In Part 1, Fractional Reserve Banking in Pictures, we saw how the banking system creates fraudulent money by creating new money on top of old. The reserve requirement limit used in the example, 10%, is the figure usually given, which means that from a $10 deposit the banking system could generate $90 of new money. Also, the FED uses Open Market Operations to create new money by writing a check upon itself.
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“The few who understand the system, will either be so interested in its profits, or so dependent on its favors, that there will be no opposition from that class. The great body of people, mentally incapable of comprehending the tremendous advantages, will bear its burden without complaint.”

- Lord Rothschild, European central banker

The below slides are meant to explain fractional reserve banking as simply as possible using pictures.  The below demonstration assumes a reserve requirement of 10%, which is the figure typically given by the banking industry and financial experts.  However, in Part 2 I will demonstrate there there is effectively NO set reserve requirement though the banking system obviously carry some level of cash reserves.
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How to Double the Money

No matter who you are or what your income, you can retire today. Here’s how:

The Fed recently said it will leave interest rates unchanged at 0.00% to 0.25%. Helicopter Ben believes their is a low danger of inflation due to high unemployment. Let’s pretend for a moment that inflation is not strictly a monetary phenomenon and could simply be defined as “an increase in the money supply.” Don’t worry that the money supply has actually doubled. Just put your faith in Old Ben.

How to Retire Without Money

First, drive/fly/walk/run to your local Federal Reserve Bank, or go straight to the source in Washington, DC. Ask to talk to Ben. Tell him Nick sent you. Tell him that you understand how tough these economic times are, and that you want to do him a favor. Due to the lack of liquidity in the credit market you are going to help out the biggest of all “too-big-to-fail” banks. All he needs to do is give you a $1,000,000,000 loan at 0.00% interest. Heck, if you have bad credit you will even settle for the 0.25% rate.

In the Citi!

Now take your billion and head down to the nearest Citibank. Tell that you would like to make a deposit. I suspect the conversation will go a little like this:

Teller: Hi. Welcome to Citi. How can I help you.

You: I would like to open a savings account.

Teller: Excellent! How much would you like to deposit?

You: (pinky finger held at corner of mouth) One billion dollars!

Teller: Very funny sir.

You: (Show them your Federal Reserve check signed by Ben) Here you go.

Teller: (Mouth agape.) Let me get my manager.

Commercial Break

Living Off the Interest

Just a quick glance at Citi’s current savings account rates shows that their Ultimate Savings Account (which you will certainly qualify for….) pays an annual interest of 1.19%. Which means if you had good credit and got the 0.00% interest loan you are now making $19 million/year on the interest alone, and if you got the 0.25% (cause you had bad credit) you are making a measly $9.4 million. Either way you should be able to retire to the life of luxary.

Doin’ Nothin’, Nothin’ Doin’

While you are sitting on the beach somewhere sipping on an Italian Margarita you may start to wonder at this magic money trick, and how fractional reserve banking and fiat money managed to steal from the poor to give to the wealthy, but put that out of your mind. Instead, think about how cool a trick it is to be able to make money from nothing and to get your chicks for free!

After all, you have just injected a billion dollars liquidity back into the markets into a struggling bank that was really pressed for cash. They can now loan that money out to small business owners at exorbitant rates. The streets will flow with money again. House prices will rise forever. Buffett will buy an entire Railroad!

Don’t worry that you didn’t actually add any real production to the economy. Forget the fact that you didn’t have to work for an honest dollar like the common man. You are a member of the elite now. And when billions of dollars are involved you can afford not to have conscience.

Just remember that the Fed and all the banks they lend to have been getting away with the exact same practice for years now.

When the Federal Reserve was signed into law in 1913, it was largely on the basis that the independent organization would assume the role of “lender of last resort” to struggling banks and institutions. This would allow the Fed to extend credit in order to prevent short-term economic hardships. As I wrote in my article, Deception in “Free Market” Banking, banks had not experienced troubles because of the free market as is regularly assumed, but through the government-protected fractional reserve system that allowed banks to overextend themselves and deceive depositors:

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.

The Federal Reserve’s “last resort” lending powers did not meet the expectation of politicians. Banks still overextended themselves with depositors’ money despite the new powers of the central bank. In fact, between 1921 and 1929 there was an average of 600 bank failures every year, which exceeded the previous decade’s average (the one in which the Fed was created) by ten times.

During the last few months of 1930 people grew increasingly weary and cautious of the banking system. Understandably, people did not react well when they realized the banks did not have their deposited money. Banks retracted credit and liquidated assets, building up a financial perfect storm that resulted in 9,096 banks suspending operations between 1930 and 1934.

Many politicians reacted by proposing a system (that had been discussed in recent years) of deposit insurance backed and paid by a federal agency, despite the failure of similar state setups of deposit insurance in the same era. Since the early 1800s many states had attempted to offer some form of deposit insurance, many failing to live up to their initial claims. All of them were broke by 1930 (some reached their demise many years earlier, such as Michigan, New York, and Vermont in the mid-1800s).

This all changed when The Banking Act of 1933 was signed into law by Franklin D. Roosevelt on June 16, 1933. The Federal Deposit Insurance Corporation (FDIC) was established as a temporary agency that started operating on January 1, 1934. In its first year the FDIC fund carried a balance of $292 million. In 1935, with President Roosevelt’s signing of The Banking Act of 1935, the FDIC was established as a permanent government agency.The act also strengthened the Federal Reserve Board of Governors, the group of seven individuals who play a major role in controlling monetary policy.

The primary functions of the FDIC include insuring deposits through the Deposit Insurance Fund (DIF) and examining/supervising “financial institutions for safety and soundness and consumer protection.” This has been the basic mission of the FDIC in its 75 year existence, the details of which I won’t fully cover in this article.

Modern economics and politics often praise the development of the FDIC as a great and necessary banking program (this alone might be reason enough to question the FDIC’s role). The main curiosity that I have is the fact that rather than recognize the failure of a government-protected banking system that had failed numerous times leading up to the Great Depression, politicians decided to once again prop up the government system. According to information on the fdic.gov website, the original FDIC legislation drew support from those “who were determined to end destruction of circulating medium due to bank failures and those who sought to preserve the existing banking structure.” (Emphasis added.) These people either failed to realize or downright ignored that it was precisely the banking structure of the fractional reserve system that made such booms and busts so dreadful.

The failure of many banks in the Great Depression was not due to the free market. Fractional reserve banking, the process of banks loaning and investing more money than they actually have in reserve, had been shot down by market forces many times throughout the 1800s in the U.S. The numerous “financial panics” of the 19th century that people often pin on the free market would not have been possible had the states and federal government ceased in protecting the ability of banks to deceitfully loan away depositors’ money. A free market system would not involve government protecting banks in this process, but enforcing the distinction of contracts between demand deposits and time deposits.

• Click here for Part 2.
  

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, an outflow of gold from the U.S. due to the suddenly more attractive prices from foreign producers, and banks were therefore forced 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.