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700 Billion Times 10

By Tim Buchholz

04 December, 2008

So, we all know about the $700 billion; let me write that out- $700,000,000,000. Where did this number come from? How did The Federal Reserve and The Secretary of Treasury come up with that number? Well, I don’t know. But I was reading a great article by John LeBoutillier called “Where Does All That Money Come From?,” and he says Bloomberg News reported that The Federal Reserve has “pledged/backed up/loaned $7.6 trillion” already to attempt to fix this crisis. Let’s look at that number -$7,600,000,000,000. That’s when I remembered a little thing that banks get to do that you and I don’t. It’s called “Fractional Reserve Banking.”

Murray N. Rothbard, former Dean of The Austrian School of Economics, has a wonderful explanation of the history of this phenomenon called, “Fractional Reserve Banking.” He says the industry started with “merchant bankers.” These folks “started as prominent merchants. In the course of their trade, the merchants began to extend credit to their customers, and in the case of these great banking families, the credit or "banking" part of their operations eventually overshadowed their mercantile activities. These firms lent money out of their own profits and savings, and earned interest from the loans. Hence, they were channels for the productive investment of their own savings.” That sounds pretty fair to me.

Rothbard says the next step was “Investment Banking,” which he says, “developed as industrial capitalism flowered in the nineteenth century. Investment bankers would take their own capital, or capital invested or loaned by others, to underwrite corporations gathering capital by selling securities to stockholders and creditors. The problem with the investment bankers is that one of their major fields of investment was the underwriting of government bonds, which plunged them hip-deep into politics, giving them a powerful incentive for pressuring and manipulating governments, so that taxes would be levied to pay off their and their clients' government bonds. Hence, the powerful and baleful political influence of investment bankers in the nineteenth and twentieth centuries.”

He says these investment bankers then wanted to get their hands into the “commercial banking” business, which is based on “deposit banking.” At first these banks were just “passive guardians of bullion” as Wikipedia refers to them. Rothbard says in the early days, it was “100 percent reserve banking,” and he compares it to storing something in a warehouse. You put your item in storage, and get a piece of paper or note, which later became paper money, that you can redeem at any time for your item. He says deposit banks used to have gold or silver to back up all the notes in reserve, thus 100 percent reserve banking. But then the bankers realized most people didn’t take all their items out of the warehouse at the same time, and the banks were left with reserves they could invest and make more money from. Modern banking was born.

The banks take in deposits and pay an interest on that deposit. Then, they lend out that money at a higher interest or invest it themselves and make their profit. The problem here comes just like the end of “It’s A Wonderful Life,” where the town knows Jimmy Stewart’s bank could go under, and all come charging in demanding their money back, or a “bank run.” Of course Jimmy Stewart can’t give them all their money back, because their money is in Tom’s house and Bob’s store. If not for a Christmas miracle, or a government bailout, Jimmy Stewart’s bank would have defaulted on the notes and gone out of business. And in today’s world, the end of that movie would have been a lot more confusing, as the town’s money would be sliced up into securities and derivatives. “I don’t have your money here, it’s in a hedge fund in China.”

Rothbard says that, “An honest warehouse makes sure that the goods entrusted to its care are there, in its storeroom or vault. But banks operate very differently.” He says “Banks make money by literally creating money out of thin air,” and continues, “This sort of swindling or counterfeiting is dignified by the term ‘fractional-reserve banking,’ which means that bank deposits are backed by only a small fraction of the cash they promise to have at hand and redeem. (Right now, in the United States, this minimum fraction is fixed by the Federal Reserve System at 10 percent.)”

So, if I am a bank and I have $10, I can loan out $100.00. Pretty good right? I only need to have $1 million to loan out $100 million, at interest. And, if I have $700 billion, I can loan $7 trillion, at interest. That’s pretty close to $7.6 trillion, remember that number? Sounds like another bubble getting ready to burst to me.

Tim Buchholz is a freelance writer living in Ohio

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