PREVENTION OF INSTABILITY IS THE TRICK
Copyright 2004 J. N. Tlaga
Let us retrace our original example, using only gold coins as money in order to eliminate even the slightest source of confusion:
It's October 1900. Upon selling his entire crop to Alcohol Distiller, Corn Farmer deposits his proceeds of 100,000 dollars in Corn Bank.
Because Corn Farmer will need no more than one-sixth of his deposit
within the next three months, Corn Bank lends five-sixths of Corn
Farmer's gold coins ($83,000) to Alcohol Distiller.
Alcohol Distiller spends $83,000 on trainload of potatoes, and as
soon as Potato Farmer deposits his money in Potato Bank, Alcohol
Distiller borrows 5/6 of that deposit ($69,000) to buy a trainload
of rye grain.
Rye farmer deposits his $69,000 at Rye Bank, and Alcohol Distiller
promptly borrows $57,500 to purchase a trainload of sugarcane, and
Sugarcane Farmer deposits his $57,000 at Sugarcane Bank.
At this point, of the original 100,000 gold dollars
17 000 sits in Corn Bank as a fractional reserve
14 000 sits in Potato Bank as a fractional reserve
11 500 sits in Rye Bank as a fractional reserve
57 500 sits in Sugarcane Bank as a full reserve
Where are the additional dollars the fractional reserve banks have
allegedly created out of thin air and added to the overall money supply in the form of deposits?
They are nowhere to be found for they were never created.
We started with 100,000 dollars, and we can pinpoint where all of them are.
If nothing extraordinary happens, Alcohol Distiller will in due course process his potatoes, rye grain and sugarcane into fuel alcohol and then repay his loans to Corn Bank, Potato Bank and Rye Bank.
After the loans are repaid, let us count the money all the parties will have in their banks:
100,000 Corn Farmer
83,000 Potato Farmer
69,000 Rye Farmer
57,500 Sugarcane Farmer
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309,500 Total
(In addition, Corn Bank, Potato Bank and Rye Bank will have earned
their interest of course. They must earn their money too in order
to stay in business.)
If Corn Bank would not have lent out 83,000 of Corn Farmer's money,
Potato Farmer would not have earned his 83,000, and...
if Potato Bank would not have lent out 69,000 of Potato Farmer's
money, Rye Farmer would not have earned his 69,000, and...
if Rye Bank would not have lent out 57,500 of Rye Farmer's money,
Sugarcane Farmer would not have earned his 57,500.
And so, my fellow gold bugs, ask not how much money is created out
of thin air by fractional reserve banking, ask how much money is earned thanks to fractional reserve banking.
Not a single dollar was added to the original 100,000 in order to make those deposits and loans. Each farmer was depositing the very same gold coins that were originally deposited by Corn Farmer.
New deposits are not created out of thin air, they are created by the same money changing hands in the course of regular business
transactions.
So called, money multiplier of the fractional reserve banking, is not the sum total of all the loans created out of thin air, it's the sum total of earnings resulting from normal velocity of the very same money changing hands again and again in the normal course of business.
Where Alcohol Distiller's money, with which he repaid his loans, did actually come from?
From people on the other end of his business transactions;
ultimately from the motorists stopping at the fuel stations and
buying few gallons of gasohol.
Money we all made is not created out of thin air by fractional
reserve banking, it comes from other people buying our goods and
services, from constant re-circulating of the money we earn.
This means, that money of all farmers in our example must stay on deposit after Alcohol Distiller loans are repaid to be available for instant re-lending again and again.
What would happen if, say, Potato Farmer decided to withdraw all his gold coins in order to look at them everyday at his home?
Another Potato Farmer would be watching his potatoes rotting rather than bringing him wealth and prosperity, and the next season our Potato Farmer would have to start spending his cherished gold coins because no one would be buying his new harvest of potatoes either.
To keep the economy at its peak performance every available dollar must be employed. None must sit under a mattress. Every dollar sitting under a mattress slows the economy down.
There are people who think that it is our right, a part of our liberty, to withdraw our money from the economy if we so elect. Here is an example of such an opinion:
"First you seem to be saying that it is all right and not a dishonest practice for the bank to take a large proportion of Joe and Jane's checking account and lending it on to others when Joe and Jane have placed it in their checking account PRECISELY BECAUSE THEY DO NOT WISH IT TO BE LENT ON. That is obviously wrong; it is dishonest and deceitful. Safe, perhaps, but not honest.
"Second you ignore the issue of the legality of charging the third party a fee (interest) for use of something (Joe and Jane's money) which the bank does not have permission of its proper owners (Joe and Jane) to lend on or otherwise encumber. This too appears to me incorrect; the proper beneficiary of a charge for use of Jane and Joe's money is Jane and Joe, not some dishonest bank which they have trusted to KEEP IT for them."
It was to alleviate the concerns of this nature that I proposed in the original article in this series, that upon return to the honest money (silver and gold) all the banks should be required by law to operate as mutual banks, meaning, they should be owned by depositors in proportion to their deposits, and all the profits should go to depositors themselves. The rationale for such a reform is that Joe and Jane will not complain about fractional reserve
banking if they will have their say in how the bank is run and they will receive their share of the profits.
Fractional reserve banking will function effectively only if the
fractional reserve is adequate, that is, large enough to cover all contingencies of withdrawals.
In our example, for the sake of clarity, every bank has only one client. Thus if Corn Farmer shows up at Corn Bank and demands more than 17,000 kept for him in reserve, the bank goes under.
In reality, each bank has multitude of clients, and for this reason, fractional reserve banking can operate on safe actuarial principles. When one client withdraws larger than budgeted fraction of his deposit, there is always another client who makes offsetting deposit. Some people take such offsetting transaction as a proof that banks create new money out of thin air by way of the fractional reserve banking after all. This is their faulty
reasoning:
Look! Corn Farmer deposited 100,000 in Corn Bank and the bank lent out 83,000. You say the bank never created these 83,000 out of thin air, it took them from Corn Farmer's 100,000. But today Corn Farmer came to the bank and withdrew more than 17,000, in fact, he withdrew the entire 100,000. This means the bank did create 83,000 out of thin air after all, because after Corn Farmer's withdrawal both his 100,000 and the 83,000 lent to Alcohol Distiller are in circulation at the same time.
The only reason bank could honor demand for Corn Farmer's deposit in full when 5/6 of that deposit was lent out was that other farmers made large enough deposits in the meantime, and their gold coins could be used to cover deficiency in Corn Farmer's deposit. Once Alcohol Distiller repays his loan of 83,000, the money taken from other deposits to satisfy Corn Farmer's demand will be returned to those deposits, only to be lent out right away.
Fractional reserve banking can operate effectively as long as deposits and withdrawals are distributed in predictable pattern. Any sudden destabilization can disrupt it, cause depositors run on the banks, and throw economy into recession.
It was not the fractional reserve banking per se that was the cause of recessions, also known as "money panics", in the years of honest money system. The root cause of every such panic was always traceable either to withdrawal of gold by the London bankers or to yet another stock market mêlée (with the sole exception of 1907 panic, which was deliberately engineered by J.P. Morgan to provide "argument" for central bank legislation).
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A digression to present a snapshot of sample mêlée will be in order:
It's April 1, 1901, and Northern Pacific common stock closes on New York Stock Exchange at 96 on heavy volume as Jacob Henry Schiff of Kuhn Loeb, acting in concert with Edward Henry Harriman of Union Pacific, begins to buy Northern Pacific stock from under John Pierpont Morgan's horrendous nose.
By May 1, Northern Pacific common is trading at 115, and on Friday, May 3, Schiff invites James Hill of Great Northern, holding sizeable block of Northern Pacific stock, to join the raid and throw Morgan overboard. Schiff announces that he is holding on bahalf of Harriman's group 420,000 of Northern Pacific's 750,000 preferred shares and 370,000 of the 800,000 common. Hill goes straight to J.P. Morgan's office, only one city block away, and tells Morgan's partners what is going on. (Morgan is "taking waters" at Aix-les-Bains at that time.)
On Saturday, Harriman receives important tip: Northern Pacific's board of directors, controlled by Morgan, can retire preferred shares and thus nullify Harriman's majority. Harriman sends a note to Schiff to place an order for additional 40,000 common shares. (Stock exchange was then open on Saturday.)
Schiff receives Harriman's message while attending service at his
synagogue, and decides not to deliver Harriman's coup de grâce. Some people say he is deeply religious and refuses to work on Shabbat, but more likely explanation is that when Hill turned him down, he began to have second thoughts about the consequences of crossing Morgan.
On Monday, May 6, Morgan's brokers, using life insurance companies cash, go into action. Northern Pacific common closes at 127, and at 150 on Tuesday when Morgan people stopped buying. But the price continues to climb. On "Blue Thursday", May 9, it hits $1,000 (one thousand dollars)!
Everyone realizes that more Northern Pacific stock was sold short than was ever printed. Desperate speculators are dumping their blue chip stocks to obtain cash (hence "Blue Thursday") but the Northern Pacific stock is unobtainable at any price.
In the nick of time a peace is announced; both Morgan and Kuhn Loeb agree to wait for delivery of the shares they bought and they promise to sell enough shares at 150 to allow the shorts to cover. In the absence of that announcement, full fledged money panic would have ensued. Banks would go on clearing house basis, meaning, they would not part with gold until the underlying transaction cleared. Runs on the banks would come next, and the economy would slow down to a crawl.
(Incidentally, Jesse Livermore lost his first $50,000 by selling Northern Pacific short, and Bernard Baruch made his fortune picking up blue chip stocks for a song.)
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The bottom line is that under honest money regime and in the absence of a central bank, fractional reserve banking can maintain national economy at peak performance level, provided there are no market shocks that can induce depositors to withdraw their money from the banks.
That was the primary reason why we proposed in
www.gold-eagle.com/editorials_01/tlaga112801.html to close
stock exchanges for good, and trade stocks directly with issuing
corporations.
In the next article of this series, we will explain how the fractional reserve banking is employed by the central bank under fiat money system.
21 January 2004
J. N. Tlaga
jtlaga@bellsouth.net
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