From The Founder's Desk
columnist: Walt Thiessen

Topic: Debate
Fraud Is the Root of Fractional Reserve Banking, Part II

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Now that we've established the fraudulent root of banking, let's see how it turns into fractional reserve banking and extends the fraud.

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by Walt Thiessen
(libertarian)
Wednesday, November 19, 2008

In the first part of this article from our debate, I established that the root of banking as it has been done for hundreds of years is fraudulent. Specifically, the idea that when you deposit money in a bank it becomes the bank's money to do as they see fit (no matter how safe or dangerous the bank's actions may be) is fraudulent. It is just as fraudulent as if you left money for safekeeping with me and I decided to spend part of it on groceries and give you an IOU in return. I'd get arrested for such behavior, but a banker gets rewarded for it.

Now, let's look at how this fraud plays out under fractional reserve banking. It is said that from tiny acorns grow might oaks. It is also true that from tiny frauds grow massive frauds.

First, let's define our term. Fractional reserve banking is the practice of lending out most of the depositors' money for the profit of the bankers via interest on those loans. Specifically, the "fractional" part of the term refers to the fact that the bank retains a small percentage of the total deposits as a "reserve" against the claims of the depositors who think they are entitled to get their money back on demand, because that's what they were promised. In fact, if all of the depositors asked for their money back at the same time, there would not be enough to go around. This is known as a "run on the bank."

The fraud I identified in Part I of this article becomes the basis for this second form of fraud. When a banker loans out money that doesn't belong to him, under the fiction that it does belong to him because it was deposited with him, he sets himself up to have his little game exposed at some undetermined point in the future. He counts on the fact that most of the time depositors don't all want their money back at the same time. Most of the time, the bankers can get away with it. However, there have been a large number of times throughout history where things did not work out quite so nicely. In our own country, there have been a large number of such failures and panics.

Paper currency was first tried as early as 1690, when Massachusetts became the first to use it as a means of financing raids against the French colony in Quebec. Between 1690 and 1764, the other colonies followed suit, leading to what author G. Edward Griffin, in his book The Creature from Jekyll Island : A Second Look at the Federal Reserve, called, "a virtual orgy of printing 'bills of credit.'" He writes:

"Prices skyrocketed, legal tender laws were enacted to force the colonists to accept the worthless paper, and the common man endured great personal losses and hardship. By the late 1750s, Connecticut had prices inflated to 800%, the Carolinas had inflated 900%, Massachusetts 1000%, Rhode Island 2300%.

"The situation was so out of hand that, beginning in 1751, the British Parliament stepped in and, in one of those rare instances where interference from the mother country actually benefitted the colonies, it forced them to cease the production of fiat money. Henceforth, the Bank of England would be the only source.

"What followed was unforseen by the promoters of fiat money. Amid great gloom about 'insufficient money,' a miracle boom of prosperity occurred. The forced use of fiat money had compelled everyone to hoard their real money and use the worthless paper instead. Now that the paper was in disgrace, the colonists began to use their English and French and Dutch gold coins once again, prices rapidly adjusted to reality, and commerce returned to a solid footing. It remained so even during the economic strain of the Seven-Years War (1756-1763) and during the period immediately prior to the Revolution. Here was a perfect example of how an economic system in distress can recover if government does not interfere with the healing process." (Griffin, pp 310-311).

Unfortunately, that didn't end the experiment with paper money. The fiat money monster returned with the Revolutionary War. Griffin reports that at the beginning of the war, the entire federal money supply stood at $12 million (1775). By the war's end five years later, that total stood at $227 million, an increase of about 2000%. He reports that the states were doing the same thing at roughly the same rate of increase, and when the Continental Army still didn't have enough money to prosecute the war, they issued "certificates" for the purchase of additional supplies totalling $200 million. That yielded a total money supply of $650 million from an initial base of $12 million, a whopping 5000% increase in five years. All this money creation gave an initial appearance of prosperity, but it eventually gave way to poverty. By the war's end George Washington wrote, "A wagon-load of money will scarcely purchase a wagon-load of provisions." (ibid, p. 312).

America's First Central Bank Is Created

The Bank of North America was chartered in 1781 by  the new American Confederacy's Superintendent of Finance, Robert Morris. It was designed to be a central bank, modeled after the Bank of England. It engaged in fractional reserve banking, but lending out money wasn't the only cause of its problems. The other main cause was the fact that the Bank of North America, like all other central banks before or since, was granted by the government the legal monopoly over the issuance of paper money. No other bank notes were permitted in circulation. Further the bank was made the official depository for all federal funds.

G. Edward Griffin writes:

"The Bank of North America was fraudulent from the very start. The charter required that private investors provide $400,000 for the initial subscription. When Morris was unable to raise that money, he used his political influence to make up the shortfall out of government funds. In a maneuver that was nothing less than legalized embezzlement, he took the gold that had been lent to the United States from France and had it deposited in the Bank. Then, using this as a fractional-reserve base, he simply created the money that was needed for the subscription and lent it to himself and his associates. Such is the power of the secret science." (ibid p. 326)

Thus, the nation's first bank was funded by defrauding the citizens of the new American Confederacy in order to provide investment money in a monopoly franchise for the benefit of Morris and his partners. It didn't take long to fall apart. As Murray Rothbard writes in The Mystery of Banking (Richardson and Snyder, New York, 1983, pp 194-95):

"Despite the monopoly privileges conferred upon the Bank of North America and its nominal redeemability in specie [gold], the market's lack of confidence in the inflated notes led to their depreciation outside the Bank's home base in Philadelphia. The Bank even tried to bolster the value of its notes by hiring people to urge redeemers of its notes not to insist on specie—a move scarcely calculated to improve long-run confidence in the Bank.

"After a year of operation, Morris' political power slipped, and he moved quickly to shift the Bank of North America from a central bank to a purely commercial bank chartered by the state of Pennsylvania. By the end of 1783, all the federal government's stock in the Bank, amounting to 5/8 of its capital, had been sold into private hands, and all U.S. government debt to the Bank repaid."

You may wonder what "inflation" Rothbard referred to. The bank had been granted the right to issue paper money, which was supposed to be redeemable in gold (sometimes called "specie"). The bank printed up more paper money than it could redeem in gold, which is what created the inflationary effect. It's also why the public lost confidence in its paper currency.

Lessons Learned In Philadelphia

The lesson was certainly clear to the new country. When the Constitution was written a few years later, the authors of that document made it very clear that the federal government should be limited regarding such activities. In Article I, Section 8, they wrote that Congress shall have the power:

"To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;

"To provide for the Punishment of counterfeiting the Securities and current Coin of the United States;"

Clearly, all those references to the word "coin" was a specific rejection of paper money issued by the federal government. The rejection is even clearer when we read some of the actual dialogue that took place on August 16, 1787 during the debates at that convention:

"Mr. Ellsworth  thought this a favorable moment to shut and bar the door against paper money. The mischiefs of the various experiments which had been made, were now fresh in the public mind and had excited the disgust of all the respectable part of America. By withholding the power from the new Government more friends of influence would be gained to it than by almost any thing else. Paper money can in no case be necessary. Give the Government credit, and other resources will offer. The power may do harm, never good.

"Mr. Randolph, notwithstanding his antipathy to paper money, could not agree to strike out the words, as he could not foresee all the occasions which might arise.

"Mr. Wilson. It will have a most salutary influence on the credit of the United States to remove the possibility of paper money. This expedient can never succeed whilst its mischiefs are remembered, and as long as it can be resorted to, it will be a bar to other resources.

"Mr. Butler. remarked that paper money was a legal tender in no Country in Europe. He was urgent for disarming the Government of such power.

"Mr. Mason was still adverse to tying the hands of the Legislature altogether. If there was no example in Europe as just remarked, it might be observed on the other side, that there was none in which the Government was restrained on this head.

"Mr. Read, thought the words, if not struck out, would be as alarming as the mark of the Beast in Revelations.

"Mr. Langdon had rather reject the whole plan than retain the three words '(and emit bills)'."

The question they were debating was whether to include the phrase "emit bills of credit" in Article I, Section 8. The idea was soundly defeated. A bill of credit is another term for paper money. Clearly, the sentiment of that convention was strongly against permitting the federal government to issue paper money, and for good reason! They had learned first hand, not just via the Bank of North America, but also via a number of other experiments with paper money both during colonial times and immediately afterward that it was ruinous in the long run.

This is the second great fraud of fractional reserve banking. Such banking inevitably leads to the issuance of paper money with little reference to gold or silver on hand. It is offered redeemable for real money, gold or silver, but the desire for easy profits gets the better of the bankers, and they end up issuing far more currency than they can possibly redeem. The currency loses value over time, until it eventually becomes worth no more than the paper it's printed on. Of course, the bank's victims in the population don't know about the problem until it's too late. It would be one thing if the bank actually published on a daily basis how much paper money it has issued relative to its gold and silver assets, but when that information is hidden, the public are inevitably harmed.

On the surface, it may seem crazy that the banks would want to risk any of that. Why bother issuing more paper money than can be redeemed in gold in the first place? The answer is that the way they issue that paper money is by loaning it out. They want to collect the interest on it, and the more such money they lend out, the more interest they collect. Thus, they have a tremendous financial incentive to lend out more paper money than they can redeem in gold.

The travesty of fractional reserve banking played itself out repeatedly in the late 18th and 19th centuries in America. It wreaked havoc with the economy, which managed to grow somewhat anyway. This was the first great period of the boom/bust cycle. No, boom/bust didn't start with the Federal Reserve, but the principles upon which the Fed was founded were the exact same principles that caused the boom/bust cycle.

The Bank of the United States Is Created

Morris's first attempt at a national bank was repeated in 1791, at the behest of Alexander Hamilton and over the strong objections of Thomas Jefferson, who wrote: "A private central bank issuing the public currency is a greater menace to the liberties of the people than a standing army....We must not let our rulers load us with perpetual debt."

Hamilton retorted: "No society could succeed which did not unite the interest and credit of rich individuals with those of the state....A national debt, if it is not excessive, will be to us a national blessing."

Do you feel blessed?

At any rate, the new Bank of the United States was modelled after the Bank of England and was a nearly direct replica of the failed Bank of North America. As before, the bank opened its doors with a tiny fraction of the capitalization it promised, clandestinely stealing the rest from the public weal. Again, its primary purpose was to create money for the federal government. Again, within five years prices had risen 72%, which meant that the money people thought they had saved had been quietly and invisibly confiscated by the government through the hidden tax of inflation. But instead of being printing press money, this inflation was caused by fractional reserves. It created its money through the creation of debt and led Jefferson to write:

"I wish it were possible to obtain a single amendment to our Constitution. I would be willing to depend on that alone for the reduction of the administration of our government to the general principle of the Constitution; I mean an additional article, taking from the federal government the power of borrowing." (Griffin, p. 332)

During this same period, the earliest "wildcat banks" began to flourish. They were so-called because they were created in remote regions of the new country and were usually the only banking game in town. They made loans and created paper money in huge quantities that eventually came back to haunt them, and their bookkeeping practices were shoddy even by traditional banking standards. The Bank of the United States acted as a central bank to these wildcat banks and saved the more fiscally sound of the bunch wherever they could, but again they did so via the inflationary effects of fractional reserve banking. It was an early case of fraud being used to pay for the effects of other fraud.

The next major fraudulent opportunity for bankers was the War of 1812, when the federal government encouraged an enormous expansion in the number of banks to provide a ready market for federal war debt. By 1814, most of the nations' banks were insolvent and could not make their required payments in gold, while the national debt had tripled from $45 million to $127 million. (ibid p. 338)

The Second Bank of the United States Is Created

Instead of letting the fraud play itself out into bank failure, Congress decided to protect the defaulting banks and thereby perpetuated the fraud by creating the Second Bank of the United States. Like the first two attempts at a central bank, this one also had the federal monopoly on monetary creation. In a twisted sort of way, it was more efficient than the previous two attempts, and it succeeded in generating a wicked cycle of boom and bust that blanketed the entire country, leading to the Panic of 1819. By 1820, public opinion was swinging back toward sound monetary policies, and when Andrew Jackson was elected president in 1828, he swore he would root it out. It took virtually all of his first term in office, but after a rather storied struggle he succeeded. The head of the bank, Nicholas Biddle, fought Jackson's attempt by heavily contracting the money supply (by calling in the bank loans early) which created a massive economic bust and triggered a national panic. He almost succeeded with his ploy. Only when the truth of what he was doing leaked out did the tide of public opinion turn against him, leading to his ultimate defeat and the end of the Second Bank of the United States in 1832.

Banking Chaos Continues with The Civil War

The demise of the Second Bank of the United States didn't end the experiment with fractional reserve banking. To the contrary, the experiment was ramped up even more, without a central bank behind it. Repeatedly, the fraud led to panics and loss of savings for the little guy. This led to the Panic of 1857. Some have called it a period of free banking, but it was really a period of rampant fraud masked as sound financial activity. As Rothbard writes:

"The banks were subject to a myriad of regulations, including edicts by state banking commissioners, along with high minimum capital requirements which greatly restricted entry into the banking business. The most pernicious aspect of free banking was that the expansion of bank notes and deposits was tied directly to the amount of state government bonds which the bank had invested in and posted as security with the state. In effect, then, state government bonds became the reserve base upon which the banks were allowed to pyramid a multiple expanion of bank notes and deposits. This meant that the more public debt the banks purchased, the more they could create and lend out new money. Thus, banks were induced to monetize the public debt, state governments were encouraged to go into debt, and government and bank inflation were intimately linked." (Rothbard, p. 216)

The economic chaos created provided a primary foundation for the Civil War, which was marked by the creation of yet another federal legal tender called the "greenback." At the heart of the conflict was clashing economic interests between the North and the South. Others have written about the nature of those conflicting interests, but the unifying theme is that those economic interests were similarly financed, and with similarly devastating results. Writes Griffin:

"In the North, neither greenbacks, taxes, nor war bonds were enough to finance the war. So a national banking system was created to convert governmental bonds into fiat money, and the people lost over half of their monetary assets to the hidden tax of inflation. In the South, printing presses accomplished the same effect, and the monetary loss was total.

"The issuance of the Emancipation Proclamation by Lincoln and the naval assistance offered by Tsar Alexander II were largely responsible for keeping England and France from intervening in the war on the side of the Confederacy. Lincoln was assassinated by a member of the People's Will, a Nihilist secret society in Russia with rumored ties to financiers in New York City, specifically, Jacob Schiff and the firm of Kuhn, Loeb & Company.

"As for the Creature of central banking, there had been some victories and some defeats. The greenbacks had for a while deprived the bankers of their override on a small portion of the government debt, but the National Banking Act quickly put a stop to that. Furthermore, by using government bonds as backing for the money supply, it locked the nation into perpetual debt. The foundation was firmly in place, but the ultimate structure still needed to be erected. The monetary system was yet to be concentrated into one central-bank mechanism, and the control was yet to be taken away from the politicians and placed into the hands of the bankers themselves." (Griffin, p. 395)

Panics continued to follow the boom and bust cycle generated by the creation of fiat money after the Civil War in 1873, 1884, 1893, and 1907. There were other panics as well, but these were the most severe and resulted in the suspension of payment of gold for paper money being redeemed by customers.

The stage was set for the creation of the Federal Reserve System. I'll explore the events surrounding its creation, and I'll examine the core operations of how money is created via its mechanisms in the third part of this article.

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©2008 Walt Thiessen, all rights reserved. You must have written permission from the author in order to republish this work.
Published: Wednesday, November 19, 2008
Last modified: Wednesday, November 19, 2008

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