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Neil Reynolds

The inherent evil of fractional banking Add to ...

Spanish economist Jesus Huerta de Soto notes that the Roman Catholic Church has elevated only two economists to sainthood: Bernardino of Siena (1389-1444) and Antonio of Florence (1389-1459). He expresses the hope that they won't be the last. He asserts, however, that most economists have strayed far from the straight and narrow in the subsequent six centuries, causing widespread economic devastation - most recently in the financial meltdown of 2008 and the Great Recession that followed.

What's the connection? In a phrase, it is fractional reserve banking - the practice, now universal, in which commercial banks treat people's deposits as though they, rather than the people who make the deposit, own the money and control its use, normally by lending it out, at risk levels the banks see fit, to other people. Banks retain only pennies on the dollar, hence, "fractional." But a single-dollar deposit, lent over and over again as it moves from bank ledger to bank ledger, can multiply into $30 (or more) worth of "money" in 30 (or more) transactions. In each case, banks own the deposit and give the depositor, in exchange, an IOU.

Prof. Huerta de Soto associates saints Bernardino and Antonio with the Spanish academics who, during that country's famous 15th-century Golden Age, first determined that bank deposits are an integral part of a national money supply, meaning that these deposits needed to be as fully protected by hard assets (such as gold in olden times) as a country's cash. These economists warned against the creation of money at the stroke of an accountant's pen. In Latin, they condemned it as chirographis pecuniarium (written money) - and regarded it as both mortal sin and criminal offence.

Prof. Huerta de Soto teaches political science at Rey Juan Carlos University in Madrid. In October, he delivered the Cobden Centre's 2010 Hayek Memorial Lecture at the London School of Economics. The London-based centre is a registered charity (committed to the pursuit of "social progress through honest money") that honours 19th-century parliamentarian Richard Cobden - who denounced central bank regulation of currency in equally harsh terms. ("I hold all idea of regulating the currency to be an absurdity," he once said. "The currency should regulate itself.")

In his review of the 2008 financial meltdown, Prof. Huerta de Soto began with the tough-minded Spanish scholastics who foresaw the boom-and-bust consequences of easy credit and inflation - which fractional banking more or less ensures. When British Prime Minister Robert Peel enacted his radical Bank Charter Act several hundred years later (1844), establishing the Bank of England as Britain's central bank, he required by law that the country's banknotes be backed 100 per cent by gold. He exempted bank deposits from this requirement, however - and financial crises continued to hit England in regular succession: 1847, 1857, 1866.

Prof. Huerta de Soto argues that financial crises have continued - for the same reason - ever since. "Bubbles [from excessive credit]did continue to form," he told the London audience. "Financial crises and economic recessions were not avoided, bank bailouts were regularly demanded, the lender of last resort or central bank was created precisely to bail out banks."

His analysis rests ultimately on morality. For capital investment to produce honest economic growth, he said, it must come from people's honest-to-God savings. And honest-to-God savings require sacrifice and discipline. Fractional banking fails because it passes off illusionary savings as real savings. In the world's larger economies, money itself now constitutes only 10 per cent of a country's money supply; fractional banking, through its magical "multiplier effect," supplies 90 per cent.

Everyone, alas, loves easy money. "Everyone is happy ... because it appears it would be possible to increase one's wealth very easily without any sacrifice in the form of prior savings and honest, hard individual work," Prof. Huerta de Soto noted. But the price for this easy money is the boom-and-bust economy.

Coincidentally, Bank of England chairman Mervyn King spoke in New York a couple of weeks ago on the same subject - radical bank reform. "Of all the many ways of organizing banking," he said, "the worst is the one we have today." One solution, he said, was "eliminating fractional reserve banking."

This central banker is downright radical and, though not yet tested enough to rank as saintly, definitely righteous.

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