The reason that private corporations such as banks have to bailed out with public money is the story of a giant fraud that came to be accepted as legal without any good reason.
We don't question it any more, even in the face of catastrophic systemic failures of the banking system and the moral hazard that is so disgusting to economic liberals.
Modern banking did not originate from lenders, who were people that lent out their money and received interests in return. Rather, it began with goldsmiths. They started offering people a service to keep their gold safe from burglars. You entrusted them with your gold, and got a warehouse receipt. Receipts from reputable goldsmiths were exchanged instead of the gold itself and became a medium of exchange. It is much easier to protect, store and transport receipts than the gold itself. That is, the receipts became money.
But then the goldsmiths could not resist the temptation. They secretly started lending the gold in their vaults, as if it were theirs and getting a good interest on it, without letting their depositors know. Even better, the goldsmiths did not even have to physically remove the gold from their vaults. The simply wrote fake receipts and gave them to the borrowers. The need for secrecy for the goldsmith is obvious. If his depositors got wind of what was going on, they might come en masse with their receipts and demand their gold back, and he didn't have it - at least not all of it. Normally, though, if they kept enough money in their vaults for the occasional customers who claimed their gold, nobody would know. It is difficult to know for how long this situation persisted.
It is clear that eventually the depositors became aware of this practice and were complicit in it. That is why depositors did not pay the goldsmith for their safekeeping services, but rather the goldsmith payed them some interest if they allowed him to keep their gold. This is proof that depositors knew that the goldsmith was lending out their gold. But the goldsmith could do this on condition that when the depositors came back with their receipts, the goldsmith would instantly give them their gold. This is the start of so-called fractional reserve banking, practically the only type of banking in existence today.
If you see a contradiction in these terms (promising to return something that may not be there), it is because there is one. The only reason both the depositor and the goldsmith-become-banker could agree on these terms rests on the law of averages. Not all depositors would ever need their gold at the same time. In fact they hardly ever needed the physical gold at all, because they could use their receipts as if it were the gold itself. Nevertheless, this situation was inherently fragile. A wave of panic could bring the whole scheme down.
The legal question of whose money it is when you give it to your banker was not clear for a long time.
Then, as late as 1848 in England, a legal case was heard, Foley v. Hills and Others. The sentence established that the customers of the banker, Foley, had not given him the gold for safekeeping, but as a loan. They were lending the money to Foley, so that their money was now the property of the bank. In this infamous ruling, Lord Cottenham wrote:
"The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal [depositor] if he puts it into jeopardy, if he engages in a hazardous speculation..."
This was an astonishing decision. If the banker could not repay their depositors, then he was not a criminal, he was merely insolvent.At any rate, the ruling of Lord Cottenham settled the matter. Bankers were finally given charte blanche to proceed with their business and fractional reserve banking started in earnest.
The waves of panic indeed happened, and happened often. They were called bank runs, and caused the demise of many early banks.
The inherent fragility of this system continues to this day, because that is how modern banks operate all over the world. A few things have changed since the age of goldsmiths, but the principle of fractional reserve banking is still the same.
Now gold has disappeared from the scene. Bank notes are no longer issued by banks. The bank notes in circulation are just paper money, and they cannot redeemed. The Central Bank has the privilege of issuing these notes. Bank notes (either in physical form or as electronic deposits that banks have with the Central Bank) now play the role that gold used to play.
Banks still play the same game by lending out the money from their depositors and retaining only a fraction of their depositors money in case they claim it back. It is the same concept, only played with at a higher level of abstraction. The fraction they keep (their mandatory cash reserves) has been diminishing over the years. Paradoxically, for most of the second half of the 20th centuries, bank runs have been rare. One reason was the appearance of Central Banks, who act as a lender of last resort for their banks in the country.
When the bank cannot repay its debts, it can request an emergency loan from the Central Bank. The Central Bank can never run out of money. That is because they have the legal power to create money out of thin air. This unlimited supply of money has a consequence. When more money is created and pumped into the economy, inflation ensues. Inflation makes us all poorer, because our savings and wages have now less purchasing power.
Today, you no longer have the option to go to a bank and tell them that you just want them to keep your money safe. You go to a bank and lend them your money for them to use it as they see fit. And the bankers do indeed engage in hazardous speculation with it. And because mostly everybody needs a bank account to function in today's world, we all become forced lenders to private companies over which we have no control.
Because all the savings of ordinary citizens are in the power of banks, a collapse of a bank affects many individuals. That is why banks need to be rescued by the Central Bank
These days, bank deposits are guaranteed by Central Banks, up to an amount. So, it's okay, isn't it?
Well, no. Let's see why.
The reason Central Banks can guarantee deposits is not because they have a lot of money. It is because they have the power to create as much money as they need out of thin air. A Central Bank, it is said, has control of the printing press. The Central Bank's newly created money generates inflation and makes all of us poorer. So, it is all of us who pay for it.
The second problem with publicly insured deposits is that creates an incentive for banks to behave recklessly and put our money at risk.The less money from their depositors that they keep without lending it out, the more profit bankers make. In the old days, depositors were aware of the risk of their bank going under, so they exercised certain caution. Today, the safety of your deposits in a given bank is taken for granted, and all you care about is the return you get and other minor services. In effect, all banks are more or less the same with regard to the risk of losing your deposits - virtually nil. And all is well, until all of a sudden disaster strikes.
This system is partly responsible for the booms and busts of the business cycle. And of course of the special protection status of banks. That is why they need to be rescued, because if they were simply left to default like any other business, millions of depositors would lose their savings.
Today, you no longer have the option to go to a bank and tell them that you just want them to keep your money safe. You go to a bank and you lend them your money for them to use it as they see fit.
Surely, they pay you an interest for your loan, but the thing here is that you have no choice. And you may think that all is well, because having the money under your mattress is silly, as it will devalue because of inflation. But inflation is mainly created by this inherently fraudulent banking system. So it first creates the problem and then offers you a partial relief in the form of interest payments.
To do this, a lot of new money would have to be created. This because banks do not have enough money to repay all the money they owe to their checking accounts depositors.
Creating huge amounts of money is something that the Central Bank can do by just typing it into a computer. This money would be directly given to the banks in the form of reserves in the accounts the keep with the central banks. Each bank would receive enough money so that they totality of the bank's balances of their checking accounts would be equal to the sum of their current amounts in cash in their vaults plus the bank's own capital plus the reserves they hold with the central bank.
From then on, banks would only be allowed to lend out the money from investors, not from the general public.
But hang on! Wouldn't this massive creation of new money generate a lot of inflation? Actually no, it would no effect on inflation at all. This is because the effect on money supply would be nil. In technical terms, all that would happen is that now M0 would equal M1. What does this mean? Well, the money you have in your account with the bank is not there at all. It has been lent to some other person who has the same money in their current accounts. So the same amount of money is counted not twice, but by a factor of 5 or 10. This is known as the money multiplier effect and is the direct consequence of the fractional reserve system.
This is why banks are said to create money. In a sense, this is absolutely true. But the phrase "create money" may be misleading. After all, if banks would be able to create money, why should they need help when in trouble? Actually, banks cannot create hard money (M0). This can only be created by the Central Bank. But they do create enormous amounts of soft money (M1) every time they make a loan. M1 is real money out there in the economy. It's what you have in your checking account.
Under the full reserve system, banks would lose their privilege to create money, so that M0 would be exactly equal to M1.
The benefits would be huge: all the instability of varying interest rates by the central banks to control inflation would be quite unnecessary, bank runs would be an impossibility, the booms and busts of the economic cycle would mostly disappear.
Banks would continue to do business as usual, but they would only risk the money of people that know full well what they're getting themselves into, and not the money of the hapless wage-earner that only need a service to keep their money safe and access to it on demand. So no more bank rescues: insolvent banks would be no different from any other insolvent business. If they go belly up, so be it.
One consequence would be that banks would have to charge checking account customers for the service of keeping their money, rather than paying them interest. If you want to get interest, you would have to explicitly make a loan to the bank, losing your right to claim it back on demand, and explicitly authorising the bank to lend it out and sharing the profits of the loans. Or you would make a time deposit, in which you know you cannot claim your money back after the specified time has expired. Both are considered investments rather than bailments.
I know you don't believe me. Surely, this can't be so easy. Any respectable economist will laugh his head off after reading this. But as I said in an earlier post, I am not alone in proposing this. This is not a crazy idea that just occurred to me. Full reserve banking is supported by many economists, like the Austrian School. Mainstream economists don't even want to discuss it. In the rare occasions that they do, their arguments are surprisingly weak. Full reserve banking is considered heterodox economics these days.
I know this is a message in a bottle. The lack of general awareness of this is astonishing. And I don't even think it is a conspiracy. Some day things will change, but it will require a lot of public demand and political will. At present I don't see how this can happen.
We don't question it any more, even in the face of catastrophic systemic failures of the banking system and the moral hazard that is so disgusting to economic liberals.
Modern banking did not originate from lenders, who were people that lent out their money and received interests in return. Rather, it began with goldsmiths. They started offering people a service to keep their gold safe from burglars. You entrusted them with your gold, and got a warehouse receipt. Receipts from reputable goldsmiths were exchanged instead of the gold itself and became a medium of exchange. It is much easier to protect, store and transport receipts than the gold itself. That is, the receipts became money.
But then the goldsmiths could not resist the temptation. They secretly started lending the gold in their vaults, as if it were theirs and getting a good interest on it, without letting their depositors know. Even better, the goldsmiths did not even have to physically remove the gold from their vaults. The simply wrote fake receipts and gave them to the borrowers. The need for secrecy for the goldsmith is obvious. If his depositors got wind of what was going on, they might come en masse with their receipts and demand their gold back, and he didn't have it - at least not all of it. Normally, though, if they kept enough money in their vaults for the occasional customers who claimed their gold, nobody would know. It is difficult to know for how long this situation persisted.
It is clear that eventually the depositors became aware of this practice and were complicit in it. That is why depositors did not pay the goldsmith for their safekeeping services, but rather the goldsmith payed them some interest if they allowed him to keep their gold. This is proof that depositors knew that the goldsmith was lending out their gold. But the goldsmith could do this on condition that when the depositors came back with their receipts, the goldsmith would instantly give them their gold. This is the start of so-called fractional reserve banking, practically the only type of banking in existence today.
If you see a contradiction in these terms (promising to return something that may not be there), it is because there is one. The only reason both the depositor and the goldsmith-become-banker could agree on these terms rests on the law of averages. Not all depositors would ever need their gold at the same time. In fact they hardly ever needed the physical gold at all, because they could use their receipts as if it were the gold itself. Nevertheless, this situation was inherently fragile. A wave of panic could bring the whole scheme down.
The legal question of whose money it is when you give it to your banker was not clear for a long time.
Then, as late as 1848 in England, a legal case was heard, Foley v. Hills and Others. The sentence established that the customers of the banker, Foley, had not given him the gold for safekeeping, but as a loan. They were lending the money to Foley, so that their money was now the property of the bank. In this infamous ruling, Lord Cottenham wrote:
"The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal [depositor] if he puts it into jeopardy, if he engages in a hazardous speculation..."
This was an astonishing decision. If the banker could not repay their depositors, then he was not a criminal, he was merely insolvent.At any rate, the ruling of Lord Cottenham settled the matter. Bankers were finally given charte blanche to proceed with their business and fractional reserve banking started in earnest.
The waves of panic indeed happened, and happened often. They were called bank runs, and caused the demise of many early banks.
The inherent fragility of this system continues to this day, because that is how modern banks operate all over the world. A few things have changed since the age of goldsmiths, but the principle of fractional reserve banking is still the same.
Now gold has disappeared from the scene. Bank notes are no longer issued by banks. The bank notes in circulation are just paper money, and they cannot redeemed. The Central Bank has the privilege of issuing these notes. Bank notes (either in physical form or as electronic deposits that banks have with the Central Bank) now play the role that gold used to play.
Banks still play the same game by lending out the money from their depositors and retaining only a fraction of their depositors money in case they claim it back. It is the same concept, only played with at a higher level of abstraction. The fraction they keep (their mandatory cash reserves) has been diminishing over the years. Paradoxically, for most of the second half of the 20th centuries, bank runs have been rare. One reason was the appearance of Central Banks, who act as a lender of last resort for their banks in the country.
When the bank cannot repay its debts, it can request an emergency loan from the Central Bank. The Central Bank can never run out of money. That is because they have the legal power to create money out of thin air. This unlimited supply of money has a consequence. When more money is created and pumped into the economy, inflation ensues. Inflation makes us all poorer, because our savings and wages have now less purchasing power.
Today, you no longer have the option to go to a bank and tell them that you just want them to keep your money safe. You go to a bank and lend them your money for them to use it as they see fit. And the bankers do indeed engage in hazardous speculation with it. And because mostly everybody needs a bank account to function in today's world, we all become forced lenders to private companies over which we have no control.
Because all the savings of ordinary citizens are in the power of banks, a collapse of a bank affects many individuals. That is why banks need to be rescued by the Central Bank
These days, bank deposits are guaranteed by Central Banks, up to an amount. So, it's okay, isn't it?
Well, no. Let's see why.
The reason Central Banks can guarantee deposits is not because they have a lot of money. It is because they have the power to create as much money as they need out of thin air. A Central Bank, it is said, has control of the printing press. The Central Bank's newly created money generates inflation and makes all of us poorer. So, it is all of us who pay for it.
The second problem with publicly insured deposits is that creates an incentive for banks to behave recklessly and put our money at risk.The less money from their depositors that they keep without lending it out, the more profit bankers make. In the old days, depositors were aware of the risk of their bank going under, so they exercised certain caution. Today, the safety of your deposits in a given bank is taken for granted, and all you care about is the return you get and other minor services. In effect, all banks are more or less the same with regard to the risk of losing your deposits - virtually nil. And all is well, until all of a sudden disaster strikes.
This system is partly responsible for the booms and busts of the business cycle. And of course of the special protection status of banks. That is why they need to be rescued, because if they were simply left to default like any other business, millions of depositors would lose their savings.
Today, you no longer have the option to go to a bank and tell them that you just want them to keep your money safe. You go to a bank and you lend them your money for them to use it as they see fit.
Surely, they pay you an interest for your loan, but the thing here is that you have no choice. And you may think that all is well, because having the money under your mattress is silly, as it will devalue because of inflation. But inflation is mainly created by this inherently fraudulent banking system. So it first creates the problem and then offers you a partial relief in the form of interest payments.
Is it now impossible to end the fractional reserve system?
Not at all. In fact, changing this state of affairs is actually much easier than it sounds. The alternative is called full reserve system. Under this system, bankers are not allowed to lend money in their checking accounts. They are limited to lending money in the savings accounts and time deposits. That is, money that has been trusted to them by investors, who are willing to take a risk and be rewarded accordingly.To do this, a lot of new money would have to be created. This because banks do not have enough money to repay all the money they owe to their checking accounts depositors.
Creating huge amounts of money is something that the Central Bank can do by just typing it into a computer. This money would be directly given to the banks in the form of reserves in the accounts the keep with the central banks. Each bank would receive enough money so that they totality of the bank's balances of their checking accounts would be equal to the sum of their current amounts in cash in their vaults plus the bank's own capital plus the reserves they hold with the central bank.
From then on, banks would only be allowed to lend out the money from investors, not from the general public.
But hang on! Wouldn't this massive creation of new money generate a lot of inflation? Actually no, it would no effect on inflation at all. This is because the effect on money supply would be nil. In technical terms, all that would happen is that now M0 would equal M1. What does this mean? Well, the money you have in your account with the bank is not there at all. It has been lent to some other person who has the same money in their current accounts. So the same amount of money is counted not twice, but by a factor of 5 or 10. This is known as the money multiplier effect and is the direct consequence of the fractional reserve system.
This is why banks are said to create money. In a sense, this is absolutely true. But the phrase "create money" may be misleading. After all, if banks would be able to create money, why should they need help when in trouble? Actually, banks cannot create hard money (M0). This can only be created by the Central Bank. But they do create enormous amounts of soft money (M1) every time they make a loan. M1 is real money out there in the economy. It's what you have in your checking account.
Under the full reserve system, banks would lose their privilege to create money, so that M0 would be exactly equal to M1.
The benefits would be huge: all the instability of varying interest rates by the central banks to control inflation would be quite unnecessary, bank runs would be an impossibility, the booms and busts of the economic cycle would mostly disappear.
Banks would continue to do business as usual, but they would only risk the money of people that know full well what they're getting themselves into, and not the money of the hapless wage-earner that only need a service to keep their money safe and access to it on demand. So no more bank rescues: insolvent banks would be no different from any other insolvent business. If they go belly up, so be it.
One consequence would be that banks would have to charge checking account customers for the service of keeping their money, rather than paying them interest. If you want to get interest, you would have to explicitly make a loan to the bank, losing your right to claim it back on demand, and explicitly authorising the bank to lend it out and sharing the profits of the loans. Or you would make a time deposit, in which you know you cannot claim your money back after the specified time has expired. Both are considered investments rather than bailments.
I know you don't believe me. Surely, this can't be so easy. Any respectable economist will laugh his head off after reading this. But as I said in an earlier post, I am not alone in proposing this. This is not a crazy idea that just occurred to me. Full reserve banking is supported by many economists, like the Austrian School. Mainstream economists don't even want to discuss it. In the rare occasions that they do, their arguments are surprisingly weak. Full reserve banking is considered heterodox economics these days.
I know this is a message in a bottle. The lack of general awareness of this is astonishing. And I don't even think it is a conspiracy. Some day things will change, but it will require a lot of public demand and political will. At present I don't see how this can happen.
