Liberty. It’s a simple idea, but it’s also the linchpin of a complex system of values and practices: justice, prosperity, responsibility, toleration, cooperation, and peace. Many people believe that liberty is the core political value of modern civilization itself, the one that gives substance and form to all the other values of social life. They’re called libertarians.
On Friday, May 1, 2012, JPMorgan Chase said it suffered a $2 billion
trading loss. Some commentators have suggested that the huge loss
emanates from so-called proprietary trading or placing risky bets using
the bank's money. The loss raised the credibility of the Volcker rule,
which restricts banks from trading their own money. Despite JPMorgan
Chase's large loss, the opponents of the Volcker rule are of the view
that the rule, if it is introduced, will only destabilize the financial
markets and make things much worse. Hence they would like to allow
market forces to do their job.
Do Fewer Banking Controls Always Equate with a Free Market?
The proponents for less control in the banking industry hold that
fewer restrictions imply a better use of scarce resources, which leads
to the generation of more real wealth.
It is true that a free banking environment is an agent of wealth
promotion through the efficient use of scarce real resources, while
controlled banking stifles the process of real wealth formation.
However, it is overlooked by the opponents of the Volcker rule that the
present banking system has nothing to do with free banking and thus a
What we have at present is a banking system within the framework of
the central bank, which promotes monetary inflation and the destruction
of the process of real wealth generation through fractional-reserve
banking. In the present system, the more unrestricted the banks are, the
more money "out of thin air" can be generated and hence greater damage
inflicted on the wealth-generation process. This must be contrasted with
genuine free banking, i.e., the absence of a central bank, where the
potential for the creation of money out of thin air is minimal.
Elsewhere we have shown that in a free-banking environment with many
competitive banks, if a particular bank tries to expand credit by
practicing fractional-reserve banking, it runs the risk of being
"caught." So it is quite likely that in a free-market economy the threat
of bankruptcy would bring to a minimum the practice of
The Existence of a Central Bank Encourages Fractional-Reserve Banking
This is, however, not so in the case of the existence of the central
bank. By means of monetary policy, which is also termed the reserve
management of the banking system, the central bank permits the existence
of fractional-reserve banking and thus the creation of money out of
The modern banking system can be seen as one huge monopoly bank that
is guided and coordinated by the central bank. Banks in this framework
can be regarded as "branches" of the central bank.
For all intents and purposes the banking system can be seen as being
comprised of one bank. (Note that a monopoly bank can practice
fractional-reserve banking without running the risk of being "caught.")
Through ongoing monetary management — i.e., monetary pumping — the
central bank makes sure that all the banks engage jointly in the
expansion of credit out of thin air. The joint expansion in turn
guarantees that checks presented for redemption by banks to each other
are netted out. By means of monetary injections the central bank makes
sure that the banking system is "liquid enough" so banks will not
bankrupt each other.
The Myth of Financial Deregulation
Prior to the 1980s financial deregulation we had controlled banking.
Banks' conduct was guided by the central bank. Within this type of
environment bank's profit margins were nearly predetermined (the Fed
imposed interest-rate ceilings and controlled short-term interest
rates); hence the "life" of the banks was quite easy, although boring.
The introduction of financial deregulation and the dismantling of the Glass-Steagall Act changed
all that. The deregulated environment resulted in fierce competition
between banks. The previously fixed margins were severely curtailed.
This in turn called for an increase in volumes of lending in order to
maintain the level of profits.
In the present central-banking framework this increase culminated in
an explosion in the creation of credit out of thin air — a massive
explosion in the money supply. (In the deregulated environment, banks'
ability to amplify the Fed's pumping has enormously increased.)
Rather than promoting an efficient allocation of real savings, the
current so-called deregulated monetary system has been promoting the
channeling of money out of thin air across the economy. From this it
follows that, in the framework of the present monetary system, in order
to reduce a further weakening of the real wealth-generation processes,
it is necessary to introduce tighter controls on banks. Murray Rothbard wrote,
Many free-market advocates wonder: why is it that I am a champion
of free markets, privatization, and deregulation everywhere else, but
not in the banking system? The answer should now be clear: Banking is
not a legitimate industry, providing legitimate service, so long as it
continues to be a system of fractional-reserve banking: that is, the
fraudulent making of contracts that it is impossible to honor. (Making Economic Sense, p. 279)
Bear in mind that we don't suggest here suppressing the free market
but suppressing banks' ability to generate credit out of thin air.
Please note that the present banking system has nothing to do with a
true free-market economy.
It must be reiterated here however that more controls within the
framework of central banking can only slow down the pace of the erosion
of real wealth formation. It cannot prevent the erosion. (Remember that
the Fed continues to pump money to navigate the economy.) More controls
will suppress banks' ability to significantly amplify the Fed's pumping,
so in this sense it is preferable to a so-called deregulated banking
According to some commentators, the huge $2 billion loss by JPMorgan
Chase, caused by the risky bets placed using the bank's money, raises
the need to implement the Volcker rule — more controls on banks'
activities. Critics of the Volcker rule are of the view that it will
only make things much worse by stifling the efficient allocation of
scarce real resources. Our analysis holds that as long as we have a
central bank, in order to minimize the damage its policies inflict, it
makes sense to impose tighter controls on banks. It is the central bank
that enables banks to practice fractional-reserve banking, thereby
polluting the economy with money out of thin air. A better alternative
is of course to have genuine free banking without the central bank.