A Libertarian Banking System

How to shift control of the public trust from the Fed to the people

With apologies to Winston Churchill, fractional banking is the worst system except for all the rest.

Some historical exceptions to the supremacy of fractional banking are the mutual guarantee syndicates that provided the financial backing for the Venetian and Genoese merchants, the New Bedford Whaling syndicates and the Dutch Raiffeisen Banks, to name a few examples.

The main challenge with a mutual guarantee syndicates is paradoxically also its main attraction. Because the risk is shared by all the members of the syndicate, the interest rate on any loans is naturally quite low. The reason the rate is low is because the principle of loss aversion leads to a reduced likelihood of borrowers being able to get loans for bad ideas or purchases they can’t afford. Essentially, if a deadbeat, but much loved friend, wants to borrow a thousand bucks to go to Vegas were probably going to say no.

In theory, fractional banking is better that a mutual guarantee system since in fractional banking pretty much anyone can get a loan whenever they want. The problem is that sometimes people should not be borrowing money!

In a fractional banking system borrowers can run up significant debts while they consume more than they earn since the high interest rates allows the lender to recoup their costs when a few borrowers end up defaulting on their loans. As well, in a fractional banking system, the lenders can share risk with each other when they securitize and resell the debt, as well as use the implicit guarantee of the public trust to take risks far beyond their ability to suffer the short term consequences of those risks.

As long as private lenders in a fractional banking system have the ability to shift bad debt from their balance sheet onto the balance sheet of the public trust then private lenders will always remain solvent. That’s what the Fed did in 2008 when they purchased all the bad debt from the banks. They bailed out the banks.

While the system of fractional banking has led to economic growth it also creates a cycle of boom and bust due to the implicit public guarantees that leads to outsized risk-taking. Think of the Fed as that line of cocaine that lets you keep doing tequila shots at 2am and that magic hangover cure that puts a smile on your face at brunch the next day.

The Federal Reserve, as stewards of the public trust, can keep interest rates below growth rates which allows the Fed acting on behalf of the public trust to absorb the huge losses sustained by private lenders in the fractional banking system.

If interest rates rise along with growth rates then people with money in the bank end up earning more money because the interest rates rise as the economy grows. If interest rates are kept low, then the money that might otherwise have gone to investors and savers ends up disappearing into the public trust. When this money disappears into the public trust it can be used to absorb losses from the fractional banking system without the public trust having to publicly account for those losses. Effectively when interest rates are kept below growth rates, the massive difference in economic potential can be used to absorb bad debts from the fractional banking system without having to ever pay back that debt. It’s magic!

For example, in the past 10 years growth rates of averaged around 2% while interest rates have averaged around 1% which creates a 1% per year implied discretionary fund for the public trust to use to absorb the bad debts of the fractional banking system. In real money this represents around $2 trillion dollars that might otherwise have gone to depositors that is been used by the Federal Reserve acting on behalf of the public trust to absorb bad debt within the fractional banking system. Currently the Federal Reserve carries around $4.5 trillion on its balance sheet so this number might suggest that interest rates will have to lag growth rates until the $4.5 dollars of bad debt has been consumed. In reality, $4.5 dollars of total debt in an economy that does just under $20 trillion a year isn’t that high a number. It’s like owing $25,000 when you make $100,000 a year. You can pay it off over time and it’s annoying but not that big a deal.

The more important issue at stake is that this $4.5 trillion dollars might otherwise have gone to citizens who could have saved it for their retirement or invested it in businesses in their communities, education for their children, or improvements to their homes. Instead of creating growth in the economy, this $4.5 trillion dollars is being used to absorb the negative consequences of some very risky financial schemes that made a few people very very rich. Now unfortunately we had no choice back in 2008 since allowing the fractional banking system fail would have destroyed our economy along with it and reduced all of our wealth by much more than the $4.5 trillion dollars sitting on the Fed’s balance sheet today. Much as we all hated the idea of bankers getting a bail-out, the alternative could have been burning cities and civil war.

Now that the worst of the crash is far behind us, the time has come to think hard about whether the fractional reserve banking system is really the most appropriate system for our economy. The choice is fairly stark. If we would like to continue letting people spend more than we earn so they can take luxury vacations, buy big-screen TVs and the latest products from Apple then the fractional reserve banking system is absolutely the right choice for our economy. It allows smart people to take huge risks lending money to disorganised morons with no impulse control who can’t afford to pay it back without an enormous amount of suffering, then shifts the majority of that risk onto the public trust so that in the event of a crash the system can absorb most of that bad debt. The people who pay to absorb that bad debt are those who live within their means since the money they saved grows at a much slower rate in order to provide the cushion that absorbs all that bad debt.

It’s like the old saying goes: “we’ve seen the enemy and he is us.”

In all likelihood this fractional reserve banking system backed by the implicit guarantee of the public trust and managed by the Federal Reserve can continue on somewhat indefinitely. All we have to do is agree as a culture that the wise and the prudent are responsible for the bad decisions of around 10% of the population that are idiots. The banking system takes a fee to manage the transfer of wealth from the 90% of us who live within our means to the 10% of us who don’t. This fee gets paid to the bankers regardless since when the crash comes most of the bill for the crash is paid for by the public trust, not the bankers because we need the bankers to keep the system going. The bankers know that they will get bailed out and price that certainty into their business models. In many ways it’s unfair to blame the banker when the real flaw is in our culture. If someone can walk into a Best Buy and purchase a $1000 TV set on credit at 20% interest, make a few payments then when times get tough stop paying for the television set, why should we be surprised when the bill for that TV ends up on the desk of the public trust? The lessons of the past hundred years have clearly shown us that the bankers don’t pay when the shits the fan - we do! Well..actually, to be fair, the bankers pay a little but the public pays almost all of the bill.

If as a society we are content to allow 10% of us to live far beyond our means then we must also as a society be content when that bill lands on our doorstep. Sure the bankers actually do the work and get a fee for their trouble but it’s the rest of us who are the real twits for allowing the business of lending money to people who can’t afford to pay it back to continue unchecked. It’s like arresting the hooker for prostitution when the real guilty party is the john who goes home and gives his wife an STD! The hooker is just filling a market demand. If we really wanted to get rid of prostitution then we need to go after the clients. Same thing with banking. A good libertarian doesn’t use the state to punish the sellers for the poor choices of the buyers. We educate, shame or exclude the buyers from our communities. We believe that everyone should be free to make bad choices and that we’re not required to be responsible for the consequences of bad choices made by others. Negative externalities and unintended consequences be damned!

A mutual guarantee syndicate banking system shifts risk from the public trust to a smaller more local group that knows and has confidence in the borrower. Now, if the borrower fails to repay his loan, the consequences of that default are immediately felt at a local and personal level. Instead of a random consumer buying a random television said he can’t afford, it’s our friend Richard who convinced us he had the ability to repay us when he really didn’t. In order for Richard to buy that television set he can’t afford, he is forced to lie and abuse the trust of his friends, neighbors, and community. It is much harder to lie to your friends and refuse to pay them back, than to exaggerate on a form that will be read by somebody you’ll never meet and not pay a company you’ll never have to deal with again.

If we returned the 4.5 trillion dollars sitting on the Fed's balance sheet to the wise and prudent members of the public, then we as a people could afford to pay for things like health insurance and education for the 10% of the population that for whatever reason can’t quite get their act together. That’s what charity is for. We all make mistakes and we need each other to help out from time to time. Let’s not rely on the banks and the government but rather rely on each other when times get rough. When we help each other it’s less expensive and makes for a far better society.

It’s not that hard to improve the banking system and to make the banking system work for everyone. We just have to agree to only buy things we can afford, invest money wisely and with the advice and consent of those we know and trust, and share with those who are truly in need and not with those who merely need a vacation.