October 5th, 2008

The Inherent Immorality of our Banking System


photo credit: Daníel Starrason

The turbulent events of recent weeks have demonstrated, in small measure, the instability of our global banking system. While minor differences do indeed exist between commercial banking institutions throughout the world, nearly every single one shares a common foundation: its fractional-reserve system.

Lest I bore those who consider this unimportant, let me begin by asserting (for the benefit of those who otherwise might not care) that the banks we patronize are counterfeiters, using our money in an immoral fashion to “cook the books”, as it were, and make money at our expense.

You see, the very essence of fractional-reserve banking implies that a financial institution will carry less reserves in its possession than is necessary to fulfill its obligations to its customers. This is made possible by the fact that few individuals withdraw their money (or in our case, Federal Reserve Notes) at any given time, and thus the banks are tempted to use our money while it sits in their vault. Thus, our money is loaned out to others, for which a profit is made by the bank.

Banks founded on this principle of counterfeiting are constantly on guard to prevent their biggest threat: a bank run. This event is triggered when a large number of customers lose confidence in their bank, and demand their rightful deposits be returned to them. Of such a threat, Murray Rothbard wrote:

The first and most devastating route, because it could happen at any time, is if the bank’s customers, those who hold the warehouse receipts or receive it in payment, lose confidence in the chances of the bank’s repayment of the receipts and decide, en masse, to cash them in. This loss of confidence, if it spreads from a few to a large number of bank depositors, is devastating because it is always fatal. It is fatal because, by the very nature of fractional-reserve banking, the bank cannot honor all of its contracts. Hence the overwhelming nature of the dread process known as the “bank run,” a process by which a large number of bank customers get the wind up, sniff trouble, and demand their money. The “bank run,” which shivers the timbers of every banker, is essentially a “populist” uprising by which the duped public, the depositors, demand the right to their own money. This process can and will break any bank subject to its power. Thus, suppose that an effective and convincing orator should go on television tomorrow, and urge the American public: “People of America, the banking system of this country is insolvent. ‘Your money’ is not in the bank vaults. They have less than 10 percent of your money on hand. People of America, get your money out of the banks now before it is too late!” If the people should now heed this advice en masse, the American banking system would be destroyed tomorrow. (Murray Rothbard, The Case Against the Fed, page 46)

Supporting his statement that fractional-reserve banks cannot honor all of their contracts, Rothbard earlier notes:

In other words, honoring the contracts, and maintaining the entire system of fractional-reserve banking, requires a structure of smoke-and-mirrors, of duping the depositors into thinking that “their” money is safe, and would be honored should they wish to redeem their claims. The entire system of fractional-reserve banking, therefore, is built on deceit, a deceit connived at by the legal system. (Ibid, page 43)

Fractional-reserve banking gets it name because literally, it is a system wherein only a “fraction” of the reserves are available at any given time. This is comparable to a company selling 200 motorcycles but only having 20 in their warehouse. It is blatantly unethical to promise things you do not have, yet this is what we allow our banks to do.

Our global banking system is highly connected, and it is therefore quite likely that a bank failure in one region will affect its operations or sister companies in another region. But regardless of the actual relationship between banks in the global economy, a cascade of bank runs would sweep over the world like an unleashed contagion of epic proportions. Once a point is reached where depositors lose confidence in banking in general (and not just their specific bank), a worldwide run on fractional-reserve banking would take place. In such a scenario, having access to your money would depend on how much of an early bird you are; first come, first served (until the bank becomes insolvent and closes its doors, that is).

Rightly, then, did Henry Ford once say that “It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” A loss of confidence in and permissiveness of the immorality and deceit of our banking system would bring it to its knees within hours.

Inasmuch as the government props up the immoral banking system (as is the case in America and a majority of other countries around the world), “liquidity” is provided through the printing press, where the central bank (an agent of the government) simply prints more money and loans it to the bank to help it meet its demands and keep up the ruse. Thus, in a scenario where massive bank runs took place, either the entire system would collapse, or the central bank would kick its printing press into overdrive to meet all the demands (as is happening right now in Greece) and thus trigger hyperinflation, which would pound the monetary unit (in our case, the dollar) into oblivion.

Either way, it’s not a pretty picture. When the foundation of the world’s (massive and numerous) banking institutions is a rotten, hollow frame ready to collapse, it quickens the rate at which the patrons catch wind of the heist and take swift action.

13 Responses to “The Inherent Immorality of our Banking System”

  1. Kelly W.
    October 5, 2008 at 8:51 am #

    Connor’s ideas and quotes raise the scenario that a bank run can happen tomorrow, if enough people become aware their money is not liquid, and start demanding it.

    Perhaps a bank run could indeed happen tomorrow.

    I have wondered about my own personal situation. About 4 days ago, I received in the US Mail a long letter from my 401k administrators, pleading with me to NOT withdraw my funds. They claimed they were safe! But, during the past 2 weeks, I have seen more than one third of my money in my 401k simply disappear. Talk about my money becoming slippery.

    The Book of Revelation chapter 18 tells us that a total collapse of commerce and merchandizing will happen preceeding the Second Coming.

    So I am left to speculate whether our current global economic collapse really is noteworthy in relation to Christ’s timetable, or if it is simply another cycle we will overcome as we did during the Great Depression of the 30’s.

    My 401k plan and the company I work for seem to think we can weather this storm and there are brighter days ahead. Perhaps this is true. If Utahns have their dream come true, McCain will be elected and he, with his vast knowledge of economics and with his maverick style, will make it all better. But I think all the talk of better days ahead is nothing but propaganda to keep us in the dark, so that we don’t watch these bank runs happen tomorrow.

    But, even if the economic collapse predicted by the Book of Revelations happens tomorrow, or is just another cycle that repeats itself as it has numerous times in past history, it is prudent that we prepare for the portent of stormy weather.

    I keep up somewhat on European Affairs. They are also having economic turmoil. Their economic situation is tightly tied to our own. A bank run in the USA would not affect only citizens within our own boundaries. Like Connor writes, a bank run within the USA would also affect the instability of the European Banks within hours.

  2. October 5, 2008 at 10:51 am #

    Why would banks hold money they could’t lend out? It seems they would be heavy on the liability side with no assets producing income.

    Who would be willing to pay for the right to keep their money at the bank? If banks did not lend out checkable deposits, they would have no reason to hold them for customers. Lending from banks would come strictly from lending out the proceeds from CDs and long-term bonds, which are not attractive to the give-it-to-me-now modern investor. Uncle Sam has conveniently shown these people that the risk of investing in higher-yield assets are covered by the government.

    The world would be much less liquid, if savers could not connect to borrowers as easily as they do under this system. Less liquidity means less economic growth, which means less improvement of quality of living. It is hard to lend a gold bar to a business and earn interest on it.

  3. Connor
    October 5, 2008 at 11:17 am #

    Why would banks hold money they couldn’t lend out?

    For the same reason that storage companies assess a fee to allow you to use their space for your items. They remain your items to retrieve at any time you wish, and you pay a small fee for the security, temperature control, and maintenance provided by the company.

    Deposit banking institutions could simply charge a fee for keeping my money in their vaults; in fact, before the temptation to change to a fractional-reserve system took off, this was the name of the game.

    Less liquidity means less economic growth, which means less improvement of quality of living.

    I’m not sure I agree. Liquidity is irrelevant if it is inflationary, since while you’re making more money, you’re having to pay more for everything you want and need. The nature of the counterfeiting process is such that those who get the money first benefit, since they are able to buy things as the lower prices before their new money inflates everything; proper economic growth, however, cannot be had when we’re debasing our currency, creating an economy based on debt, and punishing our children for our actions by deferring the consequences until later years.

  4. October 5, 2008 at 12:03 pm #

    I believe that fractional reserve is dangerous. But I’m not so sure about the specifics or all your other points.

    It is difficult to determine what is the cause and what is the effect. But I believe that people not being willing to wait for “the good life” is causing the need to borrow. A reading of Les Miserables will show you where borrowing unwisely leads. But borrowing is really at the heart of all your arguments.

    Isn’t borrowing a two-sided proposition? Don’t we share a part of the responsibility in being willing to deposit money into a bank where we know we may not be able to withdraw all of it in times of trouble?

    Is it really immoral to promise something we don’t have? Contracts are based on the WILLingness and PLAN to deliver. The actual ABILITY is determined by the parties signing the contract.

    I’m a structural engineer. I contract to deliver a set of calculations. I don’t have them at the beginning of the project. But I have the knowhow to develop them and put them to paper. Contractors don’t have the wood, concrete, steel, and other elements to build a house. But they know where they can get them.

    Every contract implies some degree of risk even when all parties are well-meaning honest people. I can promise to get the calculations done on a certain schedule. But the client decides to make what he feels is a minor change to the design. What he doesn’t know is that such a minor change in the finished product will mean almost doubling my calculation time.

    Conditions change. A bank can lend out money or maintain savings, but if there is a run on the bank . . .

    I can look at income tax as immoral or theft or unconstitutional. Or I can look at it as just another method of taxation. I have educated myself enough on tax law that I can take enough deductions to pay almost no tax. But there are some deductions I do not take because I believe it is actually my fair share to pay “some” tax. Because I have educated myself, determining that amount is back in my control.

    If I educate myself on the banking institution, I can use the system to my advantage. I only keep enough in my accounts to allow for liquidity that I need. The rest I keep in investments. Not that they’re doing too well right now. But that was my CHOICE based on the education I have in the system.

    If people have not educated themselves on the system, the natural results will soon appear. Here are a few unfortunately true cliche’s.

    A fool and his money are soon parted.
    You can’t make something fool-proof. They’re too creative.
    Eternal vigilance is the price of liberty.

    I still think that borrowing is not desireable. But depending on your goals, values, and priorites, it is sometimes a necessary evil. As long as you recognize this fact, it is often manageable. The problem is that many think debt = wealth.

    Beep! Thank you for playing anyway.

    The scariest part of the possibility of a run on the bank is that creditor nations can demand their money from America at any time. Can you imagine if China alone demanded re-payment of all it’s money all at once? It would be really easy to cut a deal and have the US government that now owns a bunch of mortgages to try to cut a deal with the Chinese government.

    Boom, we’ve lost our country without a shot being fired. Talk about Sun Tzu’s ultimate goal! Well, he was Chinese after all.

  5. Connor
    October 5, 2008 at 12:17 pm #

    Don’t we share a part of the responsibility in being willing to deposit money into a bank where we know we may not be able to withdraw all of it in times of trouble?

    Where does this responsibility come from? Are you saying that it’s the duty of all people to participate in a fractional-reserve banking system, to the benefit of others who likewise participate, and most especially the bankers who make off with our money like bandits?

    Is it really immoral to promise something we don’t have? Contracts are based on the WILLingness and PLAN to deliver. The actual ABILITY is determined by the parties signing the contract.

    Ah, but if you neither have the item nor the ability to produce the item, then your promise is immoral. If I as a web designer promise my client that I will do so, then there is no problem: I am promising at some future time agreed upon (say, one month) to produce the website. I have the ability, as you say, to produce.

    However, banking is different: under a fractional-reserve system, a bank does not have the ability to produce enough money to satisfy all its deposits. Just as it would be wrong for me to tell twenty clients that I will have their websites done this week (an impossibility), so too is it improper for a bank to promise its depositors access to their money “on demand”. It simply cannot occur.

    Additionally, any contractual obligations I enter into must be faithfully executed by me on the terms and conditions specified. I cannot promise something that may or may not happen, unless that is explicitly provided for in the contract. So in my example, I might include a provision saying that the website will have 1,000 visitors within the first week, depending on the ability to draft a good press release and generate enough interest. Thus, I am promising to do something contingent upon other factors, and am letting my client know that.

    But in banking, that’s no the case. Your bank doesn’t tell you that the deposits will be payable on demand so long as they happen to have enough cash in the bank when you make your request. No, instead they use deceit (as Rothbard notes) to make you think that that is the case. This is why bank runs are the major predator of all fractional-reserve banks: they simply cannot produce what they promise.

    The scariest part of the possibility of a run on the bank is that creditor nations can demand their money from America at any time.

    This is something that I have discussed here. Suffice it to say that there are attendant evils to drowning one’s self in debt, not the least of which is the power of your creditor over you to call in the debt.

  6. October 5, 2008 at 7:23 pm #

    Are you saying that it’s the duty of all people to participate in a fractional-reserve banking system, to the benefit of others . . .

    I don’t know HOW you got that out of what I said. Let me clarify.

    In entering into any transaction, business arrangement, contract, obligation, it is the responsibility of each party to be honest and to do due diligence in all aspects of the transaction.

    No one seems to be willing to read all the boiler plate contracts on software, loans, warrantys, etc. But it is our responsibility to do so.

    All contracts not only have explicit terms, but they also have implicit terms. One implicit term that is usually considered valid is that the contract terms can be performed under normal circumstances. A run on the bank is not a normal circumstance. And in the absence of a run on the bank, they most likely CAN provide the money that people NORMALLY ask for.

    If I say that I can get a building design done in two weeks under normal circumstance that is responsible. But if during that two weeks, an earthquake hits and one of my buildings fell down. I must drop what I’m doing and go investigate. I no longer am able to deliver on my otherwise reasonable promise.

    Now if you are talking about dishonest/deceptive practices on the part of the lender, that is different. But a practice like fractional reserve is open and above board. If you don’t accept the onus to due dilligence, then let the consequences fall.

    None of this is saying that I believe fractional reserve is a good thing. Quite the contrary. The evidence opposing that position is all around us. All I’m saying is that there is enough blame to go around.

    Today’s society has two things that work against this idea.
    1) Everything is NOW. We must have it NOW.
    2) Everything has become so diverse, complicated, and technical that no one has the capacity to understand even the basics in all fields of endeavor.

    If we didn’t have such a quick fix society and learned to slow down a bit, then we could realize that maybe we don’t need it NOW. Maybe we can take a week to read through a contract and get advice from a friend who has been through several similar tansactions.

    If we went back to basics (Walden’s food, clothing, shelter, fuel) then maybe life wouldn’t be so complex. Maybe then we could at least be experts in those fields that we MUST, in order to live in society. Then we would also have one or two other fields of study that are uncommon where we make our trade.

    I remember when I was a kid, I thought that $10 was all the money in the world. Even adjusted for inflation that is probably about $50 today. As an engineer, I make a good deal more than that every day, but I still have trouble meeting my financial goals.

    When did life get so complex?

  7. Connor
    October 5, 2008 at 9:25 pm #

    I don’t know HOW you got that out of what I said.

    Don’t we share a part of the responsibility in being willing to deposit money into a bank where we know we may not be able to withdraw all of it in times of trouble?

    Apparently I misinterpreted what you were saying here. I initially thought that you were saying that we all share a responsibility to deposit money in these banks, but I now see that you were saying that because we have deposited money in these banks, we all share a responsibility.

    While I see your point, I would still argue that the contract made between depositor and banker is that we would have access to our money at any time, regardless of what they may or may not do with our money while it is in their trust.

    All contracts not only have explicit terms, but they also have implicit terms.

    While possibly true, this is highly subjective. How does one enumerate the implicit terms without explicitly stating each? The banker might argue the implicit term of his being unable to produce my money in the event of a bank run, but I might not have known this when signing. Indeed, I would bet that few know or understand the so-called implicit terms of a banking contract, if such terms can be considered valid.

    All I’m saying is that there is enough blame to go around.

    I certainly agree with you here. To the extent that we are consciously participating in a system of deceit and fraud, we are responsible for our own actions and their consequences.

    That’s just the problem though: I believe what Henry Ford was saying in that quote above is that the mass majority of people are participating in the banking system without knowing what it’s all about. They’ve been duped, and don’t realize the risks of placing their money with an institution that loans 90% of it out to others. Should the public ever awake to this situation, bye bye banking system.

    When did life get so complex?

    Who knows.. somewhere during the rise of the mass media conglomerate that convinces us daily that we don’t have enough, don’t earn enough, and aren’t pretty enough.

  8. Connor
    October 5, 2008 at 9:33 pm #

    It’s always interesting to see some semblance of thorough journalism in the mainstream media. The current headline article on CNN is a story about the upcoming rise of bank failures.

    Of course, no mention of the faulty foundation upon which all these banks are created, thus causing their instability. Ah well, you can’t expect too much from the MSM, I guess.

  9. Jesse Harris
    October 6, 2008 at 10:28 am #

    I like the idea of banks as little more than an intermediary between willing investors and those seeking loans. The fractional-reserve banking system unwillingly (and often unwittingly) makes all account holders into lenders. I’d be happy to pay a small fee monthly to avoid that risk.

  10. Reach Upward
    October 6, 2008 at 11:23 am #

    If we have a bunch of depositors that think that the banks hold their money in a vault like Scrooge McDuck’s money bin, we have a massive failure of financial education.

    What Connor is pointing out is a difference in liquidity expectations between banking deposits and promised receipts from investment of those deposits. Depositors expect their deposits to be highly liquid, while debtors have contracts specifying various levels of liquidity, almost none of which coincide with expected deposit liquidity.

    While it is true that banks are simply clearing houses for matching willing lenders with willing debtors, our system does not actually align the interests of lenders (depositors) with those of debtors, as would be the case if you were to make a private loan to someone. In the latter case, you know when to expect to get your ‘deposit’ back and why you can’t get all of it immediately.

    In the banks’ defense, however, it would be highly inefficient and difficult to manage such equalization of interests. Would you tell the depositors, for example, that their first $500 could be withdrawn immediately, but that the next $1000 would be available only with 30 days notice, etc? This would prove untenable to most depositors.

    Instead, the system tries to factor in risk by setting prices on different types of deposit instruments and different types of lending instruments. We tend not to withdraw all of our deposits because there is an opportunity cost to doing so. This helps mitigate the differences in liquidity expectations.

    This kind of system is acceptable to most people under normal conditions. However, when we introduce distortions that skew the pricing mechanism, the system sends improper signals to the participants in the market. When the Fed increases money supply to artificially create lower interest rates, for example, it sends a false signal about the cost of risk. This causes both depositors and debtors to make unwise decisions. Likewise when the federal government implicitly guarantees high risk home loans.

    Given that risk costs help depositors understand the opportunity costs of fleeing with their assets, I’m not sure that I agree that the banking system is inherently immoral. However, I do think that it is immoral for organizations with political power to attempt to manipulate the market and to skew risk pricing in such a way as to distort the messages about true costs of participation in the market. This is a serious form of deception. As with all such things, it comes from the father of deception.

  11. Matthew Piccolo
    October 6, 2008 at 11:47 am #

    Very, very interesting, Connor, thanks for bringing this up. I think I agree with you, I’m just not sure what implications this has in my personal life or on public policy. I’m going to keep pondering this.

  12. October 6, 2008 at 4:32 pm #

    Reach wrote:

    If we have a bunch of depositors that think that the banks hold their money in a vault like Scrooge McDuck’s money bin, we have a massive failure of financial education.

    That was pretty much my point.

  13. October 8, 2008 at 7:05 pm #

    The New York Times ran a front page article last Friday (Oct 3), describing how the SECC struck-out a rule requiring big investment bank to have enough assets and capital in reserve to offset their debts. This was back in 2004.

    The Reckoning, by Stephen Labarton

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