Fractional Reserve Lending Constitutes Fraud

I was asked to reply to Karl Denninger’s Rebuttal To Mish On Fractional Reserve Lending.

Here goes: Denninger does not phrase my arguments correctly on points 2-5, however he thinks they are immaterial so the points are somewhat moot. The crux of the matter is not whether assets are backed by collateral as Denninger suggests, but rather whether the same money has been lent out multiple times.

Let’s follow through with a real life example.

Fannie Mae makes a loan of $1,000,000. Let’s be more than reasonably fair and assume Fannie Mae issued bonds for the entire amount, not borrowing a single cent into existence. So far there is no fraud.

$1,000,000 goes to the home builder. That home builder deposits $1,000,000 into a Bank of America checking account. Ignoring sweeps that would allow Bank of America to loan out every cent, let’s assume BofA keeps 10% in reserves and lends out $900,000 to a new furniture store on the corner strip mall.

The furniture store owner buys $900,000 of furniture from a wholesaler. The wholesaler deposits $900,000 into a Citigroup checking account. Again, ignoring the likelihood Citigroup sweeps the whole amount into a savings account thereby able to lend out the entire amount (savings accounts have no reserve requirements), let’s assume that Citigroup keeps 10% in reserves and lends out $810,000 to a High Roller who takes out a home equity loan on his house that is supposedly worth $3,000,000.

High Roller buys a yacht from a boating manufacturer for $810,000. The yacht manufacturer deposits $810,000 in a checking account at Wells Fargo. Following the same pattern, Wells Fargo keeps 10% in reserves and lends out $729,000 to a plumbing supply company, because home sales are going gangbusters and the plumbing supplier needs more supplies.

I think you can see where this is headed.

On the original $1,000,000 this is what FRL allows to be lent out.

$900,000
$810,000
$729,000
$656,000
$590,000
$531,000
$478,000
$430,000
$387,000
….

See where this is going?
I am going to arbitrarily stop the chain right there, but the total so far is $5,511,000 out of $1,000,000 was lent out.

Karl claims this is not fraudulent because "it’s all backed by assets".

Well for starters the value of those assets backing the loans is questionable. Clearly it does not take much of a decline in asset prices to cause some major writeoffs. But let’s get to the crux of the matter with a simple example.

Imagine I had gold depository with $1,000,000 in gold and lent out receipts for $10,000,000 in gold for people to buy things. Think that is not fraud whether or not those receipts were backed by pledges (assets) to pay back the gold?

Of course it’s fraud, and so is lending out $5,511,000 when only $1,000,000 really exists. By lending out more money or gold than exists, asset prices reach unsustainably high levels before they crash. Sound familiar?

This is where the Libertarian argument "it’s OK if two people agree" falls flat. It is not OK because it cheapens the dollar, thereby robbing everyone saving dollars via theft of inflation (making those dollars worth less over time).

Greenspan compounded this already massive problem in 1994 by allowing banks to "sweep" checking accounts (unknown to customers) into savings accounts. This made the problem worse because savings accounts have no reserve requirements at all.

Is it any wonder credit exploded?

For more on the case against Fractional Reserve Lending please see