State of Innovation

Patents and Innovation Economics

Did Midas Mulligan Run a Fractional Reserve Bank?

Was Midas Mulligan, the hero banker in Atlas Shrugged, running a fractional reserve bank?  There has been much criticism of the Federal Reserves’ handling of our money supply and its effect on the economy.  Much of this criticism has been led by Ron Paul and the Austrian school of economics.  Some critics, including Ron Paul and Thomas E. Woods, author of Meltdown, have further argued that fractional reserve banking should be outlawed.  Fractional reserve banking is how all modern banks (since at least 1750s) operate.  Wikipedia defines a Fractional-reserve banking as a type of banking whereby the bank does not retain all of a customer’s deposits within the bank. Funds received by the bank are generally on-loan to other customers. This means that available funds (called bank reserves) are only a fraction (called the reserve ratio) of the quantity of deposits at the bank. As most bank deposits are treated as money in their own right, fractional reserve banking increases the money supply, and banks are said to create money.

Ayn Rand clearly would have been against the Federal Reserve system, which her protégé Alan Greenspan headed for over a decade.  The Federal Reserve is a government institution that prints money at will and manipulates the money supply for the benefit of government looters and Wall Street looters.  In Atlas Shrugged, Rand rails against paper money and in Galt’s Gulch they use gold for their currency.  However, to the best of my knowledge, she never addressed the issue of fractional reserve banking directly.  The history of fractional reserve banking starts with the concept of an exchange bank.  I explain in my book, The Decline and Fall of the America Entrepreneur: How Little Known Laws and Regulations are Killing Innovation:

Modern banking started in the early 1600s with the Bank of Amsterdam.  Merchants could deposit coins with the Bank of Amsterdam and use this account to pay for transactions.  Using checks, a merchant’s account was debited and another merchant’s account was credited.  This meant that coins did not have to be transported from one merchant to another with the attendant risk of theft and loss or the cost of transportation.  The Bank of Amsterdam was just an exchange bank that facilitated transactions between merchants.  Next came the Swedish Riksbank established in 1656.  The Riksbank was not only an exchange bank, it also lent money making it the first modern fractional reserve bank.  Fractional reserve banking is the banking practice in which banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand.  Commonly, loans are made against collateral such as land or jewelry.  … Some people believe fractional reserve banking creates money out of thin air, but what really happens was the money for these loans were backed by some collateral other than coins or bullion.  The downside of other types of collateral is they are not as liquid as species (coins, bullion).  As a result, if large numbers of customers of a fractional reserve bank wanted species (currency) at the same time, the bank would not able to fulfill all its customer’s demands.  This is a classic run on a bank.  A run on a bank is a cash flow issue.  A sound bank may have plenty of collateral and performing loans, but if most of its customers demand species at the same time it will not be able to fulfill these requests.  Fractional reserve banks free up capital from low performing assets so that they can be invested in higher performing assets.  For example, if you owned a large tract of ranching land that was not highly profitable but represented a large amount of capital and you want to invest in an oil well, without fractional reserve banking you would have to sell some of the land in order to invest.  With fractional reserve banking you could convert your land into a generally accepted form of money, by pledging your land as collateral to a bank for a loan.  In the modern world, the loan to you is just a computer entry in your bank account.

It is clear from history that fractional reserve banks are not some sort of government institution, like the Federal Reserve.  Rand’s philosophy was that people are free to contract with each other for anything that does not involve fraud or the use of force.  A fractional reserve bank meets this requirement, with the one possible caveat that a bank should disclose this information to depositors so that the customer understands and assents to the use of his money this way.  Since most people do not know what a fractional reserve bank is, including many bank employees, I am not sure that this caveat is met.  I assume that when you open a new account banks provide you with information that they are a fractional reserve bank, but I have not been able to prove this.  Without fractional reserve banking it would be very difficult to securitize (Collateralize) many assets, such as houses and land.  This would significantly impede the economic growth of a country.

 

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July 17, 2011 - Posted by | -Economics | , , , , , , , ,

5 Comments »

  1. The US Federal Reserve is a privately owned bank, not a department of the US government. They lease money to the US government. Stupid right.

    Comment by Jeff Olstad | August 2, 2011 | Reply

  2. Hi Jeff,

    While it is technically true that Fed is not a department of the US government, because of legal tender laws they are clearly not a privately owned bank either. When they screw around with the money supply we cannot opt out and decide we will not longer accept their phony money, which would be the case if they were truly private. So it is a bit of a fraud to say they are not a part of the US government.

    Comment by dbhalling | August 3, 2011 | Reply

  3. ..What follows is a rather simplified analogy but should help to explain our modern fractional reserve banking system. As long as they honoured that receipt by replenishing their gold reserves with real gold that they earned over time the system would remain stable and intact..The only danger was that everyone who had deposited gold would come to redeem their receipts all at once. So the goldsmiths were able to maintain a fraction of their gold reserves and nobody was any the wiser..Over time even more innovation took place.

    Comment by business review | August 16, 2011 | Reply

  4. The difference between a fractional reserve bank, and the federal reserve is a person has a choice of which bank to save their money. The banking system would not work properly, and banks would not be able to lend anything if they operated any other fashion. It’s how banking has operated for centuries. The central banking system is a system that is corrupt and gives customers absolutely no choice.

    Comment by Nick Berry | October 11, 2012 | Reply

  5. Good points

    Comment by dbhalling | October 11, 2012 | Reply


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