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Sunday, May 4, 2008

In a Free Market, Banking is not Evil

In a truly free market, someone would not be prohibited from operating a bank. Can banks operate without enslaving the rest of society? Without any government intervention at all, can a bank be a productive and honest business?

If you assume that all forms of government are illegitimate, it's impossible to forbid someone from operating a bank. As long as the bank can find depositors and there is no fraud, then a bank should be allowed to operate. It turns out that, without government interference in the market, a bank is an honest business. In a truly free market with some educated customers, a bank's interest income equals its expenses plus reasonable profits. There is no Compound Interest Paradox in a truly free market.

Banking is not inherently evil, in a truly free market. A badly managed bank would have all its deposits withdrawn, and the bank's owners and management would be personally liable for any shortfall in the event of a bank run. Banks could advertise their reserve ratios and interest rates, and customers could make the decision of whether they preferred a higher reserve ratio (i.e. more security) and less interest, or more risk and higher interest. At one extreme, there would be warehouses, who would have 100% reserves and charge a storage fee. At another extreme, there would be banks with aggressive reserve ratios of 10x, 50x, or more. The customers of banks should have to agree to not withdraw all of their deposits simultaneously. If a bank was in trouble, there would be no legal tender laws forcing people to accept its notes at parity with physical gold.

In a truly free market with a pure gold standard, a bank would be required by the market to provide full disclosure of its books. Without full disclosure, people would not accept the notes of the bank at face value. Without full disclosure, a bank would be unable to attract deposits. In the present, customers are usually unconcerned about the creditworthiness of their bank, because they know the government will bail out the bank if there's a problem.

The interest collected by the bank would be paid out to depositors, and as the bank's own profits and expenses. There is no Compound Interest Paradox in a truly free market with a pure gold standard; all interest collected is paid out. Due to free market competition, the bank would pay out all interest collected to depositors, its employees, or profits to the owners.

If it turned out the banking industry's profits were excessive, competitors would join the banking industry. In the present, there are huge regulatory hurdles when starting a bank. A bank doesn't really reap the benefit of a corrupt financial system until its value is $100B or more; at that point, such a bank is "too big to fail". Even if I raised the $20M in capital required to start a small bank, that wouldn't place me in a position to exploit the flaws in the monetary system; my larger competitors would have too great an advantage.

In a free market, a bank can't earn excessive profits and use the Compound Interest Paradox to enslave the rest of society. When a bank failed, all the money it had fraudulently created would vanish. Under common law, the bank's management and owners would be personally liable for the deficit.

In a truly free market, metal coins make the best money, usually gold and silver. If the volume of metal is insufficient for the requirements of trade, banks provide a LEGITIMATE service of expanding the money supply. As long as all of the bank's loans are backed by actual goods and services, then the bank is solvent and not committing fraud. Government intervention allows insolvent banks to continue operating, even though they would be bankrupt if they were required to "mark to market" all of their assets.

Banks are not intrinsically evil. It is red market intervention in the operations of banks that is evil. It is the conspiracy between bank owners and red market workers that is evil. Banks should be allowed to advertise their reserve ratios, interest rates, and financial status.

Another problem with banks is the limited liability corporation. Limited liability corporations are an artificial creation of an exploitative government. The limited liability corporation allows for shady practices by management and owners. If a business is bankrupt and unable to pay its debts, the management and owners should be personally liable. That is what common law dictates without corporations. Corporations get all the perks of running a business, but none of the responsibilities when it fails. The only thing a corporate structure accomplishes is that it protects the management and owners from the consequences of their dishonesty. If a business is fully honest with its creditors, when it fails, it should fail with a net worth of exactly zero. As soon as a business becomes insolvent, its creditors would refuse to issue new loans and call in their debts. In a truly free market, a business is required to keep its creditors fully informed of its financial status. Current accounting laws allow corporate management to hide their true financial status, so that when bankruptcies occur, there's a huge accumulated debt.

Another problem is the "demand deposit". The "demand deposit" and loans are incompatible. If all depositors simultaneously demand withdrawal, then the fractional reserve bank is insolvent. A fractional reserve bank with demand deposits is technically insolvent at any given instant. An honest bank should tell its depositors that they may only withdraw a certain % of their gold each day. For example, a bank that offers loans with an average duration of 90 days should tell its customers that they may only withdraw 1/90 of their gold at a time. Customers who demand all their gold at any time should use a warehouse service, where they receive no interest and are charged a storage fee. Banks should advertise their reserve ratio, interest rate, redemption % per day, and loan portfolio, so customers can make an informed decision.

Alternatively, requiring all customer deposits to be time-deposits would also eliminate the inherent flaw with "demand deposits". A customer who needs cash could always sell his balance to another bank. If the issuing bank is solvent, a time-deposit could be sold for the face amount, plus accrued interest, minus a small transaction fee. Customers would know when their bank is having financial trouble, because other banks would start refusing to honor its paper at parity.

Another problem is government-mandated reserve ratios. If the size of the economy is a lot greater than the volume of gold, reserve ratios should increase and more paper gold should be created. As long as all loans issued are sound, all paper promises for gold should be honored eventually. All paper promises for gold would be convertible to gold. Interest payments by trustworthy banks would be an incentive against hoarding gold. Banks are not breaking their contract with customers by failing to honor a request to withdraw the full balance, because their deposits are not demand deposits. If a customer urgently needs physical gold, and the bank is sound, his paper gold could be sold directly back to the bank or to another bank at face value.

Gold hoarding only occurs when people mistrust the financial system. In 1933, when people anticipated a default of the gold standard, they naturally started hoarding gold to protect themselves from the default. A corrupt media decried "gold hoarders" as evil. It was the Federal Reserve and the corrupt monetary system that were evil. If banks are trusted, people would prefer to loan out their gold for the interest earned.

In the context of fiat debt-based money, fractional reserve banking is of course evil, due to the Compound Interest Paradox. I explain this in full detail in my many posts criticizing the Federal Reserve. Under a gold standard, fractional reserve banking is evil in the presence of red market regulation of banking, and requirements that taxes be paid in bank-issued money. This allows banks to raise prices over the free market level and enables the Compound Interest Paradox to begin operating. Government regulation prevents sounder banking models from competing with dishonest fractional reserve banking. In a truly free market without government, banking is not evil.

Many conspiracy theory websites say that fractional reserve banking is evil. That is not true. It is the conspiracy between banks and government that is evil. In a truly free market without government intervention, banking is an honest business. In a free market, banks that followed dishonest fractional reserve practices would be unable to find deposits. Banking legitimately expands the money supply to match the volume required for trade. Market forces themselves will keep banks honest. Without limited liability laws, owners and management are fully accountable for fraud. Without regulation restricting entry to the banking business, bank interest charges equal their expenses plus reasonable profits. There is no Compound Interest Paradox in a truly free market.


Anonymous said...


For what it is worth, I think this is one of your best posts yet, up there with the "Compound Interest Paradox" and the "Defect of Schools".

Anonymous said...

Thanks for this. It's easy to find posts critical of banking, but very difficult to find a positive solution.

Just try googling time-deposit or free banking and you'll get hardly anything!

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