The Origin and Nature of Banking

0:00Before I come to the nuts and balls of the theory of banking, let me just make a brief remark relating to some of the topics that Professor Salerno talked about, the relative Merits of the Gold Standard versus the monetarist dream of freely fluctuating paper currencies. The standard argument of opponents of the gold standard, such as Milton Friedman, has has always been that to be on the gold standard involves some sort of economic waste in the following sense. He said at some place in his work that something like 1.5% of national income would have to be devoted to the production of the currency commodity in order for prices What he's saying there is that obviously we have to devote real resources in order to get gold out of the ground and we could have devoted these resources, of course, also to produce some valuable consumer and producer goods and that it might be, so to speak, cheaper to have a paper money standard in place.

1:40Because paper money, of course, does not involve as many resources in terms of digging it out of the ground, obviously, than the gold standard does. Now, curiously, after then we introduced the monetary stream since 1971, Several years after that Friedman himself looked back on his own resource cost savings argument in favor of paper money and against the gold standard and he came to the conclusion that his entire predictions, that is that we would save resource costs, had gone bad, that every prediction that he made had turned out to be wrong.

2:29He realized, for instance, that there was absolutely no savings whatsoever, inflationary tendencies had dramatically increased, and we had, accordingly, far higher financial instability and uncertainty than we had before, that is the predictability of participants in the economy of what would happen to the value of money. The ability to predict these changes had dramatically declined. Then long-term bond markets had been essentially wiped out because long-term planning becomes very much more difficult if you have financial uncertainty than if you can rely on the certainty provided by the gold standard.

3:22Then he realized, for instance, that the number of hard money investors had dramatically increased, all of them of course also using up resources, secretaries, offices and all the rest of it. That is a profession that likely would not have come into existence if it were not for the fact that the gold standard had been abolished. Then he also had to admit that of course gold production actually had not declined. The prediction of the monitors had been that if we get rid of the gold standard, the price of gold will fall to the estimated value of gold for commodity purposes. Something like $6 an ounce was predicted would become the price of gold. Whereas all Austrians had of course predicted, look you go off the gold standard and the price of gold will of course go up. And of course as you know gold prices have risen at some point above $800 and are now close to $400 and at this price of course gold mining has certainly not declined but is higher than before. Then

4:40and then institutions like money market funds and currency, future markets, hedging, all of these techniques would not have played anywhere near the important role that they currently play and all of these institutions of course also use up tremendous amount of resources. Now after having said this, however, then you would wonder what is now his reaction towards his original proposal. We should go off the gold standard after seeing that none of his predictions actually turned out true. And the amazing thing is now that he comes to the conclusion that while he was false on all predictions, nonetheless the gold standard is still a ridiculous institution, except that he doesn't quite know what to do now.

5:30Now coming to my remarks about banking. There are two functions that banks fulfill and these

5:44two functions have historically been performed by different institutions and nowadays are performed by one and the same institution. The first function that banking institutions What the banks took over was to serve as what is called a loan bank. Now, loan banking consists of nothing else but savers depositing their money in a savings bank and entering with the bank some sort of time contract, which involves a temporary transaction

6:30The transfer of the property title onto the bank, savers relinquish for a certain time period control over a sum of money and the bank acquires for this period of time ownership of the money and then loans it out to various investors. The importance here is to recognize that in savings institutions or in loan banks that there is a time contract entered by the saver and the bank and then of course again by the bank and the person who receives loans from the bank.

7:16Of great importance is the following insight. A saver handing over in a time contract money to the bank abstains from spending this money on various goods right now. I could have bought Apple's machinery or whatever with my money that I hand over to the bank. That is, I extend, so to speak, commodity credit. That is, goods that I could have consumed, I do not consume. And these goods that I don't purchase can now be used, so to speak, by the investors who receive the money from the bank in order to finance their investment projects that are underway.

8:11That is, loan banks, genuine loan banks, give what is called commodity credit. Credit embodied, so to speak, in real goods that the saver does not currently use. Now the payment in savings and loan banks of course the bank pays an interest payment to the saver and it charges interest to those who receive the loan and the income of the loan bank is the interest differential between that interest that they grant to the savers and the interest that they charge to to the borrowers. And this earning is of course the reward, so to speak, of performing the function of intermediation, of bringing the savers and the investors together. In a market with competition in loan banking, of course this interest differential tends to become a minimum differential as competition between various loan banks sees to it that this differential becomes as small as possible.

9:31On the other hand, also realize by the way that this type of loan banking does not involve at all any increase in the money supply, that is the money that I hand over is then handed over to somebody else and is afterwards repaid. There's no increase in the money supply taking taking place because of loan banking taking place. The second function, which originally was done by a different institution, is deposit banking. Now deposit banking is basically nothing else but depositing money for safekeeping purposes and receiving from the depositing and receiving from the depositing institution a depositing ticket stating that I turned over a certain amount of gold to the bank and the ticket then states that I am entitled to redeem at any time I want my ticket for the gold that I have deposited in the bank.

10:37have deposited in the bank. Now, since the bank performs a valuable service for me that is to safe keep my money, depositors had to pay a depositing fee for this service. And for this service. And the profit of these types of deposit institutions was precisely derived from this depositing fee that was handed over to them. These deposit banks originally had 100% reserves for any amount of tickets or any ticket that they They issued, they did have precisely the stipulated amount of gold backing it.

11:34This meant that as long as the public believed that the banks were in fact engaging in this type of depositing practices, that these paper tickets acquired purchasing power just like They had purchasing power just like gold itself had purchasing power because they were nothing else but a title to gold. They were as good as gold and of course did circulate among the public as if they were gold. So we have here a distinction so to speak between genuine money, gold, and money substitutes, pieces of paper entitling you to a certain amount of gold. Though this is called 100% reserve deposit banking. Deposit banks however quickly realize that because they are dealing with the deposits of fungible commodities, that is commodities where the person redeeming the paper tickets is not genuinely interested in receiving precisely the money.

12:46the identical gold coins back that he handed in, but is only interested in receiving gold coins of the same quality and quantity. When it comes to functioning as a warehouse for fungible commodities, there exists a possibility of engaging in some sort of cheating activities. All these types of institutions realize, of course, that not all depositors will come at the same time and want to have their notes redeemed at the same time, but only a certain number of people come every day and the banks find out over time that if they keep less If they are less than 100% in reserves, they can easily fulfill all of their obligations as they arise when people come and want to have their money redeemed.

13:47These banks began to loan out, charging of course interest on these loans. Now this type of institutional setup is called fractional reserve banking. That is, these deposit institutions do not, are not in a position that they could fulfill all of their contractual obligations that they have against all of their clients at the same time as they pretend to be able to do. If they would all come at the same time and wanted to have their notes redeemed, then the bank would actually be unable to pay, because they created also fake warehouse receipts. Warehouse receipts that looked exactly like real warehouse receipts except that there was no money, no gold actually backing it.

14:57Now with respect to fractional reserve banking one should recognize two problems. The one is so to speak a legal problem and the other one is an economic problem. The legal problem is this. The depositors, of course, believe that they are entitled, that they are the owner of everything that that they have actually deposited. At the same time, the banks, by creating fake warehouse

15:43receipts, have granted control over certain sums of money to borrow us from them. Since

15:54they do not have 100 percent reserves, the paradox arises that two sets of people, that is borrows on the one hand and depositors on the other hand claim, so to speak, to be at the same time the owner of the same resources. It should be perfectly clear that this is a legal absurdity. No two people can be at the same time the exclusive owner of the same resources. Now, this should be regarded as fraudulent regardless of the fact whether that is observed or is discovered or not. Let me just give you an analogy. Let's say I park my car in front of my house and go on a trip for a week.

16:44My neighbor knows that I go on a trip for a week and now uses my car during that time period. and when I return my car is of course parked exactly where it is supposed to be. Now has a fraud occurred? Obviously the fraud has not been discovered but that a fraud has occurred seems to be rather obvious to me. Now the same thing is true as far as I can see with respect to fractional reserve banking. It is not important to make the point that yeah but the fraud has not been discovered. The decisive point is has a fraud occurred? fraud occurred and I think it has occurred. The second problem with fractional reserve banking is that it implies the seeds of a business cycle, fractional reserve banking causes business cycles, boom and bust cycles.

17:51Again, remember what I mentioned early on when I said how loan banks function. That is, entering a time contract that means that I have abstained from using certain goods. The money that comes into the hands of the investor is now the person who uses these goods, which I abstained from using in order to conduct his investment project. In fractional reserve banking, first of all we realized of course that there is in fractional reserve banking now an increase in the money supply taking place, which does not exist under 100% reserve deposit banking. 100% reserve deposit banking means of course whenever I If I deposit a gold coin, a ticket will be issued. But the total amount of money remains always the same. Gold disappears, so to speak, from circulation. A ticket is entered to circulation or vice versa. If I take the ticket back, then the ticket disappears from circulation and the gold re-enters circulation. So only the composition of money changes, but not the total amount of money.

19:14In fractional reserve banking, however, the total amount of money is increased. That is, there are additional tickets printed and these tickets now circulate. Now, the problem with the business cycle. Now, if I issue fake warehouse receipts, print up new tickets backed by nothing and loans looking perfectly identical to others and I loan these paper tickets out to potential investors, then these potential investors starting their investment project cannot possibly use resources that savers have abstained from.

20:09and from using themselves. That is, if we assume that the general public has the same investment consumption proportion as before, due to fractional reserve banking, now there will be more investment projects started than is warranted in light of the genuine savings of the Public, that is, in light of the genuine goods that people have abstained from using by engaging in savings. That is, we have more investment than is warranted in light of genuine savings. Given the fact that the consumption investment ratio is given for the general or public, the consequence must be that due to fractional reserve banking there will be over-investment, over-ambitious investment, which will have to be eventually liquidated due to a scarcity of genuinely saved goods.

21:30That is to say, fractional reserve banking will invariably not only be fraudulent, it will as the economic aspect of the problem also cause a boom, over-ambitious investment projects and then afterwards a bust, where these over-ambitious projects will have to be systematically liquidated. Now let me say a few words about the system that is referred to as free banking. Free banking is a system where we have a commodity money in place, no central bank, competing commercial banks, all of them allegedly on some sort of gold standard, but all of the banks are allowed to engage in fractional reserve banking. At least there is no law prohibiting them from engaging in fractional reserve banking. They can create money substitutes that are not backed by gold out of thin air. Now while this system of free banking, the name might actually be somewhat inappropriate because the term free of course implies that

23:13there is also no ethical objection that could be leveled against it, but as I said there There are also ethical problems involved in engaging in fractional reserve banking in the first place, so maybe the term free banking is not even accurate for this type of system, but in any case it has become some sort of technical term for this type of setup. The view that Ludwig von Mises for instance had on a system of free banking was that this Re-banking was that this was definitely superior over a system of central banking because he realized that due to the fact that if a single bank, commercial bank, issues fake warehouse The Bank could not be sure that these notes that it prints up will only circulate among the clients of the very bank itself. If they would only circulate among the clients of the very bank who issues these notes, the bank would only have to change book entries, so to speak. On the other hand, if these notes issued by banks uncovered by anything would

24:47come into the hands of non-clients of the bank, of clients of different banks, then of course these clients would immediately deposit these notes in their bank and their The Federal Reserve would approach the bank who issued these notes with a request for redemption and this would then put the issuing bank under pressure to reduce their money supply again in order to avoid bank cases of bankruptcy. called adverse clearing and it is very similar to what Professor Salerno explained in terms of the international arrangement with one country inflating more than the other one and then gold flowing out of one country and entering another country and restoring discipline so to speak. The system of free banking functions very similar within a country so to speak as this international scenario. So the relative advantage of this system is that due to the fact of adverse clearing, free banks engaging in fractional reserve banking would by and large hold very high reserve ratios. That is, they would actually operate close to a

26:13to a 100% reserve bank. Now turning to central banking or monopoly banking. In this case, we have all people, so to speak, being clients of one and the same bank, or if the people are not directly clients of one and the same bank, then all All banks, all the different commercial banks are clients of one central bank, which is to say indirectly, even if we deal with our competing commercial banks by the commercial banks using the central bank as their bank, indirectly we are made all clients of one and the same banking cartel with the government bank at the very top.

27:12The system functions basically in this way. Assuming now we are no longer under the gold standard, it works in the following way. Only the monopoly banks, central banks, can issue Federal Reserve notes or German marks or Italian lira or whatever it is. and the commercial banks can then issue checkbook money on top of Federal Reserve notes printed by the commercial bank. The way to get these commercial banks to participate in this type of scheme is to cut them basically into the counterfeiting machinations. That is, the system is set up in such a way that first you have the central bank creating out of thin air Federal Reserve notes and then the commercial banks are permitted to create additional checkbook notes out of thin air again on top of the notes created by the central bank out of thin air. So it is not very difficult to understand that the commercial banks and the central bank like this type of setup because it is basically a conspiracy between various types of counterfeiters.

28:42The money supply is then made up of two components, Federal Reserve notes and checkbook money. and checkbook money. In most of the countries there exists some sort of laws that prescribe how much reserves commercial banks must have given the outstanding demand deposits in the

29:08United States as roughly 10%. That is 10% of the demand deposit checkbook money can Checkbook money can be redeemed in the form of Federal Reserve notes, 90% could not be redeemed.

29:26Under a paper money standard, this is of course not too big a problem because even if everybody would go to the bank at the same bank, they would have to declare a bank holiday for a short period of time and then have to turn on the printing press and the central bank would supply them with sufficient liquidity in terms of Federal Reserve notes. Now briefly to the operation of the current system. The total amount of money in existence, The total amount of money in existence, the narrow definition, consists of Federal Reserve notes in the hands of the public and the amount of deposit, checkbook money.

30:29There are two factors that influence the total of these two parts. On the one hand, as I already said, the reserve requirements are decisive. That is to say how much in terms of Federal Reserve notes the commercial banks have to have in their deposit accounts with the Federal Reserve system to back up their checkbook accounts. If we would, let's say, have reserves of 20% and lower the reserve requirement to 10%, This would by and large mean that the money supply could be doubled overnight. The tendency has been by and large for reserve requirements to be lowered in the course of time. When the Federal Reserve System was founded in the United States, reserve requirements were something like 20 percent. In the meantime, they are about 10 percent. And the second The main factor that determines the total amount of money in existence are of course the reserves that commercial banks hold at the central bank.

31:57And these reserves are in turn determined by two factors. On the one hand by the public. The public has an influence on the amount of money in existence by converting checkbook money into cash or doing the opposite, that is depositing cash and receiving in return checkbook money. Now by the public withdrawing cash from the bank, the money supply is reduced by a multiple of these cash withdrawals because banks can of course pile checkbook money on top of the deposited Federal Reserve notes.

32:52So if people take out cash out of the banks, the banks must not only reduce their money supply by this amount, they must reduce it by a larger amount because they pile more checkbook money on top of each note than just simply one-to-one. Now, if we look, for instance, at some reasons that make people want to have more cash rather than checkbook money, one would have to say, for instance, that the existence of an underground economy is non-inflationary, it is, so to speak, deflationary. The more people pay in The more people pay in cash because it is more dangerous, you can be more easily traced if you pay in the form of checks, the less inflationary the situation is.

33:51Of course also the fact that foreign countries, due to the fact that they have astronomically high inflation rates, also induce very frequently dollars as their currency also contributes leads to the fact that there is less inflation, so to speak, in the United States. On the other hand, the improvement of clearing systems, let's say introducing credit cards or something like that, reduces the amount of cash used by the public and makes the public use more checkbook money. So the introduction of credit cards has a one-time inflationary These are the influence that the public has on the total amount of money in existence by either depositing cash in the banks, they increase the money supply and by withdrawing cash from the banking system they reduce the amount of money in existence.

35:01On the other hand, of course, the central bank has an influence on the amount of reserves in existence. And let me only mention here the most important way in which the central bank can influence the amount of total reserves in existence. And that is through so-called open market operations by the central bank. The central bank can buy in the open market any type of asset that they want. By and large they buy old existing government bonds, but in principle they can buy anything they want.

35:51And how do they pay for this? Now, they pay for this in the good old counterfeiting way. They simply write a check on the Federal Reserve out of thin air and write down one million dollars paid to Joe Blow for the acquisition of a house and a car and whatever it is. And then the person who receives this check can can of course not do anything with it immediately because private citizens are not permitted to deal with the central bank. What he will do is he will go to his commercial bank and deposit the check in his commercial bank. And then the commercial bank will approach the central bank and ask the central bank, please enter this amount in my account that in my account that I have at you, the central bank. Now the commercial bank has higher reserves by the same amount as the open market purchase than it had before and if it has higher reserves than it had before by the amount of the open market purchase, it can now pile of course

37:14A multiple of checkbook money on top of this check created by the Federal Reserve. So again, we have, so to speak, Federal Reserve creating money out of thin air and on top of this money created by the central bank, we have the commercial banks once again creating checkbook money out of thin air. As I mentioned before, it is in a way easy to see what huge scams this is. And it is

37:53also easy to understand that those who are the scam artists have of course no inclination whatsoever to stop their scam operations until the public one day understands what sort of and what sort of rip-off system this whole thing is. Thank you.