Fractional Reserve Banking and (The Carnage Of) The Business Cycle


Life is good… It’s Boom Time in the economy… Business is booming, everyone is spending, prices are going up which every “expert” and “analyst” on tee-vee tells you with a straight face, is Economic “Growth”… House prices are flying which give homeowners the illusion of rising wealth while pulling up the ladder behind them on the next generation, on the future… Stock markets are soaring giving everyone who owns them, mostly the financial industry and oligarchy, the illusory glow of paper and electronic wealth… An orgy of investment, spending and consumption… The good times will last forever

Then it all collapses

Recession hits… There are bankruptcies galore, payment chains breaking down, carnage, crisis… Housing bubbles collapse, and illusory paper wealth evaporates into the wind… Stock markets start tanking, and the illusory paper values of the stock of companies evaporates into the ether… The lavish investment, spending and consumption, are replaced over the period of a few months by hoarding, saving and consolidation of remaining assets… Those that haven’t gone bust sensing the fear start cutting back, adding to the unemployment misery… Everybody stops spending… The unlucky who have over extended through no fault of their own and been declared bankrupt, have to liquidate assets to pay off their debtors… Families, communities are devastated… Misery abounds

The View From The Top

What the hell just happened? From Boom Time to Bust Time, practically overnight… This makes no sense in a world of “Equilibrium” and “Efficient Markets”… It’s not that bankruptcy and liquidation isn’t a natural and organic occurrence, it happens all the time… Look at your local economy and you will find numerous examples of entrepreneurs who have gone bust while trying to provide the market with a good or service… The market is a tough mistress… If your goods and services are not desired, individuals are not compelled to purchase them (which of course is the reason for Government mandated “Private” monopolies like Central Banking)… In a free and open market you have no privilege apart from the competition of others in your field… No free lunches… It should then be expected that entrepreneur misjudgements will lead to bankruptcies, liquidation, and re-allocation of capital for other entrepreneurs to chance their hand… This Creative Destruction is easy and logical to explain…

What cannot be explained is why when a recession hits, (think 2001, 2008 and this year coming) how come there is mass bankruptcy? Instead of the odd bankruptcy here and there as anyone would expect in a competitive market, we have tens or hundreds of bankruptcies occurring at the same time, and in numerous industries and sectors within the economy… If you have a sentient brain and fully functioning frontal cortex (which rules out Statist “Economics” and the ivory halls of tenured Academia), the mere fact that so many entrepreneurs make exactly the same mistake at exactly the same time should be ringing alarm bells… It has to be more than just the “madness” of crowds

Start From Scratch

If you think about it logically, then mass bankruptcies and misery should not happen… If we go back to a simplistic model of a typical market economy, there will be producers and consumers voluntarily exchanging their goods and services for money… This money originates in the market, and is nearly exclusively precious metals, gold and silver… The money supply is controlled by the market and is necessarily scarce, otherwise it would lose its Marginal Utility as money… Let’s say that the money supply increases at a steady rate of about two per cent per year… If the economy was stagnant, this would be a two per cent inflation per year… However the market economy free of parasitic ruling elites is as dynamic as they come… Ignore even demographics and an increasing population, and just assume that in free unencumbered markets that productivity increased by five per cent per year, this would mean that productivity would be increasing at three per cent per year above and beyond the increase in the money supply… Otherwise stated, a strong natural deflation of three percent a year… By holding your wealth in scarce precious metals, ceteris paribus, buying the same goods or services in a year’s time would cost you three per cent less… In ten years the same goods and services would cost thirty per cent less… In a world of scarce money you don’t have to speculate in stock and housing markets, you simply sit on your money and prices of the stuff you desire, food, clothing, shelter and utility costs would be coming down year after year… Perish the thought! It should be clear that in this world of sound money and unhampered markets, that mass bankruptcies and the misery that comes with it, couldn’t happen… There is no reason to why it would happen… Markets unhampered are always efficient, eloquent and beautiful… There must be another reason…

The Origin of Banking

As discussed in the previous post, banking is an organic and market invention for the efficient storage, transfer and lending out of money (savings) in order to fund investment and new entrepreneurship… Banking thus originates to service the requirements of the specific market of money, the oil that allows the engine of a market economy to function…

Fractional Reserve Banking

From honest and sound banking will ultimately derive fraudulent and unsound banking… With the advent of paper money, property deeds for precious metals but not the metals themselves, comes the opportunity for easily and conveniently enriching yourself at no cost, while impoverishing everyone else who doesn’t own a printing press… As a quick recap of the subtle yet despicable fraud of printing pieces of paper, and along the same lines as the famous thought experiment by David Hume (1711-1776), imagine a thousand pounds worth of paper money as the monetary base of an economy… Now imagine printing another thousand pounds out of thin air and releasing it into the market… As you have doubled base money, it should be expected that prices double… But it’s the way that the prices double that tells you how the scam really works… Whoever is the issuer of the currency, in other words whoever has the privilege of printing the thousand pounds worth of additional paper notes, in this example let’s say the Banker, gets to spend that money first… By spending the money first he gets the goods and services in exchange at the original purchasing power… Real goods and services for nothing… It is only as the increased units of paper notes percolate through the economy, that the market adjusts the available real goods per unit of paper for the increased supply… In simple terms, prices go up… By the time the money has percolated down to the poorest in society, i.e those furthest away from the printing, prices have doubled… Under fractional reserve banking the rich get richer, at the expense of the poor getting poorer… While the market reduces inequality by the deflation that lowers prices for rich and poor, under the Political Policy of monetary inflation, the rich that control the money supply get even richer while the poor get poorer and ever closer to the jaws of the Welfare State… Capitalism vs Socialism in a nutshell

Fractional Reserve Banking Creates The Business Cycle

The pernicious side-effect of increasing the money supply to enrich one’s self and the whole reason for fractional reserve banking in the first place, is the Business Cycle… A simple way to explain what happens in a business cycle is to take the Great Ludwig von Mises (1881-1973) thought experiment about constructing houses with bricks, as a metaphor to describe how investment and consumption in an economy can be simply explained…

A builder wants to build houses… To build these houses he needs bricks… The bricks in this instance represent the savings that the economy has accumulated, and contrary to Keynesian and Mainstream economics and their worshipping at the altar of “Aggregate Demand” (spending), it is savings that drive economic growthProduction comes before consumption… You cannot consume without having produced it first… The Builder has four hundred bricks at his disposal to build four houses… A hundred bricks per house of productive capital to construct and create value… This is what would happen under honest banking…

When you add Fractional Reserve Banking into the mix, this savings base becomes distorted… You still have the underlying four hundred bricks of savings but by printing money you expand the money supply, and create additional units of “savings” which are not savings at all but “nothing” masquerading as “savings”… If you print an additional twenty percent of “savings” you are effectively printing five hundred bricks, a hundred more than the underlying real capital… Under fractional reserve banking the builder is assuming he has enough bricks to construct five houses instead of four… Through no fault of the builder, but by fault of the banker, he starts constructing five houses with only the bricks to build four…

Mis-allocating Capital

We should already know how this story ends… We have a mis-allocation of capital, or mal-investment… But because of fractional reserve banking and the fungibility of pieces of paper, the builder doesn’t know it yet… He starts out building the five houses, and the mis-allocation stays hidden for now… He keeps constructing until he reaches eighty percent up the walls of the five houses, and suddenly he’s out of bricks… There is no more productive capacity in the shape of bricks to complete this project… These bricks cannot be consumed because they have not been produced… The builder realizes his mistake… He stops building… To complete the project he will have to dismantle one house and use those bricks to finish the other four, which with honest money and banking is what would have happened in the first place… This is the stage in Business Cycle where Boom turns to Bust… This is a cycle after all


The builders dismantles one house and salvages as many bricks as he can, although it should be clear that he cannot salvage all of them… There will be breakages that cannot be recycled or reusedThis is the liquidation phase where the full extent of the mal-investment is unmasked… At the end of the liquidation period the builder realizes that he does not have the bricks to finish even four houses! He can only finish three! So far from being beneficial or even a zero sum game, fractional reserve banking is destructive to capital… The builder has one house less he can sell to settle the losses caused by his over investment

As goes the builder so goes the economy… It is only at the point of discovery of the mal-investment, can it be liquidated and purged, but it is necessarily destructive to the capital or savings of society… Innocent people suffer… Now only having three houses to sell instead of four, which should have been five, the builder has suffered losses… From there on is either lean times or bankruptcy… The market has to correct the distortion created by fraud, and that it does every time without fail as long as it’s allowed to operate…

Inter-temporal Mis-allocations

In the course of creating the business cycle, fractional reserve banking also distorts possibly the most sensitive and important price signal in the economy, that of Interest RatesThe Interest Rate simply put, is the price of money… An inter-temporal mis-allocation is simply a mis-allocation in time… By creating an excess of paper units the interest rate is lowered artificially… The consequences of this are it becomes cheaper to borrow money… Too cheapBy distorting the critical ratio at which the market discounts the future, it creates an excess of investment that cannot be satisfied by the REAL underlying interest rate, that of the natural market rate which would be higher

At a certain point mass bankruptcy hits when banks are exposed as naked emperors, there will be bank runs as people flee to the safety of physical precious metals… If they’re lucky enough to get their money back, they won’t spend it now, let alone lend it out to anybody… The consequences of a scarcity of money and hoarding is that interest rates rise, as it requires a higher price for money for their owners to part with it… The rising interest rates hurt those that have overextended by borrowing money forcing many into bankruptcy, while boosting those that have REAL savings… These interest rates will rise until it again becomes attractive for people to start thinking about lending out their hard earned money… By incentivizing saving and penalizing borrowing, the market by its breathtaking self correcting mechanism purges the mis-allocation boom created by the fraud of money counterfeiting… Trust markets


Mass bankruptcy in an economy cannot and would not happen in unfettered markets… Boom and Bust cycles can only exist as long as there is meddling in the money and the natural rate of interest, which first creates the speculative boom that cannot last, and then the devastating bust… These cycles that have been prevalent in the West since the late Eighteenth Century through to today, are exclusively as a consequence of the greed, mendacity, and fraud of bankers and later Central Bankers… If the market does not control the money supply, the market cannot function correctlyIf the market does not control the interest rate, it cannot function correctly… These mis-allocations that are created by the Industry of Money, are borne by the whole of the rest of society… This is not a zero sum game as the thought experiment above attests, fractional reserve banking and the business cycle it creates destroys wealth… As we all rely on money for exchange and trade, everyone is affected by the Business Cycle… It devastates the whole of society, to a limited extent under plain vanilla fractional reserve banking, but to its full and devastating extent as we are all about to find out again with Fiat Central Banking… After every boom comes the bust, and it’s the people that have to suffer… Abolish Central Banking and Fractional Reserve Banking tomorrow, and you abolish The Business CycleThe End of Boom and BustTake a moment to think about what that would mean for the average family

Recommended Background Information For This Post

Introduction to Austrian Economics, Lecture 7: Business Cycle Theory – Jörg Guido Hülsmann (1:09:24)

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