Mr. Ferrara’s ninth sketchy story is entitled “Fractional reserve banking” (29). He joins Austro-libertarians in regarding it as a Ponzi scheme, that is, a fraud perpetuated by bankers against their customers, but does not wish to emphasize that agreement. He prefers to create the arguably slanderous impression that Austrians indict only the government's legitimizing of capitalists who engage in it.
One of the oldest State-supported capitalist scams is the system of “fractional reserve banking,” a legalized Ponzi scheme that allows banks to treat depositors’ funds as the bank’s own reserve against which it can “lend” out a multiple of the reserve amount, thus literally creating wealth out of nothing. This practice, a foundation of the modern capitalist social order, attained formal legal approval by the State in the English common law via judicial decisions (obtained by bank lawyers) to the effect that a bank deposit is not a bailment—an entrustment of one’s property to another for safekeeping—but rather an “investment” in the bank. (29-30)
Not bad. Of course, a bank really does lend what it creates—and expects the borrower to repay it—so it’s less clear than usual what skepticism his scare quotes are intended to express. And by increasing the quantity of money at a much lower cost than that associated with mining and refining precious metals, the bank does not so much “literally create wealth” as create money substitutes—even if they are only entries on a computerized ledger—that facilitate the transfer of wealth away from their producers to the scamsters (often via the inevitable inflation).
In other words, the fraction implicit in “fractional reserve banking” (FRB) is the numerical relationship of a bank’s deposits to lendable assets. The bank has X, but lends more than X, e.g., X+Y. The fraction is therefore X/X+Y. The bank thereby effectively creates out of thin air more of its chief, if not only, productive asset.
And so the bank risks, not its own money, but rather that of its depositor-customers. The rarely questioned premise of the whole business is that the bank may lend to B the deposited funds of A, regardless of A’s understanding of his property’s exposure to risk. Depositors might, for example, think that they are simply placing valuables in a warehouse for safekeeping, for which bailment the bank reasonably charges them a fee.
What one archives, stores, or warehouses, however, one may retrieve upon demand. That is not so in the case of an investment and, regardless of what they may believe, depositors are indirect co-investors in the borrowers’ enterprises, sound and risky alike. At least that’s what the courts will tell them, should they be naïve enough these days to take their bank to court. For that’s what plaintiffs were told in 19th century courts.
(We both acknowledge and deplore the role played by material beneficiaries of that “judicial finding” in determining court personnel. We suggest, however, that the answer does not lie in the quixotic search for incorruptible personnel as in the demand for a free market in judicial services, which process would tend to weed out corrupt competitors.)
These days, every child knows that his “deposit” is not only warehouse inventory but also someone else’s investment capital. And few children care, for Big Daddy Government says their “deposits” are “insured”—according to the fairy tale in which insurable risk attaches to a conspiracy to commit systematic fraud. And the children believe.
Since some or all of the new loans may not “perform”—especially likely during the “bust” following a central bank-generated “boom”—there might not be enough money to satisfy the demand of the (self-)deluded “depositors,” whereupon the inherent bankruptcy of the banking operation is immediately exposed. It must collapse unless it is bailed out by the cartel of which the insolvent bank is a member.
Exacerbating the exposure of deposits to the risks of investment (sustained by the lullaby of FDIC “insurance”) is the fact that the relationship of deposits to lendable assets is not 1/1, but rather 1/2 or 1/6 or (as in Mr. Ferrara’s text) 1/9. If one makes money charging interest on a loan, one’s ability to profit from lending is limited by how much of other people’s money is on “deposit.”
If, however, one can create money analogously to the way God created light—Fiat lux, as Saint Jerome rendered the Hebrew of Genesis 1:3—then one can break free of that restriction. Fiat currency supplied by the central bank sustains the moral hazard, which virtually no bank resists. Inevitably, they all feel compelled to do more “business,” to decrease the value of the fraction’s “quotient” further and further until the unsustainable character of the scam becomes obvious even to the bank’s most gullible customers.
This cannot be done with gold or any other durable, portable, divisible commodity whose utility as a medium of exchange was discovered, not by bankers, but rather by those actually involved in the exchange of goods and services on the free market. But it can be done by applying ink to paper and substituting the result for money.
And it will almost certainly be done in any society that has repudiated its biblical patrimony, which includes the precept, “Ye shall have honest weights and measures” (Lev. 19:35-36). What reigns in the land is rather: “I will use any standard that I can fool anyone else into accepting and, if I can, get the authority of the State to ratify and reinforce by the threat of violence my designs on the wealth of others.”
Bernard Madoff’s Ponzi scheme was private, and so when the U.S. economy melted down, not only did he no longer have new “investors,” i.e., dupes, parading into his office, but also he also could not meet the demand of the old dupes standing in another line demanding the return of the money they entrusted to him. As he was not a dues-paying member of the banking cartel, however, there was no one to bail him out. Although one notes that financial regulators, whose powers many want to expand these days, either couldn’t or wouldn’t catch Madoff in the act.
And now for the snottily expressed slander:
Even a scholar of the Mises Institute recognizes that this capitalist scheme is a fraud involving a deliberate effort to create confusion in consumers’ minds between strict money titles to deposited funds and mere bank IOUs. In typical Austrian fashion, however, the same scholar blames “government” as “one of the most important driving forces for the establishment of fractional-reserve banking,” even as he also admits that the fractional-reserve fraud “is not necessarily the result of government activity” and that in some instances in the long history of this abuse “bankers themselves took control of the government or even set up their own,” and that “this tendency seems to be very strong in the United States.” To say the least. (30; needless to say, emphasis not in the original.)
The scholar (no scare quotes this time, but in the next sentence Mr. Ferrara exudes more than a whiff of sarcasm when he repeats that descriptor) is Jörg Guido Hülsmann, whom we mentioned in a footnote in a post from last May. Imagine that: “even” Professor Hülsmann, the author of The Ethics of Money Production, would recognize fraud when he sees it! This “recognition” is hardly undermined by his claim, patently supported by scholarship, that government was “one of the most important driving forces for the establishment of fractional-reserve banking.” The establishment of the fraud, that is, its institutionalization, requires more than greed. It requires the threat of violence against anyone who would dare compete with the fraudulent operation and thereby potentially put it out of business.
The occurrence of sin must precede its institutionalization. And so there will be Bernie Madoffs until Doomsday. The question is whether FRB—a Ponzi scheme that makes Mr. Madoff’s look like cookie-jar pilfering by comparison—could be institutionalized without State coercion. As Professor Hülsmann wrote in The Ethics of Production, the State, although not the source of the fraud or “falsification” (which is the wicked heart of fallen man), but it certainly is its great facilitator and multiplier:
. . . the legalization of false money certificates, though harmful, is virtually insignificant from a quantitative point of view, at least in comparison to the inflationary impact of legal monopolies and legal tender laws. Nevertheless this privilege is fundamental because it is the foundation of all other monetary privileges. It would seem impossible, for example, to establish legal tender laws in favor of some debased coin, or of some fractional-reserve banknote, if the latter are per se illegal. And thus it follows that the moral case for all other monetary privileges depends on the morality of legalized falsifications.
In the 2003 paper of Professor Hülsmann’s cited by Mr. Ferrara, the author, far from overlooking the factor of greed, institutionally contextualizes that cardinal sin’s effective range:
Government was one of the most important driving forces for the establishment of fractional-reserve banking. Government’s nature is to live parasitically off the property of other people. Because it coerces its subjects into supporting it, it does not act responsibly, constantly adjusting its expenses to available income, but instead always relies on the possibility of squeezing a little more out of the taxpayer’s pockets. Because of this unique source of income, government always has been a preferred debtor, receiving additional credits at levels of indebtedness that would exclude further credits for any private individual or group. Not surprisingly, therefore, in all of recorded history, government households have been a disastrous mess of rampant deficits. Especially in modern, democratic times, government income is never sufficient to satisfy the whims and greed of those who happen to be for a couple of years at the helm of the state. When governments try to cover these deficits by increased taxation, a direct confrontation with their subjects is unavoidable. Because no government likes to provoke such resistance, governments again and again have sought to cover their deficits by fraudulent means. In this endeavor, inflation traditionally has been one of the favorite means of cover-up.
In other words, while “private” frauds like Mr. Madoff’s was limited by their subordinate and dependent function within the financial system, “public” frauds like the Federal Reserve System, which owns the ball and the court, so to speak, will compound fraud upon fraud until circumstances beyond the control of its human operators crash the system.
In typical propagandistic fashion, Mr. Ferrara describes Professor Hülsmann’s specification of the indispensable role of government in the legal establishment of this particular fraud as an “admission,” as though against ideological interest. After all, did Professor Hülsmann not write that FRB “is not necessarily the result of government activity” and that “bankers themselves took control of the government or even set up their own”?
Yes, he did, but Professor Hülsmann also immediately appended that nasty little adversative conjunction, “but,” so inconvenient to the propagandist who thinks nothing of suppressing it. Let’s put those two snippets in their correct order and in context:
The relationship between government and banking, however, is not a one-sided affair. It was not always a preexisting government that transformed honest bankers into frauds issuing “money titles” on a fractional-reserve basis. Often it was the bankers who succumbed to the temptation of a fraudulent business practice with obvious material advantages for the perpetrator. Looking back on the history of fractional-reserve banking, Mises stressed that “Banknotes became fiduciary media within the operation of the unhampered market economy. The begetter of credit expansion was the banker, not the authority.” Only later did these bankers seek a closer cooperation with government to protect their interests against honest competitors and against agitation regarding false money titles. This cooperation then invigorated the government, extending its size and scope of activities beyond what they would have been without fraudulent banking. In city-states and other communities with plebiscitarian or democratic forms of government, which facilitate political takeovers, the bankers themselves took control of the government or even set up their own. Whether the bankers reinforced cooperation with government, took it over, or set up their own, the same basic scheme of political cover-up was used: the initial violation of property rights (fraudulent banking) was covered up with increased political involvement and cooperation.
In short, fraudulent banking is not necessarily the result of government activity, but sometimes is an instance of the spontaneous emergence or reinforcement of government.
In short, the State may not be the originator but is certainly the great facilitator and aggravator of the moral hazard, ultimately enabling its own further engorgement at the expense of its subjects. This causal story, fully borne out by the facts, provokes the perfectly legitimate question, and not only for anarcho-capitalists, as to whether such an institution does, on balance, more harm than good.
And what about that reference to bankers taking over governments, especially American governments? It’s nice that Mr. Ferrara concurs with Professor Hülsmann, but why did he suppress the Austrian scholar’s other, non-American, historical example?
This tendency [of capitalists to dominate governments] seems to be very strong in the United States. Another example is republican Florence, which the Medici family came to dominate in the fifteenth and sixteenth centuries. The house of Medici had purely commercial origins in the Medici merchant company, which “after the manner of these organisations from the time of their origin represented a combination of trade and banking.”
Ah, yes, the Medicis. Those pious Florentines certainly didn't resist the ring of power, did they! They gifted not only Europe with bankers, but also the Church with four popes, some of whom ran Rome as they did Florence. And all this during the height of Christendom of Distributist romance. But that’s all right. At least they didn’t enclose the commons or build factories. They just subsidized Renaissance porn!
 “Jörg Guido Hülsmann, Professor of Economics, University of Angers (France), author of Mises: The Last Knight of Liberalism and the equally magisterial The Ethics of Money Production, who confessed: ‘Once a pagan interventionist, I first saw the truths of libertarian political theory, and eventually I started to realize that the light of these truths was but a reflection of the encompassing and eternal light that radiates from God through His Son and the Holy Spirit. This realization has been a slow process and I could not say now when and where it will end.’”
 Try using gold to pay debts in accord with Article I, Section 10 of the U.S. Constitution, in contempt of “federal reserve notes,” and in defiance of legal tender laws, and then see what happens when your experiment comes to the attention of the Treasury Department.
 Jörg Guido Hülsmann,The Ethics of Money Production, 112.
 Jörg Guido Hülsmann, “Has Fractional Reserve Banking Really Passed the Market Test?,” The Independent Review, v. VII, n. 3, Winter 2003, 417-418. Emphasis added.
 Hülsmann, “Has Fractional Reserve Banking Really Passed the Market Test?,” op. cit., 418.
 loc. cit., n. 12. Hülsmann cites Ferdinand Schevill, The Medici. New York: Harper, 1949, 58.
 See Lynn Hunt, The Invention of Pornography: 1500-1800, MIT Press, 83, 86, 91, 95, 203. See also the Wiki article on that ribald recipient of Medici largesse, Pietro Aretino.