Criticism of fractional reserve banking

Main article: Fractional-reserve banking

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Criticisms of fractional reserve banking have been put forward from a variety of perspectives. Critics have included economists such as Irving Fisher, and Milton Friedman. Within the economics profession, most criticisms are from the Austrian School. There are also critics from outside the economics profession who advocate monetary reform.

Terminology

Critics of fractional reserve banking and the related fiat paper monetary system may refer to it by the term debt-based monetary system, or credit-based monetary system.

The term, "debt-based monetary system," and related terms, such as "debt money" are not used by conventional economists or academic mainstream economists. Mainstream economists often refer to "debt money" simply as credit, and distinguish between types of money only after the money is created. The mainstream generally do not discuss or comment on the fact that virtually all money is now created through individuals, or businesses, or governments going into debt to government-sponsored commercial banks. The subject of debt-based money (as distinct from traditional monetary policy) is absent from most established mainstream academic economic publications.

Typical criticisms

Norm Franz states in his Money and Wealth in the New Millennium:

Gold is the money of kings, silver is the money of gentlemen, barter is the money of peasants – but debt is the money of slaves.

Robert H. Hemphill, credit manager of the Federal Reserve in Atlanta, stated in 1939:

If all the bank loans were paid, no one would have a bank deposit and there would not be a dollar of coin or currency in circulation. This is a staggering thought. Someone has to borrow every dollar we have in circulation, cash or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. When one gets a complete grasp of the picture the tragic absurdity of our hopeless position is almost incredible, but there it is. It (the banking problem) is the most important subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it becomes widely understood and the defects remedied very soon.

Ron Paul states in his book End the Fed:

American presidents actually worked to implement and defend the gold standard, which put a brake on the ability of the largest banks to expand credit without limit. The gold standard worked like a regulator in this way. Ultimately, banks had to function like every other business. They could expand and make risky loans up to a point, but when faced with bankruptcy, they had nowhere they could turn. They would have to contract loans and deal with extreme financial pressures. Risk bearing is a wonderful mechanism for regulating human decision making. This created a culture of lending discipline.

In the jargon of the day, the system lacked "elasticity." That's another way of saying that banks couldn't expand money and credit as much as they wanted. They couldn't inflate without limit and count on a centralized institution to bail them out...

The banking industry has always had trouble with the idea of a free market that provides opportunities for both profits and losses. The first part, the industry likes. The second part is another issue. That is the reason for the constant drive in American history towards the centralization of money and banking, a trend that not only benefits the largest banks with the most to lose from a sound money system, but also the government, which is able to use an elastic system as an alternative form of revenue support. The coalition of government and big bankers provides the essential backbone of support for the centralization of money and credit...

Consider the Soviet case: to my knowledge, no business ever went under with the Soviet system but society in general grew ever poorer. Think of that Soviet system applied to the banking industry and you have the Fed.

In the foreward to Fiat Money Inflation in France, Mr John McKay wrote the following:

The story of "Fiat Money Inflation in France" is one of great interest to legislators, to economic students, and to all business and thinking men. It records the most gigantic attempt ever made in the history of the world by a government to create an inconvertible paper currency, and to maintain its circulation at various levels of value. It also records what is perhaps the greatest of all governmental efforts—with the possible exception of Diocletian's—to enact and enforce a legal limit of commodity prices. Every fetter that could hinder the will or thwart the wisdom of democracy had been shattered, and in consequence every device and expedient that untrammelled power and unrepressed optimism could conceive were brought to bear.

But the attempts failed. They left behind them a legacy of moral and material desolation and woe, from which one of the most intellectual and spirited races of Europe has suffered for a century and a quarter, and will continue to suffer until the end of time. There are limitations to the powers of governments and of peoples that inhere in the constitution of things, and that neither despotisms nor democracies can overcome.

Legislatures are as powerless to abrogate moral and economic laws as they are to abrogate physical laws. They cannot convert wrong into right nor divorce effect from cause, either by parliamentary majorities, or by unity of supporting public opinion. The penalties of such legislative folly will always be exacted by inexorable time. While these propositions may be regarded as mere commonplaces, and while they are acknowledged in a general way, they are in effect denied by many of the legislative experiments and the tendencies of public opinion of the present day. The story, therefore, of the colossal folly of France in the closing part of the eighteenth century and its terrible fruits, is full of instruction for all men who think upon the problems of our own time.

C.J. Maloney wrote of the desperation of Henry VIII of England to counterfeit gold by engaging charlatan-alchemists:

Despite his formidable education and great historic reputation, the disastrous interventions into the economy, the lifelong dishonesty with the currency in his care and, most of all, his laughable attempts to bring a sorcerer into his court to conjure gold, mark the great King Henry VIII as a fool. Yet there is no reason, be warned, for anyone to feel superior to the King; one only needs to pick up a newspaper to see that though alchemy may be a dead science, it has merely taken up new forms.

This has always been and always will be, for its immortality is powered by economic man’s most dangerous, fondest wish, the one that will drive us to endless imbecilities and repeated destruction – the ardent desire to believe that you can get something for nothing. His adherence to that belief made King Henry VIII a man of his times – and ours.

In his treatise, The Ethics of Money Production, which was published by the Mises Institute in October 2008, Jörg Guido Hülsmann presents (at pages 238-239) the following description of the perverse rise of fiat money and fractional reserve banking:

There is no tenable economic, legal, moral, or spiritual rationale that could be adduced in justification of paper money and fractional-reserve banking. The prevailing ways of money production, relying as they do on a panoply of legal privileges, are alien elements in the capitalist [i.e., true free market] economy. They provide illicit incomes, encourage irresponsibility and dependence, stimulate the artificial centralization of political and economic decision-making, and constantly create fundamental disequilibria that threaten the life and welfare of millions of people. In short, paper money and fractional-reserve banking go a long way toward accounting for the excesses for which the capitalist economy is widely chided.

We have argued that these monetary institutions have not come into existence out of any economic necessity. They have been created because they allow an alliance of politicians and bankers to enrich themselves at the expense of all other strata of society. This alliance emerged rather spontaneously in the seventeenth century; it developed in multifarious ways up to the present day, and in the course of its development it created the current monetary institutions.

…The driving force that propelled the development of central banks and paper money was the reckless determination of governments, both aristocratic and democratic, to increase their revenue, if necessary in violation of good faith and of all established rules of commerce.

Certain monetary reformers claim that a fiat money/fractional-reserve based banking system is inherently destructive and inevitably generates debasement of the currency, extreme inequality or periodic crises. Vladimir Z. Nuri has analyzed fractional reserve banking and considers it a form of economic parasitism. This view is not accepted by mainstream economists.

Critics of fractional reserve banking frequently argue that since money creation requires loans from the banking system, people are required to go further into debt in order for any new money to be created. They theorize that this eventually causes credit cycles (or business cycles) and necessarily debases the means of exchange.

Many critics find it problematic that banks "create money out of nothing" and consider this akin to counterfeiting and/or embezzlement.

Other critics link the alleged negative effects of fractional reserve banking with central banking and a government-enforced "paper" or fiat currency, which they claim allows the practice of fractional reserve banking to continue without a "natural" limitation on the growth of the money supply, thereby causing inherently unsustainable "bubbles" in asset and capital markets, which are vulnerable to Ponzi-like speculation by highly leveraged hedge funds and other bank agents.

Some critics (particularly those from the Austrian School) support a "full reserve" banking system and criticize fractional reserve banking as inherently fraudulent. Murray Rothbard held this view very strongly throughout his life. Others support free banking.

Basic debate

Many Austrian economists and monetary reformers focus on the combined use of fiat currency, fractional-reserve banking and central banking as a negative feature of modern monetary systems. These commentators use the term "debt-based monetary system" to refer to an economic system where money is created primarily through fractional-reserve banking techniques, using the banking system. This form of money is called "debt-based" because as a condition of its creation someone must go into debt in order for the money to be created and it must be paid back plus interest at some time in the future.

To some commentators, this implies that as the money supply and the economy grows, the general populace becomes increasingly indebted at the same time due to the idea that debt grows in parallel with money supply growth, and increasing interest payments (from either taxpayers or indebted consumers) are needed to pay bondholders as the money supply grows.

One argument posits that since debt and the interest on the debt can only be paid in the same form of money, the total debt (principal plus interest) can never be paid in a debt-based monetary system unless more money is created through the same process. For example: if 100 credits are created and loaned into the economy at 10% per year, at the end of the year 110 credits will be needed to pay the loan and extinguish the debt. However, since the additional 10 credits does not yet exist, it too must be borrowed. To some, this implies that debt must grow exponentially in order for the monetary system to remain solvent.

Others argue that there is in fact no mathematical necessity for the stock of money in a debt-based system to grow, as the "turnover" or "flow" or "velocity" of money can increase to allow for compounding interest payments. However this does imply that some consumers would increasingly have to consume and transact to expand the GDP sufficiently to allow the fixed stock of money to turnover sufficiently to pay for the interest compounding on top of the debt. This may mean that Ponzi-like dynamics bubble up in "pockets" of the economy with interest payments being allowed in a fixed money economy, but these "pockets" of higher consumption or speculation would pop and die out relatively quickly.

Basic nature of system

The economic, environmental and social effects arising from money creation through fractional-reserve banking have been subject to much heated political debate for well over two centuries.

Critics claim that, in contrast to "debt money" (which is money created in parallel with the issuance of debt or credit), "true" fiat currency is issued by the Treasury of a central government debt-free, as no requirement for its eventual return is made as a condition of its creation. Government-issued debt-free fiat currency (such as debt-free notes and coins) can circulate perpetually in the economy as "stable" or even sound money (if backed by gold or silver) and although not as stable as hard currency, government-issued debt-free notes and coins (such as United States Notes and silver certificates) do not have the same effects of debt-based money described below. It should be noted however that fiat currency can be a source of hyperinflation if its production is not controlled, as the government has the potential to issue unlimited amounts of fiat currency - provided it is accepted as "money" by the private banking system. Notes and coins in circulation (being defined as M0) now account for a tiny fraction of the total M3 money supply in all developed, debt-based capitalist economies (and M0 is also generally less than 10% of the total M2 money supply in most developed economies).

Similarly, gold, silver and other precious metals have in the past been used as money. Because of the difficulty in increasing the supply of precious metals quickly, some monetary reformers believe a return to the gold standard, or a similar system of "hard" or "real" asset-backed currency, is the only way to stabilize the growth of the money supply. These monetary reformers often refer to the gold standard and silver standard as "sound money" or "honest money".

Other economic and political criticisms

In a 2003 statement to the U.S. House of Representatives, Ron Paul stated "if unchecked, the economic and political chaos that comes from currency destruction inevitably leads to tyranny".

Some economic thinkers (primarily members of the Austrian School) and political commentators believe that a debt-based monetary system amounts to a subtle form of monetary "fraud" in that it creates money "costlessly" through the use of fractional-reserve banking techniques.

Michael Rowbotham is an active proponent of monetary reform, and argues that this system of money supply is perverse and inherently monopolistic and "anti-democratic", as it creates an inflationary exponential growth imperative in the economy which leads to over-centralization and environmentally damaging and unstable over-consumption. Critics such as Rowbotham argue that the indebted are forced to induce new consumers to spend their way into debt so existing loans can be repaid with new debt-created money. Failure to achieve this goal results in foreclosure for those businesses and insolvency in the banking system that leads to economic collapse due to the sudden contraction of the money supply.

Mark Anielski as well as some political thinkers such as Rowbotham and some economists (such as Hyman Minsky, Steve Keen and Mike Shedlock) argue that this system of money supply has characteristics similar to a pyramid scheme, where the newly indebted are compelled to induce others into debt to pay off their own debts. It is therefore argued by a number of monetary reformers that fractional-reserve banking and the associated exponential growth of money in the economy "forces" the economy towards indebted consumerism.

Rowbotham argues that a major negative side-effect of the debt-based monetary system is its effect on agriculture, claiming that residential development produces one of the greatest continuous injections of debt money into the economy. Therefore, significant super-normal profits can be generated by re-zoning agricultural land and replacing it with low-density housing. If this is correct, this trend will lead to the destruction of fertile arable land, as farmers cannot compete to retain fertile arable land from property developers at the periphery of major population centers, and as this land is then progressively re-zoned for speculative new residential development. Rowbotham also predicts that the global supply of fertile arable land will decline, leading to a broad decline in the quality and nutritional value of agricultural produce and, eventually, a dramatic increase in the prices of many "soft" commodities - which could then lead to actual food shortages for poorer segments of the world population.

If for any reason the monetary system broke down, urban populations (nominally "rich" but poor in terms of direct access to food supply) could find basic foodstuffs either rationed or unavailable at any price, ultimately resulting in food security becoming a major public policy issue - particularly if combined with oil supply shortages or an oil price spike, as major population centers worldwide are almost entirely reliant on mass transportation of food from distant (or even foreign) locations to survive day-to-day.

Effects on economic health

According to Michael Rowbotham the expansion of money through debt creates economic bubbles. This concentrates wealth in the hands of private banks as the populace is forced into debt simply to own a home and educate their children. Debt expansion leads to price appreciation of assets through speculation as the financial market becomes riskier. Edward Chancellor compares this type of market to a monetary Ponzi scheme.

The bust phase of this business cycle where "debt-based" money growth slows or contracts catches newly indebted businesses and consumers who are left out of the growth cycle.

Effects on the environment

There are also critics in the left-wing and environmentalist camps who contend fractional reserve banking (by creating a necessity for indefinite economic growth) leads to environmental destruction and a sudden, catastrophic depletion of natural resources as the unsustainable, exponential consumption of the world's scarce natural resources reaches its inevitable limits.

Inherent problems with the system

Some monetary reformers predict that there will be an increased incidence of financial crises in the developed world, as economic and population growth inevitably slow and as the success of financial sector lobbying results in a reduction in redistributive tax policies which, combined with the debt-legacy of the welfare state, allows an intense and unsustainable concentration of wealth and political power in the financial services sector.

Some monetary reformers argue that perverse incentives in the financial services industry lead to a collusive relationship between governments and bankers which are economically and socially destablizing in the long run.

Some monetary reformers argue that it is vital that the indebted "victims" who must sink deeper into debt for the system to survive do so voluntarily and willingly and are not made aware of the consequences of purchasing consumables with debt money. Some politicians and others have highlighted the fact that mainstream media organizations appear to downplay or minimize the seriousness of deficit spending by government and debt-sourced spending of all kinds. The associated growth of derivatives during the upward phase of the debt money cycle was referred to as "innovation" in financial markets.

Bankruptcy laws differ to a small degree in different jurisdictions but in all developed economies unpaid debt results in legal penalties, property confiscation on behalf of the creditor and income sequestration. Although in Christian, Jewish and Muslim religious practice there have been traditions of debt relief or laws against usury, in no modern Western jurisdiction are any debts periodically forgiven or cancelled in recognition of the inherent impossibility of repaying debts in circumstances where the debt-based monetary cycle has inevitably resulted in too little new debt money being injected into the money supply to pay for the currently outstanding debts.

On a national level, if the issuance of government bonds becomes unsustainable, sovereign bankruptcy can occur - and has occurred many times in history. Sovereign debt crises due to the inability of nations to pay interest on government bonds have occurred frequently and regularly in the third world and less frequently (every 30 years or so) in the first world as a result of high levels of unsustainable public debt - often because private debts are assumed by a corrupt government through large private bank bailouts. The Latin American debt crisis is an example of sovereign debt levels becoming unsustainable, resulting in a currency crisis and economic collapse, as interest rates rise precipitously due to the inability of the national government to attract financiers to purchase new government bonds to inject new debt money into the ailing economy.

At such times, it is the responsibility of the IMF to come in as a kind of supranational central bank to mediate between the national government and international financiers. The role of the IMF as central bank to the world has similar responsibilities and risks inherent in central banking which are described below in relation to the role of the Federal Reserve. If the IMF repeatedly intervenes to save financiers from loss when sovereign bankruptcy occurs, this has a tendency to induce moral hazard and can encourage the financing of reckless government spending and borrowing.

A single currency regime such as the Euro can mask national liquidity or solvency crises, by ensuring that a national currency is not quickly exchangeable for another, thereby restricting the ability of national governments to depreciate their currencies and cutting off the possibility that the real value of government bond interest repayments could decline relative to other currencies. This may however increase the risk of bond default where indebted national governments cannot pay back the interest payments in the denominated common currency.

Types of downturns

Main article: Austrian Business Cycle Theory

There are two main kinds of debt money contraction that can cause a collapse in the value of inflated assets.

A "credit squeeze" occurs where new debt money is difficult to access without a high credit rating. At such times marginal borrowers, or those who have borrowed at the end of any debt-induced asset bubble, get "squeezed" out of further borrowing and a contraction in the growth of new debt money occurs, triggering a slow down in the growth of inflated assets. Those assets can then be "harvested" by the private banks through widespread foreclosure or bankruptcy and re-sold to those with the money to buy the distressed assets.

A "credit crunch" occurs where new debt money is not available at any interest rate - even for those with previously acceptable credit ratings - due to widespread insolvency in the banking system. At such times, it is the banking system itself that is insolvent and other financial institutions (including overseas financiers) become reluctant to lend to the domestic banking system, resulting in the domestic banking system being unable to issue loans even to credit worthy borrowers.

At any stage during the downward spiral of a "credit crunch", the central bank in a modern economy can try to save the system from complete economic meltdown by purchasing (either indefinitely or temporarily) the failed debts of the private banks. This involves swapping depreciating "failed" assets with hard cash, thereby allowing the banks to maintain their net asset position and continue to give the impression of solvency to their auditors and depositors. However, doing so results in cash being transferred to the private banks in exchange for bad debt, thereby violating the general economic precept to avoid moral hazard and effectively makes liquid the failed lending decisions of the private banks. In the U.S. banking system this is called "opening the Fed discount window", where the Federal Reserve temporarily purchases the failed investment portfolios of distressed private banks in exchange for cash. However, this rescue measure may only delay, rather than avoid, the realization of losses in the banking system, as the central bank cannot "force" new borrowing into the system to inject new debt money into the money supply. Somebody has to be a counterparty to borrow the debt money that is being offered. If all market participants realize a "bubble" has formed in assets markets, there will be few (or no) buyers for new debt money, as no one wants to borrow to buy inflated assets no one else will buy. Money markets can therefore remain illiquid even with intense central bank support.

Furthermore, banks can go bust even with intense central bank support, if the issue is not one of liquidity, but one of solvency.

Pushing on a string

Some monetary economists describe the opening of the Fed discount window after the bursting of an asset bubble as "pushing on a piece of string", as this measure does not solve the key problem – creating new credit (or debt money) to keep up the growth in the money supply and maintain the required level of liquidity in credit markets. This is because unlimited central bank money and low interest rates allow credit creation, but do not force it into the system. In order for any new debt money to be created, somone has to borrow the excess reserves in order for the money to be injected into the system. If corporations and individuals are already heavily indebted (or insolvent after the bursting of another debt-induced bubble) there are no credit-worthy borrowers to lend to.

To encourage fresh borrowing, central banks generally combine these rescue measures with an interest rate cut to encourage more new borrowing to allow the existing (failed) debts to be liquidated at or close to their original value. When Alan Greenspan repeatedly resorted to this tactic to revive illiquid money markets this became known in the market as the "Greenspan put", as the effect of these repeated reductions in interest rates was similar to a put option in the stockmarket, insuring banks' lending mistakes would be covered up by the Federal Reserve.

When interest rates cannot go any lower (the so-called "zero bound" monetary problem) and people still will not - or cannot - load themselves up with more debt, then the Keynesian solution is to run large public deficits and indebt future generations (who, they hypothesize, are more likely to be able to pay through increased future growth). Fabian socialists, and Keynesian economists such as Paul Krugman and Robert Shiller, argue that governments must take charge of the responsibility of spending more (and taking on more debt) on behalf of the public (who are too fearful to take on more debt themselves) in order to compensate for the immediate and urgent present insufficiency in total private consumption. Paul Krugman is a prominent advocate of the policy of spending trillions of government money to help stimulate the economy, if spending billions does not work. For economists such as Paul Krugman, if the "more and more government spending" solution does not work initially, it is a sign that not enough government money has been spent. It is his view that the "deflationary" Japanese recession from 1991/2 could have been cured by the Japanese government going into even more debt than the current net debt to GDP ratio of 110%.

Although there is active debate as to whether this policy (indebting future generations by the government spending debt-sourced money on projects the private sector would not touch) can actually help the economy long term, there is no argument that this would undoubtedly help the present group of private bankers, as increased income from the interest payments on new government bond issuance offsets the decline in private sector debt and allows private bankers to survive when otherwise they may face collapse due to the fatal impairment of their balance sheets through private debt write-offs after an unsustainable debt-fuelled bubble bursts.

As government debt is effectively an asset on the books of the banks, increasing Treasury bond issuance necessarily increases the profitability and net asset position of the debt-issuing banks - at least until government insolvency renders the value of those bonds worthless.

Inequities in system

In a worse-case scenario, where banks cannot lend even if the government continually swaps failed assets with cash, then the government can try to spend money into the economy and try to "inflate" its way out of economic crisis. It can do this by printing money. This is now called "quantitative easing". Aside from the moral hazard issue, the key risk with quantitative easing (and the associated attempt to control interest rates, to encourage new debt money creation) is that the central bank exposes the financial system to systemic inflation, as the growth in the money supply spirals out of control due to the need to save the banks from themselves, and ultimately precipitates a currency and associated government bond crisis (as the debt-based currency becomes dysfunctional when either the currency becomes worthless or when debtors - including government debtors - cannot even pay interest on the debt money).

For these reasons, a collapse in confidence in the solvency of the domestic banking system (and the central government) is one of the most complex and difficult policy issues any central government can face.

In such crises of confidence, a central bank may choose to save the current players in the banking sector by printing money and inflating its way out of the crisis, thereby debasing the value of the domestic currency. This is now called quantitative easing. Some comentators have commented that the media and the Fed have to constantly come up with new terms (such as "quantitative easing") to hide the fact that they are simply repeating the same failed policy of monetary inflation and the creation of worthless fait money over and over.

This is also referred to by some monetary reformers and economists as "socialism for the rich and capitalism for the poor", as many indebted consumers will still lose their houses and be declared bankrupt regardless whether or not the central bank intervenes to save marginal lenders who have been made insolvent through their mis-timing of the credit cycle. Future generations of innocent taxpayers may ultimately finance any bail out of reckless lenders, as the money used to fund any bail out will be funds diverted from the general revenue of the central government.

Some bankers and financial commentators still refer to Walter Bagehot's 1873 commentary on monetary crises, Lombard Street, in an attempt to gain insights into the way in which central bankers should revive illiquid banking systems. However this old text may be outdated in circumstances where the community's debt limits have been reached and where the banking crisis arises from insolvency rather than illiquidity.

A prime example of the fatal effects of combining aging demographics with reckless bank lending in a purely fiat debt-based monetary system can be found in the case of the Japanese asset price bubble.

The Keynesian Endpoint

Some more extreme monetary reformers and conspiracy theorists anticipate the declaration of martial law and the imposition of fascist-style restrictions on civil rights and freedom of speech by the political Establishment to physically protect it from anarchy or military coup when the bubble of debt completely bursts, either through a precipitous currency crisis or debt-created depression. Some conspiracy theorists also anticipate price controls, then rationing of basic essentials, as the coalescence of a corrupt banker-government coalition solidifies to eliminate potential dissent and ensure the forced elimination - by any means necessary - of any actual or potential competing currencies that could threaten the viability or legitimacy of the monopoly currency, which could include the compulsory confiscation of all privately-owned gold (gold being the ultimate reserve currency, still used by central banks as a universally accepted medium of exchange for the settlement of international debts).

There have been many monetary crises throughout history and prior to widespread anarchy or revolution, in the late stages of a financial bubble, there are a number of warning signs of impending chaos caused by a complete breakdown of trust in the debt-based monetary system. Just prior to the complete collapse of the pyramid scheme of public and private debt, the economic system tends to feed on itself, and in the past, where debt-created depressions or periods of hyperinflation have occurred in Europe, the U.S. and China, there has been a sustained spike in predatory economic behavior, as the heavily indebted central government and producers are forced to find more extreme (previously considered unethical) methods to extract any remaining wealth from increasingly desperate and impoverished consumers, who are either unwilling or unable to go into further debt without forceful coercion. Long-term investment and sustained capital investment are almost impossible in this environment because the "measuring stick" of return on investment (the real value of money) is so uncertain at times of debt-induced credit crunch, depression or hyperinflation.

As potential new borrowers and international financiers are scared away from participating in the pyramid scheme of debt and borrowing further, the monetary system seizes up, starved of the fresh injections of debt money it needs for its survival, thereby precipitating economic anarchy, widespread lawlessness and insolvency of the monetary and banking system. Some have described the moment when governments cannot borrow any more from banks to keep up the growth in debt money as the "Keynesian Endpoint" - which is the point in time when the in extremis "emergency" measures by the government to kick-start the economy by increasing total gross debt have no lasting positive effect on GDP. Antal E. Fekete identifies this "crisis" point as the point when the marginal increase in total gross debt has no positive marginal effect on GDP. According to Professor Fekete, once the marginal productivity of debt turns negative, a disastrous depression is inevitable.

This final denouement is triggered when borrowers cannot be found to buy depreciating heavily indebted assets, and international financiers reduce lending as they experience losses on pre-existing loans either through asset or currency depreciation. Some analysts predict that the monetary system will seize up due to a deflationary depression or a sustained period of stagflationary hyperinflation resulting in a "final and total catastrophe of our fiat monetary system."

This has often occurred after a failed aggressive war, as international financiers realize the heavily indebted government they funded will not gain the resources it planned to seize as a result of the waging of aggressive war. When this pay-off does not materialize, the government is left with the debt of war without the ability to offset this government debt through the imposition of reparations on the defeated nation and the acquisition of the defeated state's resources. This occurred to Germany after the First World War and Japan after the Second World War.

Whatever the trigger, the key warning sign of any impending monetary crisis and economic anarchy is a sudden currency crisis, or a sudden spike in domestic interest rates, or a sudden credit crunch. Early warning signs that the private banks themselves are aware of an impending breakdown in the solvency of the financial system would be: a spike in the prices for oil (which is an internationally accepted, inherently limited, store of value, and therefore can act as a modern form of hard currency, oil sometimes being referred to as "black gold"), gold, silver and other stable, non-perishable, inherently limited natural resources essential for non-discretionary industrial production; a spike in the futures contracts for vital agricultural commodities such as sugar, coffee, wheat, soybeans and rice, as investors realize the debt-based monetary system has squeezed supplies of arable land; a sudden flight of money to Treasury bills and/or a sudden spike in the interest rate differential between short-term Treasury bills and asset-backed corporate paper (or a sudden spike in the LIBOR rate in London) - and then, in the very late stages of a credit crisis, a sudden and disorderly flight of money away from government bonds and a "shock" or "panic" collapse in government bond prices, as banks perceive that some governments will ultimately find it impossible to pay interest on their debt from coercively acquired taxes.

Shortly thereafter, some monetary reformers predict that there would be desperate, but ultimately futile central bank intervention, a currency crisis, a panic run on a number of marginal, insolvent banks and hedge funds as desperate wealthy investors try to get cash out before the pyramid scheme collapses to invest in inherently limited, non-perishable, in-demand commodities such as oil and gold (and undeveloped agricultural and industrial land in areas of the world with strong economic growth), followed by a recession or depression in the broader heavily indebted economy as the money supply contracts.

In 2010 Ireland and Greece experienced simiilar financial crises along the lines described above and many financial commentators and politicians expect more countries to go through the same debt crisis. In 2011, Tunisia experienced a financial and political crisis that was almost identical to those already experienced on the poorer European periphery, except that in this case the pre-existing political establishment quickly fled the country in fear for their safety - with some allegations that the wife of the deposed leader, Leila Trabelsi, ordered the country's central bank to transfer 1.5 tonnes of gold to Zine El Abidine Ben Ali and his family. Following the overthrow of the ruling elites in Tunisia, other North African countries have experienced similar uprisings - all attributable to higher food prices, according to some noted commentators, who have accused Fed Chairman Ben Bernanke of literally having "blood on his hands" due to the encouragement of food price inflation via sustained inflationary loose-monetary policies. The central banker has denied that his inflationary loose-monetary policies have contributed to food inflation. Implicit in Mr Bernanke's argument is the assumption that the central bank can create "good" inflation in some markets and avoid "bad" inflation in others. This alleged central bank power to direct good inflation and abate bad inflation is derided by a number of commentators.

Noted British Telegraph commentator Ambrose Evans-Pritchard has called these the first Malthusian "Food Revolutions" of the modern era, as agflation causes political instability on the periphery of major economies worldwide - particularly those countries that have already denuded their agricultural base and have to import grain and other foods to survive.

It is also reported that very complex, delicate negotiations are taking place between debtor and creditor nations to swap government bonds with gold at prices far in excess of the declared "market price" of gold. These so-called "off-market" deals are a sign the Keynesian Endpoint has arrived.

Potential solutions

Although time is the only real remedy for monetary crises (allowing re-inflation of the markets through the gradual injection of new debt money into the system through new borrowings), time is something panicked financiers and investors are least likely to want to give up when the threat is never getting their money out of the imploding investment bubble. In extreme cases banks could set up "independent" corporate investment vehicles to buy the assets associated with the bad debt, thereby allowing borrowers to liquidate their investments and allow time for the markets to re-inflate. Alternatively, these "sour" loans, that have gone bad through too much debt overwhelming the markets, could be dumped or "hidden" on the central bank's balance sheet, and swapped for more secure government debt (financed through compulsorily acquired taxes, which are immune from the risk of private bankruptcy). However the holding costs involved in these measures would be extremely high and would not guarantee that the losses could be averted if no new gullible investors could be found to offload these distressed assets. More fundamentally, these short-term "parachutes" used after bubbles burst do not save ordinary borrowers from foreclosure and bankruptcy, nor do they address the pernicious long-term dysfunctional aspects of fractional reserve banking described above. These problems are temporarily averted, only to be dealt with yet again by the next generation of indebted governments and peoples.

Given these repeated financial crises arising from the debt-based monetary system, many monetary reformers predict that there will inevitably be a spontaneous market-induced return to the gold standard, a fundamental change in the way money is produced and distributed (with a return to the prevalence of government-issued debt-free fiat currency and/or free banking) - or a complete financial "meltdown" as fewer young people in developed economies can be found who are willing to go into debt in sufficient magnitude to pay off the debts that have already been accumulated. As extreme inequality increases, foreclosures mount and financial crises repeatedly erupt, these monetary reformers believe a political crisis will eventually result in calls for fundamental monetary reform.

These on-going, worsening, debt-created crises in the economy and society (and the unsustainable damage to the environment caused by debt-created overconsumption) could turn monetary and economic policies either to the extreme left or to the extreme right, as there are a number of competing solutions to the debt-based monetary "problem".

Proposals for monetary reform

Libertarians, Austrians and commodity money

Libertarians and Austrian School advocates envision a society of free markets, free banking, small government and the abolition of legal tender laws, allowing money backed by a free market gold standard or silver standard to come back in circulation, along with the abolition of all monopolistic governmental central economic planning and monopolistic central banking. Some Libertarians would also support experimentation with full-reserve banking, recognizing that when fractional-reserve banking is combined with the gold standard a deflationary bias (and the systematic transfer of real wealth to the banking system) is normally inevitable. Those Libertarians who support full reserve banking would strongly support more flexible and forgiving bankruptcy laws in a fractional reserve banking environment, recognizing that no stigma should be attached to bankruptcy given the anti-Libertarian "unjust acquisition" of real wealth implicit in both fractional reserve banking and taxation.

Regarding the current accumulation of government bonds and private debt, some Libertarians believe that the creation of the Federal Reserve under the Federal Reserve Act of 1913 was unconstitutional and some Libertarians consider that at least some of this accumulated debt should be canceled or forgiven prior to a return to the gold standard in recognition of its fundamental illegitimacy. Arguably this would be supported by the "just acquisition" jurisprudence of legal philosopher Robert Nozick and Libertarian advocate Murray Rothbard.

In late 2010, financial commentator Max Keiser started the Buy Silver Crash JP Morgan Campaign 2010 in an attempt to expose the flaws underlying the fractional reserve banking system.

Reform within fiat currency systems

Stephen Zarlenga of the American Monetary Institute and Ellen Hodgson Brown call for the nationalization of the private banking system once the full losses on the banks' portfolios are recognized. Brown also supports "QE2" - which she describes as a necessary and desirable funding of government spending via money printing rather than by the indirect means of issuing of interest-bearing government bonds, which simply allows private bankers to profit from costless money creation. In late 2010, Ellen Hodgson Brown and Austrian School commentator Gary North engaged in an intense debate over the direction of monetary reform, with gold-standard supporter Gary North accusing Brown of going down a path that inevitably leads to the economics of fascism.

Michael Rowbotham also seeks the cancellation of "unjust" debts (such as third world debt), but would also support the re-introduction of strongly redistributive tax policies involving higher financial transaction taxes (such as a Tobin tax), land taxes and inheritance taxes, and, crucially and most importantly, a social security safety net involving a guaranteed minimum debt-free income (sourced from government-issued debt-free money independent of any central bank) for all citizens in the debt-based economy. Under this proposal, every adult citizen would be given a livable debt-free income transferred electronically into their bank account, simply by virtue of their citizenship. They could then use this debt-free money to pay off their mortgages or to live, debt-free, without being compelled to work as a wage slave in the market economy if they chose not to. The government would finance these payments simply by ordering the private banks to accept their electronic instructions as legal tender. It would therefore not result in the expansion of government debt.

Instead of money being created "indirectly" and "furtively" at the point of loan creation by the private banking system, with periodic bailouts to already-rich bankers, it would be created directly and openly by the democratically elected government and issued to its citizenry by way of instruction to the private banking system.

Rowbotham and Ellen Hodgson Brown both argue in their books that this would not be inflationary (or at least would not be as inflationary or as dysfunctional as the present system). This would also reduce overconsumption and the associated environmental damage associated with debt-based consumerism. It would also give individuals the free time to engage once again in non-marketable religious, artistic and recreational activities if they chose to do so.

Ex-U.S. Treasury Department analyst Richard C. Cook also supports the issuance of debt-free money and zero-interest credit by the central government and has provided a detailed blueprint of monetary reform recommendations to transition to a debt-free money supply.

Many monetary reformers who call on the government to take back the money creation from debt-sourced banks also call for full reserve banking to remove the bank's alleged "embezzlement" and "counterfeiting" abilities.

It is to be expected that these policies would be violently opposed by the private banking "elite", as it would render impotent their control over the money supply, dissipating this crucial decision-making power away from its current power base. It would also be likely to reduce economic growth, dramatically increase the cost of labor and, potentially, simply increase monetary and price inflation as individuals used the additional income to bid up the cost of health care, education, housing, food and other real assets. However, this proposal would undoubtedly address the problem of inequality inherent in a debt-based monetary system and reduce the devastating impact of personal bankruptcy and allow individual citizens to quickly recover from financial hardship. It would also ensure that this social security measure (and government spending in general) would not have to be paid for by future generations from future streams of income tax.

Left-leaning ideas

Many left-leaning social democrats would also support the taxing of the banking system and the enforcement of strongly redistributive income and land taxes to ensure the financially dispossessed are "replenished" with income. They would also support a social security safety net involving the provision of unemployment benefits and government-supplied free medical care, education and other essential services and public goods. It is to be expected however that, without the issuance of debt-free fiat currency, this system would result in the persistent, exponential, accumulation of government debt, financed by the private banking system by the issuance of government bonds. If not properly managed, this could result in a progressively higher tax burden and may result in higher interest rates in the long term, as financiers require higher interest rates to lend to the increasingly indebted central government. Without the issuance of debt-free money these policies can be self-defeating, with the net result simply being that a larger stream of guaranteed income goes to the private banking system via the issuance of interest-bearing government bonds (which are purchased by the private banks "out of nothing" through fractional reserve banking techniques). This government debt must then be financed in perpetuity by compulsorily acquired taxes from future generations.

It could be argued that the early success of extreme right-wing fascism in Nazi Germany and Italy in the period after World War I was a response to the economic chaos created by the debt-based monetary system in early 20th century Europe. Some of the economic policies introduced by Hitler and Mussolini were in direct response to the economic collapse and social anarchy caused by soaring government and personal debt levels in both countries in the post-Versailles Treaty era, and (indirectly) arose from the writings of Silvio Gesell and others on the nature of the problems associated with a debt-based monetary system. Although many historians justifiably criticize many of the non-economic policies of the fascist governments of Germany and Italy during this period, it cannot seriously be disputed that the economics of fascism provided a degree of prosperity to the populace, and that the economic policies that were implemented during this period by these fascist governments succeeded in their stated objective of restoring economic and social order during the pre-World War II era.

Similarly it could be argued that socialism and communism were movements inspired by the inequalities caused by the intense (and in Karl Marx's view unsustainable) concentrations of monetary wealth, power and influence inherent in the practice of fractional reserve banking in a laissez-faire, free market capitalist environment (particularly when fractional reserve banking is combined with a gold standard or other hard currency monetary system).

The communist/socialist solution to the problem of fractional reserve banking is simple: complete removal (and if necessary, violent non-democratic removal) of the allegedly "parasitic" political and financial capitalist class, wholesale repudiation of government debt resulting in complete debt default; forced expropriation of land and wealth from the upper classes to the dispossessed and needy working classes; nationalization of the private banks (which has required armed coups by the military in some past revolutions); and the return of the banking function from a dominant, speculative to a subordinate, administrative institution, where the banking system is reduced to a subservient arm of the centralized Leviathan. In this system, government-owned banks are directed by government policy; often provide different kinds of loans to different industry sectors at different interest rates depending on the perceived "needs" of the economy and the community; normally have a significant proportion of non-performing loans due to weak or non-existent bankruptcy laws; and periodically "forgive" failed debts in recognition of the impossibility of some businesses in paying this debt money back.

It is to be expected that the profitability of the government-owned banking system would be more stable - but dramatically lower - than that in a debt-based capitalist economy. It is also to be expected that a significantly higher misallocation of resources could occur in this system, where lending decisions are "infected" by political considerations and are not made on the basis of expected return on investment. The risk of corruption in the banking system is also expected to be higher where there is no separation between the political and monetary systems in an economy. Market-oriented monetary reformers and neo-classical economists therefore do not support nationalization of the private banking system.

It should be noted that partial nationalization of the private banking system would only be temporary, as any remaining private banks could still engage in unlimited fractional reserve banking and facilitate the eventual acquisition and control of any strategic assets in a partially socialized economic system. It is to be expected that in the absence of complete nationalization of the banking system, the private banking system would eventually dominate the financial system in any nominally socialist society.

Status under current systems

Whatever their political leanings, nearly all monetary reformers agree that the current mixture of policies prevalent in most Western democracies, involving the perpetuation of government-protected private banks (organizations legally permitted to engage in unlimited and inherently speculative fractional reserve banking activities, with recourse to monopoly central banks - and in some cases corrupt governments - to provide bail outs of fiat money), "deregulated" labor markets (which have the effect of increasing the marketization and commodification of human activity), strictly enforced bankruptcy laws (which permit the periodic transfer of assets from failed bankrupt investors to the private banks and their associates) and personal income tax (which, combined with periodic economic collapses, dispossesses the majority of the populace from their accumulated income and wealth and transfers this wealth to the owners of government bonds) amounts to an inherently unstable, unjust and dysfunctional economic system resulting in environmentally damaging over-consumption, the systematic and irredeemable destruction of fertile arable land and the government-sponsored (and ultimately unsustainable) oppression of the indebted, impoverished and economically enslaved majority.

See also

• Austrian Business Cycle Theory
• Central bank
• Monetary reform
• Murray Rothbard
• Ron Paul

External links

• Libertarian Nation Foundation - Money and Banking
• Fractional Reserve Banking as Economic Parasitism
• Monetary Reform websites
• James Robertson: Creating New Money: A Monetary Reform for the Information Age
• I want the Earth Plus 5%
• Money As Debt (videoplay animation)
• Money and Banking
• MISH
• Max Keiser
• Web of Debt
• PrudentBear.com
• Market Oracle
• RGE Monitor
• Financial Armageddon
• The Dollar Meltdown