The Mises Institute is one of the finest institutions for those interested in economics, and primarily Austrian economics. We interviewed Mark Thornton, who has been with Mises for over 30 years, on how banks work, and how government regulations are affecting the average American.
I really wanted to dig a little deeper into our current financial system, some of the flaws, and danger signs, we should be looking out for today in order to spot the potential problems for tomorrow.
Also, I wanted to better understand the banking system that the Federal Reserve uses to control the monetary system.
According to Mark, there are two fundamental flaws in our current banking system. These flaws, if they remain unchecked and unchanged, may end up being the key causes for the future decline of America.
Fundamental Flaw 1: Fiat Money
He tells us, “Our most fundamental flaw is that the banking system uses fiat, or paper money rather than gold, rather than silver, rather than copper or some other tangible item.”
This fiat money, because it is put into our financial system unevenly, creates what we call the business cycle.
Simply put, business cycle is this: in a market economy there are boom and bust cycles. The Federal Reserve is making an attempt to control these boom and bust cycles by increasing or decreasing the money supply accordingly. In a word, they are trying to control the economy, and limit extreme changes.
However, how does this end up affecting our economy overall?
Well, the problem arises when banks issue too much money that isn’t backed by gold. It puts the economy into a boom. Mark continues…
“That boom is unsustainable because that money is printed out of thin air, essentially, because there are no resources backing it. And, as a result, entrepreneurs undertake projects because they are getting cheap sources of funds. But there are no resources being set aside by consumers in savings to make these projects sustainable. So, once these projects start to come online, and start producing, the booming economy gets unwound, and we find ourselves in a bust, or a crisis.”
Let’s look at this from a healthy economic perspective. In a healthy economy what happens? When people have excess dollars, they save those dollars up, storing them in a bank. What happens next? The bank takes those dollars and lends them out. Because there is an abundance of dollars to be loaned out, there is more incentive to entrepreneurs to borrow money and start new businesses. This is a healthy cycle.
But what we learn here is the basic flaw that happens in our current economic structure. Money is produced from thin air, giving the appearance of economic growth and cheap money. So, entrepreneurs and those looking to borrow money for purchases, get the idea that the economy is growing.
However, the fact is the economy is not growing, the Federal Reserve is merely creating the illusion that this is so, the entrepreneur borrows the money, starts his business venture, and all this only then to realize that people do not have any excess income to spend, and the business dies.
This is where having a gold backed currency shines. There isn’t a way for governments to fake economic production.
“Because that (fiat) money comes in unevenly, it tends to create the business cycle. So, you have your booms and your busts and resources destroyed in the process. The whole…foundation for our banking system is fundamentally flawed… Instead of trying to understand what causes the business cycle, (the government) instead applys policy measures to try to limit the ups and downs in the economy.”
This is flaw number one. On its own, this appears to be an egregious flaw in our monetary system, one that can have very severe consequences. However, partnered with what Mark considers the second fundamental flaw, our predictions for the future may get worse…much worse.
Fundamental Flaw 2: Fractional Reserve
“The other fundamental flaw is that our banking system runs on a fractional reserve basis. Our money can be multiplied by ten, or twenty, or thirty.”
He continues, “A lot of people live their life with the impression in their mind that when they deposit money in their banking account that somehow your money is sitting in a little pile on a shelf inside the vault with their name on it. Once you realize the banks aren’t just holding that money, they are giving your money to other people, and by law they only have to hold a very small percentage of your deposits on reserve.”
Well, let’s take a step back and let me show just how the banking system creates this money out of thin air.
Let’s say you go to the bank and you deposit 100 dollars. The life of that 100 dollars is what we are interested in. Well, the bank itself is required to keep 10 dollars, or 10 percent, of that money on reserve. This is where fractional reserve gets its name, because only a fraction of the dollars that you deposit are required to stay on reserve.
But, this is where it takes a turn for the worst. We’ll take this from me down the line, so I’ll just use the names A, B, C, and so forth for the people involved in this little sketch.
You deposit 100 dollars into your bank. They keep 10 dollars and loan 90 dollars to A.
A deposits 90 dollars into his bank. They keep 9 dollars, and loan 81 dollars to B.
B deposits 81 dollars into his bank. They keep 8 dollars, and loan 73 dollars to C.
C deposits 73 dollars into his bank. They keep 7 dollars, and loan 66 dollars to D.
D deposits 66 dollars into his bank. They keep 6 dollars, and loan 60 dollars to E.
E deposits 60 dollars into his bank. They keep 6 dollars, and loan 54 dollars to F.
And you can see how this goes on and on. This is why the multiplier used is 10, meaning that for every 100 dollars you deposit into your bank, you can expect that to become 1000 dollars of debt loaned out.
This means that, for every 100 dollars you put into the bank, the bank creates 900 dollars basically out of thin air.
And they are making interest off of 900 dollars. Not a bad business to be in.
Creating Money: A Bad Business to Be In
Lately, however, we have seen the market decline. So, in order to stimulate growth in the economy, the Federal Reserve has lowered interest rates artificially. This is their attempt to stimulate the economy by incentivizing people to borrow money. But, Mark tells us how this hasn’t been going as planned for our friends at the Fed.
“The low interest rate policy of the Federal Reserve has backfired, and as a consequence (banks have) turned to this quantitative easing where they just go out and buy a certain quantity of government bonds and a certain quantity of mortgage backed securities from Fannie May and Freddie Mac.”
The banks are too afraid to lend money out because of the crisis. And they have found that it’s easier and much more efficient for them to just buy bonds and mortgage backed securities.
So, as a result of this, what can we expect? Well, if a majority of our fiat dollars are currently tied up in government bonds and mortgage backed securities, and the financial environment changes, then what happens? All of these dollars will get dumped into the market. If this happens, there will be more supply, and with more supply comes lower prices. As a result, the dollar drops, and this drop could be extremely dramatic.
This is a terrifying observation for the future of our economy. If something happens, and all these dollars get dumped back into our fiscal system, we could see some very heavy inflation, even to a point that we haven’t seen before.
In the end, the real problem boils down to human nature. Why is the government trying to control human nature? Why are they attempting to even out the boom and bust cycles that will occur in their natural way? Why are we creating debt out of thin air?
My real question is, why are we even relying on debt in the first place?
This has been a big portion of what Nelson Nash and the Infinite Banking Concept have been trying to teach Americans. Every dollar you put into the banking system is causing more of a problem.
Does this mean you shouldn’t use a bank? No, I’m not saying that. What I am saying is that there are these innate flaws in our banking system, and that we need to find a way to be self-reliant. Not relying on banks for auto, vacation, and business loans is one of the first steps you can take.
However, the main purpose of banks isn’t to provide you with these smaller services, the purpose of the banking system is to rob the American people through inflation and debt.
We have to enact responsibility and change on an individual level in order to have a large-scale change in the long run. This is what the Infinite Banking Concept, to me, is all about—individual change and responsibility.
We cannot rely on governments to take responsibility for our financial system. The unfortunate part is that things have to change. Will we begin changing it now with our own personal decisions, or will we wait for a mass scale disaster to do it for us?