Fractional Reserve Banking, Government, and Moral Hazard--Ron Paul's Weekly Update for 7/9

"It is amazing that people who think we cannot afford to pay for doctors, hospitals, and medication somehow think that we can afford to pay for doctors, hospitals, medication, and a government bureaucracy to administer it." - Thomas Sowell

Fractional Reserve Banking, Government, and Moral Hazard

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 Each dollar of cash that is withdrawn unwinds the multiplier, resulting in a contraction in credit.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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Posted in reply to the post by ubaru:

"It is amazing that people who think we cannot afford to pay for doctors, hospitals, and medication somehow think that we can afford to pay for doctors, hospitals, medication, and a government bureaucracy to administer it." - Thomas Sowell

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It's not the same "we".


Some people think that those who need medical help can't necessarily pay for it. So "we #1" are some of those who need medical help. Some people (not necessarily the same ones) think that a civilized society should provide medical care for all of its members. So "we #2" are the members of a society who pay (gasp) taxes to cover shared obligations.

What's so hard to understand about that?

Now, to disagree with the premise that there needs to be government-sponsored health care, I'd think you have to remove yourself from one of the above "some people" categories. Either you don't believe that people exist who can't pay for medical care, or you don't believe that you have any obligation as a member of society to assist those in need of it. Please enlighten me if there's another group in play here that I've forgotten.

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Posted in reply to the post by podfish:

It's not the same "we".


Some people think that those who need medical help can't necessarily pay for it. So "we #1" are some of those who need medical help. Some people (not necessarily the same ones) think that a civilized society should provide medical care for all of its members. So "we #2" are the members of a society who pay (gasp) taxes to cover shared obligations.

What's so hard to understand about that?

Now, to disagree with the premise that there needs to be government-sponsored health care, I'd think you have to remove yourself from one of the above "some people" categories. Either you don't believe that people exist who can't pay for medical care, or you don't believe that you have any obligation as a member of society to assist those in need of it. Please enlighten me if there's another group in play here that I've forgotten.

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I'm not denying the need for health care, but I disagree that I, a healthy person, should be forced to buy health insurance that I don't need or will use to subsidize an obese person who smokes two packs a day. In a free society no one is forced to do anything.

Thomas Sewell's quote, "It is amazing that people who think we cannot afford to pay for doctors, hospitals, and medication somehow think that we can afford to pay for doctors, hospitals, medication, and a government bureaucracy to administer it," begs the question how can we create affordable healthcare for the greatest number of people WITHOUT the government running it? Because as soon as the government is out of the equation, the cost goes down, and more people will be able to afford it.

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Posted in reply to the post by ubaru:

I'm not denying the need for health care, but I disagree that I, a healthy person, should be forced to buy health insurance that I don't need or will use to subsidize an obese person who smokes two packs a day. In a free society no one is forced to do anything..

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you're right, that's a pretty intractable problem. But don't stop thinking through the implications of your reaction. Are you willing to say that the undeserving person you just described has forfeited their claim on society's help? That because they're "responsible" for their health problems, they will be refused treatment?? I presume if they attempt to die in the street, they'll at least be imprisoned, though that too generates expenses for the taxpayers.

I'm not saying that's an untenable position, by the way. It's not one I hold myself, but many societies (actually, including ours) and nature itself are pretty damn tolerant of the suffering and death of an individual. But I find it unconscionable to enter discussion of the way a society is organized without being willing to follow the logic through to the end.

Also, your argument doesn't make sense, unless you're saying that you would refuse treatment yourself if you found yourself unable to pay the going free-market rate. Check out the biography of Ayn Rand for an example of how that's played out in the past.

I'd love to see the argument moved to a different plane. One of the things people think is implicit in Adam Smith's description of economics is that by exploiting people's natural motivation of greed, good things happen; that's extrapolated to a sense that trying to get people to act on more noble motives is doomed. Fine, accept that logic but take advantage of a few hundred years' of research into human nature when designing a more humane society. Monetizing everything distorts everything. Food and care weren't monetized till quite recently in human society. Using economic transactions as the model for describing -all- forms of interactions is only decades old. We're trapped by our immediate tendency to see the cost for everything. How can a lazy, smoking soda-drinker be accommodated in our society without me having to pay for his expenses?? Instead, frame it as how can everyone be provided with basic needs and how can we modify our society so individual behaviors don't overstress the system's capabilities? Our current politics aren't really up to asking the question that way, but that's the question that really needs an answer.

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Posted in reply to the post by podfish:

Are you willing to say that the undeserving person you just described has forfeited their claim on society's help? That because they're "responsible" for their health problems, they will be refused treatment?

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Why the quote marks around the word responsible? Of course everyone is responsible for themselves. And thinking otherwise that the government knows what's best for you and can claim authority over you is the consequence of not owning our responsibility. In a free society everyone is free to do as they please so long as it hurts no one else. They can live an unhealthy lifestyle AND pay the consequences of that if they choose. In a truly free society you do have the right to hurt yourself AND face the consequences. Otherwise you're getting into collectivism and that's what China has and what is increasingly happening here. No thank you.

In the question you pose

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Instead, frame it as how can everyone be provided with basic needs and how can we modify our society so individual behaviors don't overstress the system's capabilities? Our current politics aren't really up to asking the question that way, but that's the question that really needs an answer.

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the government will have to penalize (make more laws, fines, penalties) against certain eating and lifestyle habits that are deemed unhealthy. That means less freedom, more intrusion. In other words common sense responsibility of the individual is thrown out the window, the individual is assumed to be too stupid to be responsible for himself (public education helps instill this dependency and dumbing down) and the government can step in and be your parent. That's not the kind of country I want to live in. If we had a LOT less government, it would encourage people to be and act more responsibly because they would know they have self ownership and self-responsibility. In the fiscally socialist view popular on Wacco, the government has ownership over you and responsibility over you, and you think taxes and giving up that sovereignty are just fine. That's called the Nanny State and I can't relate.

Imagine this instead; you live in a system with no taxes and no social "security" to be paid under threat of fine and imprisonment, and you have instead the choice to voluntarily tithe your income to the poor, the disabled, the sick, the elderly through a broad and rich culture of charity and philanthropy. Savings and investment are taught from the time you are in grade school at the private school your parents can afford because the dollar is backed in gold and is considerably more valuable instead of being inflated away. Your mother doesn't have to work and has the option to home school you, and for sure has more time to parent you and cook you wholesome meals. You are more healthy, secure, intelligent, and a better person by having this. By the time you are working you know many ways how to invest your earnings for your retirement, and you are encouraged to because you know that you own and are responsible for your self. When you graduate from college no greedy loan shark banks have offered you credit cards, and you already have savings. It is a savings culture, not a debt culture. Everyone is a lot wealthier and completely free. The description of this could expand in many more areas of life such as how you are accurately represented in a government whose only duty is to uphold your rights.

Check out this demo of the philosophy of liberty:

https://www.youtube.com/watch?v=muHg86Mys7I

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Posted in reply to the post by ubaru:

In the question you pose ...
the government will have to penalize (make more laws, fines, penalties) against certain eating and lifestyle habits that are deemed unhealthy. That means less freedom, more intrusion. In other words common sense responsibility of the individual is thrown out the window,..

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You're evading the real question. Are you advocating a society where people pay the price of their irresponsibility (to adopt one perspective on them) and are denied access to physical needs? To the point where they should not be given help by their society - also known by the pejorative term "government"? There's a lot of talk about how they should face up to their own problems, and accept their responsibility for themselves. What do the rest of us expect to see happen when they don't?

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Posted in reply to the post by podfish:

You're evading the real question. Are you advocating a society where people pay the price of their irresponsibility (to adopt one perspective on them) and are denied access to physical needs? To the point where they should not be given help by their society - also known by the pejorative term "government"? There's a lot of talk about how they should face up to their own problems, and accept their responsibility for themselves. What do the rest of us expect to see happen when they don't?

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I am advocating a society where the people voluntarily take care of such an individual through the example I gave, NOT the government.

pe·jo·ra·tive

   [pi-jawr-uh-tiv, -jor-, pej-uh-rey-, pee-juh-]

adjective 1. having a disparaging, derogatory, or belittling effect or force: the pejorative affix -ling in princeling.


I'm all in favor of belittling the government!

I'm on the decentralization team ;-)

How many ways can what the government does be done by the private sector?

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Posted in reply to the post by ubaru:

I am advocating a society where the people voluntarily take care of such an individual through the example I gave, NOT the government. ]

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you still won't say how to handle the case where such a society isn't in place.

It isn't in place, it won't get there in any hurry, so what happens to people in the meantime? Do they serve as object lessons, suffering and dying so those who need persuasion on the errors of their ways will be persuaded? Or don't you really believe that anyone will be living with, and eventually dying from, medical problems that they can't get treated?

the libertarian goals are great as goals. Personally I think anyone who lets themselves end up at the mercy of anyone/any organization that they can't control is either unlucky or foolish, and is in a very vulnerable position. I'm all in favor of encouraging people to act that way, and in finding ways to build a society that is supportive of those positions. I don't have a problem with social engineering at all. But I'm also pragmatic and a realist, and I won't pretend that I can ignore what is happening just because it's not following my preferred script. I also am more interested in the gaps in my ideas, so they can be addressed. I don't think you can take any plan of action seriously if it doesn't deal with cases where it may break down, and all the libertarian or other utopian political plans I see fall into that category.

Podfish,

I respect your efforts here, but the other day I think Ubaru articulated the crux of the issue quite well, when she wrote,

"In a free society no one is forced to do anything."

In that amazing claim, lies all the difference between doing functional political theory, and spinning an ideological pipe dream based on an absolute. It pretty much says it all.

Cheahs,

yep. Reminds me of a line from an old Zappa song... "free is when you don't have to pay for nothing or do nothing. I want to be free!" (chorus: "free as the wind").

actually, that song's not particularly relevant to this discussion at all, but it's a great song anyway. And by the way, the Grandmothers of Invention are due at the Mystic next week, with some of my favorite Zappa band members...

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Posted in reply to the post by "Mad" Miles:

Podfish,

I respect your efforts here, but the other day I think Ubaru articulated the crux of the issue quite well, when she wrote,

"In a free society no one is forced to do anything."

In that amazing claim, lies all the difference between doing functional political theory, and spinning an ideological pipe dream based on an absolute. It pretty much says it all.

Cheahs,

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Another song has the line: "Freedom's just another word for nothing left to lose . . ."

Libertarianism makes the great point that nobody else knows better than you what you need. What's missing is that, to meet our needs, we must have access to those resources - physical-material, knowledge and skills, relational-social - whereby our needs can be met. Nobody is responsible for meeting our needs, but anyone who denies us access to vital resources (especially natural resources such as arable land) puts us in economic dependency and a form of bondage that requires our service to the owner class. Until this most fundamental economic injustice ends, there can be no real freedom.

CSummer

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Posted in reply to the post by podfish:

yep. Reminds me of a line from an old Zappa song... "free is when you don't have to pay for nothing or do nothing. I want to be free!" (chorus: "free as the wind").

actually, that song's not particularly relevant to this discussion at all, but it's a great song anyway. And by the way, the Grandmothers of Invention are due at the Mystic next week, with some of my favorite Zappa band members...

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