This Blog Has Moved!

My blog has moved. Check out my new blog at

Your Ad Here

Saturday, June 7, 2008

The Compound Interest Paradox Revisited - Free Market Banking

Table of Contents

The Federal Reserve
Free Market Banking
A List of Monetary Systems
Edward Flaherty is a Troll

What would banking look like in a free market? In a stateless society, there still will be banks. After all, in a free market, you can't forbid someone else from operating a bank if they want to and they can attract depositors!

In a really free market, banking is *NOT* exploitative. Banking is not an intrinsically exploitative industry. It is only the conspiracy between banks and government that is evil.

Honest Stateless Time-Deposit Banking

What would banking look like in a stateless society? It actually looks very similar to the monetary policy that Austrian Economists advocate. However, Austrian Economics is still a pro-State theory of economics. An Austrian Economist says "Instead of a corrupt and dishonest monetary policy, the State should adopt an honest monetary policy." The correct answer is "Who needs a government?"

Without a government, money *HAS* to be backed by something tangible. Gold and silver are what the free market selected as money before the government started interfering with money. The free market would probably select a multi-metallic system. Gold and platinum coins are suitable for large purchases, because they have a large value per ounce. Silver and copper coins are suitable for small purchases. As long as the exchange rate between metals is set by the market, a multi-metallic monetary system works. (State-mandated bi-metallic systems fail due to Gresham's Law. The State fixes the exchange rate between metals, rather than letting the free market decide. People then hoard the metal that is artificially cheap and spend the metal that is artificially expensive.)

One evil practice of fractional reserve banks is that they can issue more loans than deposits. Suppose a bank has 100 ounces of gold on deposit, and it issues loans totaling 1000 ounces of gold. As long as the loans are paper promises for gold, and not physical gold, the bank may not get caught. If/when the fraud is discovered, people will rush to convert this bank's paper promises for gold to actual physical gold. At this point, government violence intervenes, declaring a "banking holiday".

This is exactly what happened in 1933. The Federal Reserve had printed a lot more Federal Reserve Notes than there was gold in the US Treasury. Instead of forcing the Federal Reserve into bankruptcy, President Roosevelt defaulted on the dollar and outlawed private ownership of gold. Government violence protected the Federal Reserve from the negative consequences of their fraud. In 1933, instead of confiscating gold from US citizens, President Roosevelt should have declared the Federal Reserve bankrupt; holders of Federal Reserve Notes would then be paid a fraction of the face amount, based on the amount of gold the Federal Reserve had.

In a FREE market, a bank that operates fraudulently by issuing more loans than it has deposits is committing a crime. A stateless justice system will not intervene on behalf of the bank's owners and management to protect them from the consequences of their fraud. As soon as its depositors discover the fraud, they would rush to redeem that bank's paper promises for gold. For this reason, in a free market, depositors would demand the right to inspect the bank's books. In practice, accounting associations would perform the audit, and they would be personally liable in the event of fraud.

The first fraudulent fractional reserve banking practice, where loans exceed deposits, cannot occur in a free market.

There is a second problem with fractional reserve banking. A fractional reserve bank tells its customers they have "demand deposits", available for withdrawal at any time. Suppose a bank has 1000 ounces of gold on deposit, and it issues 900 ounces of loans, keeping a reserve of 100 ounces. If all the depositors simultaneously demand withdrawal, the bank is insolvent. It only has 100 ounces of gold on hand, but the depositors all are entitled to 1000 ounces of gold immediately. For this reason, a fractional reserve bank is technically insolvent at any given time.

The fractional reserve bank using a 10x reserve ratio has fraudulently increased the money supply by 10x. The customers all think their "demand deposits" are available at any time. The recipients of the loan also have gold. As long as all customers don't simultaneously demand withdrawal, the fraud is not discovered. This allowed the Federal Reserve fraud, which began in 1913, to not be discovered until 1933, when there was a run on the dollar.

There's another problem with offering customers demand deposits while making term loans. The short-term "demand" interest rate is typically lower than the long-term interest rate. This allows banks to collect the spread between the short-term interest rate and long-term interest rate as an unearned profit, further exacerbating the Compound Interest Paradox. The short-term interest rate is lower than the long-term interest rate because the fraudulent fractional reserve banking practice is increasing the money supply.

Again, state violence declares a "banking holiday" when a large bank becomes subject to a run. State violence protects fractional reserve banks from the consequences of their fraud.

In a stateless society, a fractional reserve bank is committing fraud. The owners and management will be held personally liable for their fraud. Again, depositors should refuse to put their money with a bank that practices fractional reserve banking.

The problem is that government "legitimizes" the fraudulent fractional reserve banking practices. After practicing fractional reserve banking for a few decades without getting caught, bankers wielded enough influence to affect the government. Banks were then shielded from the negative consequences of their fraudulent practices.

There is a banking model that is not fraudulent. This is "time-deposit banking". In a time-deposit bank, customers make term loans to the bank. The bank, in turn, issues term loans to customers. If the bank balances its cashflow, it is operating honestly. There will always be a liquid secondary market for deposits, if the issuing bank is solvent. In practice, customers would always be able to sell their deposits for the face amount, plus accrued interest, minus a small transaction fee.

In this way, time-deposit banks ARE expanding their money supply when they issue loans. However, this money supply expansion is NOT inflationary, because all paper promises for gold are convertible to gold at any time. This is logically equivalent to the "Real Bills Doctrine", which mainstream economists falsely say is a discredited theory. Time-deposit banks are also logically equivalent to the Social Credit Monetary System, where interest payments are credited/charged on all nonzero balances. I assumed that frequent trading partners won't charge each other interest on small balances.

All stateless banking has to be based on sound money. Money must be backed by gold, silver, or other metals. Time-deposit banking is a sound, non-fraudulent model for banking.

In a stateless society, competition among banks prevents interest rates from rising about the fair free market level.

There's no Compound Interest Paradox in a Free Market

In a truly free market, with some educated workers, the paradox cannot occur. In a truly free market, there is no government and no forced taxation. It isn't necessary for everyone to be capable of understanding the Compound Interest Paradox. As long as there is a free market without government coercion, and there are some people who understand the Compound Interest Paradox, the paradox cannot occur. If the paradox starts occurring, some smart people will open banks and reduce the spread between the "fair" interest rate and the market interest rate. Government coercion is needed to create a spread between the "fair" interest rate and the market interest rate.

That's a very interesting conclusion. As long as some people understand the Compound Interest Paradox, that's enough to free everyone else. Similarly, only a handful of people converting to agorism is enough to free everyone else.

Before the creation of a central bank, the government demanded that taxes be paid in gold. When the government collected taxes, it deposited its gold in a fractional reserve bank. This guaranteed that, eventually, all gold is held by banks. People need gold to pay taxes. There is a demand for the services of banks, backed up by government force. Government force allows the banks to raise prices above the free market level. The Compound Interest Paradox begins operating. The larger banks are able to buy out smaller banks, and the effect of the Compound Interest Paradox grows. Eventually, all the banks are acting as a cartel. There no longer is a free market interest rate. The cartel is powerful enough to cause boom/bust cycles. Even if some people become aware of what is happening, there is no escape, because they need gold to pay taxes. Government courts only recognize gold as valid for paying debts. Government force prevents people from escaping the Compound Interest Paradox trap.

Government force, demanding taxes and debts be paid in gold, created an oligopoly for the banks. The banks are allowed to charge an interest rate higher than their legitimate expenses, due to their government-granted monopoly/oligopoly. Even with many competing banks, there is a Compound Interest Paradox. The largest banks operate the paradox most efficiently, and eventually there's a cartel and no free market. Eventually, the banks are powerful enough to create a central bank with debt-based fiat money, and now the Compound Interest Paradox has the full force of law. People are forced to use the fiat money, because the government only recognizes fiat money as legitimate for paying taxes and debts.

What would a banking look like after the government collapses? Without government, banking is an honest business that provides a useful service.

In a free market, a bank LEGITIMATELY increases the money supply. If the bank is soundly managed, its paper promises for metal can be converted to metal eventually as loans are repaid. In a pure gold standard, an ounce of gold represents a certain amount of labor. If the total value of the economy is a lot greater than the total value of all gold, a bank LEGITIMATELY increases the money supply so that the labor represented by an ounce of gold equals the labor represented by goods and services. A bank is providing a legitimate arbitrage service.

Suppose that one person controlled all the gold. In such a case, he could demand usurious interest rates and achieve the Compound Interest Paradox. However, if he attempted to loan out gold under usurious terms, some intelligent people would switch to another form of money. The person controlling all the gold would fail to enslave all the intelligent people, and those intelligent people would have enough resources to unite and oppose him.

In order for someone to profit from cornering the gold market, government violence is NEEDED. Otherwise, people will just switch to another form of money and the person who cornered the gold market accomplished nothing. In fact, he would have lost out on all the transaction costs he paid when trying to corner gold. The price of gold would have skyrocketed relative to other forms of money, as the person starts achieving his corner.

Suppose one person attempted to acquire all the gold. This would cause interest rates to rise. All the gold he didn't control would start circulating really rapidly; high interest rates would encourage people to make long-term time-deposits in banks. At some point, people would stop making gold-denominated contracts and start using another form of money. The small amount of gold that person didn't control would be used to pay off all outstanding loans and a new monetary unit would start being used. The person's gold would still retain its metal value, but he wouldn't be able to hold the rest of the economy hostage. If he managed to acquire 100% of the gold and people started defaulting on their debts to him, they could claim, quite correctly, that alternate payment should be accepted because one person is hoarding all the gold.

In other words, if one person attempted to corner the market on gold, he really couldn't accomplish much. It only pays to corner the gold market if there is a government forcing people to pay their taxes and debts in gold.

In the present, intelligent people can't get together and say "We're boycotting Federal Reserve Points. We're refusing to pay taxes, and switching to a fair monetary system." Red market policemen would rapidly interfere and shut them down. The only hope for the intelligent people is to get together and trade in private. That is the hope of an agorist revolution.

In a truly free market, there is no requirement to use gold as money instead of other metals. Silver, copper, aluminum, or iron coins are just as legitimate as gold. Gold and silver have stood the test of time, but other metals can trade freely as well. I choose silver because, in the present, 1 ounce silver coins are readily available at a reasonable price. There is no requirement to use metal, but metal money has many advantages. Metal doesn't spoil. Metal is fungible; i.e. all 1 ounce coins of .999 purity are equivalent. For example, if you decide to issue money backed by shirts you manufacture, your shirts may be of a higher or lower quality than shirts manufactured by someone else. It's simpler to issue metal-denominated debt, backed by your ability to manufacture and sell shirts.

With multiple competing banks, there is no Compound Interest Paradox. A bank will charge enough interest to cover its expenses and earn a reasonable profit. All interest collected is paid out and spent, and there is no paradox. Multiple competing banks will ensure that the profits earned by banks are not excessive. Government regulation of the banking industry restricted the number of banks and enabled the Compound Interest Paradox to operate.

The depositors of a bank are its creditors. The creditor has the right to inspect the balance sheet of the debtor. The depositors would be able to verify that the bank wasn't issuing more notes than it had deposits. It isn't necessary for every depositor to perform an audit; only a few would need to do it, and anyone who wanted to verify would be able to check. With multiple competing banks expected to honor each other's paper, the audit would be performed by the competing banks themselves. A customer would know his bank was in trouble when other banks started refusing to redeem its paper at face value.

In the event of a bankruptcy, there is no "limited liability" protection. The banks' owners and management would be personally liable for their fraud. "Limited liability" incorporation encourages fraudulent behavior by bank management.

The right of depositors to inspect the balance sheet of banks wouldn't come from a government mandate. It would come from free-market competition. In the present, banks' books are well-hidden. Even if you could see the full details, the morass of derivative transactions would make it practically incomprehensible. Besides, the Federal Reserve will always bail out a struggling bank by printing new money and loaning/giving it to a bank. A small bank that fails is typically bought out by a larger bank, with the bailout financed by the Federal Reserve; this is what happened with Bear Stearns.

In a free market, a bank that refused to open its books to depositors would not have any depositors at all.

The Compound Interest Paradox is only possible when there is a government and forced taxation. Only certain money is recognized as valid for payment of taxes, and that money is issued only by banks. Even if there was some money not controlled by banks, it would fall under their control when it is used to pay taxes. Eventually, taxes would suck up all the money not controlled by banks. The government's conspiracy with banks means that taxes collected are deposited in fractional reserve banks, so the banks can loan it out and more taxes can be paid.

When banks have a monopoly of money, then the Compound Interest Paradox takes hold. The incentive is for banks to form a cartel, increasing interest rates. There is no escape, because taxation forces people to use the banks' product. The government issued monopoly creates a spread between the "free market" interest rate and the rate banks can actually charge. Banks are able to earn profits in excess of their reasonable business expenses and reasonable profits. This becomes self-increasing. The biggest bank is able to impose the Compound Interest Paradox most efficiently, allowing it to buy out other banks and increase the spread. Then, the bank's owners are able to buy out and control other industries. There is no longer a free-market interest rate. The interest rate is chosen by the cartel, allowing it to create boom/bust cycles. Finally, the cartel leader is strong enough to get itself named the central bank. Now, the Compound Interest Paradox itself is backed with the full force of government. Before, there was, in theory, a potential escape, because people could set up a bank outside the cartel's control. Finally, with central banking and income taxes, a system of perfect enslavement has been established.

Under a gold standard, suppose the fair free market rate is 3%. Due to the government-granted oligopoly, banks are able to charge 5% interest. This is an unearned profit of 2% for the banks. This means that the banks get to steal the wealth of the rest of society at a rate of 2%/year. Eventually, the banks are powerful enough to create boom/bust cycles to increase their wealth confiscation rate. The banks' power grows exponentially over time.

What is the "fair" interest rate with debt-based fiat money? The only interest rate that causes no Compound Interest Paradox is a 0% interest rate. Any positive interest rate leads to the Compound Interest Paradox. But what happens with a 0% interest rate over an extended period of time? There's a hyperinflationary collapse of the monetary unit. People will just borrow as much as they can, knowing the money supply will keep increasing. In other words, there's no fair way to set up a debt-based fiat money system. You can have a fairer monetary system with fiat money that isn't debt based. It is possible for the government to directly spend money into circulation, rather than borrowing it from a central bank. Under a fiat monetary system, what right does the issuing authority have to claim seignorage income?

This is my surprising conclusion. Banking is not, by itself, evil. Without government, banking is an honest business. There is no need to regulate or eliminate banks. It is government itself that needs to be eliminated. A bank can operate honestly, provide it discloses its balance sheet to depositors and tells them that their deposits are not demand deposits.


Anonymous said...

I do not believe any Austrian theory of economics supports the use of government in money(or any thing for that matter. Murray Rothbard hated government with a passion). That is my only complaint about this article. Otherwise, you do an excellent job explaining a free market banking system

Martin said...

"In a stateless society, a fractional reserve bank is committing fraud. The owners and management will be held personally liable for their fraud. Again, depositors should refuse to put their money with a bank that practices fractional reserve banking."

This is simply false. Even with no paper money involved, banks would exist. If I had excess gold in a free market society I would likely seek a bank to deposit it with 2 potentially different objectives. Objective A) would be to simply to store my gold in a safer place. Objective B) to loan my gold to someone else in order to accrue interest on it while I am not using it. A free market bank could/would offer both of these services.

If a depositor wanted extremely low risk, they could opt for an account which only performs A. But since the bank would not have any reason to provide service A for free, it would cost money to store your gold in their vaults, so accounts of this type would incur management fees. Some people would opt for service A nevertheless (as some people do today, with their gold).

However, if a depositor was willing to forgo some liquidity and potentially take some risk with their gold, they would opt for an account of type B from the bank. The gold they deposited into this account would earn interest because the bank would take the gold from depositors with the explicit overt intention (no secrets) of lending this gold to people, and thus the bank will be practicing fractional reserve banking on those accounts. There is nothing fraudulent about this, it simply is a voluntary loan from the depositors to the bank. The depositors would be aware of the risks in a free market (in state backed, FDIC, banks, the state pretends this risk does not exist by pushing it off onto tax payers) and potential non-liquidability of their accounts of type B. In return for this risk, they are paid interest and do not have fees levied for "storing" their money with the bank.

Even with accounts of type B, people getting gold loans are likely to buy services from other people who will deposit their gold in the same banks and the cycle would repeat itself. This is the same thing you describe above with fiat money and effectively makes the gold supply provide more value than without this exchange. But in no way is there ever more gold than to start with! Where do you see fraud in this gold only scenario?

FSK said...

Fractional reserve banking under a stateless gold standard is not a viable business. The bank tells customers they have demand deposits, while making term loans.

What happens if all depositors simultaneously demand withdrawal? Then, the fraud is exposed.

Time deposit banking is a legitimate business. The bank accepts term deposits and makes term loans. The liabilities and assets balance.

Stateless banking is a legitimate business. It can't be based on fractional-reserve principles.

An educated customer would never make a fractional reserve deposit. No accountant or regulator would sign off on the soundness of a fractional reserve bank, because he'd be personally liable when the fraud is exposed.

Martin said...

Your are confusing not being a viable business with being a fraudulent one. Many businesses fail and are perfectly legitimate (non fraudulent).

The issue of fractional versus full reserves is not tied to demand deposit versus time deposit. If time deposit had full reserves, what would be the point in the bank borrowing the money since it would provide them no benefit and would cost them to store/protect it?

Yes, demand deposit is riskier than time deposit, but do you think time deposit has no risk? What happens if all the debtors cannot pay the bank on their term loans? They will not be able to pay out their time based deposits either. Why is one fraud and not the other?

The difference in the risk and liquidity accounts for the difference in interest rates. This does not make either fraudulent, neither does it mean that people would not be willing to make use of demand deposits in a free market. Although naturally, they would assume a greater risk to their money than they do today and not be able to force tax payers to make up for losses in such a system.

This Blog Has Moved!

My blog has moved. Check out my new blog at