Free Capitalist Network - Community Archive
Mises Community Archive
An online community for fans of Austrian economics and libertarianism, featuring forums, user blogs, and more.

How fractional reserve banking destroys capitalism

This post has 24 Replies | 2 Followers

Top 25 Contributor
Posts 4,532
Points 84,495
Stranger Posted: Sun, Feb 28 2010 9:24 PM

In a free market economy, one comes to own capital in two ways: by originally appropriating and transforming natural resources into productive capital, or by transforming capital goods that one originally appropriates and selling them in return for capital goods. Over time, those individuals who are the most productive and most efficient for the market will come to own the largest amount of capital goods that they will exploit to their full efficiency. They will form the capitalist class.

Some of these capitalists, over very long periods of time, will come to recognize upcoming capitalists with the ability to produce a lot of capital goods. They will use the capital that they themselves have accumulated through their productive talents and lend it to these upcoming capitalists at interest, in the expectation that their productive ability will exceed the rate of interest and that their own capital will grow as a result of their accurate selection of rising capitalists. These individuals will form the banker class. Successful bankers will be selected based on their ability to select successful capitalists, and they will come to control the largest asset banks from which loans are available. Bad bankers will deplete their capital and exit the business.

This process no longer holds under fractional reserve banking. A fractional reserve bank does not need capital, but simply unlimited credit from which to make loans. This unlimited credit is ensured by a central bank, which is protected by a government-granted monopoly. Because a fractional reserve bank has unlimited credit, it does not need to first demonstrate an ability to earn, accumulate, safeguard and employ capital before earning the right to go into the banking business. A fractional reserve bank's economic power does not rely on any past achievements, but on the protection of government from bankruptcy.

Of course, before the transition to fractional reserve banking is made, it is safe to assume that all of the top banks are excellent capitalists. Once a fractional reserve system is in place, the same banks become fractional reserve banks, and for a time preserve their ability to select capitalists. It is only over the long run that the banks become corrupted and the process of renewing the banking class results in a class of bankers whose main quality is the ability to secure government protection instead of the ability to select capitalists. This becomes, in effect, the "bankster" class.

Things get worse the more political power this bankster class wields, as the unlimited credit granted by the central bank is reduced in interest cost. The banksters can now supply a demand for loans at ever-lower interest rates and drive out of the market all capitalists who attempt to become bankers from their own accumulated capital. This means that fewer upcoming capitalists will be selected for loans and that more incompetent borrowers will be selected. These incompetent borrowers will borrow from the banksters to purchase all capital assets in society, and attempt to earn enough returns to pay the rent to the banksters. Once their attempt inevitably fails, the bank will foreclose on the asset. In this way the banksters use their unlimited credit to purchase all capital in society and ruin it, driving the capitalist class into destitution by making the purchasing power of their savings worthless, and enticing the debtors to make financial decisions they cannot uphold.

Only in a recession that wipes out the entire bankster class and sends asset prices plummeting can the legitimate capitalist class be reconstituted. If the bankster class succeeds at obtaining a bailout that prevents their collapse, then they can use this bailout to complete their takeover of the entire economy and to throw the remaining capitalists into destitution.

The final outcome of this process is that all producers of capital are ruined and unable to direct the economy towards valuable production, and a class of politically connected counterfeiters owns all capital in society without the required competence to employ it to productive use. The result, over time, is economic ruin and the collapse of entire enterprises and corporations, mass unemployment, and poverty.

  • | Post Points: 65
Top 100 Contributor
Male
Posts 871
Points 15,025
chloe732 replied on Sun, Feb 28 2010 10:56 PM

Stranger - In paragraph 2, what prevents the banker class (a subset of the capitalist class) from engaging in fractional reserve banking from the beginning?  You mention in paragraph 1 that it is a free market, so what's to stop them other than the risk to their own liquidity (and the risk to the depositor's money)?

In paragraph 3 you introduce the central bank.  It seems like you're discussing the ills of "central banking" for the remainder of the post, not "fractional reserve banking", per se. 

"The market is a process." - Ludwig von Mises, as related by Israel Kirzner.   "Capital formation is a beautiful thing" - Chloe732.

  • | Post Points: 20
Top 25 Contributor
Posts 4,532
Points 84,495
Stranger replied on Sun, Feb 28 2010 10:58 PM

chloe732:

Stranger - In paragraph 2, what prevents the banker class (a subset of the capitalist class) from engaging in fractional reserve banking from the beginning?  You mention in paragraph 1 that it is a free market, so what's to stop them other than the risk to their own liquidity (and the risk to the depositor's money)?

In paragraph 3 you introduce the central bank.  It seems like you're discussing the ills of "central banking" for the remainder of the post, not "fractional reserve banking", per se. 

The central bank is what ensures the banker's credit with the other banks. Without it, the moment a banker attempted to make loans that weren't covered by his capital, the other banks would drain all his reserves and force his failure.

  • | Post Points: 20
Top 100 Contributor
Male
Posts 871
Points 15,025
chloe732 replied on Sun, Feb 28 2010 11:54 PM

Stranger:
The central bank is what ensures the banker's credit with the other banks. Without it, the moment a banker attempted to make loans that weren't covered by his capital, the other banks would drain all his reserves and force his failure.

This is true.  You are describing the natural "brake" the free market would have on fractional reserve banking.  In addition, depositors would get wise to liquidity problems, making additional demands, putting additional pressure on the FRB.  But it is central banking that removes that free market "brake" and allows the FRB's to expand together, and provides the political power to bailout the system when it fails.  Therefore, isn't it the central bank that is the problem, not fractional reserve banking, per se?  (I'm sure this has been debated before, so I'm not trying to restart the debate, just trying to clarify things.)

"The market is a process." - Ludwig von Mises, as related by Israel Kirzner.   "Capital formation is a beautiful thing" - Chloe732.

  • | Post Points: 20
Top 25 Contributor
Male
Posts 3,113
Points 60,515
Esuric replied on Mon, Mar 1 2010 1:37 AM

Stranger:
In a free market economy, one comes to own capital in two ways: by originally appropriating and transforming natural resources into productive capital

This is the first phase of production (which requires capital itself). Individual's don't venture into the woods and try to create their own capital with natural resources.

Stranger:
by transforming capital goods that one originally appropriates and selling them in return for capital goods.

Firms which produce capital goods sell them on the market (their status as a capital goods depends on their future intended employment). They use that income to cover expenditures and to pay dividends. Banks provide funds to entrepreneurs who then use that money to buy real capital goods.

Stranger:
Over time, those individuals who are the most productive and most efficient for the market will come to own the largest amount of capital goods that they will exploit to their full efficiency. They will form the capitalist class.

I don't know what you mean by "capitalist class." There are many so-called "capitalists" who are also laborers, and there are many laborers who are wealthier than "capitalists."

Stranger:
Some of these capitalists, over very long periods of time, will come to recognize upcoming capitalists with the ability to produce a lot of capital goods. They will use the capital that they themselves have accumulated through their productive talents and lend it to these upcoming capitalists at interest, in the expectation that their productive ability will exceed the rate of interest and that their own capital will grow as a result of their accurate selection of rising capitalists. These individuals will form the banker class.

This is not how banking emerged. Banks were initially money warehouses which began to lend the resources entrusted to them at interest, and then they paid interest to those who deposited their wares with them (in order to increase their reserves). They were seen as sound institutions, which enabled them to create fiduciary media.

Stranger:
Bad bankers will deplete their capital and exit the business.

Banks don't hold real capital.

Stranger:
This process no longer holds under fractional reserve banking. A fractional reserve bank does not need capital, but simply unlimited credit from which to make loans.

They never really had real capital to begin with. When money warehouses became banks, then only money and credit were exchanged.

Stranger:
Because a fractional reserve bank has unlimited credit, it does not need to first demonstrate an ability to earn, accumulate, safeguard and employ capital before earning the right to go into the banking business. A fractional reserve bank's economic power does not rely on any past achievements, but on the protection of government from bankruptcy.

Fractional reserve banking can only extend unlimited credit (gratuitous credit) when there is a central monetary authority, or when the whole banking system acts as one (a banking cartel).

Stranger:
It is only over the long run that the banks become corrupted and the process of renewing the banking class results in a class of bankers whose main quality is the ability to secure government protection instead of the ability to select capitalists. This becomes, in effect, the "bankster" class.

These "banksters" are just rational agents who use leviathan to achieve their desired ends. Bankers aren't the only ones who do this--toy companies, farmers ("farmsters"), investors, and basically every other industry, does this.

Also, your use of the word "capitalism" is rather curious.

"If we wish to preserve a free society, it is essential that we recognize that the desirability of a particular object is not sufficient justification for the use of coercion."

  • | Post Points: 35
Top 25 Contributor
Posts 4,532
Points 84,495
Stranger replied on Mon, Mar 1 2010 10:35 AM

chloe732:

Stranger:
The central bank is what ensures the banker's credit with the other banks. Without it, the moment a banker attempted to make loans that weren't covered by his capital, the other banks would drain all his reserves and force his failure.

This is true.  You are describing the natural "brake" the free market would have on fractional reserve banking.  In addition, depositors would get wise to liquidity problems, making additional demands, putting additional pressure on the FRB.  But it is central banking that removes that free market "brake" and allows the FRB's to expand together, and provides the political power to bailout the system when it fails.  Therefore, isn't it the central bank that is the problem, not fractional reserve banking, per se?  (I'm sure this has been debated before, so I'm not trying to restart the debate, just trying to clarify things.)

I don't really see that there is any difference. The central bank exists to safeguard fractional reserve banking.

  • | Post Points: 5
Top 25 Contributor
Posts 4,532
Points 84,495
Stranger replied on Mon, Mar 1 2010 10:40 AM

Esuric:

This is the first phase of production (which requires capital itself). Individual's don't venture into the woods and try to create their own capital with natural resources.

They do in fact do this. How do you think America was colonized? People deforested the land and built farms, which they then exploited to productive use.

Esuric:

This is not how banking emerged. Banks were initially money warehouses which began to lend the resources entrusted to them at interest, and then they paid interest to those who deposited their wares with them (in order to increase their reserves). They were seen as sound institutions, which enabled them to create fiduciary media.

This is incorrect. There have always been capital lenders separate from the currency deposit system. Remember The Merchant of Venice?

Even today there are many banks that have no deposit operations whatsoever.

Esuric:
Also, your use of the word "capitalism" is rather curious.

I use capitalism in the classical definition as used by Marx and Bohm-Bawerk,

  • | Post Points: 35
Top 25 Contributor
Male
Posts 3,055
Points 41,895

Money is not capital in AE.

  • | Post Points: 20
Top 25 Contributor
Male
Posts 3,113
Points 60,515
Esuric replied on Mon, Mar 1 2010 8:01 PM

Stranger:

Esuric:

This is the first phase of production (which requires capital itself). Individual's don't venture into the woods and try to create their own capital with natural resources.

They do in fact do this. How do you think America was colonized? People deforested the land and built farms, which they then exploited to productive use.

They imported capital. Cutting down trees and farming land requires capital.

Stranger:
This is incorrect. There have always been capital lenders separate from the currency deposit system. Remember The Merchant of Venice?

No I don't, but monetary economies don't have financial institutions which lend and trade real capital.

Stranger:
Even today there are many banks that have no deposit operations whatsoever.

Investment banks, insurance companies, and funds are not banks--they are a different kind of financial intermediary. Depository institutions (commercial banks, credit unions, and thrifts) all turn deposits into loans.

"If we wish to preserve a free society, it is essential that we recognize that the desirability of a particular object is not sufficient justification for the use of coercion."

  • | Post Points: 35
Top 25 Contributor
Posts 4,532
Points 84,495

Caley McKibbin:

Money is not capital in AE.

?

Never seen such a bizarre idea.

  • | Post Points: 20
Top 25 Contributor
Posts 4,532
Points 84,495

Esuric:
Investment banks and funds are not banks--they are different kind of financial intermediary. Depository institutions (commercial banks, credit unions, and thrifts all have deposits).

Investment banks are not banks.

Thanks for your insight.

  • | Post Points: 20
Top 25 Contributor
Male
Posts 3,113
Points 60,515
Esuric replied on Mon, Mar 1 2010 8:04 PM

Stranger:

Investment banks are not banks.

Thanks for your insight.

No problem.

Caley McKibbin:
Money is not capital in AE.

Not just in AE.

"If we wish to preserve a free society, it is essential that we recognize that the desirability of a particular object is not sufficient justification for the use of coercion."

  • | Post Points: 5
Top 50 Contributor
Posts 2,360
Points 43,785
z1235 replied on Mon, Mar 1 2010 9:47 PM

Good OP, Stranger.

Z.

 

  • | Post Points: 5
Top 25 Contributor
Posts 2,966
Points 53,250
DD5 replied on Mon, Mar 1 2010 10:45 PM

Esuric:

Stranger:

Esuric:

This is the first phase of production (which requires capital itself). Individual's don't venture into the woods and try to create their own capital with natural resources.

They do in fact do this. How do you think America was colonized? People deforested the land and built farms, which they then exploited to productive use.

They imported capital. Cutting down trees and farming land requires capital.

The first Americans probably did come equipped with some capital.  

However, Robinson Crusoe had no such luxury.  He had nothing but his bare hands and mental capacity - he had human capital, until he built his first tool, which became his first capital good.

 

  • | Post Points: 5
Top 25 Contributor
Posts 2,966
Points 53,250
DD5 replied on Mon, Mar 1 2010 10:54 PM

Stranger:

Caley McKibbin:

Money is not capital in AE.

?

Never seen such a bizarre idea.

We talk of capital value in terms of money, which is why the confusion occurs.

 

  • | Post Points: 5
Not Ranked
Posts 1
Points 35

While I do not necessarily defend a fractional reserve banking system, finance capital itself - regardless of form - is a threat to industrial capitalism because of the intrinsic dependency the latter has on the former, and the tendency of both to concentrate market power into fewer and fewer hands. The English and the Dutch both had the experience of finance outgrowing manufacturing before the fell from being the global economic leaders. They same happened to the US in 1990s. The problem is finance produces no actual value itself, it is meant simply to lubricate those parts of the economy that do. If left unchecked, though, finance uses its position of power to leech from rather than facilitate the productive sectors of the economy.

 

"In a free market economy, one comes to own capital in two ways: by originally appropriating and transforming natural resources into productive capital, or by transforming capital goods that one originally appropriates and selling them in return for capital good."

 

What is your understanding of "originally appropriating?" Natural resources are generally acquired either by receiving it from a government that has laid claim to the land in which those resources are found, or by purchasing said land. The first instance is clearly not a free market example. The later still requires that Capital be owned in advance. Same for transforming capital goods, how does one acquire those goods with having capital in the first place. In either case one can only come to own capital, by your definition, by either having already accumulated capital or by borrowing from someone who has. Which leads us to the next issue.

"Over time, those individuals who are the most productive and most efficient for the market will come to own the largest amount of capital goods that they will exploit to their full efficiency. They will form the capitalist class."

 

This may be true at first, however consider what is mentioned above, to acquire capital one must already have capital or must go into debt. That being said, there is a distinct advantage to those who have already accumulated capital (they're not contained by debt), an advantage they can exploit to stifle, rather than foster, competition. Furthermore, even if we had a system in which the government had absolutely no power in the financial markets, corruption and cronyism would still exist because those who went into banking would have the power to decide who they were going to lend to and would not necessarily always make that decision based on economic efficiency, but based on prejudice or preference for friends or family. While in a perfectly competitive economy, this sort of uneconomic discrimination would put one out of business, the more the cycles of boom and bust concentrate wealth (one profits during the booms, uses savings to tide them over during the bust and also buys up assets at depressed prices, usually selling them back to the public in the next boom. Keep repeating this cycle and wealth becomes more and more concentrated), the less competitive the markets will become allowing for monopoly and oligopoly power.

 

"Some of these capitalists, over very long periods of time, will come to recognize upcoming capitalists with the ability to produce a lot of capital goods. They will use the capital that they themselves have accumulated through their productive talents and lend it to these upcoming capitalists at interest, in the expectation that their productive ability will exceed the rate of interest and that their own capital will grow as a result of their accurate selection of rising capitalists. These individuals will form the banker class."

 

Not how banking works at all. Banks bank money, they don't use their own personal money. Bankers don't lend money out of their own salary, they lend our bank deposits. The banking system can run under two principals. The free market way would be to allow banks to lend as the please with no regulation, and it would be up to consumers to research and choose a responsible bank before putting their money in them. This still leaves the risk that shareholders and deposit holders can be ripped off by executives that make short term profits but long-term losses, and leave with their bonuses before the losses come in. Now, without government guarantees, and their implicit moral hazards, shareholders and deposit holders would hopefully hold greater scrutiny and provide better incentives to their executives.

 

Much of the public, however, does not want a free market bank system. That is why, regardless of whether we agree with the decision, the FDIC was created. Because when banks fail under the aforementioned system, you have runs on the banks, and people's deposits can be lost. A strict free market supporter might say that is just the risk you take, but I doubt you could get most people to agree with you. If you insure bank deposits (and back that insurance company with the full faith and credit of the federal government) you create a moral hazard for bankers. That is why the same act that created the FDIC, separated deposit and investment banking (this rule was then removed by deregulation just 8 or 9 years before our current crisis began). You need either no insurance and no regulation, or insurance with regulation, otherwise we have privatized gains and socialized costs (pretty much the definition of a kleptocracy). Notice, I'm not saying either one is necessarily better, regulated or unregulated, just that a half and half system often results in the worst of both.

"Successful bankers will be selected based on their ability to select successful capitalists, and they will come to control the largest asset banks from which loans are available. Bad bankers will deplete their capital and exit the business."

 

As I said before, as wealth become concentrated and markets become less competitive, firms begin to have market power which they can use to block out competitors and favor or disfavor certain groups and/or people. The weakness in the orthodox free market argument is that the idea that an unregulated free market naturally tends towards maximum efficiency only holds true in a perfectly competitive market (it's like using the perfect gas law in physics, and not factoring in the environmental variables, in this case problems of information and externalities). It also ignores the advantages that groups and individuals who have already accumulated wealth have in the market place (not having to secure debt or pay interest on it). Even if we are to imagine that we start with a perfectly level playing field, certain firms eventually win the competition and use the assets and market power in their industry to hold back future competition. Competition cannot, therefore, maintain itself naturally, instead it will destroy itself and declare victors. And in reality there has never been a level playing field. A great number of the wealthy today have inherited that wealth, and almost all the wealthy capitalist countries first accumulated their capital not through free market competition but through mercantilist colonialism. As competition is allowed to continue declaring victors and allocating them the according spoils, success is less and less based on merit, and more and more on the inherited advantages which you brought to the field in the first place.

Top 25 Contributor
Posts 4,532
Points 84,495

ProgressiveLibertarian:
This may be true at first, however consider what is mentioned above, to acquire capital one must already have capital or must go into debt. That being said, there is a distinct advantage to those who have already accumulated capital (they're not contained by debt), an advantage they can exploit to stifle, rather than foster, competition.

Simply in order to grow up to adulthood, one must be gifted an enormous amount of capital. That does not mean that competition is stifled.

Capital-owners will always find it in their interest to invest capital in order to earn back even more capital. This is what prompts them to become bankers. They have no interest in stifling competition. To the extent that anti-competitive practices are imposed, it is because the least efficient capital-owners want to forbid the more efficient from competing with them by lending and earning capital.

  • | Post Points: 20
Top 50 Contributor
Male
Posts 2,221
Points 34,090
Moderator

bump.

"Look at me, I'm quoting another user to show how wrong I think they are, out of arrogance of my own position. Wait, this is my own quote, oh shi-" ~ Nitroadict

  • | Post Points: 20
Top 50 Contributor
Male
Posts 2,221
Points 34,090
Moderator

2nd bump, hopefully PL will return to elaborate.

"Look at me, I'm quoting another user to show how wrong I think they are, out of arrogance of my own position. Wait, this is my own quote, oh shi-" ~ Nitroadict

  • | Post Points: 5
Page 1 of 1 (25 items) | RSS