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.

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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.

In the midst of the constant economic meddling we have grown accustomed to, it astonishes me when mainstream “economic experts” such as Ben Bernanke, Tim Geithner, and Nobel Prize winner Paul Krugman simply say that “bubbles happen.” It is commonplace, they say, for bubbles to appear and the role of government and central powers is to step in to prevent its popping. Essentially they are saying that the market created the problem, but it is too dangerous to let the market to correct itself; therefore new regulations and interventions must come into play to solve the problem.

The first flaw with this theory is that bubbles are not just created by accident. It is not the natural course of a strong economy to be either constantly on the upswing of a boom or the downswing of a bust. It is not the natural course of a currency to depreciate over time. It is not the natural course of prices to consistently increase. Yet over the past several decades, it seems that the economy is always on the verge of “overheating”, “deflating”, “slowing”, nearly any term you can think of.

It’s become a mainstream belief that too much economic growth and productivity is a bad thing, and will lead to a terrible recession. The Fed raises interest rates to slow growth, but subsequently lowers rates dramatically when the economy begins to slow down to make sure it doesn’t halt too much.

Through the laws of supply and demand, which people generally seem to think they understand, prices should go down over the long run, not up. In recent history, ever since the Fed came into existence and the gold standard was diminished, general prices are increasing due to the rapid expansion of the money supply. It is vital to realize that it is not prices that should go up, and the currency that should go down, but rather the currency that appreciates value and the prices that fall.

Even in the 19th century, probably the closest thing to a real free market in recorded history, the government’s intervention managed to create numerous financial panics. The U.S. had two central banks during the century that, along with various acts by Congress, played a large role in cheapening credit to artificial levels and encouraging unsustainable speculation. During the Civil War period the U.S. adopted both a fiat monetary system and income tax, which contributed to the 1873 panic. Escalated government intervention, central planning, and behind-the-scenes manipulation have been the natural trends of all countries throughout history, and they have never worked.

Bubbles are not created by voluntary, personal exchange that you have in a free market. Today, bubbles are created when interest rates and credit are constantly manipulated (by the Federal Reserve) beyond or below their natural levels, causing malinvestment and artificial wealth and opportunity. This provides short-term relief and optimism to the economy at the expense of the creation of a larger, irrational, unsustainable bubble that is fueled by the easy credit. Activating the printing presses and creating cheap credit appear to be some of the easiest illusions for government and central planners to work under in order to expand their power and presence within the economy.

Ever since we lost the last connection to gold in 1971, the U.S. has been on a path of self destruction by ignoring sound monetary policies that a lasting economy is built upon. We have followed the flawed Keynesian economics’ belief that you can devalue the currency and pile up debt with little consideration of the longer-term consequences.

The Fed injects money into the economy at low rates that would not be acceptable with a free market monetary system. This manipulation devalues the dollar, pressures the middle class (due to decreased purchasing power of the currency), and promotes irresponsible and unsustainable behavior such as excessive speculation, overvaluing assets, and discouraging wise saving practices. This is the reality that we will have to face sooner rather than later. No amount of government control and central intervention can sustain failed ideas and principles.

It is not the principles of the savings, production, and individual responsibility that create massive bubbles; rather, it is the Keynesian ideals of currency inflation, debt and borrowing, and interventionism that create messes like the one we face today.

Bubbles do not come out of nowhere, but they are pushed along by money and credit created out of thin air by an elite few. An economy built on corporatism, central planning, and government control is forever destined to suffer the perils of an unstable, manipulated, inflated foundation. The only lasting cures for these economic ills are the principles of hard work, savings and investment, with the freedom and responsibility of private property.