Central Banking, Fractional Reserving, and Legal Tender Laws

Is Fractional Reserve banking fraud? Is it the same thing as a central bank?

The Federal Reserve caused the financial crisis of 2008, according to many of its critics. On the other hand, many people have credited the Fed with avoiding another great depression. This debate often becomes confused because people intermingle the concepts of a central bank, fractional reserve banking, and legal tender laws. For instance, Ron Paul has argued that fractional reserve banking creates money out of thin air and intersperses this with his arguments to end the Federal Reserve. A commonly proposed solution is a return to the gold standard. Proponents of the Federal Reserve also seem to believe that these concepts are a package deal.

The idea of a modern central bank that controls the money supply, sets interest rates separate from market forces, and creates money out of thin air to buy government bonds, is relatively new.

The idea of a modern central bank that controls the money supply, sets interest rates separate from market forces, and is allowed to create money out of thin air to buy government bonds, is relatively new. In the case of the U.S. this dates from the creation of the Federal Reserve in 1913. As explained in the article A Brief History of Central Banks on the Federal Reserve Bank of Cleveland’s website:

A central bank is the term used to describe the authority responsible for policies that affect a country’s supply of money and credit. More specifically, a central bank uses its tools of monetary policy—open market operations, discount window lending, changes in reserve requirements—to affect short-term interest rates and the monetary base (currency held by the public plus bank reserves) and to achieve important policy goals.[1]

When you read this explanation of the functions of a central bank in black and white it is clear that it is a central planning system for a country’s money and credit.[2] Central planning of economic activity has always resulted in market distortions and the Federal Reserve is no different.

A central bank is different from a national bank, such as the First National Bank (FNB) of the United States set up during Washington’s presidency. The FNB was a private bank in which the federal government had a twenty percent equity interest. It was forbidden from buying government bonds, had a mandatory rotation of directors, it could not issue notes or incur debt beyond its capitalization, and the federal government could withdraw its money from the FNB and place it with another bank.[3] The FNB of the United States was a truly a private bank not a central bank. It did not set the policies that “affect a county’s supply of money and credit.”

The First National Bank of the United States was a fractional reserve bank however. A fractional reserve bank is a bank in which a fraction of the bank deposits are kept in reserve. Or stated another way the bank’s loans exceed its capital. The Riksbank, founded in Sweden in 1656, is commonly accepted to be the first fractional reserve bank. Murray N. Rothbard has argued that fractional reserve banks are counterfeiting money.[4] This is incorrect. Unfortunately, in order to explain why it is wrong it is necessary to delve deeper into the history of banking. Originally, bank notes were issued by a bank to indicate that a depositor had so much gold or silver on deposit. When the depositor wanted to retrieve their gold, they would present the bank note to the issuing bank. Since bank notes were bearer notes, meaning the bank paid whoever presented the note, holders of the notes started exchanging these notes instead of going to the bank and pulling out coins (gold). The cost and risk of transporting large sums gold made bank notes a much more practical currency. Think about a merchant living in England that needed to purchase large sums of tobacco in the colonies or spices from the Far East or lumber to repair his ship.

What the banks had done with bank notes is securitize the gold they had on deposit. However, gold and silver are not the only things of value. Banks realized that they could securitize other property. For instance, quality farmland had significant value. There was a difference of course. You cannot put your land on deposit with a bank. However, the bank could have a contingent legal title to the land. The bank did not need land, so it would provide you with a loan against this contingent title, known a mortgage or deed trust. The borrower would pay the bank back in bank notes or species that he earned from his farm. If the farmer defaulted, then the bank would take legal title to the land and sell it. A bank that can only loan money from its capital reserve is a 100% reserve ratio bank. But there is no logical reason that bank notes should only be backed (secured) by gold. If I want to buy some land adjacent to my farm, but I do not have the funds, it makes economic sense to take out a loan. I could pledge to pay the widow who owns the farm over time. This might work, but she may have pressing financial needs and a payment plan is not a good solution for her. This problem is compounded if the farmer/borrower needs to buy extra seed corn, build a barn on the property, and pay extra laborers to realize the full economic potential of the farm he is buying. He cannot promise to pay all these people on time. The bank steps in and issues bank notes that are recognized as currency secured by the land owned by the farmer. If the farmer dies, becomes disabled, or is just not able to pay back the loan, the bank takes over the farm and sells it for currency, which could be bank notes or gold coins. This ensures that they have enough gold on hand to pay off any holder of their bank notes. In a fractional reserve bank, the bank has not created money out of thin air, they have backed their bank notes by both gold deposits, their capital reserve, and the farmers land or whatever other collateral they have for the loans they have made.

It may be legitimate to require a bank to disclose that they are a fractional reserve bank to their depositors. I asked a former president of a bank if they ever did disclose this to customers when they setup an account. The answer was no. As a lawyer, it seems that banks should have to disclose that they are a fractional reserve bank. However, in discussions with mid-level bank employees, most of them do not know they work at a fraction reserve bank.

Bank securitization of farms is no different than a company selling bonds against its assets and future earnings. The bonds it issues are not backed by gold, they are backed by the assets of the company. You might argue that the purchasers of the bond have given gold to the company. This may be true, but a company does not hold the gold in reserve. It spends the gold for plant and equipment or expansion. You may argue that a bond is not money. That is true in this day and age of legal tender laws, but before legal tender laws there was very little difference. Even today if you owe someone $10,000 you might sign over some bonds to that person to pay them. Clearly, those bonds are acting like money. Money is anything that functions as a medium of exchange and a store of value. Rocks, tobacco leafs, paper, bonds, stock options, gold, silver, computer entries, and bonds, are just a few of the ‘things’ that have functioned as money in history. An interesting experiment in money is being conducted by the company Bitcoin. Bitcoins (cyrptocurrencies) have appreciated significantly against other currencies in the last couple of years and they are just computer entries.

Legal tenders laws mandate that certain state approved money can be used to satisfy debts within the country. The first legal tender law in the United States was passed by the North during the Civil War. Eventually this law was declared unconstitutional in Hepburn v. Griswold, 75 U.S. 603 (1870). The Court reasoned that the Constitution allowed the federal government to coin money, but not the power to make paper legal tender. The government argued that since it had the power to carry out war and the issuance of the legal tender was necessary for carrying on the war, then legal tender laws fell under the “necessary and proper’ clause of the Constitution. The Court rejected this argument and also pointed to the fact that the Constitution prohibited the states from interfering with contracts. The Constitution did not specifically, prohibit the federal government from interfering with private contracts, but it would be against the spirit of the Constitution to allow the federal government to do so.  Unfortunately, this case was quickly overruled by the Knox v. Lee, 79 U.S. 457 (1871) Supreme Court decision. Multiple competing bank notes were the norm at that time. According to the Cato Institute, “the government did not entirely monopolize issuance of notes until 1935, but the laws that made the monopoly possible date from the Civil War.”[5] Today the legal tender law in the US is 35 USC § 5103 which states:

United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues. Foreign gold or silver coins are not legal tender for debts.-

Legal Tender laws are necessary for government counterfeiting to be successful.

Legal Tender laws are necessary for government counterfeiting[6] to be successful. Without legal tender laws, people would quit accepting the money government printed. A central bank is not necessary for the government to counterfeit money. The Union was able to print $450,000,000 of counterfeit money without a central bank.

The Federal Reserve uses a more sophisticated method of printing money. The Federal Reserve can affect the money supply by either changing the interest rates or by buying and selling bonds. However, the money supply in a free market also varies. A fractional reserve bank is not a government creation and neither are bonds. When a bond is issued or a bank funds a loan, they both increase the supply of money. However, the amount of money that can be created in this manner is limited by the size of the economy, since bonds and loans have to be backed by productive assets. If too many loans are funded, then the bank goes out of business, which shrinks the supply of money. If too many bonds are floated, then they are not repaid and become worthless, shrinking the supply of money. The Federal Reserve can use its interest rate setting mechanism to encourage too many bad loans, but eventually this short term increase in the money supply will evaporate. If the Federal Reserve wants to permanently increase the money supply, then it needs to use its open market operations to buy Treasury Bills or more recently to buy bad mortgages from private banks. It is these open market operations that are used to create money out of thin air and why the Federal Reserve’s balance sheet is the best way to determine how much money the Federal Reserve has counterfeited.

The most effective way to stop the damage caused by government manipulation of the money supply and interest rates is to repeal the legal tender laws. The North was able to print money without a central bank, but not without legal tender laws. If the Federal Reserve attempted to flood the market with counterfeit money and there were no legal tender laws, the market would quickly discount the value of government issued currency and individuals would price their contracts in other more stable currencies. This is why FDR outlawed the ownership of gold and gold clauses in contracts. Presently, the Federal Reserve and other central banks are convinced that by counterfeiting money as fast as they can, they can create wealth. Ben Bernanke believes that wealth can be created by the government dropping money out of a helicopter.[7] If this were true, we could all be rich if every citizen were given the power to print money or just go online and change the amount of money in their bank accounts.
 

[1] Bordo, Michael D., A Brief History of Central Banks, Federal Reserve Bank of Cleveland,

http://www.clevelandfed.org/research/commentary/2007/12.cfm, A Brief History of Central Banks, December 1, 2007.

[2] I think there is a quote on this from the book Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse Unfortunately, I do not have a copy of this book anymore.

[3] The book, Hamilton’s Blessing, is a great reference for this but I do not have a copy anymore.

[4] Rothbard, Murray N., Taking Money Back, Ludwig Von Mises Institute website, June 14, 2008, http://mises.org/daily/2882, This article originally appeared in The Freeman, September and October 1995.

[5] Schuel, Kurt, Cato Journal, Vol. 20, No. 3 (Winter 2001) p 454.

[6] Counterfeiting in an economic sense is any currency that is not backed by productive or creative effort that someone willing exchanged their creative effort for.  Gold is clearly not counterfeit money, since it requires productive effort to mine gold.  Buy paper money presents a problem.  It takes productive effort to make and print paper, but no one would trade twenty dollars of their effort for someone who printed a twenty dollar bill.  Economic counterfeiting is really a fraud where someone believes the other person has provided value that they did not provide and purposely withheld this fact from the other party.

[7] Wikipedia, Ben Bernanke, http://en.wikipedia.org/wiki/Ben_Bernanke

Related Posts:

1. Paul Krugman’s Invective Insults the Economics Profession
2. Why Central Banking Must End
3. Central Banks: Alchemists of Finance Part III

   

About the Author: Dale B. Halling

Dale B. Halling is a software developer with a BSEE, an MS in Physics, and a JD. He is the author of The Decline and Fall of the American Entrepreneur: How Little Known Laws and Regulations are Killing Innovation and the Source of Economic Growth. He is the coauthor of the novels Pendulum of Justice and Trails of Injustice. Dale B. Halling is also a named inventor on nine patents.