Criticism of fractional-reserve banking

A debt-based monetary system is an economic system where money is created primarily through fractional reserve banking techniques, using the private banking system.

This form of money is called "debt-based" because as a condition of its creation it must be paid back at some time in the future.

Although debt money is a form of fiat currency (because it is not backed by a real asset such as gold or silver), it can be distinguished from "true" fiat currency in that it is intrinsically "temporary" money, requiring its eventual repayment as a condition of its creation.

Some argue 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 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.

Others argue that there is in fact no mathematical necessity for the money supply in a debt-based system to grow, since the interest portion of loan payments is not taken out of circulation, but goes into the lender’s account, where it can be spent back into the circulation and eventually be used to pay off some loan principal. Given that the total debt-based money supply is exactly equal to the total principal outstanding on all loans, there is always enough money in circulation to meet loan payments for the current amortization period, except for the case of nearly all loans in existence coming due at the same time, with no other outstanding loans large enough to cover the interest portions of the final payments (generally a tiny fraction of the final payment). These monetary economists argue that the money supply could (at least theoretically) be stable and yet not cause widespread insolvency in the broader economy. This would however require the delicate balancing of the maturing of some loans with the issuance of new debt to compensate for the diminution in the money supply caused by the repayment of those maturing loans.

Regardless whether there is a necessity for the money supply to exponentially increase in a debt-based system, it is not seriously disputed that when a bank loan is repaid, the money is extinguished, in a reverse process by which the money was originally created, “Money is created when loans are issued and debts incurred, money is extinguished when loans are repaid” John B. Henderson, Senior Specialist in Price Economics, Congressional Research Service of the Library of Congress.

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.”

In contrast to debt money, "true" fiat currency is issued by the government debt-free as no requirement for its eventual return is made as a condition of its creation. Fiat currency (such as 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 notes and coins do not have the potentially pernicious economic 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 (which may or may not occur depending on the political relationship at the time between the Treasury and the private banking system). It should also be noted that due to the exponential growth of debt-based money, "true" fiat currency (notes and coins in circulation) now account for a tiny fraction of the total M3 money supply in all developed, debt-based capitalist economies (M0 generally being less than 10% of the total M2 money supply - and a tiny fraction of the total M3 money supply - in most developed economies).

Similarly, gold, silver and other precious metals have in the past been used as a form of debt-free money and their introduction into the economy is not debt-based as no future repayment is required as a condition of their introduction into the money supply. 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. This position is supported by such Libertarian thinkers as Ron Paul.

Economic and political opposition

Some economists (particularly the Austrian School) and political commentators (particularly Libertarian thinkers such as Murray Rothbard) believe that a debt-based monetary system amounts to a subtle form of monetary "fraud" in that it creates real money (and therefore real wealth) "out of nothing" through the use of fractional reserve banking techniques.

Some monetary reformers also argue that this system of money supply is perverse and "anti-democratic", and inevitably creates an exponential growth bias in the economy which is superfluous, unnecessary, environmentally damaging and unstable. They argue that the already indebted are forced to induce new consumers to spend and go into debt so that existing loans can be repaid with this new debt-created money. If this is not achieved, the result is foreclosure for those businesses who do not successfully induce new consumers to go into debt for their benefit - and, more broadly, economic collapse due to the sudden contraction of the money supply.

Some political thinkers, such as Michael Rowbotham, argue that this system of money supply has all the essential characteristics of a monetized Ponzi or pyramid scheme, where the newly indebted find themselves compelled to induce others into debt to enable them to pay off their own debts.

It is therefore argued by a number of monetary reformers that fractional reserve banking and the associated predominance of debt-based money in the economy inevitably creates a form of Darwinian "survival of those who can induce others into debt", as it forces the economy inexorably towards indebted consumerism and as it continually and steadily pulls in newly indebted "consumers", to inject more debt-money into the economy to pay off the existing debts that have already been accumulated by producers who have borrowed to set up and expand their businesses. Some monetary reformers see the encouragement of increased (debt-sourced) government spending in defence and social welfare; hyperinflation in the "essential", "non-discretionary" markets of housing, education and health care; increased secularism (which encourages materialism and consumerism and discourages non-marketable religious activities); the introduction of women into the workforce; the marketization of childcare and the marketing to children as potential new consumers; and the push for increased immigration and free trade as a natural consequence of the expansion of debt-based consumerism.

Many monetary reformers believe that the over-reliance of debt-based money in the modern economy has inevitably created all the features of an economic bubble, with fundamental, structural instability in financial markets, which inevitably produces waves of booms and bust due to the "bubble-like" credit cycle, where banks lend new debt money and subsequently force the return of this money from the economy as growth slows, due to the inevitable mismatch between the growth in the real economy (which is slowed by physical and political constraints) and the volatile and potentially unlimited growth in the debt-based money supply, where ever more new debt money is required to pay off the debts that have already been accumulated.

The total property value of America is about $38 Trillion while the total debt burden is $48 trillion. If in the hypothetical case that the debt was called in simultaneously, it is self-evident that the system would be exposed as insolvent and the "value" of the assets would be substantially less than the total debt outstanding. It should also be noted that the total debt is volatile and dependent on the unstable growth in the money supply.

The "cyclical" side-effect of debt-based money inevitably means that those caught at the end of any business cycle (or those caught in economies with declining productivity, low population growth or aging populations) suffer most financially, as the contraction in the growth of credit slows the economy just as these newly indebted businesses and consumers find they have been left out of the growth cycle in debt creation. This "boomerang" effect in the creation (and subsequent return) of debt-based money also inevitably means that the private banks systematically gain greater control over the real assets of an economy over time, as these cycles create waves of foreclosure, allowing the banks and their associates to "harvest" real assets and real wealth "on the cheap" (less the now-worthless equity contribution of the bankrupt investor) - or strictly speaking, in Murray Rothbard's words, "for nothing", given that the whole system of fractional reserve banking involves the creation of money "out of nothing" and in his view amounts to monetary fraud.

Michael Rowbotham, in his book The Grip of Death, argues that the overwhelming prevalence of debt-based money in the modern economy is systematically concentrating real wealth in the hands of the private banks through a form of subtle monetary fraud, as the populace is forced into debt "slavery" simply to own a home and educate their children, only to have any accumulated net wealth periodically "stolen" during periods of static or negative credit growth.

In countries with slowing economic growth caused by low population growth or an aging population, it is therefore inevitable with a debt-based monetary system that, in the absence of a strong and effective redistributive tax system or the issuance of debt-free fiat currency to the financially dispossessed, there will be a systematic and inexorable concentration of intense wealth in the financial services sector, accompanied by sporadic "bubble-like" financial crises, with volatile periods of hyperinflation in asset markets and deflation in the consumable goods market as price-conscious indebted consumers inevitably search for cheaper (generally imported) consumer goods as their net disposable income is "squeezed" by higher and higher debt servicing levels, and their net wealth is periodically "stolen" during periods of monetary contraction.

Bankruptcy laws differ to a small degree in different jurisidictions 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 in third world countries as a result of high levels of unsustainable third world debt. 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.

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 allow the real value of government bond interest repayments to decline relative to other currencies.

Policy Implications

Some monetary reformers predict that there will be an increased incidence of financial crises in the developed world, as economic and population growth inevitably slows and as the success of laissez-faire economic political policies result 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 sector.

Some monetary reformers see this ultimately resulting in a political crisis, between the vast majority of dispossessed who have had any accumulated net wealth periodically "stolen" during periods of "credit crunch" (and find themselves in permanent inter-generational debt, being forced to work involuntarily in the money-economy simply to house themselves and survive in the debt-based economy), and a tiny minority of inter-generational super-rich elites connected close to the font of the money supply (being the private banking sector), who will strongly resist calls for redistributive economic policies by using all of their financial strength and lobbying power in an attempt to entrench and sustain their artificially privileged status.

It is also to be expected that this privileged minority will seek special government protection for the banking sector to protect it from financial insolvency when the debt-based financial system inevitably experiences periodic collapses due to the "bubble-like" nature of the growth in the money supply. This is referred to in some circles as "systemic risk" in the financial sector, as banks inevitably face periods of actual or near insolvency due to the mismatching of the high exponential growth in debt and slower growth in the real economy. During these periods there are sporadic collapses in the value of inflated assets, resulting in a sudden collapse in the demand for new debt-money, and an associated contraction in the growth of the money supply. Without government bail outs these waves of boom and bust would inevitably wipe out marginal lenders, resulting in a concentration of the banking industry into an oligopoly/oligarchy or monopoly.

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. 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 liquidate 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, thereby allowing them to escape liability for mistaken lending practices which have resulted in these portfolios losing value as the borrowers default on their loan payments and are made bankrupt. This rescue measure can occur with or without an interest rate cut to encourage more borrowing to allow the existing (failed) debts to be liquidated at or close to their original value.

Many monetary reformers consider the technical term "systemic risk" to be a code word for a time when the pyramid scheme of debt inevitably faces periods of collapse due the mismatch between the volatile, unstable growth of "debt money" and the liquidity requirements of the slower-growing real economy. These economists consider any calls for government or central bank intervention at such times as an illegitimate policy of "saving" the system from being exposed as a financial fraud on the general (indebted) populace. It may also trigger a currency crisis as overseas financiers can no longer trust the integrity of the domestic monetary system to process bad debts appropriately by permitting financial institutions to go bankrupt and be acquired by other financial institutions. Instead the central bank signals its willingness to print money and inflate its way out of the crisis, thereby debasing the value of the domestic currency.

Many central bankers 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. Walter Bagehot's exhortation to "lend freely" at times of monetary crisis to lift the system into liquidity and encourage new debt creation may work temporarily, but in circumstances where fundamental changes are occurring in the underlying economy (for example, where demographic changes - such as an aging population - result in too few new indebted consumers, or where extreme inequality results in the inability of impoverished workers to either qualify for, or be encouraged to, borrow) this will only result in a delay in (and perhaps exacerbation of) the collapse of any debt-created "bubble".

Many monetary reformers argue that there will either be a 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.

At such times, in the late stages of volatile, unstable, heavily indebted laissez faire capitalism, 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, predatory economic behavior has become prevalent, with short term high profit/high cash flow activities such as drug trafficking, arms trafficking, prostitution (including child prostitution), gambling, extortion and other high margin/high return criminal activity becoming increasingly prevalent, as heavily indebted producers are forced to find more extreme ways 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 credit crunch, depression or hyperinflation.

These debt-created crises in the economy and society 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".

Libertarians plan a return to genuine free markets, small government and sound money backed by the gold standard, as originally contemplated by the Founding Fathers in the U.S. Constitution. Most Libertarians would eliminate all income taxes and encourage private charity to provide social services. Some Libertarians would also support experimentation with free banking or 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 the anti-Libertarian "unjust acquistion" of real wealth implicit in fractional reserve banking.

Regarding the current accumulation of government bonds and private debt, there is an arguable case 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 cancelled or forgiven in recognition of its fundamental illegitimacy. Arguably this would be supported by the "just acquisition" jurisprudence of Libertarian legal philospher Robert Nozick.

Left-leaning monetary reformers such as Michael Rowbotham also seek 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 a social security safety net involving a guaranteed minimum debt-free income (sourced from government-issued debt-free fiat currency) for all citizens in the debt-based economy.

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 fiat currency 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 purchased by the private banks 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 facism was a response to the economic chaos created by the debt-based monetary system in the early 20th century, and some of the economic policies introduced by Hitler and Mussolini were in response to the economic collapse in both countries caused by soaring government and personal debt levels and (indirectly) arose from the writings of Silvio Gesell and others on the nature of the problems associated with a debt-based monetary system.

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.

The communist/socialist solution to the problem of fractional reserve banking is simple: wholesale repudiation of government debt resulting in complete debt default, forced nationalization of the private banks 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, the government-owned banks are directed by government policy; normally have a significant proportion of non-performing loans; 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 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.

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 (that are legally permitted to engage in unlimited and inherently speculative fractional reserve banking activities, with recourse to central banks to provide bail outs as lenders of last resort), laissez-faire economic policies (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 unjust and dysfunctional economic system resulting in environmentally damaging over-consumption and the government-sponsored (and ultimately unsustainable) oppression of the indebted, impoverished and economically enslaved majority.

See also

• Austrian School
• Debt
• debt-free money
• free banking
• hard currency
• Libertarianism
• Michael Rowbotham
• Murray Rothbard
• Robert Nozick
• Ron Paul
• Silvio Gesell
• Socialism
• Social Democrats
• soft currency
• usury