mathematically perfected economy™ (MPE™)    1  :   the singular integral solution of  1) inflation and deflation,  2) systemic manipulation of the cost or value of money or property, and  3) inherent, artificial multiplication of debt into terminal systemic failure;    2  :  every prospective debtor's right to issue legitimate promises to pay, free of extrinsic manipulation, adulteration, or exploitation of those promises, or the natural opportunity to make good on them;    3  :  our right to certify, to enforce, and to monetize industry and commerce by this one sustaining and truly economic process.

MORPHALLAXIS, January 14, 1979.

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 Post subject: The WHOPPER? The End Of Fractional Reserve Banking 101?
PostPosted: 13 Dec 2008, 1:01 pm 

Joined: 29 Jan 2008, 6:06 pm
Posts: 731
The End Of Fractional Reserve Banking 101?
: By Mr. Dan McLaughlin
Citizen Economists
Thursday, December 11, 2008

MS:Verbal misrepresentation of the words 'Federal Reserve System' exposed at last.

United States Treasury Notes were recently auctioned off for a yield of 0%. That means that very smart people running mutual funds, brokerage houses and other very large organizations were willing to invest lots of money and get nothing in return other than a return of their principal. We can probably rule out the motives of benevolence or Christmas spirit. There must be some other reason.

Those smart people are investment managers, who’s job it is to make money for the organizations through their investing. With the extreme volatility of the stock market, those people would rather sit on their cash than risk it on companies that will likely lose a significant portion of their share value. That is not irrational. However, considering the fact that there are brokerage commissions & fees involved in buying treasury notes, those managers are losing money for their organizations by investing at 0%. Why would they not just keep their cash at 0% & not pay the commissions? It doesn’t seem to make sense.

An organization that has $100 million of cash doesn’t have a room full of twenty dollar bills. They have a bank account with some accounting entries. With all of the turmoil in the banking industry, it is not unreasonable for these money managers to feel a little queasy about leaving that money in a bank. FDIC deposit insurance only covers the first $250,000. The other $99,750,000 is unsecured. If the bank goes belly up, they may or may not get all of their money back, and if they do, they have no idea how long they would have to wait.

With that in mind, it makes sense that large scale investors would rather own treasury notes that appear to have a high level of safety, even if they lose a little money on the transaction. It sounds perverse, doesn’t it? If you understand fractional reserve banking, you can understand why it actually is so perverse.(ms: 1: directed away from what is right or good. 2: obstinately persisting in an error or fault.)

When you put your money in a checking account at a bank, you do so with the understanding that it is still all your money. You have a right to withdraw it in any amount, at any time. This is opposed to investing in a Certificate of Deposit at the same bank. With the CD, you are actually loaning the bank your money. You do not have a right to withdraw it without penalty before the due date.

Banks have figured out that, on average, their depositors will not be withdrawing all of their money. Only a fairly small fraction will be taken on a given day. The bankers believe that all of that money should not be just sitting around collecting dust. They say “Someone should be making money from it, it might as well be me.” So they take a portion of that money & lend it out to other customers at interest to be paid over time. That’s pretty clever. In any other setting, that is called embezzlement, but in banking it is called generally accepted business practice.

At any point in time, every bank is technically bankrupt. Most of its liabilities, the deposits due to customers, are very short term. Most of its assets are very long term, such as loans. Mortgages that a bank lends out for 30 years are balanced by a checking deposit that is due today. In normal times it is not an issue because people are pretty predictable. In abnormal times, like now, people aren’t so predictable. They may have very valid reasons for pulling out their cash, such as believing that the bankers won’t have their money when they need it.

Unfortunately, that is a very valid concern. The underlying problem has nothing to do with market psychology or confidence or any such nonsense. The core issue is that, due to the bank’s systematic embezzlement, they do not have the cash available to meet their contractual obligations.

Using taxpayer money & the FDIC to secure a portion of deposits against banker fraud is not the solution to the problem. The solution is not to use billions, or even trillions, of taxpayer dollars to bail out banks who did stupid things with the money they embezzled. The 'solution'is to make the embezzlement illegal, to stop the fraud.

How Fractional Reserve Banking Engineers, CONstructs & Manage to Cause Bubbles?
The fractional reserve system allows banks to leverage reserves and rapidly expand money & credit. We witnessed that with the current housing bubble, the 1990’s stock bubble and every other bubble market before that. Rapid credit expansion is a two edged sword. Once the bubble bursts, there is a rapid deflation as irresponsible loans go bad and reserves diminish. They can’t hide the embezzlement in the downside of the bubble, because people want their deposits & banks don’t have them to give.

:? Hallelujah :grin:
There is a very simple way to prevent future bubbles and economic crises, or at least minimize them. If banks were forced to live by the laws that everyone else must live by, bank runs would be very unlikely, even in the worst economic conditions. People could always get their money because it would always be there. There is a fairly simple cause and effect relationship. A simple policy change of requiring 100% reserves for all banks would prevent a meltdown like we are suffering through today.

It would be a fairly easy policy to implement, if there was the political will to do so. Given that the banking industry is one of the most wealthy and powerful lobbyists in Washington, that is not likely until taxpayers and voters connect the dots, and get fed up with footing the bill and bearing all the pain.


Raymond, on December 11, 2008 at 7:49 am, said:


Money is not even taught in schools, much less banking practice. We’ll need a knowledgeable political body before we can expect them to exercise political will. How many legislators even know how our banking system work today?
2 Stephan Zimmermann, on December 11, 2008 at 2:45 pm, said:

It seems that you and some of the other writers on CE should be ideal candidates for sharia-style (Islamic) banking that is increasingly gaining accetance world-wide.

Think of it - NO INTEREST (no usury allowed - haram!), 100% reserve requirements, sharing risks and profits, careful adherence to religious rules … although no specific gold standard, much attention is paid to gold as an asset!

Why bother with unproven “principles” and theories when there is an ideal, centuries-old, proven system that works in practice, even though fractional reserve lending arose from gold in the first place and usury was forbidden by all three Western faiths!

It requires politicians, not economists, to change the “system!”

Given the tenor of American politics and “Joe the Six-pack plumber,” sharia banking is unlikely to gain much acceptance unless most of that “conservate” electorate shifted their deposits from conventional to Islamic banks. They can (and are, in most cases) FDIC insured, but do not have to be a member of the Fed! There is currently somewhat less than a billion in assets in U.S. sharia banks.

Oh, yes, if you want to open an account in one of the institutions, you have to sign an agreement to abide by sharia principles. Doubt any “principled” Americans would still still for that clause!
3 Dan McLaughlin, on December 11, 2008 at 7:49 pm, said:

Hi Stephan,

I would have expected a little more thoughtful and logical critique from you rather than an appeal to emotionalism.

Here are the underlying assumptions:
1. The central bank induces inflationary bubbles with below market interest rates.
2. Fractional reserve banking magnifies the swings in money and credit creation.
3. Depositors are defrauded and damaged when banks cannot keep their commitments.
4. Elimination of fractional reserves will eliminate the cause of much of the periodic damage.

Read through the explanation and poke holes in it. I am always willing to learn.

The first assumption implies that interest rates are inherently a market phenomenon. Manipulation of rates by a central bank amounts to price controls that distort normal market signals in the supply and demand for money and credit.

The whole point of the article is the very real and indisputable fact that fractional reserve banking leverages new reserves from the central bank. It whipsaws the market with hyper fluctuations in the money supply. In the deflationary portion of the cycle, it is also an indisputable fact that banks don’t have enough money to pay everyone, even though they have a contractual obligation to do so, because they lent it out to someone else over a longer period. That’s where we are right now.

If the reserve ratio is 10%, then $1 billion dollars in new reserves created by Fed open market operations becomes $10 billion after the creation of credit with the 90% that the banks are not required to hold. In many cases, the reserve ratio is less than that, exaggerating the inflationary effect even more.

That leverage acts to exacerbate the inflationary portion of the central bank induced cycle. For every dollar of new loans made under fractional reserve, there is a dollar of new money created out of thin air. The original depositor owns the money and the new borrower also owns the same money. Where there once was one dollar, there now are two.

Say you deposit $1 million in a bank with a 10% reserve requirement. The bank is only required to keep $100,000 of it. The bank can lend $900,000 to someone else. When that person deposits that money, the bank only has to keep $90,000 of it and can lend out $810,000 of it. The process continues until the bank, or more likely the network of banks, has $10,000,000 in deposits and $9,000,000 in new loans from the original $1,000,000 deposit. The fact is that $9,000,000 of money was created from nothing and can happen over a fairly short period of time. That is the inflationary part of the cycle.

Fractional reserves also leverages the deflationary portion of the cycle. If a $1 million loan goes bad, that reduces the bank’s reserves by $1 million. If reserves are reduced by $1 million, with that same 10% reserve ratio, the bank must, by law, reduce its loans by $9 million. It must sell its loans to another bank, but the purchase of the $9 million in loans reduces the available reserves of the purchasing bank by $9 million, which means it has that much less to support its portfolio. The money and credit is reduced in a rapid, leveraged way, the opposite of the rapid, leveraged inflation.

That is the unwinding portion of the cycle that we are living through now. That is the very source of the severe deflationary pressures the markets are reeling from.

The bubble market exists because prices were bid up far beyond the value that could be supported by normal wages, good and services in the overall market. Real estate prices (or stocks in the 1990’s) were bid up to extreme levels because of low interest rates and easy credit. Lots of people and businesses shouldn’t have gotten the loans they did. It is conventional wisdom that the Fed should pump trillions of dollars into the markets to reflate, in other words, to prop up the absurdly high prices. That would only mean that responsible people would not be able to afford them and the market will remain frozen.

The only long term solution is to allow the market to adjust, for prices to deflate, for bad loans to go to bad, for credit and money to decline, so people will be in a position to get on with their lives again. It would be painful but it would be over in a short time, as most depressions were before social engineers began trying to “help” the situation in the 1930’s. It would cause no more pain than what we are being put through now, it just wouldn’t be in slow motion.

Fractional reserve banking does not have the sterling history that you seem to attribute to it. John Law was a very brilliant man and showed us just how effective fractional reserve banking was back in the 1700’s. It was very effective in devaluing the currency at the expense of the people, making himself very wealthy and providing his government with a seemingly unlimited amount of money to spend. That is until it reached its limits. Then it crashed. It has been crashing, inflating and crashing again, ever since, wherever it has been instituted.

There are those who try to burnish the story to make John Law a hero and the fractional reserve system look like the best thing since sliced bread. Where you see significant economic turmoil, however, look also for central banks or fractional reserve banking and inflationary credit. They are probably there, lurking in the shadows.
4 Dan McLaughlin, on December 11, 2008 at 8:58 pm, said:

Raymond and Stepahn,

You are right, it will take a political solution. Not many people understand it. An even smaller portion of politicians know or would care even if they did know.

That is why it is important to let people know that banking fraud is the source of many of the economic problems. Politicians will change only when there is political pressure to change.

Everything that is being talked about today is hackihg at the leaves of the problem. The root is thriving and grinning.
5 Stephan Zimmermann, on December 11, 2008 at 10:28 pm, said:

Dan - You seem to think I was being “emotional?”

I was not. Nor was I being facetious.

Sharia banking is a very real and growing phenomenon, and exists under Islamic law from Saudi Arabia to Jakarta to th U.S.

Look it up, and see which countries suffered the least impact of the recent financial crisis.

Also look up (if you don’t know it already) the history of fractional reserve measures, from the classic “Goldsmith” principle to the present.

There is nothing wrong with the system per se and it has been proven time and again, stimulating growth and overall well-being, no matter whether in the U.S. or other nations. Booms and bust have occurred in most countries.

The problem lies with the individuals running the system, not the system (or theory) itself. Your argument seems to lie with the Fed specifically, and central banks, in general.

One of my gurus at the University of California was the late Don MacLaughlin, one of the greatest experts on gold then extant (1960’s, Chairman of Homestake Mining Co.)

He described gold, central banking, fractionnal reserve systems, etc. in both the classroom and private meetings in his home, in terms both applicable and realistic. He did not point to the “evils” of bankers or the Federal Reserve. He did point out the folly of some of the politicians … and some of the constituents!

If properly administered sans greed and corruption and the general ignorance of the voter, you and some of the other writers beg the question with the
somewhat naive assumption of the “free market” and the benign results resulting from merely eliminating some of the systems.

I certainly do not advocate a communist or even socialist political system.

However, under your definition, do you really believe a “free market” would truly benefit the whole of this large and diverse society?

The average voter (esp. in the U.S.) looks immediately to “the government” to fix all their ills, from segregation to medical ills to “free” education and more. The voters bask in prosperity and balk at any adversity.

Who should set the rules and what rules should be enacted? At what penalty aceptable to the individual?

While you see the central banks and fractional reserves and lack of a gold standard as one of the roots of the problem, I continue to believe that the core is people - not systems.

Why not attack the system of taxes, which certainly is one of the key elements at the core of the problem?

Why not attack the unions and their dislocating effect on the economy, from the AMA to the ABA and the UAW? Any economist can clearly and simply explain the effects of unions on an industry.

Why not attack the myopic immigration policy which affects the U.S. (and other countries) without attention to the economic fundamentals (supply and demand) instead of catering to paranoic, xenophobic voters and politicians?

It all comes back to the responsibility of “people” and their individual and collective choices. That is both the curse and blessing of living in a democracy.That is one of the lating fundamental difference in the Jefferson - Hamilton feuds in the beginning of this country.

Islamic sharia provides a means for provinding for societies social and banking needs and the system works. As an inevitable price for stability, Islam forces a strict, simple adherence to the system.

So does the American democracy.

Before microeconomics was even considered “worthy” of being taught, macroeconomics was essentially left to the “free” market an “intellectuals” in universities.

The result? Massive depression, recessions or boom times.

Immense social inequality, wealth and poverity as a means of conveying “the warnings of G-d” as a means of justifing ills,

If we are going to change humanity, it would be toward a global society. If not, check very closely how “free” the free market was in the U.S. even before the Fed was ever enacted.
6 Dirk, on December 11, 2008 at 10:58 pm, said:

It is true that $1M in Fed deposits can turn into $10M if the reserve requirement is 10%.

It is also true that there will then be $10M- plus interest- in promises of payments from production. The borrowers now have incentive- and capital- to produce. If they can’t produce, they give the money back, and, unless they go through bankruptcy, will eventually have to produce enough to pay back the balance.

Fractional reserve banking creates more opportunity and growth- what’s wrong with that? Oh yes, the ability of the Fed to artificially constrain economic activity based on their whims (a valid complaint I think we all share). But as the old saying goes, “better to have loved and lost than to never have loved at all…”.

It seems to me that Stephen’s post provides a reasonable explanation as to why our economy is so much larger and creative than Islamic economies (even with the benefit of our discovery of oil on their land for them).
7 Frederic, on December 12, 2008 at 10:19 am, said:

Are you all out of your mind? Sharia finance is only the first step before a total enforcement of sharia in the West.
You are either muslims in disguise for saying this or complete fools. I’m not interested in having banks that won’t pay me interest. It’s a return to the dark age of money under the mattress! Muslims are currently rejoicing over the subprime crisis which they see as the downfall of the US imperialism they despise so much. The fractional reserve system is wonderful and has certainly contributed to the exponential innovations of the latest century and beyond. Booms & busts are part of the business and you just need to learn to surf through the cycles. I want no sharia in the West.
8 Dan McLaughlin, on December 12, 2008 at 11:05 am, said:

Hi Stephan,

I understand you were not emotional, but it actually was an appeal to emotion to support your claim, because Islam and Sharia banking have nothing to do with the discussion. Because two things have something in common does not mean they are the same. That is like saying that a Mercedes Benz is like a bicycle because they both have wheels.

From the article: “The core issue is that, due to the bank’s systematic embezzlement, they do not have the cash available to meet their contractual obligations.” Can there be any question of the fact that banks cannot meet their contractual obligations because they did not keep the funds in trust for their clients? Surely you cannot be questioning that. That is an easily observable phenomenon. As far as calling it embezzlement, is there a better, more descriptive word? They used money that wasn’t theirs in order to make a profit.

Would you have a problem with the term “embezzlement” if a department store manager “borrowed” funds so he could make some money from it, even if he intended to pay it back? There is no difference, other than one is legally protected and the other is not.

The fact that goldsmiths and banks have been doing it for a long time doesn’t make it not embezzlement. It doesn’t make it any easier on depositors who cannot get their money back because banks embezzled it from them.

One thing from your comments may shed a little light on the issue, however. Those countries that rely on 100% reserve requirements have not suffered much from the depression, as fractional reserve systems have. That is an important insight. The implication that you make that they are all backward countries, however, is not at all due to lack of fractional reserve banking, but lack of secure property rights and economic freedom. Look at the various reports on economic freedom in the world.

I think banking is extremely important in a modern economy. It is essential. I also think that banking could easily be organized to provide all of the important services needed without the severe negative effects inherent with fractional reserves.

Banks could charge fees for the services they render to depositors. Banks could still be involved in the loan process, but more as a natural intermediary, a broker, aligning the needs of borrowers with those of the depositors with excess cash that they would like to make extra income from. The individual lender would get the interest from the loan, the bank would get fees for connecting borrower and lender. There are all sorts of scenarios that would work.

There is a tremendous pool of money which can be used for investing, but the limits of the pool would put natural restraints on bubbles by letting the market decide what interest rates should be. There would never be a crash because there wouldn’t first be a bubble. Inflationary bubbles only cause distortion and not long term growth. There couldn’t be a crisis of confidence because everyone would be assured that their money was there when they need it. If not, it was because of their own choice.

One of your key statements was “If properly administered, sans greed and corruption…” That is a mighty big if. From my perspective, I cannot understand why you call a faith in the markets naïve, when you put your faith in politicians and bankers operating their system without greed or corruption. That is totally ignoring the whole pathetic record of politicians and bankers. Why would people put faith in politicians and bureaucrats when they have proven themselves wrong, corrupt, immoral, unprincipled, etc, etc time after time. That strikes me as being pretty naïve.

The fact is that I have attacked the unions, the AMA and the ABA. Any organization that uses government coercion for their competitive advantage is immoral and is the antithesis of free markets. They are mercantilists. You can’t blame the markets for things not done by the markets.

I audited banks back in my CPA days. I have a pretty good understanding of how they operate. Even then, however, I didn’t understand all of the implications of money creation. I have since done a great deal of research, and I believe that I have a pretty good grasp of how things work.

Two of the many books that have informed my views:

“Money, Bank Credit and Economic Cycles” by Jesus Huerto de Soto, comprehensive theoretical treatment.

“The Mystery of Banking” by Murray Rothbard, more readable and interesting.

I have also read justifications of fractional reserves, and they just don’t seem to fit for me. The massive depressions, recessions and boom times seem to coincide with fractional reserve banking, central banks and inflationary credit creation.

Intellectualism in universities has largely become a repudiation of economic laws. Everyone tries to build a new economic model, but they can’t work because they fly in the face of principles that have been show to us long ago. Trying to force society into their models is the problem. It’s like trying to force people not to fall when they jump off a bridge. If you ignore natural law, you pay the consequences.
9 Dan McLaughlin, on December 12, 2008 at 11:07 am, said:

Hi Dirk,

“Better to have loved and lost than to never have loved at all’ translates into “Better to have taken out that big mortgage to buy the vastly overpriced house and subsequently gone bankrupt than to wait for a reasonable market and not go bankrupt.” It doesn’t make sense.

I will be a pretty hard sell to get me to believe that the housing market was not severely overpriced, and that the severe overpricing was not due directly to the artificially induced inflationary credit bubble. The way to get houses selling again is to let the prices deflate to a level that real, ordinary people can afford on their real, ordinary income.
10 Dan McLaughlin, on December 12, 2008 at 8:45 pm, said:

Hi Frederick,

The whole idea of comparing this to sharia law is merely an emotional attack over a pretty straight forward issue that lends itself well to debate.

Sharia law is a repudiation of individual rights and has absolutely no place in a free society. Fractional reserve banking is also a repudiation of the property rights of depositors. The banks refuse to honor their legal obligation because they have used the money for their own profit. In that sense, it is just as wrong as Sharia law, but their embezzlement is protected by our law. There would be no loss of confidence and no bank runs if banks always had depositor’s money on hand. It is unlikely that there would be much, if any, of a business cycle.

Booms and busts are not inherent to free markets, but are actually an inherent flaw of the fractional reserve system. It acts like an accordion rapidly expanding and contracting. Everybody doesn’t just surf through the cycles, many people get wiped out, and it is totally unnecessary. You might want to study the posts above regarding mathematics of credit and money creation before you are too critical.

I think you miss the whole point about interest. How satisfied are you with 1/2 % interest on your savings? Your savings accounts now get significantly less interest when the central bank artificially lowers interest rates to stimulate the boom. You would get more interest, and more people would be encouraged to save, if the interest rates were not artificially held down, but rather to be determined by the market. The greater savings would be available for investment in further non-inflationary growth. People lament the low savings rate in America, but can’t quite make the connection that artificially low interest rates will cause artificially low levels of savings.

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While 12,000 homes a day continue to go into foreclosure, mathematically perfected economy™ would re-finance a $100,000 home with a hundred-year lifespan at the overall rate of $1,000 per year or $83.33 per month. Without costing us anything, we would immediately become as much as 12 times as liquid on present revenue. Transitioning to MPE™ would apply all payments already made against existent debt toward principal. Many of us would be debt free. There would be no housing crisis, no credit crisis. Unlimited funding would immediately be available to sustain all the industry we are capable of.

There is no other solution. Regulation can only temper an inherently terminal process.

If you are not promoting mathematically perfected economy™, then you condemn us to monetary failure.

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