In today's mixed economy, the expansion of credit emanates from two sources: the creation of money by the Federal Reserve bank and the creation of money by the private banking system.
First, the federal government creates new money when it purchases bonds on the open market. It essentially pays for the bonds with counterfeit notes. Any time the Federal Reserve wishes to expand the money supply, it can simply purchase assets on the open market in exchange for a credit (fake money) made to the sellers account at the Federal Reserve. Historically, the Fed has inflated the money stock by continually purchasing government bonds on the open market. For example, over the past year alone, the Federal Reserve purchased over $1 trillion of mortgage backed securities on the open market. It paid for these securities with fake money which banks are now keeping on reserve at the Fed. However, as I have pointed out previously, and as Reisman points out, these funds are "excess reserves" - not "required reserves" - which means that they are funds that banks can withdrawal or lend at any time. (Even the Fed recognized that this is an inflationary time bomb and began paying banks interest on these reserves in order to try and keep these funds from entering the banking system.)
Second, as Reisman explains in detail, private banks are allowed (and encouraged) to create funds to lend as long as they maintain a fixed ratio of deposits (reserves) to loans. This process is known as fractional reserve banking and results in a multiplicative effect on the money supply. Reisman states:
Furthermore, Reisman explains how increasing sales revenues and low interest rates, due to credit expansion, encourage "extreme debt and dangerous leverage." To convey just how leveraged the banking system had become, he points out that the total ratio of reserves to the outstanding money stock fell to about 1%. That means that, effectively, banks were holding about $1 of reserve for every $100 in loans. Reisman states:
The current plight of the economic system is the result of credit expansion and the malinvestment it engenders. Capital in physical terms is the physical assets of business firms. It is their plant and equipment and inventories and work in progress. As Mises never tired of pointing out, capital goods cannot be created by credit expansion. All that credit expansion can do is change their employment and shift them into lines where their employment results in losses. The empty stores and idle factories around the country are very much the result of the loss of the capital squandered in malinvestment in housing.
Of course, read this excellent speech for a more detailed explanation.
when credit expansion finally gives way to the recognition of vast malinvestments and the accompanying loss of huge sums of capital, the economic system is also mired in debt and deficient in cash. Thus, it is poised to fall like a house of cards, in a vast cascade of failures and bankruptcies, first and foremost, bank failures.
My recent posts advocating a 100% reserve standard, i.e., the elimination of fractional reserve banking, seemed to create tremendous controversy as many seem to believe it is a violation of property rights and the principles of laissez faire. To clarify my position, let me reiterate that I believe my opposition to fractional reserve banking follows logically from a proper legal definition of property rights which, in this context, represents an essential pre-condition of laissez faire and therefore, justice. That is, it is impossible for a court of a law to uphold claims to the same property made by two different parties. Certainly, two parties should be free to contractually agree to anything that does not entail force or fraud. However, for a contract to be upheld within an objective legal system, the contract must also not be contradictory. For example, I could not reasonably ask a court to uphold a contract in which I agreed to have my house painted both blue and red at the same time.
For the same reason, courts should not uphold the practice of fractional reserve banking as it is based on contradictory legal premises. Such a contract enables a deposit holder to both lend his money, yet have it remain available to him at all times for his immediate withdrawal. I hold that, legally, a deposit and a loan should require two completely separate contracts. In a deposit contract, the depositor retains title to his property (or the tantundem in the case of fungible assets) and the bank merely stores his property. In a loan contract, the lender transfers title to his property (or tantundem) in exchange for the future payment of interest or some other consideration. This line of argument closely follows Jesus Huerta de Soto treatise, Money, Bank Credit, and Economic Cycles.
Although Reisman does not discuss the issue in the terms used above, he explains how his plan would work as it relates to the distinction between deposit and loan banking:
To clearly establish the magnitude of checking deposits, bank depositors should be asked if their intention is to hold money in the bank, ready for their immediate use and transfer to others, or to lend money to the bank. In the first case, their funds would be in a checking account, against which the bank would have to hold a 100-percent reserve. In the second case, their funds would be in a savings account, against which the bank could hold whatever lesser reserve it considered necessary. In this case, the bank’s customers could not spend the funds they had deposited until they withdrew them from the bank.In essence, bank customers must decide whether they are making a deposit or a loan and the contractual agreement related to the account should reflect this fact.
First, I find Reisman's proposal to create an amount of money equal to outstanding checking deposits and then mandate a 100% reserve ratio to be a very practical first step on the way to a 100% reserve gold standard. Second, in regard to his straightforward proposal to allow wage rates to decline, I find it amazing that mainstream pundits (liberals) can not understand why minimum wage laws cause permanent unemployment. If the minimum wage was set at $1 million per hour, do these pundits realize that no one would be employed, or do they really think that everyone would just get rich? I honestly do not know.