Case Against the Fed and Fractional Reserve Lending

Posted: May 11th, 2009 by Militant Libertarian

From Mish’s Trend Analysis

Fractional Reserve Lending (FRL) is fraudulent. Indeed, FRL in conjunction with micro-mismanagement of interest rates by the Fed is the root cause of the financial crisis we are in.

Unfortunately many do not see FRL for the fraudulent scheme that it is. Here are the most common defenses against the allegation of fraud.

Five Arguments Used To Defend FRL

1. FRL is not fraud because the lending is backed by assets.
2. FRL is not fraud because it is allowed by law.
3. Eliminating FRL would require unwarranted “regulation”.
4. No one is harmed by FRL.
5. People have a legal right to make agreements with banks allowing their money to be lent with no reserves


1R. To those who claim credit extended by fractional reserve lending is not fraudulent because it’s backed by assets, I ask: “What assets?” The answer of course is ….

Fannie Mae and Freddie Mac debt that would be worthless were it not for taxpayer bailouts.
Asset backed commercial paper that has ceased to trade.
Toggle bonds and other such nonsense where debt is paid back with more debt.
Loans to hedge funds for speculation in credit default swaps and commodities.
Commercial real estate boondoggles including scores of condo towers now sitting empty.
A whole array of other silly loans that should never have been made.

Close analysis shows the “backed by assets” claim only holds true as long as asset prices are rising. When asset prices are falling as they are now, the true state of the non-existent backing is plain to see.

Credit extended via FRL is backed by nothing more than thin air and promises. Those promises are currently worth pennies on the dollar, and the entire global banking system is insolvent as a result.

2R. Some claim that fractional reserve lending cannot be fraud because it is legal. However, Just because something is legal does not make it right. For example: Slavery was once legal. It certainly never was right. Government decree cannot make slavery right, but it can and did make it legal. By the same token, government decree alone cannot change the fact that fractional reserve lending is fraudulent. Proof of fraudulence will be offered in the rebuttal to point number 4.

3R. Some claim that FRL cannot be eliminated because that would require regulation and such regulation would in and of itself be against free market principles. The fact of the matter is that a free market would quickly shut down any bank lending out more money than it had in the vault. No one would possibly trust such a bank. It is only government decree (regulation) that allows banks to get away with such obvious fraud.

Furthermore, people are confused by what “libertarian” means. Libertarian does not mean anarchy. There are laws against murder, theft, fraud, and slavery that no libertarian I know would argue against.

Indeed, for any society to function, there must be certain laws (regulations) in place. Here are the basic tenants of valid laws.

Protection of property rights
Protection of civil rights
Freedom of religion
Equal protection under the law regardless of race, creed, color, sex, nationality, wealth, etc.

4R. Proponents of FRL claim no one is harmed by it. In practice, everyone is harmed by it. Here is how it starts. Those with first access to money accumulate assets and those with later access to money bid up those assets. Consider housing. GSE creation of credit out of thin air is a perfect example of what happens. By the time credit was available to those of lower economic status, the bubble was already formed and ripe for a collapse. Even the non-participants were harmed. How so? Via rising property taxes and rising prices of goods and services without the benefit of rising wages.

Ironically, even those with first access to money (the banks and wealthy) ultimately did not fare well because they were greedy. When the bubble popped (as all debt bubbles eventually do) the only winners were the few who made timely bets on the demise of the bubble.

FRL is the enabler for credit bubbles. Given enough time, credit bubbles are guaranteed to implode in deflationary fashion. History is replete with examples. The South Seas bubble, the John Law Mississippi bubble, and tulip mania are prime examples.

5R. People have no such right to agree to commit fraud. Here are more things people have no right to do: Shout fire in a movie theatre, conspire to steal someone’s money, agree to start a toxic waste dump in a location where it would poison every water source in the neighborhood. There is an infinite number of things two people cannot agree to do. The right of people to do things ends when it affects the property rights of everyone else. And as noted in 4R, everyone is affected by fraudulent agreements that allow more credit to be extended than there is money in the bank.

Read the rest at this link.

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