Legal Tender, the Fed, and Fractional Reserve Banking

I am no economist, and I never pretend to be, but my simple understanding of the economy and my firm beliefs in individual sovereignty are enough fuel for me to blow up whenever I hear someone defend legal tender, or the Federal Reserve, or fractional reserve banking. These three institutions necessarily are aggressions against the individual. They cannot exist without someone being forced or defrauded into accepting something that they would not otherwise accept. You don't need an intricate understanding of stocks, hedge funds, sub-prime mortgages, liquidity, credit expansion, etc. to be able to understand that the main institutions in the U.S. economy are fundamentally immoral. All you need to know is how the main players in our economy depend on the initiation of force or the misrepresentation of fact, and that's what I'll try to show in this post.

Fractional Reserve Banking

Present practices in bank lending are necessarily fraudulent in that they give multiple people exclusive control over the same things. Let's say that you have a thousand dollars in a savings account (yes, that's not much, but that's all that some students have left when they graduate with loads of debt and no job). The bank takes nine hundred of those dollars (the reserve ratio is only 10%) and lends them out to other people, to be spent at those debtors' will. So when your $1,000 are supposedly in the bank, $900 of it is in other people's accounts, or, when they withdraw some of it, in their pockets. Nine hundred of your dollars are BOTH yours and other peoples', and they are BOTH in your account and in theirs.

There's nothing wrong with accumulating wealth by lending through a bank. It would be perfectly legitimate for a bank to accept and loan out some of your money on the express condition that you not make a big withdrawal until such-n-such date, by which time all or most of the debt would have been repayed into your account with interest. Under such a scheme, the ownership of the money is clear. It belongs to you, you're allowing someone else use it for a period of time, during which you cannot use it, after which it will be given back to you. Someone is allowed to use something that belongs to someone else, but no two people are given exclusive control over the same thing. Conventional banking is different. What typically happens is you put some money in the bank, and any time you want you can take some of it out. They might charge you extra for taking too much out, but you're still free to take it out whenever you want, as if it actually is sitting right there in your account waiting for your warm touch. And so whenever you want, you do go to the ATM and pull out as much of your money as you need to meet your expenses, and the other debtors go to the ATM and pull out as much of "their" money as they need to meet their expenses.

Let's suppose that you need alot of money right now, and so you take out 900 of your $1,000. You then have 900 of your $1,000 in your pocket. BUT SOMEONE ELSE ALSO HAS 900 OF YOUR $1,000. After you deposited your $1,000 into your savings account, your bank loaned $900 of it to another guy. So that other guy has $900 in a savings account. But he's not the only one who's keeping nine-tenths of someone else's money and calling it his. After that $900 was put into his account, $810 of it was loaned to another debtor. And after that $810 was loaned to that other debtor, $729 of it was loaned to somebody else, etc. So WHO HAS YOUR MONEY? And who does it belong to? You supposedly have it right there in your pocket, but loads of other people also have loads of your money in their accounts and in their pockets too!

No two people can have exclusive ownership over the same thing. The car that your parents own and let you drive is not yours to sell. Maybe you can have joint ownership of the car with your parents. But the car is not BOTH yours to sell AND your dad's to sell. And you can't drive it to Stanford at the same time that your dad's driving it to Berkeley. Fractional reserve banking is the practice of making money BOTH yours AND somebody else's. Suppose you were to rent a car from a car rental company, with the understanding that the car is yours to use until such and such date, and then you were to find out that the car is ALSO rented by another man with the understanding that it is ALSO HIS to use until the very same date. Wouldn't you feel ripped off? What word besides fraud can describe such a practice? Intentionally renting the same car to two different people at the same time is rightfully called fraud; but lending the same money to many different people is called bank lending.

In the good old days, when forcing people to answer for other people's malpractice wasn't smiled on, banks that borrowed and lent frivolously went under. Any time a bubble burst people would run to the banks, crowd around the tellers, and pull out all their money once they got to the window. Since only a small fraction of the money was in reserve, there wasn't enough of it to go around, and only those who got to the window first would get their money. You would be lucky if you were one of these. But if you weren't, you would find in the most sobering manner that what you thought was your money isn't there. And where'd it go? Into the pockets of those who got to the window before you did. Banks that kept too little money in reserve naturally went bankrupt. Those who call for more financial regulation correctly point out that bank runs wouldn't be a problem if banks weren't so careless about lending money. But the fundamental problem isn't that banks are borrowing and lending a lot of money; the problem is that banks are comitting fraud by giving the same money to different people and saying that it belongs to all of them at the same time. That's why -- SURPRISE! -- banks ran out of money when a lot of it was pulled out at once.

Back in those good old days, a bank could continue the fraud of fractional reserve banking only so long as the amount of money withdrawn remained below the reserve ratio (that is, so long as there wasn't a bank run). Today, however, a lovely mechanism has been set up to prevent a bank from going broke should there be any run, and so the fraud could be committed to a greater degree and for a much longer period of time, at the risk of individual depositors and the economy in general.

The Federal Reserve

When a bank starts running out of money and still needs to give more money out, it tries to get a loan from another bank. But banks can't lend any money to each other when they're all in the same predicament (and they typically are in the same predicament when they've all been running the same scam). Enter the Lender of Last Resort. WaMu doesn't have enough money to pay its depositors? No problem! The Great Lender will lend it as much money as it needs to meet its depositors' demands! Now WaMu has enough money to pay the depositors when they want their money back, and plenty left over to make more loans. And there's virtually no need to worry about the bank being unable to pay its debt to the Great Lender -- the loan was made at a very very VERY low interest rate, so the bank doesn't have to be prudish about the loans it makes to other debtors. With all this money, the bank is able to pay you your $1,000 should you for some reason demand it, the other guy his $900 should he for some reason want to borrow it, another guy his $810 should he for some reason want to borrow it, etc., all of this coming from the $1,000 you originally deposited. Since there's an unnaturally large amount of money rolling around, it's unnaturally easy to get a loan. Since it's unnaturally easy to get a loan, economic growth accelerates at an unnatural rate (and it's unnaturally easy to get loans for bad business ideas). This is the "stimulus" that Obama, Bernanke, et.al. sing about. Expand the monetary supply so that a lot of people get a head rush and buy a lot of stuff that they wouldn't buy if it weren't for a central bank propping up that fraudulent scheme called fractional reserve banking.

Central banking encourages runaway spending not just by private banks and private individuals, but also by government. When the government doesn't have enough money to fund its current programs, it borrows the needed amount from the Fed. The debt is passed on to future tax-payers, who are forced to pay these taxes that are levied onto them without any representation.

Besides propping up the fraud of fractional reserve banking and the unfair taxation of the young, central banking has another downside -- inflation. When the increase in the monetary supply is greater than the increase in goods, the value of the monetary unit (in our case the U.S. dollar) drops. You get too many dollars chasing too few loaves of bread. The $1,000 you put in your account four years ago is worth a lot less than it does now, even with accrued interest. You simply can't live off the money that you save, and any hope you had of climbing the socio-economic ladder is dimmer than it was before. Older people are unable to pay for their medicine, and poorer people can only pray that their wages rise fast enough to catch up with the rising cost of living.

Do note that there's nothing immoral about inflation per se. An alternative currency backed solely by silver (which would be a wonderful thing) would naturally devalue when a lot of silver is discovered at once. The supply of silver dollars would increase faster than would the supply of other goods, and so there would still be too many dollars chasing too few loaves of bread. The difference between this inflation and the inflation caused by the Fed, though, is that no one is forced to use the silver dollars, while everyone in the U.S. is forced to use the U.S. dollar. The people are forced to use a currency which the central planners can inflate whenever and however much they want.

Legal Tender

Competition and freedom of exchange are still popular catch-phrases in our semi-free market. But we all know that certain industries are not open to competition and free exchange. Banking is one of these industries. If we were allowed complete economic freedom, we would be free to demand repayment of our loans in the currencies that we want. But we aren't allowed such freedom. We are forced, by the state (which is a monopoly of violence), to accept payment of loans in Federal Reserve Notes. Government has effectively put a gun to lenders' and savers' heads and said "accept repayment in our currency, OR ELSE." Since we aren't allowed to demand repayment in any currency besides the U.S. dollar, we are bound to save and lend in the U.S. dollar. And since the U.S. dollar is the only currency available to us, there is no incentive for those in charge of maintaining it to regard its value. They can print as much of it as they want, without the fear that we would change all our money in the bank to a different currency.

Since the U.S. dollar is legal tender, we aren't allowed to print our own currencies to compete with it. And since there isn't any competition, we are subjected to a monetary unit whose value can drop as low as the Fed wants it to. This would not happen in a free market of currencies. No bank that constantly debases its currency would be able to last if it had to compete with banks that had more stable currencies.

Legal tender is the root of all economic woe. Without it there would be no cheap credit that results from the deliberate expansion of the money supply, and since bad ventures would be allowed to flop, there would be much less malinvestment. Without it there would be no Federal Reserve, since money can't be dumped into the market without depositors being forced to accept their savings in Federal Reserve notes. Without it the beast of fractional reserve banking would be tamed. Banks that reserve only a fraction of their deposits would have to compete with other banks that back all their demand deposits with 100% reserves, and accrue interest on savings through time deposits and not demand deposits.