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Posts Tagged ‘Federal Reserve’


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 manipulate 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 is would be very difficult to securitize (Collateralize) many assets, such as houses and land.  This would significantly impede the economic growth of a country.

 

 
Were the Recessions of 2000 and 2008 Both Caused by Easy Money?

It is common for pundits to declare that the last two recessions were due to easy money on the part of the Federal Reserve.  Both free market proponents, such as Austrian economists, and Keynesians agree on this point.  David Faber even did a one hour show called the “Bubble Decade.”  First, let’s distinguish between easy credit bubbles and investment manias.  The recession of 2008 was clearly the result of excessive debt and is therefore a credit bubble.  Not only did the Federal Reserve hold interest rates low, but more importantly the federal government pursued a number of policies to encourage overinvestment (borrowing) in the housing sector.  Among these policies were the creation of Fannie and Freddie Mac and their investment in subprime mortgages and debt rating agencies, sanction by the SEC, that rated securities based on these mortgages as AAA.  Both of these contributed to a false sense of security on the part of investors.  It was believed that even if these securities (CMOs) failed the government would stand behind any mortgages backed by Fannie and Freddie.

Now compare this to the recession of 2000.  There were no policies encouraging debt (or equity) investments in technology start-up companies.  Banks do not loan money to even highly successful technology start-up companies.  Even very accommodative money policies by the Federal Reserve do not result in direct loans to these companies.  The Fed has small indirect effects.  For instance, easy money by the Fed makes it easier for founders to mortgage their house (or other property) and invest in their start-up.  Another indirect effect is that lower interest rates make it more attractive to invest in technology start-ups than debt instruments.  A third indirect effect is low interest rates encourage margin accounts for stock investors.  As a result, it is unlikely that the investment mania of the late 90s was the result of easy money policies on the part of the Fed.

Some people seem to believe that manias and bubbles can only occur because of easy money policies on the part of the Federal Reserve (Central Bank).  This cannot be right, because the tulip mania of Holland reach its peak in 1623.  This was before fractional reserve banking.  The first fractional reserve bank was the Swedish Riksbank established in 1656.  The first central bank was not established until the next century.  Clearly, investment manias can occur without central bank.

Gold is one of the most sensitive barometers of inflation due to excessive money creation.  The price of gold fell from about $400.00 an ounce in 1996 to below $300.00 per ounce in 1999 and most of 2000.  This is not the sort of response we would expect in gold prices, if the Federal Reserve was inflating the money supply.  The Discount Rate was 4 ½% in November 1998 and was increased to 6% by May 2000.  Again this is not one would call an easy money policy.  The investment mania in technology companies in the late 90s was not the result of over inflating the money supply.  Part of the deflation of the late 90s was due to a rapid increase in the amount of goods and services being produced, due to the new technologies being developed.  This may be one of the cases where the GDP measurement actually understated the actual growth.

The recession of the 90s was not caused by too easy money, but imprudent tightening of the money supply.  Alan Greenspan was determined to cool the stock market.  As a result, the Fed increased interest rates until they caused a recession.  The yield curve turned negative 1999 or early 2000.  A negative yield curve would never occur in a free market economy – that is without a central reserve bank.  No one would ever loan out money for a longer term at a lower interest rate in than a shorter term loan.  An inverted yield curve is the product of a central bank.

The economic growth of the 90s was built on companies developing new technologies, which is the only way to increase real per capita income.  As a result, the recession of 2000 was relatively mild.  Alternatively, the housing bubble was built on easy credit and did not result in new technologies.  The recession of 2008 was the deepest since the recession of 1980.

 
Still Subsidizing Banks and Wall Street

The TARP bailout of Wall Street may be over but we are still bailing out the millionaires on Wall Street.  The Federal Reserve has purposely set the fed funds rate to zero in order to “recapitalize” (bail out) Wall Street and the big banks.  This is nothing more than crony capitalism, where middle class Americans are forced to bail out multimillionaires.  As if this were not bad enough the bankers on Wall Street are acting like they are genius because they can borrow money from the federal government for zero percent interest and loan it back to the government at three percent interest.  This transfer of wealth from the rest of America to the politically connected in Wall Street is not moral and it is not good for the country.  An excellent video on this point is   Huge, Ongoing Wall Street Subsidy Allows Banks to Coin Money Every Day at Savers’ Expense .

Pat Choate’s book “Saving Capitalism”  points out that middle America has bailout Wall Street at least nine times since 1980.  Many of these bailouts are framed as bailouts for a country such as Greece today or Mexico in the early 1990s, however the bailout funds are not used to help the people of Greece or Mexico they are used to pay back big banks that made bad loans.

The finance industry and Washington have conspired to steal all the wealth generated from hard working Americans.  If we want our country to be great again and our economy to grow again Wall Street has to be allowed to fail and Washington’s budget needs to be cut in half.

 

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