Miraj Patel: Free markets, Freedom, and Peace

The fractional reserve banking system

As I have said before, understanding monetary policy and how money works is important in order to get a firm grasp of how the economy of any nation works. In my post, “What is money?,” I briefly explained how the government printing large supplies of money can be disastrous. Believe it or not, it is not only the government that creates the money we use.

The United States currently uses the fractional reserve banking system, which means that banks are allowed to lend more money than they actually have. This too leads to the creation of money (it is estimated that 95% of the current money supply was created through fractional reserve banking.) This system is contrary to the popular belief that the bank keeps all of one’s money with them in their safes. In fact, if every single person went to the bank to withdraw their money, there would be what is called a “bank run”, and the bank would not have enough cash to pay out to everyone. Such an occurrence would lead to the collapse of the bank. This is exactly what happened recently with the now failed IndyMac bank. A similar thing also happened to failed Washington Mutual, the largest bank failure in history, when too many depositors withdrew funds electronically, in what is known as a “silent run.”

So how does the system allow banks to do this?  When a bank receives central bank money (money that is created by the Federal Reserve,) it is required to keep a certain amount of it in reserves, but is free to loan the rest out. The loaned out money can then of course be deposited somewhere else, where the next bank (or the same bank if it was deposited there again) will keep what is needed for the reserve requirement and then loan out the rest. Remember, that when these loans are being made, the accounts of the original depositors still stay the same, which means that virtual money, in the form of loans, is being created. How much money can be lent and hence created out of thin air depends on what is known as the money multiplier, a ratio of 1/r, where r is the reserve requirement. The reserve requirement changes from time to time, but at current levels it is far from 1:1 (which would be full reserve banking- when banks can only lend the money that they actually have.) This is why the banks don’t have all of the money that its depositors have put in it.

The money that is created by fractional reserve banking is in the form of debt, since it is made when loans are created. That money that is loaned out is completely new money, as the account of the depositors still stays the same. Loans play an important role in the growth of modern economies as they spur growth, but the current system is too inflation prone. This is because if the amount of money created through this system (along with what the government prints) surpasses the amount of economic growth experienced, we experience inflation and again, we, the people suffer because of it.

Because fractional reserve banking requires exponential economic growth to avoid inflation (since the monetary supply grows exponentially under it,) inflation is very likely because as soon as the economy stops growing exponentially, we will see the currency inflate. It is a sad reality and something that we really need to look at again. Our monetary system is broken and we need to rethink fractional reserve banking and printing money above the level of economic growth. The loss in the strength of a dollar in recent decades is not something that simply happened, a large part was (and still is) caused by the current system and it can really be avoided.

Adult industry asks for bailout

Hustler publisher Larry Flynt told reporters today that they will be asking Congress for a 5 billion dollar bailout, stating that they too have been hit hard by the recession. A spokesperson for Flynt added that everyone is asking for bailouts, so why not the porn industry?

Some are taking these statements seriously, while others are playing it off as a joke. But, whatever the real intention behind the motion is, Flynt has made a point (whether or not he wanted to make it.) And a very good one at that. It is something that true free market capitalists have been making all along: when does this trend of bailouts end? Is the government seriously willing to prop up any failing institution with money that they don’t have? And if so, how is this capitalism at all? It is not. It is government intervention and socialism. The bailouts are a trend that is not sustainable and not practical and it needs to change.

The tax behind the tax cuts

President-elect Obama recently proposed a new $300 billion tax cut. While I am all for tax cuts as a paleoconservative, I find it very sad that along with these tax cuts Obama is proposing billions of dollars in spending increases. Our nation is already in tons of debt and what does he want to do? He wants to spend billions more and cut 300 billion more in revenue. How does this make any sense? And then the government wonders why so many Americans are in debt. Maybe they should worry about their spending habits first. The nation has a much more serious spending problem than the people, the only reason it gets away with it is because it controls the presses that print the money.

While tax cuts are great and support free market ideals, we need to realize that with Obama’s proposal he is cutting taxes, while indirectly taxing us right back. How? With inflation. The government doesn’t have the billions or even trillions Obama wants to spend. They will try to garner money through sale of securities such as bonds, but there is no way that much will be raised. So, to make up the difference for what they need they will print it. We are already printing money at a rate above economic growth and that means inflation. Print more money like Obama wants and that will lead to more inflation. That means the money we have is worth less. Essentially, it is taxed.

So, while the plan may seem helpful, it really isn’t. In fact, in the long run it is disastrous for the financial well being of this country. This plan only tries to make Obama look good in front of those who don’t understand or care about how the monetary system works. In reality, it is a disaster.

Austrian economics does not condone fraud

As a believer in the Austrian theory of economics, I would like to clear up a misconception that many critics have of the theory. This is the idea that Austrian economics allows fraud, since they vouch for free markets. This is a false notion. It is not true.

No economic theory condones fraud because fraud is unfair and all economic theories try to establish fairness. Fraud does not fit into any theory except for anarchy, where anything goes. Free markets do not mean anarchy. There are many supporters of Austrian economics, myself included, who still want oversight for fraud. Oversight is ok and it is necessary to punish those who commit fraud, but it is not acceptable to meddle in markets and companies from the get go.

The government needs to stop worrying about “leveling the playing field” with things such as corporate taxes and penalties for companies, and instead should start working on creating a more efficient fraud-monitoring system. As we saw with the recent Madoff story, the SEC and other measures against fraud aren’t doing so well. It is time to catch the cheaters instead of hurting and controlling the successful.

What is money?

Money is an integral part of our lives and every economy in the modern world. For this reason it is vital to understand the history of money and how the monetary system works. Upon scrutiny it is clear that our current monetary policy is only hurting the people and the government.

Before the creation of currency, people bartered, or traded things. For example, a corn farmer may trade his excess corn to a wheat farmer for some of his excess wheat. This way both farmers would have wheat and corn. It was simple enough, but the system posed problems for several reasons. First of all, it was very difficult to trade large quantities of product because everything would have to be physically moved. Also, if someone wanted something that they didn’t own, they would have to find someone else that did have that product. If the corn farmer wanted soy, but knew no soy farmers, he probably wouldn’t be able to get soy.

The solution to this problem was using a commodity that everyone wanted and would trade for their products. Different civilizations used different things from conch shells to precious metals (such as gold, which eventually became the most popular form of money), as long as it was something that everyone wanted. Since everyone wanted it, everyone accepted it as payment for whatever products they wanted to trade. This was the invention of money.

Pretty soon the banks started issuing receipts to depositors, so that they could claim their gold when they needed it. People soon realized that the receipts were “as good as gold” because they could be turned in for the gold any day. Since it was easier exchanging the paper receipts than the heavier gold coins, the system stuck and paved the way for paper money. Eventually, governments would just print official paper currency that was backed by gold. Each bill of paper money had a set amount of gold behind it, that the government held in reserves. Originally, most countries (including the United States) allowed its citizens to turn in the paper money in exchange for gold (since it was the same thing in theory.)

As money evolved, a new type of currency was created: the fiat currency. A fiat currency is not backed by any commodity (and hence can’t be turned in for anything,) but is accepted around a nation because of the government’s order. The United States currently uses a fiat currency, as do most major world currencies. This wasn’t always the case though.

The United States has flipped between commodity-backed and fiat currencies a few times in its history. Governments have historically changed to fiat currencies in times when more money is needed such as wartime because fiat currencies have no backing, so there is no restraint to how much can be printed. The United States did this during the Civil War, but changed back to a commodity-backed currency after the war. In 1971, President Nixon signed a bill that made the USD a fiat currency (theoretically it was to stay that way forever.) At that time, many world currencies were pegged to the USD (essentially they were backed by the USD, which was backed by gold,) so when the USD became a fiat currency, so did the currencies that were pegged to it. This is why most of the major currencies today are fiat.

Fiat currency is fine as long as the people accept it and as long as it isn’t printed at a rate higher than the economic growth of the area it serves. When the rate of printing does exceed the economic growth of the area, the value of each existing bill decreases and we see inflation. This is exactly what our government is currently doing.

We don’t have money, but big government insists on spending more, so a lot of what is needed is simply printed. Every time a new bill is printed after the rate of printing exceeds the rate of economic growth, we experience inflation. This is because when that bill is printed, all existing bills take a hit in value. One dollar printed above this balance may not be so detrimental to an economy as big as ours, but when the government starts printing billions (as it currently is,) the buying power of the dollar goes down and everything seems more expensive.

When this overprinting of money gets to a certain point, it gets ugly, and fast. We start to see hyperinflation, which is exactly what it suggests: massive inflation. The currency has lost a lot of its value and if the government doesn’t stop printing it, it risks becoming worthless; even to the point where the bill is worth less than the paper on which it is printed. This is not a theoretical situation because it actually has happened. There are several historical examples of such collapses, most notably the Weimar Republic (in more recent news, Zimbabwe is headed down a similar path as the government just announced the issuance of the $10 billion note- which is worth less than $20 USD.) In situations such as these, the part that hurts the most is hearing about those who had savings.

Say you saved $100,000 over your lifetime. If we experience hyperinflation and everything costs huge numbers of dollars, that 100,000 will be worth almost nothing. When you saved it the dollar would’ve been worth a lot more and it certainly would’ve taken a long time to save all that money up, but in a state of hyperinflation all the hard work turns into a waste. That money is worthless. People can lose their life savings because of this.

This is why it is no joke when the government prints money at a rate higher than economic growth. Even though it hasn’t been done enough to cause hyperinflation in the United States yet, it certainly has caused inflation. The government essentially steals the money from you in order to give value to its newly printed bills, which it needs to support big government. Many like to call this the inflation tax because the government is essentially taxing all the dollars you have by reducing the value of them.

So next time you see a new proposal to increase spending think twice before supporting it because if we continue to support and spend as much as we currently are, our money will quickly become worthless.