WEBVTT NOTE The Fed, the FDIC, and Other Problems 1 00:00:00.000 --> 00:00:03.000 Our next speaker is Dr. Joseph Salerno. 2 00:00:04.000 --> 00:00:07.000 Joe is professor of economics at Pace University 3 00:00:07.000 --> 00:00:12.000 and head of the graduate program in economics right here in New York City. 4 00:00:13.000 --> 00:00:16.000 He's the academic vice president of the Mises Institute, 5 00:00:16.000 --> 00:00:19.000 the editor of the quarterly journal of Austrian Economics, 6 00:00:19.000 --> 00:00:26.000 a close friend and student and eventual colleague of Murray Rothbard's. 7 00:00:26.000 --> 00:00:32.000 and Joe is going to talk to us today about the Fed, the FDIC and other problems. Joe. 8 00:00:32.000 --> 00:00:38.000 Thank you very much. 9 00:00:38.000 --> 00:00:43.000 Thank you for the introduction, Lew, and welcome to the afternoon sessions. 10 00:00:43.000 --> 00:00:51.000 All the topics that I've been assigned have been touched on more or less broadly by this morning's speakers. 11 00:00:51.000 --> 00:00:56.000 David Stockman did a wonderful job of talking about Bernanke's Day of Infamy 12 00:00:56.000 --> 00:01:02.000 and Walter introduced the problem of fractional reserve banking 13 00:01:02.000 --> 00:01:07.000 while Doug talked about the FDIC and its special programs 14 00:01:07.000 --> 00:01:14.000 and Peter talked about the intermechanics or rather machinations of the Federal Reserve system. 15 00:01:14.000 --> 00:01:19.000 What I want to do though is to focus a little bit more closely 16 00:01:19.000 --> 00:01:24.920 And what I believe is the core of the problem, that is the core of the financial crisis, 17 00:01:24.920 --> 00:01:34.920 the meltdown, and the reason why the Fed had to respond as it has done yesterday. 18 00:01:34.920 --> 00:01:38.760 And really what I'm talking about is fractional reserve banking. 19 00:01:38.760 --> 00:01:43.880 Now Walter dealt with the ethics of it, but I want to take a little closer look at the 20 00:01:43.880 --> 00:01:49.940 and mechanics of it, and of how it can exist in today's world, okay, and to give away 21 00:01:49.940 --> 00:01:57.120 a little bit of the answer, it's really enabled by the Federal Reserve system, a monopoly 22 00:01:57.120 --> 00:02:05.400 central bank that can issue money at will and bail any banker, any company out. 23 00:02:05.400 --> 00:02:12.100 The fact that we have something called a too-big-to-fail doctrine for banks and financial institutions, 24 00:02:12.100 --> 00:02:16.780 But we all know if something is too big to fail, it's too big, and the market will 25 00:02:16.780 --> 00:02:20.860 cut it down to size, but that's not allowed to happen because of the existence of the 26 00:02:20.860 --> 00:02:21.860 Fed. 27 00:02:21.860 --> 00:02:26.380 And finally, of course, the existence of deposit insurance. 28 00:02:26.380 --> 00:02:34.180 So let me just talk a little bit about fractional reserve banking, why it exists, we'll see 29 00:02:34.180 --> 00:02:41.020 there's a problem with public confidence, and then briefly go over a solution. 30 00:02:41.020 --> 00:02:46.780 Let me just start with fractional reserve banking, really a bank is simply a business firm that 31 00:02:46.780 --> 00:02:53.100 issues claims to a fixed sum of money in return for a deposit of cash. 32 00:02:53.100 --> 00:02:57.260 These claims are payable on demand and without cost to the depositor. 33 00:02:57.260 --> 00:03:01.100 In today's world, these claims may take the form of checkable deposits or checking accounts 34 00:03:01.100 --> 00:03:05.900 or even savings deposits, which are payable on demand or at ATM machines. 35 00:03:05.900 --> 00:03:12.900 In the United States, the cash for which the deposit claim is redeemable are Federal Reserve notes. 36 00:03:12.900 --> 00:03:17.900 Those are the dollar bills that we are all familiar with. That is the cash of the system. 37 00:03:17.900 --> 00:03:26.900 Previously, prior to 1933 and especially prior to 1914, the ultimate cash of the system were gold coins. 38 00:03:26.900 --> 00:03:31.900 Fractional reserve banking occurs when the bank lends or invests some of its depositors' funds 39 00:03:31.900 --> 00:03:34.900 and retains only a fraction of the deposits in cash. 40 00:03:34.900 --> 00:03:39.300 This cash is the bank's reserves, hence the name fractional reserve banking. 41 00:03:39.300 --> 00:03:43.900 All commercial banks and thrifts in the U.S. and in the world today engage in fractional 42 00:03:43.900 --> 00:03:44.900 reserve banking. 43 00:03:44.900 --> 00:03:49.780 Now, Walter gave an illustration of this, I'll give another illustration. 44 00:03:49.780 --> 00:03:57.280 Assume that a bank with deposits of $1 million makes $900,000 worth of loans and investments. 45 00:03:57.280 --> 00:04:03.860 If we ignore for simplicity the capital paid in by the bank's owners, the deposits constitute 46 00:04:03.860 --> 00:04:09.600 The bank's liabilities because the bank is contractually obligated to redeem them on-demand. 47 00:04:09.600 --> 00:04:14.980 The assets of the bank are its reserves, loans and investments. 48 00:04:14.980 --> 00:04:19.360 Bank reserves consist of the dollar bills in its vaults and its ATM machines, and the 49 00:04:19.360 --> 00:04:23.820 bank's deposits at the Federal Reserve System, which can be cashed in on-demand for dollar 50 00:04:23.820 --> 00:04:29.780 bills, which are printed by the Federal Bureau of Engraving and Printing at the order of 51 00:04:29.780 --> 00:04:30.860 the Fed. 52 00:04:30.860 --> 00:04:36.520 The bank's loans and securities are non-cash assets, which are titles to sums of cash payable 53 00:04:36.520 --> 00:04:41.080 only in the near or distant future. 54 00:04:41.080 --> 00:04:44.800 These assets include business loans, credit card loans, mortgage loans and securities 55 00:04:44.800 --> 00:04:48.240 issued by the U.S. Treasury and foreign governments. 56 00:04:48.240 --> 00:04:52.960 The key to understanding the nature of fractional reserve banking and the problem it creates 57 00:04:52.960 --> 00:04:57.880 is to recognize that the bank deposit, the checking deposit, is not money itself. 58 00:04:57.880 --> 00:05:03.640 It is rather a money substitute, a claim to standard money, a claim to dollar bills, that 59 00:05:03.640 --> 00:05:07.840 is universally regarded as perfectly secure. 60 00:05:07.840 --> 00:05:13.160 Bank deposits are transferred by check or debit card will be routinely paid and received 61 00:05:13.160 --> 00:05:19.600 in exchange as substitutes for money, only as long as the public does not have the slightest 62 00:05:19.600 --> 00:05:25.000 doubt that the bank which creates these deposits is able and willing to redeem them without 63 00:05:25.000 --> 00:05:27.080 delay or expense. 64 00:05:27.080 --> 00:05:33.560 Under these circumstances, bank deposits are eagerly accepted and held by businesses, households 65 00:05:33.560 --> 00:05:38.000 and they're regarded as indistinguishable from the dollar bills that they are claims 66 00:05:38.000 --> 00:05:39.680 to. 67 00:05:39.680 --> 00:05:42.560 And they are included properly as part of the money supply. 68 00:05:42.560 --> 00:05:47.740 Now, the balance sheet of a fractional reserve bank represents an immediate problem. 69 00:05:47.740 --> 00:05:52.760 On the one hand, all of the bank's deposit liabilities mature on a daily basis because 70 00:05:52.760 --> 00:05:56.720 it is a promise to cash on demand. 71 00:05:56.720 --> 00:06:01.560 On the other hand, only a small fraction of its assets is available at any moment to meet 72 00:06:01.560 --> 00:06:03.600 these liabilities. 73 00:06:03.600 --> 00:06:09.140 For example, during normal times, U.S. banks effectively hold much less than 10% of deposits 74 00:06:09.140 --> 00:06:10.500 in cash reserves. 75 00:06:10.500 --> 00:06:15.600 The rest of the bank's liabilities will only mature after a number of months, years, or 76 00:06:15.600 --> 00:06:18.160 in the case of mortgage loans, decades. 77 00:06:18.160 --> 00:06:24.200 In the jargon of economics, fractional reserve banking always involves term structure risk, 78 00:06:24.200 --> 00:06:30.800 which arises from mismatching the maturity structure of the liabilities with assets. 79 00:06:30.800 --> 00:06:36.800 Now in layman's terms, all that means is that banks borrow short and lend long. 80 00:06:36.800 --> 00:06:41.720 They promise to pay off in the short term, but they lend the money out for much longer 81 00:06:41.720 --> 00:06:42.720 periods of time. 82 00:06:42.720 --> 00:06:47.680 And of course, the problem is revealed when demands for withdrawal of deposits exceeds 83 00:06:47.680 --> 00:06:50.320 a bank's existing cash reserves. 84 00:06:50.320 --> 00:06:55.760 The bank is then compelled to hastily sell off some of its longer-term assets, many of 85 00:06:55.760 --> 00:06:58.420 which are not readily saleable. 86 00:06:58.420 --> 00:07:03.560 It will thus incur big losses because it must dump these assets at bargain-basement prices. 87 00:07:03.560 --> 00:07:07.400 This will cause a panic among the rest of the depositors, who will scramble to withdraw 88 00:07:07.400 --> 00:07:10.520 the deposits before they become worthless. 89 00:07:10.520 --> 00:07:14.400 A classic bank run will then occur, and at this point the value of the bank's remaining 90 00:07:14.400 --> 00:07:19.320 assets will no longer be sufficient to pay off the deposit liabilities, and the bank 91 00:07:19.320 --> 00:07:20.320 Bank will fail. 92 00:07:20.320 --> 00:07:25.320 Now, let me talk about why this doesn't happen on a regular basis. 93 00:07:25.320 --> 00:07:29.840 A fractional reserve bank, therefore, can only remain solvent for as long as public 94 00:07:29.840 --> 00:07:35.440 confidence exists that its deposits really are secure claims to cash. 95 00:07:35.440 --> 00:07:41.140 If for any reason the faintest suspicion arises among its clients that a bank's deposits 96 00:07:41.140 --> 00:07:46.360 are no longer payable on demand, the bank's reputation as an issuer of money substitutes 97 00:07:46.360 --> 00:07:58.200 The banks brand of money substitutes is then instantly extinguished and people rush to 98 00:07:58.200 --> 00:08:03.060 withdraw their deposits in cash, cash that no fractional reserve bank can provide on 99 00:08:03.060 --> 00:08:09.140 demand in sufficient quantities, thus the threat of instant insolvency is always looming 100 00:08:09.140 --> 00:08:14.200 over fractional reserve banks, that is all banks in the world today. 101 00:08:14.200 --> 00:08:18.160 The particular bank's deposits may still exist as part of people's wealth, but they will 102 00:08:18.160 --> 00:08:20.720 no longer be treated as money substitutes. 103 00:08:20.720 --> 00:08:25.640 You will be able to use them to purchase goods and services and assets. 104 00:08:25.640 --> 00:08:31.080 Thus, in order to issue money substitutes, a bank must develop what Ludwig von Mises 105 00:08:31.080 --> 00:08:35.600 called a special kind of goodwill that goes beyond business goodwill. 106 00:08:35.600 --> 00:08:41.280 On a free market, this kind of goodwill is very difficult and costly to acquire and maintain, 107 00:08:41.280 --> 00:08:47.480 But it is this reputational asset that induces a bank's clients to abstain from immediately 108 00:08:47.480 --> 00:08:53.480 cashing in the deposit at every moment and driving the bank into instant insolvency. 109 00:08:53.480 --> 00:09:00.080 So at every moment there has to be a decision to hold these banks' claims to cash. 110 00:09:00.080 --> 00:09:06.480 Once any suspicion arises that the bank's not going to pay off, at that moment you have 111 00:09:06.480 --> 00:09:08.500 the bank run. 112 00:09:08.500 --> 00:09:14.960 But unlike the common form of goodwill, essential to all successful business ventures, the goodwill 113 00:09:14.960 --> 00:09:19.820 that is necessary for fractional reserve banks' deposits to circulate as money substitutes 114 00:09:19.820 --> 00:09:22.140 is highly peculiar. 115 00:09:22.140 --> 00:09:28.860 Now either all customers trust the bank and hold its deposits, or no one does. 116 00:09:28.860 --> 00:09:33.620 Once some people lose confidence and begin to cash in their deposits, the bank's days 117 00:09:33.620 --> 00:09:37.900 are numbered, the bank's moments are numbered. 118 00:09:37.900 --> 00:09:42.380 Now Ludwig von Mises described the loss of confidence in a bank's solvency and the 119 00:09:42.380 --> 00:09:48.420 related phenomenon of brand extinction, meaning that their deposits are no longer considered 120 00:09:48.420 --> 00:09:49.860 legitimate claims to money. 121 00:09:49.860 --> 00:09:54.340 And here's what he said, the confidence which a bank and the money substitutes it has issued 122 00:09:54.340 --> 00:10:01.140 enjoy is indivisible, it is either present with all its clients or it vanishes entirely. 123 00:10:01.140 --> 00:10:05.000 If some of the clients lose confidence, the rest of them lose it too. 124 00:10:05.000 --> 00:10:10.400 One must not forget that every bank issuing fiduciary media, that is, unbacked checking 125 00:10:10.400 --> 00:10:16.980 account deposits, is in a rather precarious position. Its most valuable asset is its reputation. 126 00:10:16.980 --> 00:10:22.000 It must go bankrupt as soon as doubts arise concerning its perfect trustworthiness and 127 00:10:22.000 --> 00:10:25.640 solvency. 128 00:10:25.640 --> 00:10:32.320 And Murray Rothbard echoed this. Murray Rothbard wrote, but in what sense is a bank sound? 129 00:10:32.320 --> 00:10:38.280 In one whisper of doom, one faltering of public confidence should quickly bring the bank down. 130 00:10:38.280 --> 00:10:43.640 In what other industry does a mere rumor or hint of doubt bring down a mighty and seemingly 131 00:10:43.640 --> 00:10:45.800 solid firm? 132 00:10:45.800 --> 00:10:50.320 What is it about banking that public confidence should play such a decisive and overwhelmingly 133 00:10:50.320 --> 00:10:52.120 important role? 134 00:10:52.120 --> 00:10:56.920 The answer lies in the nature of our banking system, in the fact that both commercial banks 135 00:10:56.920 --> 00:11:01.660 and thrift banks have been systematically engaging in fractional reserve banking. 136 00:11:01.660 --> 00:11:07.420 is they have far less cash on hand than there are demand claims to cash outstanding. 137 00:11:07.420 --> 00:11:11.260 I want to give you a few examples. 138 00:11:11.260 --> 00:11:15.580 Rothbard's point about the extreme fragility of public confidence in issuers of fractionally 139 00:11:15.580 --> 00:11:20.940 backed money substitutes is illustrated by the stunning collapse of Washington Mutual, 140 00:11:20.940 --> 00:11:27.220 or Waymu as it was called, in September 2008, the largest bank failure in the United States 141 00:11:27.220 --> 00:11:28.220 history. 142 00:11:28.220 --> 00:11:33.580 EMU had been in existence for 119 years and was the sixth largest bank in the United States 143 00:11:33.580 --> 00:11:36.820 with assets of $307 billion. 144 00:11:36.820 --> 00:11:41.260 It had branches throughout the country and billed itself as the Walmart of banking. 145 00:11:41.260 --> 00:11:43.380 Everyone remember that? 146 00:11:43.380 --> 00:11:48.660 It was one of the top performers on Wall Street until shortly before its failure. 147 00:11:48.660 --> 00:11:52.180 So Wall Street did not see the failure coming. 148 00:11:52.180 --> 00:11:56.440 Its depositors clearly had confidence in its solidity, especially given that its deposits 149 00:11:56.440 --> 00:12:00.920 were ensured by the Federal Government, reinforced by the existence of the Fed's too-big-to-fail 150 00:12:00.920 --> 00:12:02.200 policy. 151 00:12:02.200 --> 00:12:07.560 And yet, almost overnight, the special goodwill that gave its deposits the quality of money 152 00:12:07.560 --> 00:12:13.760 substitutes vanished as panic-stricken depositors rushed to withdraw their funds. 153 00:12:13.760 --> 00:12:26.280 The unlikely event that triggered the sudden loss of confidence and subsequent brand extinction 154 00:12:26.280 --> 00:12:34.200 was a failure of Lehman Brothers, a very venerable investment house, it wasn't initially a problem 155 00:12:34.200 --> 00:12:38.360 with Washington Mutual at all, it was a contagion. 156 00:12:38.360 --> 00:12:45.960 A week after Lehman failed, Mighty Waymo was no more, it was gone, it was completely gone. 157 00:12:45.960 --> 00:12:50.480 The highly publicized Lehman Brothers failure had shaken public confidence in the solvency 158 00:12:50.480 --> 00:12:55.160 not only of Waymo but of the entire banking system, had the Fed and Treasury not acted 159 00:12:55.160 --> 00:13:00.400 aggressively to bail out the largest banks in the fall of 2008, there is no doubt that 160 00:13:00.400 --> 00:13:03.240 the entire system would have collapsed in short order. 161 00:13:03.240 --> 00:13:09.040 Indeed, on a single day in December, the combined emergency lending by the Fed and the U.S. Treasury 162 00:13:09.040 --> 00:13:11.640 had risen to a peak of $1.2 trillion. 163 00:13:11.640 --> 00:13:18.240 The recipients of these billions included some of the most trusted and reputable brand 164 00:13:18.240 --> 00:13:23.980 names in banking, Citibank, Bank of America, Morgan Stanley, as well as European banks 165 00:13:23.980 --> 00:13:30.100 Banks like the Royal Bank of Scotland and UBS AG, despite their long existence, despite 166 00:13:30.100 --> 00:13:35.540 their reputation for solidity, the slightest doubt that they were no longer able to pay 167 00:13:35.540 --> 00:13:43.340 off their deposit claims would have brought them down within a week after the Washington 168 00:13:43.340 --> 00:13:45.820 mutual failure. 169 00:13:45.820 --> 00:13:49.980 Now let's contrast this example with the Tylenol murders that occurred in Chicago in 170 00:13:49.980 --> 00:13:54.180 in 1982, which you may still remember. 171 00:13:54.180 --> 00:13:58.580 In this incident, seven people died from ingesting capsules of the analgesic, super-strength 172 00:13:58.580 --> 00:14:01.860 Tylenol that were laced with potassium cyanide. 173 00:14:01.860 --> 00:14:06.340 However, not only was the parent company, Johnson & Johnson, able to maintain its own 174 00:14:06.340 --> 00:14:11.460 business goodwill by its successful and prompt response to the tragedy, it was also able 175 00:14:11.460 --> 00:14:15.660 to recover the goodwill of the Tylenol brand name itself, so the brand name didn't vanish 176 00:14:15.660 --> 00:14:16.660 in the thin air. 177 00:14:16.660 --> 00:14:21.680 It is true that many customers stopped purchasing the Tylenol brand for a while, and that its 178 00:14:21.680 --> 00:14:29.020 share of the painkiller market swiftly plunged from 37% to 8%, didn't disappear, got very 179 00:14:29.020 --> 00:14:30.020 small. 180 00:14:30.020 --> 00:14:34.340 Nevertheless, its market share rebounded back to 30% in less than a year. 181 00:14:34.340 --> 00:14:37.700 A few years later, Tylenol was again the most popular painkiller. 182 00:14:37.700 --> 00:14:41.540 Furthermore, the Johnson & Johnson stock, which had been trading at an all-time peak 183 00:14:41.540 --> 00:14:47.620 shortly before the incident plunged, but then rose back to its peak three months later. 184 00:14:47.620 --> 00:14:54.060 This doesn't happen in the banking industry. Once the bank's reputation is impugned, it 185 00:14:54.060 --> 00:15:00.040 is gone. It is as good as gone, okay? It can take a few days, it can take maybe a month, 186 00:15:00.040 --> 00:15:09.540 but the bank is no longer a functioning issuer of reputable deposits, checking deposit claims. 187 00:15:09.540 --> 00:15:14.780 This can only occur in banking. Moreover, the reputational setbacks suffered by the Tylenol 188 00:15:14.780 --> 00:15:21.580 brand did not spread to the other brands marketed by Johnson & Johnson or obviously to any other 189 00:15:21.580 --> 00:15:26.020 over-the-counter painkillers. And of course, there was never any question that the incident 190 00:15:26.020 --> 00:15:33.500 would bring down the entire over-the-counter pharmaceuticals industry. The events of 2008 191 00:15:33.500 --> 00:15:38.600 would have brought down the entire banking system, not just here in the U.S., but throughout 192 00:15:38.600 --> 00:15:45.840 So the ever present threat of insolvency is really a minor problem with fractional reserve 193 00:15:45.840 --> 00:15:49.720 banks, because its effects are restricted to the banks, stockholders, creditors and 194 00:15:49.720 --> 00:15:56.320 depositors who voluntarily assume these peculiar risks involved in this business. 195 00:15:56.320 --> 00:16:02.440 The major problems I'm just going to mention, and then I want to give you a solution, are 196 00:16:02.440 --> 00:16:07.520 of course the fact that fractional reserve banking is inherently inflationary. 197 00:16:07.520 --> 00:16:12.560 As soon as the bank lends any deposits out, that increases the money supply, because the 198 00:16:12.560 --> 00:16:19.340 person who puts $10,000 in a checking account still has full access to that $10,000. 199 00:16:19.340 --> 00:16:24.480 But if you now lend $9,000 out to someone else to expand their dry cleaning establishment, 200 00:16:24.480 --> 00:16:26.480 that person now has $9,000. 201 00:16:26.480 --> 00:16:30.100 So now there's, instead of $10,000, there's $19,000. 202 00:16:30.100 --> 00:16:36.320 And that goes on and on, and it multiplies to a maximum of 10 times the original deposit. 203 00:16:36.320 --> 00:16:42.000 So it's inherently inflationary and when the money's lent out it falsifies interest rates, 204 00:16:42.000 --> 00:16:48.000 it pushes them below the market rate, the equilibrium rate, and that causes entrepreneurs 205 00:16:48.000 --> 00:16:56.080 and homeowners to make errors in their financial decisions and that brings about, eventually, 206 00:16:56.080 --> 00:17:00.760 the recession or depression or lingering stagnation as we now have. 207 00:17:00.760 --> 00:17:03.160 Okay, what is the solution to this? 208 00:17:03.160 --> 00:17:11.040 The solution is going to sound paradoxical. 209 00:17:11.040 --> 00:17:15.400 Inflation and the boom-bust cycles generated by fractional reserve banking are enormously 210 00:17:15.400 --> 00:17:20.280 intensified by the Federal Reserve and U.S. government interference with the banking industry. 211 00:17:20.280 --> 00:17:26.560 Indeed, this interference is justified by economists and policymakers precisely because 212 00:17:26.560 --> 00:17:29.800 of the instability of the fractional reserve system. 213 00:17:29.800 --> 00:17:34.300 The most dangerous forms of such interference are the power of the Federal Reserve to create 214 00:17:34.300 --> 00:17:40.680 bank reserves out of thin air, really just with a keystroke, okay, they create these 215 00:17:40.680 --> 00:17:45.880 reserves in cyberspace, okay, they just credit the bank's account. 216 00:17:45.880 --> 00:17:51.960 So instantaneously new money is created and that is what will happen every month to the 217 00:17:51.960 --> 00:17:58.520 tune of 40 billion new dollars of bank reserves. 218 00:17:58.520 --> 00:18:03.880 It's actually done between 11 and 11 o'clock to 12 o'clock in the morning every day. 219 00:18:03.880 --> 00:18:09.140 It's called Fed time where they go into the market and there's an auction and they purchase 220 00:18:09.140 --> 00:18:13.520 these mortgage-backed securities and treasuries and so on. 221 00:18:13.520 --> 00:18:20.480 So in purchasing them, they create money because the Fed obviously does not tax. 222 00:18:20.480 --> 00:18:25.960 Its only power to purchase comes from the ability to create money. 223 00:18:25.960 --> 00:18:31.680 So that's one of the problems. The other is its use of these phony reserves to bail out 224 00:18:31.680 --> 00:18:37.280 failing banks in its role as a lender of last resort and federal insurance of bank deposits, 225 00:18:37.280 --> 00:18:41.820 which Doug talked about this morning. In the presence of such policies, the deposits of 226 00:18:41.820 --> 00:18:48.520 all banks are perceived and trusted by the public as one homogeneous brand of money substitutes 227 00:18:48.520 --> 00:18:52.560 guaranteed by the federal government and backed up by the Fed's power to print up bank reserves 228 00:18:52.560 --> 00:19:09.560 In other words, people don't distinguish between sound banks and unsound banks. When you have deposit insurance and you have a Fed willing and able to bail out failing banks, everyone looks on a checking account at any bank as pretty much the same thing. 229 00:19:09.560 --> 00:19:21.560 Under the current monetary regime, there is thus absolutely no check on the natural propensity of fractional reserve banks to mismatch their assets and liabilities. 230 00:19:21.560 --> 00:19:28.560 and Liabilities, to borrow short and lend long, which then leads to an expansion of the money 231 00:19:28.560 --> 00:19:33.180 supply and an artificial depression of interest rates and all the problems that result. 232 00:19:33.180 --> 00:19:37.500 With our fundamental changes in the U.S. monetary system, the growth of bubbles in various sectors 233 00:19:37.500 --> 00:19:41.640 of the economy and the subsequent financial crises will continue. 234 00:19:41.640 --> 00:19:45.300 The solution is to treat banking as any other business and permit it to operate on a free 235 00:19:45.300 --> 00:19:51.080 market, a market completely free of government guarantees, of bank deposits and of the possibility 236 00:19:51.080 --> 00:19:57.360 of Fed Bailouts. In order to achieve the latter, Federal Deposit Insurance must be phased out 237 00:19:57.360 --> 00:20:02.560 and the Fed would have to be permanently and credibly deprived of its legal power to create 238 00:20:02.560 --> 00:20:07.200 bank reserves out of thin air. The best way to do this is to establish a genuine gold 239 00:20:07.200 --> 00:20:11.840 standard in which gold coins would circulate as cash and serve as bank reserves. At the 240 00:20:11.840 --> 00:20:16.840 same time, the Fed must be stripped of its authority to issue notes and conduct open 241 00:20:16.840 --> 00:20:22.520 and Market Operations. Also, banks would once again be legally enabled to issue their own 242 00:20:22.520 --> 00:20:28.120 brands of notes as they were in the 19th and early 20th century. Once this mighty rollback 243 00:20:28.120 --> 00:20:32.080 of government intervention and banking is accomplished, each fractional reserve bank 244 00:20:32.080 --> 00:20:38.120 would be rigidly constrained by public confidence when issuing money substitutes. One false 245 00:20:38.120 --> 00:20:43.880 step, one questionable loan, one imprudent emission of unbacked notes and deposits would 246 00:20:43.880 --> 00:20:49.780 would cause instant extinction of its brand substitute, of its money substitutes, a bank 247 00:20:49.780 --> 00:20:55.520 run and insolvency. So banks would now compete to be solid. There's no bailout, there's 248 00:20:55.520 --> 00:21:01.900 no guarantee, okay? Each bank is on its own bottom, each bank is undertaking its own risk. 249 00:21:01.900 --> 00:21:06.080 In fact, on the banking market, as I have described it, I foresee the ever-present threat 250 00:21:06.080 --> 00:21:11.720 of insolvency, forcing banks to refrain from further lending of their deposits to payable 251 00:21:11.720 --> 00:21:13.000 on Demand. 252 00:21:13.000 --> 00:21:18.820 This means that if a bank wished to make loans of shorter or longer maturity, they would 253 00:21:18.820 --> 00:21:22.360 do so by issuing credit instruments whose maturities matched the loans. 254 00:21:22.360 --> 00:21:23.860 Let me give you some examples. 255 00:21:23.860 --> 00:21:28.480 For short-term business lending, they would issue certificates of deposits with maturities 256 00:21:28.480 --> 00:21:30.260 of three or six months. 257 00:21:30.260 --> 00:21:35.400 So if you're lending to a business for six months, you borrow from someone who cannot 258 00:21:35.400 --> 00:21:38.760 reacquire their money for another six months. 259 00:21:38.760 --> 00:21:43.860 The finance car loans, they might issue three-year or four-year short bonds. 260 00:21:43.860 --> 00:21:46.920 Mortgage lending would be financed by five or ten-year bonds. 261 00:21:46.920 --> 00:21:50.880 Without government institutions like Fannie Mae and Freddie Mac, which is backed by the 262 00:21:50.880 --> 00:21:59.880 Fed's money-creating power, implicitly guaranteeing mortgages, mortgage loans would probably be 263 00:21:59.880 --> 00:22:06.360 transformed into shorter five or ten balloon loans, as they were until the 1930s. 264 00:22:06.360 --> 00:22:10.820 The bank may retain an option to roll over the mortgage loan when it comes due pending 265 00:22:10.820 --> 00:22:18.180 a re-evaluation of the borrower's current financial situation and recent credit history. 266 00:22:18.180 --> 00:22:23.480 In short, on a free market, fractional reserve banking with all its inherent problems would 267 00:22:23.480 --> 00:22:25.880 slowly wither away. 268 00:22:25.880 --> 00:22:31.620 This was also the position of Murray Rothbard who concluded, quote, contrary to propaganda 269 00:22:31.620 --> 00:22:36.300 and myth, free banking would lead to hard money and allow very little credit expansion 270 00:22:36.300 --> 00:22:38.420 of fractional reserve banking.