Simon Black on the “Fraud” of Fractional Reserve Banking

Today's letter from Simon Black is regarding fractional reserve banking.  He begins with an example of furniture storage:

Any run of the mill storage facility has a simple mission: store people’s stuff. Simple. If you bring them your bedroom set to store for a few months, they have to keep it safe and secure.

They certainly must treat it in accordance to the contract.

They’re not allowed to rent it out to someone else on the side.

They certainly can if the contract says they can.

If they do, this constitutes fraud, and it’s illegal.

Not if the contract said they could.

Yet this is exactly what banks do.

Not exactly.

I have written several times before about the contract.  The contract makes clear that there will be occasions where your assets are not available – including “a suspension of payments by another bank.”  Now why would payments from another bank be an issue if the bank was holding your funds?

Additionally, when you place your furniture in a warehouse, you pay a monthly fee for storage.  On top of this, the warehouse doesn’t pay you for the privilege of storing your furniture. Yet for most so-called demand deposit accounts a) with a minimum balance there is no monthly fee, and b) the depositor is paid interest.

How is this possible if the bank is storing the asset?  Blank-out.

Let’s assume you deposit $100 at the only bank in town. The bank will hold a $5 reserve, then make a $95 loan to someone else. That guy ends up depositing the funds right back in the bank. But there’s a problem here: the bank now has deposits worth $195, but only the original $100 in cash. They’ve effectively ‘created’ $95 that doesn’t exist.

This is true.  It is inflationary to the money supply.  The bank is betting that no more than $5 will be demanded at any one time.

Like our furniture example, this is also fraud.

From both a contractual sense and a business sense, there is no fraud.  When you deposit in the bank, it is clear both contractually and from a business standpoint that the bank is loaning out some portion of the funds.  Again – where is the storage fee?  How is the depositor earning interest?

As such, because of fractional reserve banking, the commercial banks have enormous influence in distorting the money supply. It’s not just the Fed. So doing away with central banks, or even going back to the gold standard, won’t really solve the problem.

To really attack the root cause, you’d have to eliminate all the vestigial institutions like the FDIC that underpin this fraud of fractional reserve banking… plus the concept of fractional reserve banking itself.

Simon Black is kind of in the neighborhood of the problem and the solution.  The banks influence doesn’t come from fractional reserve lending, but from the monopoly protected by a government backed cartel.  A free market would never create the system today, with the extreme levels of leverage made possible by this monopoly cartel.

To attack the root cause, eliminate government backing in all forms – the Fed, FDIC, etc.  Leave the Fed in place thereafter, if you like.  In this case, see if the world returns to some options for true depository institutions, where the depositor pays a fee for storage.  See how long deposits stay in the cartel banks without the government guarantee of FDIC insurance.

Eliminate the monopoly and the government protections that support it.  Quit talking about fractional reserves – competition will limit this practice, as will the threat of bank runs.

But as you’re probably aware, nobody is talking about this idea…

Besides Ron Paul….

The talk should focus on the monopoly and not the fractional reserves.  Economists of all stripes rail against monopoly power – except when it comes to the production of money and credit.  Attack this hypocrisy.  Fractional reserve lending will then solve itself.