Criticism of fractional-reserve banking

Debt-based monetary system is a political term used by critics of the Federal Reserve, based upon heterodox economics, such as that of the Austrian school.

Conventional economic analysis

Conventional economic analysis does not generally use the terminology "debt-based money." The link between the currency regime (for example, fiat currency or precious-metal backed currencies) and the banking regime (fractional reserve or full reserve banking) is not seen as fixed, however (virtually all banking systems worldwide operate on some form of fractional reserve banking). Neither is the insight that banks "create money by extending loans" considered new, and the subject is covered in most introductory economics textbooks and many popular reference works.

Banks will also hold "reserves" (cash or other liquid assets) to meet the demands of depositors on their own, in some fraction of total depositors, to avoid potentially damaging liquidity shortages, bank runs or even ultimately bankruptcy. Government regulation of minimum reserve amounts is, in this sense, a form of consumer (depositor) protection.

Traditional economics sees fractional reserve banking as a mechanism for transmission of monetary policy: reserves and other limits upon the banking sector's ability to "create money" are usually controlled by the government or central bank. According to this approach, the monetary authorities use the pricing mechanism (via various monetary policy instruments) to adjust the quantity of money in circulation and protect depositors and the integrity of the financial system. The use of these tools is adjusted according to the nature of the banking system's propensity to create money by lending.

The weaknesses of the nature of fiat currency (and the capacity of the banking system to create money) and the relationship to the business cycle (including booms, busts and credit cycles) are widely recognized. In particular, the possibility that governments or central banks will create too much money (either directly or through the banking system) is a frequent topic of academic, economic and political commentary. Conventional economic analysis differs primarily in that it does not hold that the more extreme predictions of certain monetary reformers (regarding, for example, the inevitability of "debasement of the currency" or periodic crises) are necessarily true; they do not, however, exclude the possibility of such events due to exogenous events or poor management of monetary, fiscal and financial policy. The negative effects of inflation are also frequently and widely addressed in conventional macroeconomic and monetary analysis.

According to this (conventional) analysis, "debt-based money" is a heterodox economic theory that, although it may differ little in analysis of the basic structure, is largely irrelevant, and the main issues are addressed in various schools of economic thought. Economists generally address the issue of choice of monetary regime (such as fiat currency) and banking policy as entirely separate issues, since fractional reserve banking dominates most economic systems; the level of banking reserves and other regulatory measures are simply instruments of monetary policy. Differences in terminology (debt money, for example) do not represent, from the "mainstream" perspective, new analysis, and the more extreme conclusions about the "inevitable" negative impacts of so-called debt-based money and "fraud" perpetrated by banking circles upon the public are considered akin to conspiracy theories. The subject of debt-based money (as distinct from traditional monetary policy) is absent from reputable academic economic publications, and is largely relegated to fringe status.

It should be noted that various other schools of monetary thought (including other "monetarists" such as the Austrian School) do not necessarily ascribe to, for example, the conclusion that full-reserve banking is an issue; some explicitly advocate for "free banking" (with no required reserves at all). Some have referred to the concept of monetary policy with full-reserve banking as "nonsense" (that is, a contradiction in terms). More detailed analyses argue that full-reserve banking would impose similar costs of price adjustments in reaction to growth (through a reduction in the overall price level) as would inflation, and hence offer no inherent advantages over fiat currencies and fractional reserve banking.

Basic debate

The debt-based monetary system is a departure from traditional monetary systems, which were backed by gold deposits or the gold standard, or other precious metals. Because of this departure, it is the subject of continuing political and economic debate.

Some argue that since debt and the interest on the debt can only be paid in the same form of money, the total debt (principal plus interest) can never be paid unless more money is created through the same process. For example: if 100 credits are created and loaned into the economy at 10% per year, at the end of the year 110 credits will be needed to pay the loan and extinguish the debt. However, since the additional 10 credits does not yet exist, it too must be borrowed.

Others argue that there is in fact no mathematical necessity for the money supply in a debt-based system to grow, since the interest portion of loan payments is not taken out of circulation, but goes into the lender’s account, where it can be spent back into circulation and eventually be used to pay off some loan principal. Given that the total debt-based money supply is exactly equal to the total principal outstanding on all loans, there is always enough money in circulation to meet loan payments for the current amortization period, except for the case of nearly all loans in existence coming due at the same time, with no other outstanding loans large enough to cover the interest portions of the final payments (generally a tiny fraction of the final payment). These monetary economists argue that the money supply could (at least theoretically) be stable and yet not cause widespread insolvency in the broader economy. This would however require the delicate balancing of the maturing of some loans with the issuance of new debt to compensate for the diminution in the money supply caused by the repayment of those maturing loans.

Basic nature of system

Regardless whether there is a necessity for the money supply to grow exponentially in a debt-based system, it is not seriously disputed that when a bank loan is repaid, the money is extinguished, in a reverse process by which the money was originally created, “Money is created when loans are issued and debts incurred, money is extinguished when loans are repaid” John B. Henderson, Senior Specialist in Price Economics, Congressional Research Service of the Library of Congress.

On January 24, 1939, Robert H. Hemphill, Credit Manager of the Federal Reserve in Atlanta stated: "We are completely dependent on the commercial Banks. Someone has to borrow every dollar we have in circulation, cash or credit.' If the Banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is. [The banking problem] is the most important subject intelligent persons can investigate and reflect upon.”

The economic, environmental and social effects arising from a central government's concessional granting of the legal power to create money through fractional reserve banking techniques to the private banks of the world has been subject to much heated political debate for well over two centuries.

In contrast to debt money, "true" fiat currency is issued by the government debt-free as no requirement for its eventual return is made as a condition of its creation. Fiat currency (such as notes and coins) can circulate perpetually in the economy as "stable" or even sound money (if backed by gold or silver) and although not as stable as hard currency, government-issued notes and coins do not have the same effects of debt-based money described below. It should be noted however that fiat currency can be a source of hyperinflation if its production is not controlled, as the government has the potential to issue unlimited amounts of fiat currency - provided it is accepted as "money" by the private banking system (which may or may not occur depending on the political relationship at the time between the Treasury and the private banking system). It should also be noted that due to the exponential growth of debt-based money, "true" fiat currency (notes and coins in circulation) now account for a tiny fraction of the total M3 money supply in all developed, debt-based capitalist economies (M0 generally being less than 10% of the total M2 money supply in most developed economies).

Similarly, gold, silver and other precious metals have in the past been used as a form of debt-free money and their introduction into the economy is not debt-based as no future repayment is required as a condition of their introduction into the money supply. Because of the difficulty in increasing the supply of precious metals quickly, some monetary reformers believe a return to the gold standard, or a similar system of "hard" or "real" asset-backed currency, is the only way to stabilize the growth of the money supply. These monetary reformers often refer to the gold standard as "sound money" or "honest money".

Economic and political criticisms

Some believe that "if unchecked, the economic and political chaos that comes from currency destruction inevitably leads to tyranny".

Some economists (particularly the Austrian School) and political commentators (particularly Libertarian thinkers such as Murray Rothbard) believe that a debt-based monetary system amounts to a subtle form of monetary "fraud" in that it creates real money (and therefore real wealth) "out of nothing" through the use of fractional reserve banking techniques.

Some monetary reformers (such as Michael Rowbotham and Ellen Hodgson Brown) also argue that this system of money supply is perverse and inherently "anti-democratic", and inevitably creates an inflationary exponential growth bias in the economy which causes gross over-consumption and is unnecessary, environmentally damaging and unstable. They argue that the already indebted are forced to induce new consumers to spend and go into debt so that existing loans can be repaid with this new debt-created money. If this is not achieved, the result is foreclosure for those businesses that do not successfully induce new consumers to go into debt for their benefit - and, more broadly, insolvency in the banking system and economic collapse due to the sudden contraction in the growth of the money supply.

Mark Anielski as well as some political thinkers such as Michael Rowbotham and some economists (such as the Keynesian monetary economist Hyman Minsky) argue that this system of money supply has all the essential characteristics of a pyramid scheme, where the newly indebted, who have have control at the top, find themselves compelled to induce others into debt to enable them to pay off their own debts.

It is therefore argued by a number of monetary reformers that fractional reserve banking and the associated exponential growth of debt money in the economy "forces" the economy towards indebted consumerism.

Michael Rowbotham argues that a major negative side-effect of the debt-based monetary system is its effect on agriculture. As Michael Rowbotham claims, residential development produces one of the greatest continuous injections of debt money into the economy. Therefore, significant super-normal profits can be generated by re-zoning agricultural land and replacing it with low-density housing.

If Michael Rowbotham's analysis is correct, this will lead to the destruction of fertile arable land, as this land is progressively re-zoned for speculative new residential development. He also predicts that the global supply of fertile arable land will decline, leading to a broad decline in the quality and nutritional value of agricultural produce and, eventually, a dramatic increase in the prices of many "soft" commodities - which could then lead to actual food shortages for poorer segments of the world population. Coincidentally, the prices of many "soft commodities" such as wheat "skyrocketed" in 2007.

If for any reason the monetary system broke down, urban populations (nominally "rich" but poor in terms of direct access to food supply) could find basic foodstuffs increasingly expensive, ultimately resulting in food security becoming a major public policy issue.

Effects on economic health

According to some, given that the solvency of the fractional reserve banking system requires a continual stream of new debtors, some left-leaning monetary reformers also consider the waging of aggressive wars and modern imperialism as an essential component in the survival of any debt-based economic system.

More broadly, many monetary reformers believe that debt money has created all the features of an economic bubble, with structural instability in financial markets, which produces waves of booms and bust due to the "bubble-like" credit cycle.

The "cyclical" side-effect of debt-based money purportedly means that those caught at the end of any business cycle (or those caught in economies with declining productivity, low population growth or aging populations) suffer most financially, as the contraction in the growth of credit slows the economy just as these newly indebted businesses and consumers find they have been left out of the growth cycle in debt creation.

Michael Rowbotham, in his book The Grip of Death, argues that the prevalence of debt-based money in the modern economy is concentrating real wealth in the hands of private banks through a form of "monetary fraud," as the populace is forced into debt simply to own a home and educate their children.

In countries with slowing economic growth with a debt-based monetary system, there is predicted to be a concentration of wealth in the financial services sector, accompanied by sporadic "bubble-like" financial crises, with periods of hyperinflation in asset markets and deflation in the consumable goods market as consumers search for cheaper consumer goods.

Political and legal solutions

Bankruptcy laws differ to a small degree in different jurisdictions but in all developed economies unpaid debt results in legal penalties, property confiscation on behalf of the creditor and income sequestration. Although in Christian, Jewish and Muslim religious practice there have been traditions of debt relief or laws against usury, in no modern Western jurisdiction are any debts periodically forgiven or cancelled in recognition of the inherent impossibility of repaying debts in circumstances where the debt-based monetary cycle has inevitably resulted in too little new debt money being injected into the money supply to pay for the currently outstanding debts.

On a national level, if the issuance of government bonds becomes unsustainable, sovereign bankruptcy can occur - and has occurred many times in history. Sovereign debt crises due to the inability of nations to pay interest on government bonds have occurred in third world countries as a result of high levels of unsustainable third world debt. The Latin American debt crisis is an example of sovereign debt levels becoming unsustainable, resulting in a currency crisis and economic collapse, as interest rates rise precipitously due to the inability of the national government to attract financiers to purchase new government bonds to inject new debt money into the ailing economy.

At such times, it is the responsibility of the IMF to come in as a kind of supranational central bank to mediate between the national government and international financiers. The role of the IMF as central bank to the world has similar responsibilities and risks inherent in central banking which are described below in relation to the role of the Federal Reserve. If the IMF repeatedly intervenes to save financiers from loss when sovereign bankruptcy occurs, this has a tendency to induce moral hazard and can encourage the financing of reckless government spending and borrowing.

Policy Implications

Inherent problems with system

Some monetary reformers predict that there will be an increased incidence of financial crises in the developed world, as economic and population growth inevitably slows and as the success of laissez-faire economic political policies result in a reduction in redistributive tax policies which, combined with the debt-legacy of the welfare state, allows an intense and unsustainable concentration of wealth and political power in the financial services sector.

Some monetary reformers (in particular, Helen Hodgson Brown in her 2007 book, Web of Debt) argue that by necessity the promotion of the pyramid scheme inherent in private banking must be conducted by a tiny, secretive, ever-watchful minority because, unlike, for example, labor-intensive agriculture, which is self-sustaining, banking is not. If the majority of the populace were bankers nothing would be produced other than debt and inflation (and very detailed insolvency laws). Historically, usury has therefore often been criticized as inherently parasitic and non-self-sustaining.

Some monetary reformers argue that, given the parasitic nature of usury, it is vital that the indebted "victims" who must sink deeper into debt for the system to survive do so voluntarily and willingly and are not made aware of the consequences of purchasing consumables with debt money. Some politicians and others have highlighted the fact that mainstream media organizations appear to downplay or minimize the seriousness of deficit spending by government and debt-sourced spending of all kinds. The terms "debt" and "usury" are now virtually extinct, with "debt" being replaced by its antonym, "credit"; the cycle in "debt creation" is referred to euphemistically as the "credit cycle"; a shrinking of "debt money" as a "credit crunch" or "credit squeeze"; and the unsustainable growth in debt and the associated growth of derivatives that live off debt during the upward phase of the debt money cycle as "innovation" in financial markets.

Some monetary reformers see the prevalence of the debt-based monetary system ultimately resulting in a political crisis, between the vast majority of dispossessed who have had any accumulated net wealth periodically "stolen" during periods of "credit crunch" (and find themselves in permanent inter-generational debt, being forced to work involuntarily in the money-economy simply to house themselves and survive in the debt-based economy), and a tiny minority of inter-generational, super-rich elites connected close to the font of the money supply (being the private banking sector), who will strongly resist calls for redistributive economic policies by using all of their financial strength and lobbying power in an attempt to entrench and sustain their artificially privileged status. Given that the profession of this privileged minority is to produce nothing other than debt and inflation, and given that they face being rendered impotent if the power to print debt-free money was returned to government, it is to be expected that those associated and aligned with the private banking interests will use any means necessary to preserve their power, as they have no other skill other than the issuance and distribution of debt money.

Some monetary reformers believe that this privileged minority also always seek special government protection for the banking sector to protect it from financial insolvency when the debt-based financial system inevitably experiences periodic collapses due to the "bubble-like" nature of the growth in the money supply. This is referred to in some circles as "systemic risk" in the financial sector, as banks inevitably face periods of actual or near insolvency due to the mismatching of the high exponential growth in debt money and slower growth in the real economy. During these periods there are sporadic collapses in the value of inflated assets, resulting in a sudden collapse in the demand for new debt money, and an associated contraction in the growth of the money supply.

Types of downturns

There are two main kinds of debt money contraction that can cause a collapse in the value of inflated assets.

A "credit squeeze" occurs where new debt money is difficult to access without a high credit rating. At such times marginal borrowers, or those who have borrowed at the end of any debt-induced asset bubble, get "squeezed" out of further borrowing and a contraction in the growth of new debt money occurs, triggering a slow down in the growth of inflated assets. Those assets can then be "harvested" by the private banks through widespread foreclosure or bankruptcy and re-sold to those with the money to buy the distressed assets.

A "credit crunch" occurs where new debt money is not available at any interest rate - even for those with previously acceptable credit ratings - due to widespread insolvency in the banking system. At such times, it is the banking system itself that is insolvent and other financial institutions (including overseas financiers) become reluctant to lend to the domestic banking system, resulting in the domestic banking system being unable to issue loans even to credit worthy borrowers.

At any stage during the downward spiral of a "credit crunch", the central bank in a modern economy can try to save the system from complete economic meltdown by purchasing (either indefinitely or temporarily) the failed debts of the private banks. However, doing so results in cash being transferred to the private banks in exchange for bad debt, thereby violating the general economic precept to avoid moral hazard and effectively makes liquid the failed lending decisions of the private banks. In the U.S. banking system this is called "opening the Fed discount window", where the Federal Reserve temporarily purchases the failed investment portfolios of distressed private banks in exchange for cash, thereby allowing them to escape liability for mistaken lending practices that have resulted in these portfolios losing value as the borrowers default on their loan payments and are made bankrupt. However, this rescue measure may only delay, rather than avoid, the realization of losses in the banking system, as the central bank cannot "force" new borrowing into the system to inject new debt money into the money supply. Somebody has to be a counterparty to borrow the debt money that is being offered. If all market participants realize a "bubble" has formed in asset markets, there will be few (or no) buyers for new debt money, as no one wants to borrow to buy inflated assets no one else will buy. Money markets can therefore remain illiquid even with intense central bank support.

And banks can go bust anyway, even with intense central bank support, if the issue is not one of liquidity, but one of solvency.

Pushing on a string

Some monetary economists describe the opening of the Fed discount window after the bursting of an asset bubble as "pushing on a piece of string", as this measure does not solve the key problem - creating new credit (or debt money) to keep up the growth in the money supply and maintain the required level of liquidity in credit markets.

To encourage fresh borrowing, central banks generally combine these rescue measures with an interest rate cut to encourage more new borrowing to allow the existing (failed) debts to be liquidated at or close to their original value. When Alan Greenspan repeatedly resorted to this tactic to revive illiquid money markets this became known in the market as the "Greenspan put", as the effect of these repeated reductions in interest rates was similar to a put option in the stockmarket, insuring banks' lending mistakes would be covered up by the Federal Reserve.

Inequities in system

Aside from the moral hazard issue, the key risk with this tactic (cutting interest rates to encourage new debt money creation) is that the central bank exposes the financial system to a currency crisis, as the growth in the money supply spirals out of control due to the need to save the banks from themselves.

For these reasons, a collapse in the confidence of the solvency of the banking system is one of the most complex and difficult policy issues any government can face.

In such crises of confidence, a central bank may choose to save the current players in the banking sector by printing money and inflating its way out of the crisis, thereby debasing the value of the domestic currency.

This is referred to by some monetary reformers and economists as "Socialism for the rich and Capitalism for the poor", as many indebted consumers will still lose their houses and be declared bankrupt regardless whether or not the central bank intervenes to save marginal lenders who have been made insolvent through their mis-timing of the credit cycle. Future generations of innocent taxpayers may ultimately finance any bail out of reckless lenders, as the money used to fund any bail out will be funds diverted from the general revenue of the central government.

Many central bankers still refer to Walter Bagehot's 1873 commentary on monetary crises, Lombard Street, in an attempt to gain insights into the way in which central bankers should revive illiquid banking systems. Walter Bagehot's exhortation to "lend freely" at times of monetary crisis to lift the system into liquidity and encourage new debt creation may work temporarily, but in circumstances where fundamental changes are occurring in the underlying economy (for example, where demographic changes - such as an aging population - result in too few new indebted consumers, or where extreme inequality results in the inability of impoverished workers to either qualify for, or be encouraged to, borrow) this will only result in a delay in (and perhaps exacerbation of) the collapse of any debt-created "bubble".

A prime example of the fatal effects of combining aging demographics with reckless bank lending can be found in the case of the Japanese asset price bubble. Once the downward spiral of a financial implosion begins, it is almost impossible to stop if there are no new indebted "victims" to replace those that have either retired, or died.

Potential societal impact

Some more extreme monetary reformers and conspiracy theorists anticipate the declaration of martial law and the imposition of fascist-style restrictions on civil rights and freedom of speech by the political Establishment to physically protect it from anarchy or military coup when the bubble of debt completely bursts, either through a precipitous currency crisis or debt-created depression. Some conspiracy theorists also anticipate the forced elimination - by any means necessary - of any actual or potential competing currencies or voluntary mediums of exchange that could threaten the viability or legitimacy of the monopoly currency, which could include the compulsory confiscation of all privately-owned gold (gold being the ultimate reserve currency, still used by central banks as a universally accepted medium of exchange for the settlement of international debts).

There have been many monetary crises throughout history and prior to widespread anarchy or revolution, in the late stages of volatile, heavily indebted laissez faire capitalism, there are a number of warning signs of impending chaos caused by a complete breakdown of trust in the debt-based monetary system. Just prior to the complete collapse of the pyramid scheme of public and private debt, the economic system tends to feed on itself, and in the past, where debt-created depressions or periods of hyperinflation have occurred in Europe, the U.S. and China, there has been a sustained spike in predatory economic behavior, as the heavily indebted central government and producers are forced to find more extreme (previously considered unethical) methods to extract any remaining wealth from increasingly desperate and impoverished consumers, who are either unwilling or unable to go into further debt without forceful coercion. Long-term investment and sustained capital investment are almost impossible in this environment because the "measuring stick" of return on investment (the real value of money) is so uncertain at times of debt-induced credit crunch, depression or hyperinflation.

As potential new borrowers cannot be found to buy depreciating heavily indebted assets, and international financiers reduce lending as they experience losses on pre-existing loans either through asset or currency depreciation, some analysts predict that the monetary system will seize up due to a deflationary depression or sustained period of stagflationary hyperinflation, resulting in a "final and total catastrophe of our fiat monetary system."

This has often occurred after a failed aggressive war, as international financiers realize the heavily indebted government they funded will not gain the resources it planned to seize as a result of the waging of aggressive war. When this pay-off does not materialize, the government is left with the debt of war without the ability to offset this government debt through the imposition of reparations on the defeated nation and the acquisition of the defeated state's resources. This occurred to Germany after the First World War and Japan after the Second World War.

Whatever the trigger, the key warning sign of any impending monetary crisis and economic anarchy is a sudden currency crisis or bank run. Early warning signs that the private banks themselves are aware of an impending breakdown in the solvency of the financial system would be: a spike in the prices for oil (which is an internationally accepted, inherently limited, store of value, and therefore can act as a modern form of hard currency, oil sometimes being referred to as "black gold"), gold and other inherently limited natural resources essential for non-discretionary industrial production; a spike in the futures contracts for "non-perishable" agricultural commodities such as sugar, coffee, wheat, soybeans and rice, as investors realize the debt-based monetary system has squeezed supplies of arable land; a sudden flight of money to Treasury bills; and/or a sudden spike in the interest rate differential between short-term Treasury bills and asset-backed corporate paper (or a sudden spike in the LIBOR rate in London).

Shortly thereafter, some monetary reformers predict that there would be desperate, but ultimately futile central bank intervention, a currency crisis, a panic run on a number of marginal, insolvent banks and hedge funds as investors try to get cash out to invest in inherently limited, non-perishable, in-demand commodities such as oil and gold (and undeveloped agricultural and industrial land in areas of the world with strong economic growth), followed by a recession or depression in the broader heavily indebted economy as the money supply contracts.

Potential solutions

Critics assert that, although time is the only real remedy for monetary crises, as it allows re-inflation of the markets through the gradual injection of new debt money into the system, time is something financiers and investors are least likely to want to give up when faced with not getting their money out of the imploding investment bubble. In extreme cases banks could set up "independent" corporate investment vehicles to buy the assets associated with the bad debt, thereby allowing borrowers to liquidate their investments and allow time for the markets to re-inflate, however the holding costs involved in this measure would be extremely high and would not guarantee that the losses could be averted if no new gullible investors could be found to offload these distressed assets. More fundamentally, these short-term "parachutes" used after bubbles burst do not save ordinary borrowers from foreclosure and bankruptcy, nor do they address the pernicious long-term dysfunctional aspects of fractional reserve banking described above. These problems are temporarily averted, only to be dealt with yet again by the next generation of indebted governments and peoples.

Given these repeated financial crises arising from the debt-based monetary system, many monetary reformers predict that there will inevitably be a return to the gold standard, a fundamental change in the way money is produced and distributed (with a return to the prevalence of government-issued debt-free fiat currency and/or free banking) - or a complete financial "meltdown" as fewer young people in developed economies can be found who are willing to go into debt in sufficient magnitude to pay off the debts that have already been accumulated. As extreme inequality increases, foreclosures mount and financial crises repeatedly erupt, these monetary reformers believe a political crisis will eventually result in calls for fundamental monetary reform.

These on-going, worsening, debt-created crises in the economy and society (and the unsustainable damage to the environment caused by debt-created overconsumption) could turn monetary and economic policies either to the extreme left or to the extreme right, as there are a number of competing solutions to the debt-based monetary "problem".

Proposals by economic reformers

Libertarians

Libertarians plan a return to genuine free markets, small government and sound money backed by a gold standard or silver standard, as originally contemplated by the Founding Fathers in the U.S. Constitution. Most Libertarians would eliminate all income taxes and encourage private charity to provide social services. Some Libertarians would also support experimentation with free banking or full-reserve banking, recognizing that when fractional reserve banking is combined with the gold standard a deflationary bias (and the systematic transfer of real wealth to the banking system) is normally inevitable. Those Libertarians who support full reserve banking would strongly support more flexible and forgiving bankruptcy laws in a fractional reserve banking environment, recognizing that no stigma should be attached to bankruptcy given the anti-Libertarian "unjust acquisition" of real wealth implicit in fractional reserve banking.

Regarding the current accumulation of government bonds and private debt, there is an arguable case that the creation of the Federal Reserve under the Federal Reserve Act of 1913 was unconstitutional and some Libertarians consider that at least some of this accumulated debt should be canceled or forgiven prior to a return to the gold standard in recognition of its fundamental illegitimacy. Arguably this would be supported by the "just acquisition" jurisprudence of Libertarian legal philosopher Robert Nozick.

Leaving aside the legality of the Federal Reserve Act, it is commonly accepted by market-oriented economists that any policy where the central bank repeatedly provides bail outs to failed banks and reduces interest rates to encourage new (speculative) borrowing will risk chronic "moral hazard" and is a key factor in emboldening reckless lenders to inflate assets with excessive debt, thereby creating an environment conducive to the creation of financial bubbles and speculative excess in financial markets.

Many Libertarians derisively refer to bail outs of the private banking system by the Federal Reserve and the associated reductions in interest rates to encourage more borrowing as "Socialism in reverse". For many Libertarians this simply encourages more speculative debt creation by the private banking system, and brings the economic system ever closer to monetary tyranny.

Libertarians would go further than regulating or cautioning the Federal Reserve to avoid repeated bail outs of failed banks - they support repeal of the Federal Reserve Act of 1913 and the elimination of the Federal Reserve itself, thereby removing this artificial insurance policy for the private banks, ensuring that they face the full consequences of poor lending decisions with the real prospect of being wiped out by bankruptcy. If the Federal Reserve Act was repealed, depositors would also have to be on guard to ensure their bank was not lending recklessly, thereby ensuring more conservative lending practices. This would however present the real prospect of old-fashioned "runs" on the banking system after any period of speculative excess.

Authors, analysts and alternatives

Michael Rowbotham also seeks the cancellation of "unjust" debts (such as third world debt), but would also support the re-introduction of strongly redistributive tax policies involving higher financial transaction taxes (such as a Tobin tax), land taxes and inheritance taxes, and, crucially and most importantly, a social security safety net involving a guaranteed minimum debt-free income (sourced from government-issued debt-free money) for all citizens in the debt-based economy. Under this proposal, every adult citizen would be given a livable debt-free income (for example, $30,000 per annum, adjusted for inflation), transferred electronically into their bank account, simply by virtue of their citizenship. They could then use this debt-free money to pay off their mortgages or to live, debt-free, without being compelled to work as a "wage slave" in the market economy if they chose not to. The government would finance these payments simply by ordering the private banks to accept their electronic instructions as legal tender. It would therefore not result in the expansion of government debt.

Instead of money being created "indirectly" and "furtively" at the point of loan creation by the private banking system, it would be created directly and openly by the democratically elected government and issued to its citizenry by way of instruction to the private banking system.

Michael Rowbotham argues in his book, The Grip of Death, that this would not be inflationary (or at least would not be as inflationary or as dysfunctional as the present system). This would also reduce overconsumption and the associated environmental damage associated with debt-based consumerism. It would also give individuals the free time to engage once again in non-marketable religious, artistic and recreational activities if they chose to do so.

Ellen Hodgson Brown, in her 2007 book, Web of Debt, also supports the issuance of debt-free fiat currency by the central government, in a manner similar to that proposed by Michael Rowbotham.

Ex-U.S. Treasury Department analyst Richard C. Cook also supports the issuance of debt-free money and zero-interest credit by the central government and has provided a detailed blueprint of monetary reform recommendations to transition to a debt-free money supply.

It is to be expected that these proposals might be opposed by private bank officials; reformers say this is because the proposals would reduce the banks' control over the money supply, dissipating this key decision-making power away from its current base. It would also be likely to reduce economic growth, dramatically increase the cost of labor and, potentially, simply increase asset price inflation as individuals used the additional income simply to bid up the cost of housing. However, this proposal would undoubtedly address the problem of inequality inherent in a debt-based monetary system and reduce the devastating impact of personal bankruptcy and allow individual citizens to quickly recover from financial hardship. It would also ensure that this social security measure (and government spending in general) would not have to be paid for by future generations from future streams of income tax.

Many left-leaning social democrats would also support the taxing of the banking system and the enforcement of strongly redistributive income and land taxes to ensure the financially dispossessed are "replenished" with income. They would also support a social security safety net involving the provision of unemployment benefits and government-supplied free medical care, education and other essential services and public goods. It is to be expected however that, without the issuance of debt-free fiat currency, this system would result in the persistent, exponential, accumulation of government debt, financed by the private banking system by the issuance of government bonds. If not properly managed, this could result in a progressively higher tax burden and may result in higher interest rates in the long term, as financiers require higher interest rates to lend to the increasingly indebted central government. Without the issuance of debt-free money these policies can be self-defeating, with the net result simply being that a larger stream of guaranteed income goes to the private banking system via the issuance of interest-bearing government bonds (which are purchased by the private banks "out of nothing" through fractional reserve banking techniques). This government debt must then be financed in perpetuity by compulsorily acquired taxes from future generations.

It could be argued that the early success of extreme right-wing fascism in Nazi Germany and Italy in the period after World War I was a response to the economic chaos created by the debt-based monetary system in early 20th century Europe. Some of the economic policies introduced by Hitler and Mussolini were in direct response to the economic collapse and social anarchy caused by soaring government and personal debt levels in both countries in the post-Versailles Treaty era, and (indirectly) arose from the writings of Silvio Gesell and others on the nature of the problems associated with a debt-based monetary system. Although many historians justifiably criticize many of the non-economic policies of the fascist governments of Germany and Italy during this period, it cannot seriously be disputed that the economics of fascism provided a degree of prosperity to the populace, and that the economic policies that were implemented during this period by these fascist governments succeeded in their stated objective of restoring economic and social order during the pre-World War II era.

Similarly it could be argued that socialism and communism were movements inspired by the inequalities caused by the intense (and in Karl Marx's view unsustainable) concentrations of monetary wealth, power and influence inherent in the practice of fractional reserve banking in a laissez-faire, free market capitalist environment (particularly when fractional reserve banking is combined with a gold standard or other hard currency monetary system).

The communist/socialist solution to the problem of fractional reserve banking is simple: wholesale repudiation of government debt resulting in complete debt default; forced expropriation of land and wealth from the upper classes to the dispossessed and needy working classes; nationalization of the private banks (which has required armed coups by the military in some past revolutions); and the return of the banking function from a dominant, speculative to a subordinate, administrative institution, where the banking system is reduced to a subservient arm of the centralized Leviathan. In this system, government-owned banks are directed by government policy; often provide different kinds of loans to different industry sectors at different interest rates depending on the perceived "needs" of the economy and the community; normally have a significant proportion of non-performing loans due to weak or non-existent bankruptcy laws; and periodically "forgive" failed debts in recognition of the impossibility of some businesses in paying this debt money back.

It is to be expected that the profitability of the government-owned banking system would be more stable - but dramatically lower - than that in a debt-based capitalist economy. It is also to be expected that a significantly higher misallocation of resources could occur in this system, where lending decisions are "infected" by political considerations and are not made on the basis of expected return on investment. The risk of corruption in the banking system is also expected to be higher where there is no separation between the political and monetary systems in an economy. Market-oriented monetary reformers and neo-classical economists therefore do not support nationalization of the private banking system.

It should be noted that partial nationalization of the private banking system would only be temporary, as any remaining private banks could still engage in unlimited fractional reserve banking and facilitate the eventual acquisition and control of any strategic assets in a partially socialized economic system. It is to be expected that in the absence of complete nationalization of the banking system, the private banking system would eventually dominate the financial system in any nominally socialist society.

Conclusion

In summary, many monetary reformers and critics of modern debt-based monetary systems (which have been "unhinged" from the gold standard since the Nixon era) assert these recently-developed debt-based systems will erode the economic rights and stability of much of society, due to private banks' inherently speculative fractional reserve banking activities, in which they have recourse to central banks to provide bail outs as lenders of last resort.

Some of the reasons these critics cite include laissez-faire economic policies, which they say increase the marketization and commodification of human activity, and strictly enforced bankruptcy laws, which permit the periodic transfer of assets from failed bankrupt investors to the private banks and their associates. They also assert that debt-based systems cause environmentally damaging over-consumption and the systematic and irredeemable destruction of fertile arable land through the periodic issuance of over-extended debt financing for housing, which leads to urban sprawl which encroaches on arable land.

See also

• Austrian School
• Credit money
• Credit crunch
• Credit squeeze
• Debt
• Debt money
• Free banking
• Hard currency
• Hyman Minsky
• Libertarianism
• LIBOR
• Michael Rowbotham
• Murray Rothbard
• Robert Nozick
• Ron Paul
• Silvio Gesell
• Socialism
• Social Democrats
• Soft currency
• Treasury bills
• Usury

External links

• I want the Earth Plus 5%
• Money As Debt (videoplay animation)
• Money and Banking
• Web of Debt
• PrudentBear.com
• Market Oracle
• RGE Monitor
• Financial Armageddon
• Money Matters