By: L. Carlos Lara
Yes, it is true that I do gain a lot of insight into the mechanics of money, banking and credit creation from reading the works of Austrian Economists. I would place Murray Rothbard at the top of that list, however, a lot of the information I speak about comes directly from the Federal Reserve itself. Most of the information that is available is astonishing. For this reason, I would strongly recommend that everyone become well informed about this subject for themselves.
Here is one brief example of what I mean. The quote is taken from a publication written by the Federal Reserve of Chicago and explains my point.
âMoney is such a routine part of everyday living that its existence and acceptance ordinarily are taken for granted. A user may sense that money must come into being either automatically as a result of economic activity or as an outgrowth of some government operation. But just how this happens all too often remains a mystery.”
âFederal Reserve Bank of Chicago, Publication 1994
“The actual process of money creation takes place primarily in banks and the major control rests with the Central Bank. Banks can build up deposits by increasing loans and investments. This unique attribute of the banking business was discovered centuries ago. It started with “goldsmiths.” â¨â¨Bankers discovered that they could make loans merely by giving their promises to pay, or bank notes, to borrowers. In this way, banks began to create money. More notes could be issued than the gold and coin on hand because only a portion of the notes outstanding would be presented for payment at any one time. Transaction deposits are the modern counterpart of bank notes. It was a small step from printing notes to making book entries crediting deposits of borrowers, which the borrowers in turn could âspendâ by writing checks, thereby âprintingâ their own money.” 1
If you can get to the point in your individual studies to comprehend that increasing the money supply is the most disastrous thing you can do to an economy, this Federal Reserve statement should invoke instant fear. Furthermore, if you took the time to investigate the Federal Reserve and fractional reserve banking you would see what I see, and what you would see is that what they do and how they do it is nothing short of outrageous. Yet, it is as though this elite group of bankers do not need to be either embarrassed or afraid to continue these activities. In fact, they are quite brazen about it. You can analyze this by observing the manner in which they answer questions in congressional meetings about what they do. If you have ever wondered why they behave in this way then here is your answer. The reason for this cavalier attitude is because this elite group is accountable to no one. No one to date has been able to displace its ruling position. However, I am convinced that their greatest insulation is the ignorance on the part of the general populace in understanding how money and banking really work in our economyâŚ, especially fractional reserve banking. This naivety infects the depths of academia, the media, Wall Street and an astonishing number of well-known financial gurus, including the financial experts that run most of our financial institutions. In fact, some of the greatest concentration of ignorance can be found on Capitol Hill, in Washington, D.C. For this reason, the Federal Reserve remains insulated, shrouded in mystery.
Hopefully this brief article will assist our readers in gaining additional insight into the origins of Deposit Banking and, in particular, fractional reserve banking. We cannot even think straight about money until this huge mystery has been exposed.
To begin to put all of this into perspective we should note that historically, there have been two major kinds of legalized counterfeiting, one is Government Paper Money and the other is Fractional Reserve Banking.
Fortunately, private counterfeiting has never been much of a problem in our society. Although it frequently occurs, the punishment for those who attempt to print their own money is stiff. It is a crime to counterfeit money, but when counterfeiting is mandated by government, when it is legalized, it becomes a serious economic and moral problem.
We can broaden our perspective by admitting that the perception of what a bank is can be confusing. For example, one view of a bank is simply as an institution that makes loans. By studying good historical records, we learn that the earliest bankers were merchants who extended credit to their customers and charged a fee for the delay of payment. This fee or interest was the price on time. This type of lending became a good business practice where transactions of this sort multiplied and were conducted outside in the market place with the merchants and their clients sitting on âbank-asâ âthe Italian word for âbenchesâ or “banks.” One family in the 14th century, the Medici family, became so successful at this type of business that they became known as the first institutionalized bankers. But, the importance of this type of banking business is that it was non-inflationary. In other words, the business did not counterfeit or increase the money supply. It was just a good legal and very profitable business, perhaps the most profitable business there is among all businesses.
Curiously, however, most people think of banks and bankers as borrowing money from one set of people and relending that money to another set of people and charging an interest differential because of their investment banking expertise in lending. An example of this in our modern times would be the bank CD. A bank CD is a non-inflationary form of lending. It is simply loan banking.
There is, however, another type of bank that has no connection with loan banking as just described. This type of bank came about because it had a practical connection to money not banking. It is this type of bank that we need to investigate more carefully.
To begin with, gold coins and bullion are heavy to lug around, plus they can be lost or stolen. For this reason, people began to deposit their gold and other valuable items into warehouses for safe keeping. These money warehouses came to be known as âDeposit Banksâ and were usually operated by goldsmiths. In most storage warehouses the depositor, when he deposited his gold, received a paper âdeposit ticketâ or “coupon.” The ticket holder could demand the return of his gold upon presentation of the ticket and would be charged a âstorage feeâ for the storage services provided.
As previously explained, this unique attribute of the banking business was discovered centuries ago and it started with “goldsmiths.” 2
Now, please keep in mind that a depositor could also deposit other precious items into these money warehouses besides his gold, for example an antique chair, a family ring, a painting, etc., and the depositor would receive a paper deposit ticket for these items also. The point is that the depositor is storing these items for safekeeping; they are not being âlentâ to the warehouseman. In other words, it would be incorrect to say that the warehouseman was a âdebtorâ of the depositor or that the depositor was a âcreditorâ of the warehouseman. If the exact antique chair is not returned upon presentation of the storage ticket, the depositor has every right to accuse the warehouseman of theft. That is because placing your goods in a storage facility, or better yet, âa safety deposit boxâ is not a âdebt contractâ between the depositor and the storage facility, it is in fact a âbailment contract.â
However, some items placed in storage are of a special nature; they are âhomogenousâ or âfungible.â This means that you cannot tell these items apart. One such example would be grain in a grain elevator. But, there is an item that is even more fungible than grain and that item is money. All money, whether it is gold or government paper money, looks the same. In contrast to money, grain, which is used to make something edible, eventually has to be removed from the storage facility. Money, which is not edible and is only used for exchange purposes, does not have to be removed from the warehouse at all! This element of moneyâs homogenous nature eventually opened the door for embezzlement and before long the temptation became too much to resist.
This temptation eventually turned into the counterfeiting of warehouse receipts when it was realized that depositors were trading the warehouse receipts as money. Rather than demanding the gold back each time they wanted to make a purchase, depositors simply signed over the warehouse receipts. This meant that there was always a certain amount of unredeemed money in storage. In other words, there was a margin to play with and profit by using someone elseâs money.
âBankers discovered that they could make loans merely by giving their promises to pay, or bank notes, to borrowers. In this way, banks began to create money. More notes could be issued than the gold and coin on hand because only a portion of the notes outstanding would be presented for payment at any one time.â 3
âFederal Reserve Bank of Chicago, Publication 1994
Couldnât we say that honest warehousing would be where every warehouse receipt is backed by a deposited item and may be referred to as â100% reserve warehousing?â On the other hand, if a warehouseman issues fake warehouse receipts and the gold stored in the warehouse is only a fraction (or something less than 100% of the receipts circulating) then he could be said to be engaged in âfractional reserve warehousingâ which is simply a sophisticated form of fraud.
This form of embezzlement is highly inflationary and morally wrong. It victimizes all private property owners and is a terrible crime to society. Yet, these are the true origins of deposit banking and fractional reserve banking as we have them in our modern times. Over the centuries the warehouse receipt became known as a âbank note.â Much later, deposits came to be known as âdemand deposits.â A transfer order could be written from the demand deposit to another bank. This transfer order became known as the âcheck.â Then, of course, the âdemand depositâ became the âchecking account.â
âTransaction deposits are the modern counterpart of bank notes. It was a small step from printing notes to making book entries crediting deposits of borrowers, which the borrowers in turn could âspendâ by writing checks, thereby âprintingâ their own money.â 4
âFederal Reserve Bank of Chicago, Publication 1994
In 2025 the Federal Reserve Banking System has a 0% fractional reserve limit on all demand deposits. It was fraud then and it is fraud now.
Message of Hope
Were it not for Austrian Economics I would not be able to see the reason behind why I must always oppose government intervention. Were it not for Ludwig Von Mises, the champion of liberty and Dean of the Austrian School, I would not feel the inspiration to argue quietly and with confidence as he did in favor of the superiority of a decentralized, consumer-oriented market, in contrast to a bureaucratic, centrally planned economy.
Mises was clear and forthright about the responsibility we all have with this advice:
“Everyone carries a part of society on his shoulders; no one is relieved of his share of responsibility by others. And no one can find a safe way out for himself if society is sweeping towards destruction. Therefore everyone, in his own interest, must thrust himself vigorously into the intellectual battle. None can stand aside with unconcern; the interests of everyone hang on the result. Whether he chooses or not, every man is drawn into the great historical struggle, the decisive battle into which our epoch has plunged us.”
On November 28, 1964, a group of friends gathered on the occasion of the 70th birthday of Austrian Economist Henry Hazlitt. Ludwig Von Mises rose to the podium to pay tribute to his distinguished friend.
“Every friend of freedom may today be rather pessimistic about the future. But let us not forget that there is rising a new generation of defenders of freedom. If we succeed this will be to a great extent your merit, the fruit of the work that you have done in the first 70 years of your life.”
Hazlitt then rose to the podium to reflect on his life, and in so doing painted a very dark picture of the state of human liberty. Yet, “none of us are yet on the torture rack; we are not yet in jail; we’re getting various harassments and annoyances, but what we mainly risk is merely our popularity, the danger that we will be called nasty names.” So long as this is true he said, “We have a duty to speak even more clearly and courageously, to work hard, and to keep fighting this battle.â
The great voices of Hazlitt and Mises, the economic conscience of our country and our nation, are now quiet, but they are not forgotten. With an incredible new surge of revival in our time, their written legacies continue to inspire. Be inspired as well! With each passing day, more and more people are waking up to see our digressions. We all must continue to help others see. This is the way that our mentor, R. Nelson Nash, saw it too, and continued to do so much for the School of Austrian Economics.
Notes: 1, 2, 3, 4. Bank Reserves and Deposit Expansion, Public Information Center, Federal Reserve Bank of Chicago, P O Box 834, Chicago, IL 60690-0834, by Dorothy M. Nichols, May 1961, Revised, February 1994.
