On Money and Banking

As everyone is aware, the world’s economy is in trouble right now.  For your own economic survival, it is imperative that you educate yourself so that you can understand what is going on and how to protect yourself.  Unfortunately, most of the information and advice that you see in the mainstream media and that you get from the financial industry is self-serving drivel designed to separate you from your savings.

It’s impossible to get a good understanding of where we are without a good grasp of history.  I strongly recommend that you read Murray Rothbard’s important work, A History of Money and Banking in the United States: The Colonial Era to World War II.  For an overview of monetary events since World War II, Wikipedia (at the time of this writing) has a decent article.  Suffice it to say that the history of money is essentially a long chain of broken promises.

If left to their own devices, people for centuries have gravitated toward the use of gold and silver as money.  Then some enterprising individual gets the idea that the precious metals can be stored more securely and conveniently in a central location, and he issues paper receipts that can more easily be carried and transferred from person to person in commerce.  It is also straightforward at this time to invent the demand deposit account, which is a promise by the warehouse to issue precious metals in specie (usually coin) form on demand whenever the customer should need them.

From there it is a short leap to fractional reserve banking, where the repository has outstanding more notes and deposits than it has actual specie with which to back them.  This situation would result from either loaning out some of the deposited specie or by creating new notes and deposits that are then lent out at interest.  Either way, at this point, banking becomes a confidence game.  It should be obvious that if all note and deposit holders were to attempt redemption at once, the scheme would collapse forthwith.  Indeed, history is replete with runs on banks that have been too profligate with note and deposit creation.  Such crises of confidence seem to occur in waves, alternating with periods of euphoric expansion in which bankers exploit the public trust in their institutions by expanding the supply of notes and deposits on an ever-smaller proportion of reserves.

When the inevitable crash takes place, the bankers invariably appeal to government to release them from their contractual obligations to redeem notes and deposits.  Governments usually oblige, allowing the banks to remain open when they should be liquidated in bankruptcy.  In 1933, Franklin Roosevelt declared a bank holiday and suspended payments nationwide in an effort to stop the bank runs of the Great Depression.  The general population was attempting (rightly so) to check out of the banking system made fragile by the over-expansion of credit in the 1920s.  When he confiscated all privately held gold bullion, he eliminated a vital escape route that people could have used to protect their wealth from the storm.  Instead, the people were stuck with irredeemable Federal Reserve Notes and dollar-denominated bank deposits that were then devalued by FDR from $20 to an ounce of gold to $35 an ounce (of course, this exchange rate was only available to foreign governments for settlement of trade imbalances).  Big government programs throughout the history of the United States have depended on the monetization of the fiscal deficit, whether it be the printing of Continentals during the revolution, the Greenbacks of the Civil War, or the easy-money policies of the Federal Reserve since 1913 that funded two world wars in addition to numerous other more minor skirmishes, along with an ever-growing welfare state.

Some argue that fractional reserve banking is itself a fraudulent activity and should be prohibited.  To the extent that some depositors believe their accounts are backed 100% by actual specie, this view has some validity.  However, rather than outlaw the fractional reserve bank, I would rather educate the public.  When you open a deposit account at a bank, you are making a loan.  There is always some risk that the loan will be defaulted.  Customers should research the condition of prospective banks and make educated decisions about where to place their funds.  For example, individuals might consult a source such as Institutional Risk Analytics to help them in this process.

Of course, people today don’t do this because of ubiquitous federal deposit insurance.  The average consumer has far less than the FDIC insured limits, and so feels comfortable banking anywhere the FDIC logo is displayed.  This guarantee has led to complacency not only on the part of the depositor but also of his bank.  Until very recently, banks were usually fully loaned up to the maximum legal limit, keeping only the bare minimum of reserves against outstanding deposits (officially 10% of transaction accounts in the US, but nota bene).  The government sponsored enterprises (Fannie Mae and Freddie Mac) were buying up mortgages with the implied backstop of the federal government, and the Federal Reserve was adding money to the system through its open market operations.  The banks assumed that this expansion of credit could go on indefinitely, and under that assumption, they made loans that today look, well, pretty stupid.  If you were to mark these loans to their current real value, most banks would be insolvent.  That is, the total value of their liabilities (deposits) would greatly exceed the total value of their assets (loans plus reserves).  The current environment is like a dry forest full of tinder waiting for a spark that will set off a wildfire of bank runs.  The banks and the Fed know this.  In an attempt to head off a crisis of confidence, the Fed has been dramatically increasing its balance sheet by purchasing assets with newly created money.  The banks have been accumulating most of this money as excess reserves, and the Fed is paying interest on these balances as part of its scheme to keep the extra money from being multiplied by the reserve ratio into hyperinflationary proportions.

So what happens next?  What we have witnessed so far could be described as a trip down the inverted money pyramid.  The crisis of confidence has spread from the wide top of exotic financial assets such as derivatives and securitized sub-prime mortgages, to all of the housing market, to investment banks, to commercial banks.  The Fed and the US Treasury have been there every step of the way with bailout after bailout to essentially turn the bad money into good.  Will they ultimately be willing to redeem all those excess reserves into Federal Reserve Notes should the public demand it?  On this point, be sure to study carefully footnote 7 of that Fed paper.

Clearly, there are more bank failures in our future, and the FDIC insurance fund has already run dry.  I have no doubt that the Fed will print all the money necessary so the FDIC can pay depositors.  But, ask yourself, what will the money be worth when that day comes?  What will happen if our foreign creditors stop buying Treasury bonds?  In the third quarter of 2009, the Fed essentially bought about half of all the issued Treasury paper.  What happens when the Fed is the only taker, and we have reached the point where the government operates by outright monetization of its debt?  There is no political will to bring our deficit under control; it would require dramatic reductions in spending or oppressive tax increases to bring it about.  The United States is on a path to default on its obligations.  The default will either be outright, through missed interest payments on the debt, or it will take a more insidious form through massive depreciation of the currency and hyperinflation.

So what can you do to protect yourself and your loved ones from the coming storm?  Thankfully, the right to own gold was restored to the people of the US in 1975.  Action in the price of gold should clue you in to the oncoming financial trainwreck.  You should consider checking out of the teetering banking system and obtaining some.  Learn how to set up a wire transfer from your bank account, and then look up one of these fine folks:  California Numismatic Investments, Tulving, or APMEX.  There is no substitute for having real gold coins in your physical possession.  Be prepared to defend your hoard from jack-booted thugs and other criminals, using whatever means you deem appropriate.

Longer term, keep watching this space.  I have the inklings of a plan for how to transform our monetary system into one that will serve us better.  More to come.