Dr. North on Inflation and Fractional Reserve Banking

Dr. North has written an essay on inflation, comparing the economy’s addiction to it to the addiction of a drug addict.  It is, as is all of his work on monetary and economic subjects, well worth the read (and public!).  I will comment on a few points.  (All emphasis in original.)

I start, not at the beginning of his essay but toward the end:

Free banking, even without the legally enforced one hundred percent reserve requirement, can never develop the rampant inflation described here. The inflation came as a direct result of State-enforced policies, and the State must bear the blame.

Why do I start here?  Dr. North touches on one of my main points when it comes to this subject of inflation and fractional reserve banking (FRB) – it’s the monopoly with comprehensive government backing (“State-enforced policies”) that is the issue, not FRB per se.

Why introduce debatable concepts such as fraud?  Why demand a “legally enforced one hundred percent reserve requirement”?  Legally enforced as opposed to contractually enforced; but legally enforced by whom?  When the market performs a good check, via contract (as both Mises and Rothbard conclude), why not leave it at this?

Now, before I move on, a point: let’s look for the fraud.  There is no such thing as a traditional demand deposit in today’s banking system.  There is no traditional deposit mechanism that requires, by contract, that the bank hold 100% of your deposit in an unencumbered form, not subject to the creditors of the bank in case of insolvency.

Every deposit becomes the property of the bank first; second, in case of insolvency, the next claim is by secured lenders (hint: that isn’t the depositor). More precisely, the property rights in the same deposit are divisible, as I have recently written.

As the bank’s property – with only the commitment to make funds available to you up to your account balance, under specific conditions and with certain exceptions – the bank is free to do what it will with the funds, subject to the prudence of its officers and (today) to government regulations.

Banking practice is quite similar to treasury policy, and the State, realizing that the banks are an excellent source of loans, permits and even encourages bankers to continue this fraudulent counterfeiting.

The legal restrictions on the circulation of inflated bank credit are not restrictions at all: they are licenses, virtual guarantees to permit fraud. Demanding ten percent reserves is licensing ninety percent counterfeiting. Demanding a twenty-five percent gold backed dollar, is permitting seventy-five percent fraud.

It isn’t fraudulent if it isn’t fraudulent.  Read the contract.  Until someone points out specifically where in the contract it states that the bank will hold your funds, unencumbered in any way, I will stick to what I have found to be the case – they are not obliged to hold your funds. 

A bank, assuming an enforced legal reserve limit of ten percent (which is about average), can receive $100 from a depositor, permitting him to write checks for that amount, and then proceed to loan $90 of this money to a borrower, virtually allowing him to write checks on the same deposit!

Set aside the backing of the state and the central bank: a bank makes an estimate of how much of the deposited funds will be called over time.  It lends out the rest (again, in accordance with the terms of the deposit contract – no fraud).

Yes, the depositor can write checks up to $100, but there will be other depositors that do not write any checks against their account.  If the bank is prudent in estimating the totally of their depositors demands, there will always be funds available to meet the redemptions.  If the bank isn’t prudent?  Bank run.  A pretty good regulator; one without need of the state.  Seemingly libertarians and Austrians would be jumping for joy at this….

Presto: instant inflation, to the tune of ninety cents on the dollar.

Inflation, in and of itself, I don’t see as a violation of the NAP.  One has a right to his property; one does not have a right to the value of his property.  If the property consists of a bank account of $100, held by the bank under certain conditions and restrictions and the bank doesn’t violate these conditions and restrictions, then the property owner has his property.  That it $100 tomorrow does not have the same value as $100 today may be a problem, but it isn’t a violation of the NAP.

This, however, is only the beginning. The borrower takes the $90 to his account, either at the same bank or at another one. This second deposit permits the bank involved to issue an additional $81 to a third borrower, keeping $9 in reserve, and the process continues until a grand total of $900 comes into circulation from the original $100 deposit. This practice is commonly known as "monetization of debt," and the banking system which practices it is called "fractional reserve banking."

I agree that the sum of every account-holder’s account balances will add to much more than $100; however the bank is betting that not more than $100 will be drawn at any one time.  Again, if prudent?  Funds will be available to meet redemption.  Imprudent?  Bank run. 

Inflationary?  Likely.  But, to quote North: “The inflation came as a direct result of State-enforced policies, and the State must bear the blame.”  Without the state, the inflation would not be total and systemic.  It would be local, regional, limited.  Bankruptcies would occur, ensuring the damage was limited and contained.

Anyone who doubts the magnitude of the effects of this combined bank and treasury note inflation should pause and consider the fact that in the years 1834-1859, the highest per capita total of currency, deposits, and specie in the United States was under $18, and in the low year it was just over $6 per person! In the high year, 1837, there was only $2 of specie to back up the $18, and the banks had to suspend payment, so even in this period the nation was plagued by a money mechanism based upon unbacked IOU notes.

Andrew Jackson famously killed the bank that made this “high point” possible:

The Second Bank of the United States, located in Philadelphia, Pennsylvania, was the second federally authorized Hamiltonian National Bank in the United States during its 20-year charter from February 1816 to January 1836.

The efforts to renew the Bank's charter put the institution at the center of the general election of 1832, in which BUS president Nicholas Biddle and pro-Bank National Republicans led by Henry Clay clashed with the "hard-money" Andrew Jackson administration and eastern banking interests in the Bank War. Failing to secure recharter, the Second Bank of the United States became a private corporation in 1836, and underwent liquidation in 1841.

Check the dates – Jackson mortally wounded the bank in 1836; it finally died five years later.

The high point of leverage was 1837, while the heart of the beast was still beating, at 9:1.  But, even at the low (my guess, at some point after the bank was kaput), the leverage was 3:1.

Two points: 1) without government backing, the leverage was greatly reduced (a nice market regulator), and 2) without government backing, there was leverage.

Back to North:

The new money does not appear simultaneously and in equal amounts, through some miraculous decree, in all men's pockets…. Each individual's bank account is not increased by $5 more than it was yesterday.

North is right to label this possibility as “miraculous.”  I don’t think there is any way absent divine intervention to make such an inflation simultaneous and equal.  Central bankers couldn’t do this even if they wanted to do so.  How, specifically, would they do it?  Increase everyone’s wages equally?  Increase everyone’s bank accounts?  And what is equal?  By an equal dollar amount?  By an equal percentage?

I am sure some monetary economist somewhere has written some very impressive academic papers on this subject; perhaps we will see when Yellen uses these papers as justification for what comes next.

But for today, it is the favored – those closest to the source – who receive the new money first:

The first individuals' incomes are immediately swelled, and they find themselves able to purchase goods at yesterday's less inflated prices.

Then there is this – one reason of many why focusing on the walnut shell labeled “price inflation” is to focus on the wrong walnut shell:

Another fact that is not generally realized is that the price level may remain somewhat stable while inflation is going on…. The laymen, and a considerable number of economists, forget that in a productive economy, the general level of prices should be falling. If the money supply has remained relatively stable, the increased supply of goods will force down prices, if all the goods are to be sold. In fact, the free market should generally be characterized by increasing demand prompted by falling prices, with increasing supplies due to increased capital investment. If prices remain stable, then the economy is very likely experiencing inflationary pressures.

Precisely – in the last 30 years or so, both China (low cost labor) and the explosion of technology / telecommunications afforded a burst of productivity that should have thereafter resulted in generally falling prices.  Instead, the entire benefit of these efficiencies and then some (as witnessed by the continually increasing price level) was taken by those closest to the money-printing spigot.

This much is certain, the deliberate inflating of a nation's circulating media is an ancient practice which has generally accompanied a decline of the national standards of morality and justice. The prophet Isaiah called attention to the coin debasing of his day, including it in a list of sins that were common to the society. They are the same social conditions of our own era.

How is the faithful city become an harlot! it was full of judgment; righteousness lodged in it; but now murderers. Thy silver is become dross, thy wine mixed with water: Thy princes are rebellious, and companions of thieves ... (Isa. 1:21-23a).

Debased currency is a sign of moral decay. In the final analysis, inflation is not just a question of proper economic policy. Above all, it is a question of morality. If we should permit the State to continue its fraud of indirect taxation through inflation, then we would have little argument against what is clearly the next step, the final removal of all natural resistance to inflation through the establishment of a world banking system. Mises warned half a century ago that the establishment of a world bank would leave only panic as the last barrier to total inflation.

Setting about the debate about fraud (for which I have made my point of view quite clear on many occasions), it is clear that a world with less inflation would be better than a world with more inflation.  If there is a wrong in this, it is that the state uses its full force to increase inflation to the maximum extent possible: central banking, deposit insurance, crushing alternative currencies, etc.  In other words, legislating a monopoly and providing it with complete and total protection from imprudent practices.

It is a moral question, and banking as practiced today is one of the more egregious signs of moral decay in society.  The moral question, for me, is simple: some people have access to chits from the central bank – the same chits that others have to work for, earned via market-driven demand.  Yet all chits can command commodities produced by the subset doing productive work.  Price inflation or no price inflation, the immorality is in the favoritism played by the system – rewarding the dependent while penalizing the independent.

One doesn’t need to debate fraud to find the biggest elephant in the room – the monopoly:

In the realm of practical recommendations, at least two seem absolutely imperative. The first is simple: completely free coinage as a right of private property, with the government acting as a disinterested third party ready to step in and prosecute at the first sign of fraud on the part of the private firms.

I have a different view on the need for the government to perform this role (when and where has government ever acted as a “disinterested third party,” especially when it comes to money?), otherwise the recommendation is sound.

The second recommendation, free banking, is similar to the first one of free coinage. The banks must be made to gain their profits from the charging of storage costs, clearing house operations for checks, and the investment of private trust funds.

Again, I will stay away from the concept of what the banks “must be made” to do – as long as “must be made” is made by the market and contract, fine by me.

Otherwise, Dr. North lets the cat out of the bag with this next one – those who believe the bank is actually holding their property unencumbered are a bit delusional – how can this be if a) interest is being paid on the deposit, and b) no storage fee is charged?

When banks create credit (and the power of credit creation is precisely what defines a bank, as distinguished from a savings and loan company), they charge interest on loaned funds which have been created by fiat. There are no gold or silver reserves backing this money, yet the banks profit by lending it. It involves fraud, and it is therefore immoral. The practice must be hindered.

Hinder it by taking away the monopoly, not by disallowing a practice to which a depositor might willingly agree:

Depositor: I have $100.  Can I deposit it with you?

Banker: Sure!

Depositor: What are my options?

Banker: Well, I can hold your deposit, unencumbered.  You will earn no interest and I will charge you a storage fee.  Or, I can lend out a portion of your deposit thus paying you some interest and also avoiding the storage fee.  While I will likely be able to meet your requests for an instant return of your funds upon demand, given the overall portfolio of the bank, there may be times when I might have to restrict your access – the conditions are all outlined in the contract.

Why should this option be denied?  What is immoral about this proposed agreement?  But then, you say, it isn’t really a demand deposit contract.  And then I say there is virtually no such thing (contractually) in today’s banking environment (and with government deposit insurance, why should there be?).

If the banker promises the first option but then practices the second, yes there is a problem and a breach of contract.  For this, call it fraud and arbitrate away.  Otherwise, it’s is between the depositor and banker to agree as they like.

Now, to my favorite part of the essay:

Mises argues that free banking will keep bankers honest. Mutual competition will tend to destroy banks that are insolvent because of their heavy speculative policies of credit creation. Bank runs will tend to drive the less conservative banks out of business. There may be some credit creation, but very little in comparison to that which exists today, when the governments support fractional reserve fraud.

Thank you, Ludwig!

He fears a law which would require one hundred percent reserves for banks, however, for the power of the State to demand one hundred percent reserves implies the power to demand ninety-nine percent reserves, ninety-five percent reserves, fifty percent reserves, or ten percent reserves.

This is so good on so many fronts: first of all, those who require a 100% reserve requirement are inherently asking government to a) intervene in the market counter to the likely wishes of free-market participants), and b) giving the government license to change the requirement.

It is safer, he argues, to leave government out of the picture completely, given the past failures of government to keep the banking system honest. Fractional reserve banking is too tempting to governments as a source of ready loans. Mises, in short, does not trust the government bureaucracy when it comes to the regulation of banking. I tend to agree with him on this matter.

As do I.

Rothbard argues cogently for a State-enforced one hundred percent reserve requirement for all banks. Any bank not abiding by this must be prosecuted. It must be stressed that Mises is not absolutely hostile to this recommendation, since he admits that "Government interference with the present state of banking affairs could be justified if its aim were to liquidate the unsatisfactory conditions by preventing or at least seriously restricting any further credit expansion." Mises is willing to let some regulation in on the grounds of expediency; things are so bad today that any restrictive legislation would be an improvement. Rothbard is arguing, however, in terms of principle. Fraud is involved in fractional reserve banking, so it must be eliminated by law. It is a strong argument. Unfortunately, Rothbard sacrifices its cogency by his philosophical anarchism. If there is no State to enforce the provision, how will his one hundred percent reserve banking scheme be different, operationally, from Mises' free banking?

It can certainly be enforced by private arbitration; the first thing the arbitrator will want to see is the contract….

It must be remembered that Rothbard also recognizes that – whatever his belief about the fraudulent nature of the practice – the market will be the best regulator of banking and the best check on the expansion of credit.

The coinage power must be left to private citizens who are subject to competition from other citizens and to the enforcement by the government of the private coins' stated weights and fineness. Logically, one might argue, this would hold true for government enforcement of 100 percent reserves in banking, too. Perhaps so, but in any case, the benefits of free banking, with or without the 100 percent reserve law, would provide a remarkably sound monetary system.

I don’t see why the government must do any such thing – it is in the interest of the private coiners to ensure quality product, just like for every other commodity available on the market.  Once the government has a hand in it, the slippery slope has begun.

Free market inflation and deflation, caused by the fluctuation in the supply of money-metals, are inescapable in this imperfect world, but their burden is light.

I recall reading a quote from Mises, and I will paraphrase (because I cannot find it): when asked “what is the cure for inflation?” He replied “death!”

There is no escape from inflation.  But at least in a free market for money and banking, one has choices; one can move to institutions with more prudent practices.  Given the variety of choices the market would likely make available, it strikes me that no one will even speak of general inflation anymore – the choice of bank and currency will be just one more of the already many choices a businessman must make, like choosing a grade of steel or resin as raw material. 

The better businessmen, as demonstrated by making better choices about the future (including choices regarding money, credit and currency), will survive and thrive.  As it should be.

Imagine that – money and credit left to the free market, just like every other good and service.

The free market; it would be nice if more free-market proponents supported it.