continue to put bandages on a system that is rotten to the core. Banking in its current form is not capitalism. It is fraud and crony capitalism, kept afloat by ever-more desperate government interventions. It should be dismantled. Under a system of 100 percent reserves, loan banks (100 percent equity-financed investment trusts) would be like any other business and would not need any more regulation than that of the makers of potato chips.


[1] Quoted in Murray Rothbard’s, The Mystery of Banking (Auburn, AL: Mises Institute, 2008), p. 92.

Frank Hollenbeck teaches finance and economics at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and as an Associate Director of a Swiss private bank. See Frank Hollenbeck’s article archives.

This article was published on and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

After 100 Years of Failure, It’s Time to End the Fed! – Article by Ron Paul

After 100 Years of Failure, It’s Time to End the Fed! – Article by Ron Paul

The New Renaissance Hat
Ron Paul
December 15, 2013

A week from now, the Federal Reserve System will celebrate the 100th anniversary of its founding. Resulting from secret negotiations between bankers and politicians at Jekyll Island, the Fed’s creation established a banking cartel and a board of federal-government overseers that has grown ever stronger through the years. One would think this anniversary would elicit some sort of public recognition of the Fed’s growth from a quasi-agent of the Treasury Department intended to provide an elastic currency, to a de facto independent institution that has taken complete control of the economy through its central monetary planning. But just like the Fed’s creation, its 100th anniversary may come and go with only a few passing mentions.

Like many other horrible and unconstitutional pieces of legislation, the bill which created the Fed, the Federal Reserve Act, was passed under great pressure on December 23, 1913, in the waning moments before Congress recessed for Christmas with many Members already absent from those final votes. This underhanded method of pressuring Congress with such a deadline to pass the Federal Reserve Act would provide a foreshadowing of the Fed’s insidious effects on the US economy—with actions performed without transparency.

Ostensibly formed with the goal of preventing financial crises such as the Panic of 1907, the Fed has become increasingly powerful over the years. Rather than preventing financial crises, however, the Fed has constantly caused new ones. Barely a few years after its inception, the Fed’s inflationary monetary policy to help fund World War I led to the Depression of 1920. After the economy bounced back from that episode, a further injection of easy money and credit by the Fed led to the Roaring Twenties and to the Great Depression, the worst economic crisis in American history.

But even though the Fed continued to make the same mistakes over and over again, no one in Washington ever questioned the wisdom of having a central bank. Instead, after each episode the Fed was given more and more power over the economy. Even though the Fed had brought about the stagflation of the 1970s, Congress decided to formally task the Federal Reserve in 1978 with maintaining full employment and stable prices, combined with constantly adding horrendously harmful regulations. Talk about putting the inmates in charge of the asylum!

Now we are reaping the noxious effects of a century of loose monetary policy, as our economy remains mired in mediocrity and utterly dependent on a stream of easy money from the central bank. A century ago, politicians failed to understand that the financial panics of the 19th century were caused by collusion between government and the banking sector. The federal government’s growing monopoly on money creation, high barriers to entry into banking to protect politically favored incumbents, and favored treatment for government debt combined to create a rickety, panic-prone banking system. Had legislators known then what we know now, we could hope that they never would have established the Federal Reserve System.

Today, however, we do know better. We know that the Federal Reserve continues to strengthen the collusion between banks and politicians. We know that the Fed’s inflationary monetary policy continues to reap profits for Wall Street while impoverishing Main Street. And we know that the current monetary regime is teetering on a precipice. One hundred years is long enough. End the Fed.

Ron Paul, MD, is a former three-time Republican candidate for U. S. President and Congressman from Texas.

This article is reprinted with permission from the Ron Paul Institute for Peace and Prosperity.