Ron Paul: Banks Should Stop Hiding from Free-Market Regulation

by Ron Paul

Last week my subcommittee held a hearing on fractional reserve banking and the moral hazard created by government (taxpayer) insured deposits. Fractional reserve banking is the practice by which banks accept deposits but only keep a fraction of those deposits on hand at any time. In practice, nearly 100% of deposits are loaned out, yet depositors believe that they can withdraw the full amount of their deposit at any time. Loaned funds are then redeposited and reloaned up to the limit of the bank’s reserve requirements, compounding the effect.

As Murray Rothbard put it, “Fractional reserve banks … create money out of thin air. Essentially they do it in the same way as counterfeiters. Counterfeiters, too, create money out of thin air by printing something masquerading as money or as a warehouse receipt for money. In this way, they fraudulently extract resources from the public, from the people who have genuinely earned their money. In the same way, fractional reserve banks counterfeit warehouse receipts for money, which then circulate as equivalent to money among the public. There is one exception to the equivalence: The law fails to treat the receipts as counterfeit.” *

While mainstream economists extol this “money multiplier” as a nearly miraculous process that results in a robust economy, low reserve requirements actually enable banks to create trillions of dollars of credit out of thin air, a process that distorts the structure of production and gives rise to the business cycle. Once the boom phase of the business cycle has run its course and the bust commences, some people will naturally look to hold cash. So they withdraw money from their bank accounts in order to hold physical currency. But bank deposits consist of a huge amount of credit pyramided on top of a small of amount of original cash deposits. Each dollar of cash that is withdrawn unwinds the multiplier, resulting in a contraction in credit. And if depositors en masse attempt to withdraw more funds than are available in reserves, the entire of house of cards comes crashing down. This is the very real threat facing some European banks today.

Since the amount of deposits always exceeds the amount of reserves, it is obvious that fractional reserve banks cannot possibly pay all of their depositors on demand as they promise – thus making these banks functionally insolvent. While the likelihood of all depositors pulling their money out at once is relatively rare, bank runs periodically do occur. The only reason banks are able to survive such occurrences is because of the government subsidy known as deposit insurance, which was intended to backstop the stability of the banking system and prevent bank runs. While deposit insurance arguably has succeeded in reducing the number and severity of bank runs, deposit insurance is still an explicit bailout guarantee. It thereby creates a moral hazard by encouraging bank deposits into fundamentally unsound financial institutions and contributes to instability in the financial system.

The solution to the problem of financial instability is to establish a truly free-market banking system. Banks should no longer have a government backstop of any sort in the event of failure. Banks, like every other business, should have to face the spectre of market regulation. Those banks which engage in sound business practices, keep adequate reserves on hand, and gain the confidence of their customers will survive, while others fall by the wayside.

Banking, like any other financial activity, is not without risk – and the government should not continue its vain and futile pursuit of trying to eliminate risk. Get government out of the way and allow the market to function. This will result in a more stable system that meets the needs of consumers, borrowers, and investors.

* Murray N. Rothbard, The Mystery of Banking, 2nd ed. (Auburn, Alabama: Ludwig von Mises Institute, 2008), p. 98.

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111 Comments:

  1. I also wanted to correct a typo. It’s “100 percent reserve banking” and not “100 percent banking”

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  2. Therefore I believe my second sentence is entirely correct. If they have more money in their reserves, where’s the money for making loans to businesses and people? Without fractional reserve banking, banks would just accumulate deposits and keep it all for withdrawals (100 percent banking). With all due respect, I support the opinions expressed in your top comment, but I just wanted to correct any misunderstandings. Please feel free to prove me wrong if you’re still not convinced.

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  3. The less money they allocate to reserves (which is meant for withdrawals from a customers who have made deposits to the bank) for their assets, the more they can use for making loans (which is where banks make their profits from). The money that you withdraw isn’t the money you deposited. It’s from a pool of money from all other customers put in reserves so that they can allow you to withdraw money while they have your money invested else somewhere.

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  4. I don’t believe I am wrong. I’ve taken intro introductory and intermediate macroeconomics at my university, and in both classes I learned that the less a bank has in its reserves the more money the bank generates (increasing money supply but not creating wealth). I think you may not have a clear understanding of fractional reserve banking. Banks have assets (reserves and Loans) and liabilities (deposits).

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  5. Not even Sweden (the social democratic experiment) use state backed fractional reserve banking! It is theft, pure and simple.

    Believe it or not, but we also have lower inflation and less regulations for small businesses than the USA! Most of the people here have never heard of Ron Paul though, as the media seems to simply be copying the American mainstream.

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  6. More people need to pay attention to this!

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  7. This is funny. Something I just realized (and I think vaguely mentioned in the speech) is that by the government insuring all deposits, that will encourage the banks to take EVEN RISKIER business practices to make more money. It’s not to say that the banks plan to fail and think it’s ok, but the logic is….

    With a much lower risk of bank runs, they think they can safely hold onto even LESS money… thereby multiplying it more… thereby counterfeiting a greater magnitude of money… which then causes the business cycles to be more severe.

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  8. I appreciate your positive spin on the debate but your second sentence is completely off the mark. . It should read ‘The MORE they have in reserves, the more money they can loan out’. Such an understanding to this very tricky subject is essential if FRB is to be understood.
    Hope this helps out.

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  9. HE IS TEACHING US HOW FREE WORLD WOULD LOOK LIKE AND HOW THE SLAVERY CAN BE LIFTED.

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  10. If people don’t realize it yet:

    The banks are bankrupt and have been for a long long time. The government will always collude to hide this fact and will create as much money and as much credit as is necessary to hide it.

    The dollar is going to zero. All fiat currencies eventually do and this time, it’s no different.

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  11. Fractional banking will never die even if the Fed and all forms of gov’t do. Fractional Reserve banks need two types of insurance to not be a burden (potential thieves of the people). 1) Banks need need to form a network with other banks (a contract) to cover excesses depositor withdraw requirements. 2) Banks need to obtain free market, NON-GOVERNMENT insurance, which will kick-in in the event that depositors withdraw funds from the network in excess of the network’s capacity. NO FED REQUIRED!

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  12. Fractional reserve banking is how banks make money: they are a business after all. The less they have in their reserves, the more money they can loan out and profit off of from the interest. Most banks have a similar(?) set fraction of the reserves they must have at all times to fulfill withdrawals from their customers. But some banks play risky and keep very low reserves to maximize profit. F.R.B isn’t theft unless the banks belly up and can’t give you all your deposits/ get government bailouts

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  13. yeah they should but they wont unless we stop them

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  14. Bottomline, the government should stop governing.

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  15. It hurts to always hear this and still get nothing done with it. And what do we have to look forward to Romney?

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  16. But Americans can’t see it… Facepalm!!!

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  17. Fractional reserve banking! What a wonderful idea (for crooks)

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  18. I agree with the overall sentiment of your comment but feel that the issues of liberty can become a trap within themselves i.e. freedom from what?, for instance. It is then that the kids see everything wrong in the world as an offset, only to feel isolated, lonely, clinging only to hope. Now,I accept that the message of liberty is a positive one but in practice, as witnessed in these columns, it engenders negative emotions and endless conspiracy theories. So, no thank you, for my kids anyway

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  19. 3:00 TURN ON (cc) CAPTIONS
    ,
    Shit brix , CORRUPT TRANSLATION TURNING HIS POINT

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