The Essence of a Fractional Banking Reserve Requires A Bailout of the Banking System!

``From the fact that people are very different it follows that, if we treat them equally, the result must be inequality in their actual position, and that the only way to place them in an equal position would be to treat them differently. Equality before the law and material equality are therefore not only different but are in conflict with each other; and we can achieve either one or the other, but not both at the same time.”-Friedrich Hayek, Austrian economist, The Road to Serfdom

In addition, as discussed last August 13 to 17, [see US FEDERAL RESERVE Is Financial Markets Sensitive!) since the US economy’s core source of financing for its household consumer spending patterns has been the financial markets, we argued that the FED would do everything (“inflationary”--you can name all sorts of programs or rescue packages) it can to avert a crisis.

Another very important aspect which we would like to add in the considering the present predicament is the construct of today’s de facto monetary standard, the US dollar standard.

Such essentially operates under the FRACTIONAL BANKING RESERVE principle as defined by wikipedia.org, ``refers to the common banking practice of issuing more money than the bank holds as reserves. Banks in modern economies typically loan their customers many times the sum of the cash reserves that they hold.”

When we deposit 100,000 pesos to a bank, our expectation is that our deposits will be safeguarded and the bank will pay us 100,000 pesos when we demand it. The unfortunate part is that under the fractional reserve banking standard, on an aggregate basis, “reserves” reflect only a fraction of our accrued deposits, (to our example such bank has only 10,000 pesos!).

The fractional banking principle is actually a “cartelization” of banking industry. The distinguished Murray Rothbard of the Austrian School of Economics in a 1995 describes the present money standard (highlight mine),

``In modern central banking, the Central Bank is granted the monopoly of the issue of bank notes (originally written or printed warehouse receipts as opposed to the intangible receipts of bank deposits), which are now identical to the government's paper money and therefore the monetary "standard" in the country…

``Here's how the counterfeiting process works in today's world. Let's say that the Federal Reserve, as usual, decides that it wants to expand (i.e., inflate) the money supply. The Federal Reserve decides to go into the market (called the "open market") and purchase an asset. It doesn't really matter what asset it buys; the important point is that it writes out a check. The Fed could, if it wanted to, buy any asset it wished, including corporate stocks, buildings, or foreign currency. In practice, it almost always buys U.S. government securities…

``Thus, the Federal Reserve and other central banking systems act as giant government creators and enforcers of a banking cartel; the Fed bails out banks in trouble, and it centralizes and coordinates the banking system so that all the banks, whether the Chase Manhattan, or the Rothbard or Rockwell banks, can inflate together. Under free banking, one bank expanding beyond its fellows was in danger of imminent bankruptcy. Now, under the Fed, all banks can expand together and proportionately.”

Two things to bear mind:

One, today’s highly leveraged non-banking finance (hedge funds, security dealers insurance and pension funds, credit derivative companies, et. al.) reflects on the basic principles of the FRACTIONAL RESERVE Banking standard but have been unsupported by a cartel of Central banks (once again as my premise last week…government policies reflects on the markets and not the other way around) and…

Second and most importantly, as Murray Rothbard asserted, the banking industry as an indispensable conduit of the fiat monetary standard cartel, authorities will ALWAYS contrive actions to bailout the system REGARDLESS of the costs. Abandoning the banking cartel is almost equivalent to a rescindment of today’s fiat money standard. Such is unlikely to happen.

This has been echoed by mainstream economists such as Harvard’s Martin Feldman who on Friday warned of a growing risk of US recession and recommended immediate rate cuts, quoting a report from Bloomberg, ``Lowering interest rates may result in a ``stronger economy with higher inflation than the Fed desires,'' a situation that Feldstein described as the ``lesser of two evils.''