 This hearing will come to order without objection all members opening statements will be made a part of the record the chair notes That some members may have additional questions for this panel, which they may wish to submit in writing without objection The hearing record will remain open for 30 days for members to submit written questions to these witnesses and to place their responses in the record I Now recognize myself for five minutes to make an opening statement. I Think all the members attending today, and I think the panel for being here today. I Will make a brief statement because we're anxious to get to the testimony but I Find today a very interesting day in our history because there's lots in the news today. There's There's a contempt vote in the house that will be voted on as well as there was a major Supreme Court ruling today which is which has caught the attention of Not only people in Washington, but everybody around the country but I would like to suggest that The hearings we're holding today are not to be dismissed as insignificant because we're dealing with a subject That is rarely thought about but has a major impact on our economy on how deficits are financed how government grows and How financial bubbles are formed and why we have crises which are the corrections and the depressions It's for so for this reasons I think this emphasis today on fractional reserve banking is very Apropos apropos because without the understanding of this and the understanding of the nature of money We really can't get to the bottom of the business cycle There are certainly those who argue that fraction reserve banking is something that is Advantages it facilitates the market. It makes credit easy. It causes economic growth Others would choose to say that there was also a downside for fraction reserve banking because There is an encouragement of those who can find credit Rather easily not coming from savings, but from a computer or printing press or fraction reserve banking Causes problems it causes problems because it does affect interest rates. It sends out bad signals It causes malinvestment and over investment that indeed the marketplace Requires that these mistakes be corrected and this is the reason why We're having these hearings today because much has been talked about in the last several years about the influence of the Federal Reserve itself How it can increase the monetary base and high-powered money, but it doesn't end there money continues to expand With the cooperation of the banks with what we call the fractional reserve banking But we we also have to deal with and think about Exactly where capital comes in a free market system my understanding that capital should come from work hard effort and having a savings Don't consume everything you earn if you can't save you can't invest and that's a big difference If you understand that capital comes from hard work and savings and then investment And it be distributed by the marketplace by the so-called price or the interest rates Compared to saying well savings are unnecessary Don't ever worry. We can always provide the liquidity and the credit either directly from the Fed or indirectly through fractional reserve Banking so if we indeed think about fraction reserve banking We have to think about actually where capital come from and where the mistakes come from and what causes them but the fractional reserve banking is a major contributing factor to the ease with which governmental bodies accumulate debt and We can also Emphasize the importance and nature and we'll talk more about this today is why there is a moral hazard connected to this So if there is risky financial behavior with the monetary system, we have it is Compounded by the fact that there are going to be guarantees in the system the lender of last resort the insurance It says that people can be taken care of and be actually Rewarded for these for the mistakes that they made and it seems to me that The system seems to work on one part of the cycle and it's a total disaster on the downturn of the cycle And that is a something I think every American every congressman everybody Who cares about their fellow man and about a healthy economy should think about and consider it because if indeed The business cycle is caused in this manner There's actually an answer for us and there's something that we can do about it rather than the demagoguing and the politicizing of these issues as goes on so often So I want to pause there and make sure that there's anybody else has an opening statement If not, we will proceed to the witnesses The first witness I'd like to introduce is Dr. Joseph Salerno who is a professor of economics and chair of the economics graduate degree program at Pace University in New York City He is also academic vice president of the Ludwig von Mises Institute in Auburn, Alabama Research associate of the foundation of the market economy at NYU and policy expert for the heritage foundation He has written extensively on monetary policy theory and banking and comparative economic systems He finished his undergraduate study at Boston College and received his MA and PhD in economics from Rutgers University Also with us today We have dr. John Cochran is emeritus professor of economics and emeritus dean of the school of business at Metropolitan State College of Denver and a senior scholar of the Ludwig von Mises Institute He has published numerous scholarly articles on the refinement and development of the Mises Hayek Austrian theory of the business cycle He received his PhD in economics from the University of Colorado Colorado in Boulder Dr. Lawrence White is professor of economics at George Mason University Where he specializes in the theory and history of money and banking Dr. White is one of the leading experts on free banking and as a member of the financial markets working group at the Mercatus Center He's he is published in the American Economic Review in the Journal of Monetary Economics It has also authored three books on monetary matters including the theory of monetary institutions He received his PhD in economics from UCLA and his undergraduate degree in economics from Harvard Without objection your written statements will be made part of the record You will be now recognized for a five-minute summary of your testimony Dr. Salar no Is this Mike on? Is it Mike on? See I'm deeply honored to appear before you to testify on the momentous topic of fractional reserve banking Thank you for your invitation and attention in the short time I have I will give a brief description of fractional reserve banking identified the problems it presents for the economy and suggest a solution A bank is simply a business firm that issues claims to a fixed sum of money in receipt for the deposit of ready cash These claims are cashable on demand and without cost to the depositor In today's world these claims may take the form of checkable deposits that are transferred to a third party by writing out a check They may also take the form of so-called savings deposits that require withdrawal in person at one of the bank's branches or an ATM machine in the United States the cash for the cash for which the claim is Redeemable consists of Federal Reserve notes the dollar bills that we are all familiar with Fraction reserve banking occurs when the bank lends or invests some of its deposits payable on demand and retains only a fraction in cash reserves Hence the name fractional reserve banking All us banks today engage in fractional reserve banking Let me illustrate how fractional reserve banking works with a simple example Assume that a bank with deposits of one million dollars Makes nine hundred thousand dollars of loans and investments if we ignore for simplicity the capital paid in by its owners This bank is holding a cash reserve of ten percent against its deposit liabilities The assets of the bank or its cash reserves and various non cash assets the non cash assets include business loans credit card loans mortgage loans and Securities issued by the US Treasury and other financial authorities These assets are titles to cash receivable only in the near or distant future Now the key to understanding the nature of fractional reserve banking and the problems it creates is to recognize that a bank deposit is Not itself money. It is rather money substitute. That is a claim to standard money or dollar bills Widely regarded as perfectly secure bank deposits will be routinely paid and received in exchange in lieu of money Only as long as the public does not have the slightest doubt that the bank which creates these deposits is Willing and able to redeem them without delay or the expense when this is the case Bank deposits are regarded as indistinguishable from cash itself The very nature of fractional reserve banking however presents a problem for the bank on the one hand all of the banks deposit Liabilities mature on a daily basis because it has it has promised to cash them in on demand on the other only a small fraction of its assets Is available at any moment to meet these liabilities? The rest of the banks liabilities will only mature after a number of months years or even decades in the jargon of economics Fraction reserve banking always involves term structure risk arising from the mismatching of the maturity profile of its ass Liabilities without of its assets in layman's terms banks borrow short and lend long The inherent problem is revealed when the withdrawal of deposits exceeds a bank's existing cash reserves The bank is then compelled to hastily sell off some of its longer term assets many of which are not readily sellable It thus will incur big losses This will cause a panic among the rest of its depositors who will scramble to withdraw the deposits before they become worthless a Classic bank run will ensue and the bank will fail But the failure of fraction reserve banks is only a minor problem Its effects are restricted to the banks stockholders creditors and depositors who voluntarily assume the peculiar risks Involved in this kind of business more important are the harmful effects that fraction reserve banking has on the overall economy first fraction reserve banks or Fraction reserve banking is inherently inflationary the issue of money substitutes unbacked by cash Expands the money supply and drives up prices Second the lending of unbacked money substitutes artificially reduces interest rates below market equilibrium rates This causes businesses to make unwise and wasteful investments and households to indulge in overconsumption It destroys wealth and it creates financial bubbles that end in recession and financial crises The inflation and business cycles generated by fraction reserve banking are greatly intensified by federal reserve and US Government interference with the banking industry The most dangerous forms of such interference are the power of the Federal Reserve to create bank reserves out of thin air via open market Operations its uses of these reserves to bail out failing banks in its role as the lender of last resort and Federal insurance of bank deposits in the presence of such policies the deposits of all banks are perceived and trusted by the public as One homogeneous brand of money substitute fully guaranteed by the federal government and backed up by the Fed's power to print up Bank reserves and bailout in solvent banks under such a monetary regime There's absolutely no check on the inherent propensity of fraction reserve banks to borrow short and lend long to issue unbacked money substitutes to expand the money supply and to artificially depress interest rates The solution to the problem is to treat banking as any other business and permit to operate in a market completely free of government guarantees of bank deposits and Assurance of Fed bailouts in order to achieve this ideal The Fed would have to be permanently and credibly deprived of its legal power to create reserves from nothing The best way to do this is to establish a genuine gold standard in which gold coins would circulate as cash and serve as bank reserves At the same time the Fed must be stripped of its authority to issue notes and conduct open market operations Also banks would once again be legally permitted to issue their own competing brands of notes as they were Throughout the 19th century and even into the 20th century To conclude in fact on the banking markets. I have described it I foresee the ever-present threat of insolvency lurking over fraction reserve banks to compel banks to refrain from further lending of their Deposits on demand they would retain in their vaults and ATM machines the full amount of the cash deposits This means that if a bank wish to make loans of a longer or shorter maturity They would only do so by issuing credit instruments whose maturities match their loans thus for short-term business lending They would issue certificates of deposits with maturities of three or six months the finance car loans They might issue three or four-year short bonds Mortgages would take the form of five ten-year balloon loans as they did in the 1930s and Be financed by bonds of five or ten years Ensured on a free market fraction reserve banking with all its inherent problems would slowly wither away. Thank you Thank you. Dr. Cochran Chairman Paul and members of the subcommittee Thank you for this opportunity to discuss the fractional reserve banking central banking and its relationship to economic and financial instability Fractional reserve banking has historically been viewed by some economists and most monetary cranks as a panacea for the economy a source of easy credit and New purchasing power to quickened trade better economists, however Recognize fractional reserve banking with its ability to create credit as a major source of financial and economic instability Credit created by fractional reserve banks credit extended beyond what could be supported by actual savings while initially appearing beneficial output and employment increase in areas supported by the expanding credit is Unsustainable and will end in a bust a secondary consequence of the bust is a financial and banking crisis the bank run an associated bank panic The establishment of a central bank was often when not driven by fiscal priorities of a government an attempt to achieve the first While mitigating or eliminating the second for the United States in particular the effort was misguided per Vera Smith a retrospective consideration of the background and Circumstances of the foundation of the Federal Reserve system would seem to suggest that many perhaps most of the defects of American banking Could in principle have been more naturally remedied Remedyed otherwise than by the establishment of central bank that it was not the absence of a central bank per save That was the root of the evil Recent research supports their conclusion Compared to the pre-federal reserve era the Fed has failed to provide the promised stability and the Fed has guided a Significant decline in the purchasing power of the dollar the dollar currently has a purchasing power of less than 5% of the 1913 dollar Fractional reserve banks developed from two separate business activities Banks of deposit or warehouse banking were banks offering transaction service for a fee and banks of circulation or financial intermediaries Circulation banking if clearly separated from deposit banking reduces transaction costs and enhances efficiency of capital markets leading to more savings investment and economic growth Fractional reserve banking combined these two types of banking institutions into one a single institution Offering both transaction services and intermediation services While a development of fractional reserve banking money creation either through note issue or deposit expansion and Credit creation became institutionally linked Banks create credit if credit is granted out of funds especially created for this purpose as the loan is granted The bank prints banknotes or credits the depositor on account. It is a creation of credit out of nothing Created credit is credit granted independently of any voluntary absence abstinence from spending by holders of money balances The existence of a central bank with its ability to create high-powered or base money is a necessary prerequisite for excessive credit creation and a resultant boom bus cycle While a hundred percent reserves could eliminate or reduce the boom bus cycle and eliminate the threat of bank runs and panics Boom bus business cycles are really a phenomena of central banking not fractional reserve banking per se Without a central bank credit creation by fractional reserve banks would be limited in extent Large misdirections of production caused by credit creation Require either newly created base money or the promise to create new base money in the event of a crisis by a central bank During a period known as a great moderation roughly 1982 to 2000 The US economy experienced a period of apparent relative stability and prosperity The US economy was then buffeted by two boom bus cycles tied directly to credit expansion and low interest rates While much of the discussion following the recent crisis Focused on why the recovery has been so slow a lesson that should have been learned is that credit driven artificial booms cannot last High-powered money driven credit expansion enhanced by the money multiplier fractional reserves is a major destructive power that misdirects Production falsifies calculation even in a period of relatively stable prices and destroys wealth policy-induced booms tend to piggyback on whatever economic development Is underway the interest rate break which normally would stop the event before they turn into boom Bubbles and booms is effectively neutered by credit creation Central bank response to the most recent crisis has moved the direction Moved in the direction of greater not lesser central bank involvement in the economy Recent trends are troubling John Taylor recently reported that the Federal Reserve Purchased 77% of the net increase in the debt by the federal government in 2011 the Fed is moving from a monetary policy to an industrial policy a policy environment That is not a monetary framework. It's an intervention framework Financed by money creation these trends make a return to sound money Which involves abolishing the central bank and paper fiat money and restoring caught commodity money chosen by the market and totally subject To the market and imperative fractional reserve banking supported by a federal bank is a cause of a boom bus cycle both the dot-com and the 2007 financial crisis in great recession Elimination and distort this source of instability requires monetary reform Chet's is how HR resolution 1094 which is most consistent with the recent reforms written in the in the written testimony HR 4180 would be a strong improvement over current Fed operations as would HR 245 But those both of these while improving monetary policy would still leave the economy subject to boom bus cycles I thank you and now I recognize dr. White Thank You chairman Paul and members of the subcommittee. I want to Second what's been said by dr. Salerno and dr. Cochran The problem is not fractional reserve banking per se But the lack of constraints on fractional reserve banking which have been created by one the Federal Reserve System to our system of deposit insurance Combined with too big to fail and three other restrictions and privileges placed upon banks In my statement, I offer some historical background on the origins of fractional reserve banking Talk a little about the effect of fractional reserve banking on the money supply But I think the important issue here is to focus on the problems of Bank runs and financial instability and the reforms needed to improve our banking system So let me focus on that Undoubtedly the leading argument made In favor of government regulation of banks at least since the 1930s Has been the argument claiming that fractional reserve banking is inherently fragile And so it needs a lender of last resort. It needs deposit insurance to prop it up I Find that's actually not correct and Uninsured fractional reserve banking system is not in fact inherently prone to runs It's not inherently prone to panics the runs and panics that have been a problem in the United States In the late 19th century and in the Great Depression Were due to weakness that was specific to the United States and created by The legal restrictions and privileges that I've mentioned It's true that runs have harmful effects I don't think there's much disagreement about that at least when a run takes place on a bank that's actually solvent in In a sense the depositors think there's not enough to go around but there really is we'd all like to prevent that But banks would like to prevent that too. I'll talk about how they can do that and The supposed remedy of deposit insurance although it does reduce the number of runs It does so at a cost. That's probably a greater than the bet well I think almost surely greater than the benefit that it provides by doing so because it not only eliminates That the tragic runs, but it also eliminates the runs that are healthy the ones that eliminate insolvent banks and in the absence of That kind of mechanism we rely on the good graces of the bank regulators to close banks when they begin to get Insolvent and we found that they're not actually very good at it. They tend to delay closure And that creates great moral hazard problems So a fraction reserve bank it makes promises to pay on demand more than it has in its vault then it is Possible that enough people will claim their money back that the bank can't pay everyone and If that happens as dr. Salerno said the bank is forced into haste deliquidation of assets That's certainly possible It typically happened historically when a bank was already insolvent So it actually the run closed the bank that ought to be closed But it could happen even against a solvent bank and because that's a possibility some economic theorists have jumped to the conclusion that Banks in practice are actually fragile, but if we look at the historical record and especially if we look outside the United States We find that that's not what prompted bank runs what prompted bank runs was a justifiable fear that a bank was already insolvent and That explains the pattern of bank runs over the over the season over the business cycle And it explains why bank runs were more of a problem in the United States than they were in say Canada Because the United States had a weak banking system In ways that Canada didn't and the United States system was weak because we restricted branching for so many years And because we restricted note issue by banks Under the national banking system in ways that made them unable to meet peak demands for currency so the way banks can protect themselves from runs is Two ways one is to have a clause in their accounts that says if necessary we can Delay redemption until we have enough time to liquidate assets in an orderly manner That was used by some trust companies in the United States But most importantly banks have to assure their customers that they are solvent and they have to behave in such a prudent way That there's no doubt about their solvency and before deposit insurance banks did that they held large capital Positions 20% capital was typical But when the FDIC act came along the banks hired they banks used to actually paint in their window This bank has five million dollars in capital when the FDIC act passed They hired someone and go scrape that paint off the window and put in the FDIC sticker Right, so FDIC protection took the place of what should be protecting depositors namely bank capital And since then banks have held as little capital as the FDIC will let them get away with and the FDIC is not particularly good at Monitoring bank capital or discovering when banks have bigger liabilities than they admit on their balance sheet So I think our biggest problems today. Let me talk about very briefly in conclusion about What we need to do We need to find some way of rolling back and ultimately ending deposit insurance at the federal level We need to certainly end immediately the too big to fail doctrine because that compounds the problem and means that even Uninsured depositors are not shopping around for a safe bank. So nobody is Monitoring banks for prudent behavior. So some way of ending that needs to be found immediately. Thank you Thank you. I Know you own myself five minutes for questioning I'm going to direct this question to dr. Soler. No, but The rest of the panel feel free to also answer it I wanted to talk a little bit about under today's circumstances when we have The Fed doing what they're doing and we are concerned about fraction reserve banking We know the Fed has an effect on interest rates and In an inflationary impact or certainly on the monetary as well as price inflation But is there any way to just roughly maybe separate the two how much of an impact is fraction reserve banking have on Interest rates and how much does it have an impact on actually the inflationary impact which ends up with prices going up Is this a major contributing factor or not too relevant because the bled is to the Fed is to be blamed for everything Can you put that into a proper perspective? Yes on a free market as I said, I don't think fraction reserve banking would be Too too problematic it would eventually I think wither away. I disagree with Larry on that but When there is the Fed a lender of last resort someone who can print up reserves out of thin air There's there's a really a symbiotic relationship between the two the Fed needs fraction reserve banking fraction reserve banking needs the Fed So when when when fraction reserve banking, which I believe is inherently stable Gets in the trouble as when Washington Mutual failed overnight You then have the Fed intervening because of the too big to fail doctrine and it's a very fragility of fraction reserve banking That causes the Fed then to engage in Quantitative easy one and two so without fraction reserve banking. We would not have had these These unconventional ways of injecting money into into the system So I think yes, the fraction reserve bank does contribute a great deal to the problem But but does it affect the interest rates per se the fraction? Yes, actually if the government just printed money and issued it It wouldn't affect interest rates if the government just printed up money and spent it It wouldn't it wouldn't affect interest rates It needs to have fraction reserve banking in order to put down a pressure on interest rates and therefore cause bubbles and recessions Either of the others have a comment Yeah, I'm I think the Fed even in a world without fractional reserve demand deposits could affect interest rates by going out and buying a huge quantity of government bonds That kind of open mark operation will push down the price. Sorry push up the price of bonds push down the yields on bonds So the it's true that fraction reserve banking gives the Fed in a sense more leverage When it comes to the price level If the Fed expands the money supplied by 10% Quantity theory of money tells us and at least it's an approximation for the long run The price level will rise 10% and that's true whether you have a hundred percent reserve banking or fractional reserve banking So the Fed can raise the price level by a given percentage by expanding its own liabilities by that percentage And whether the commercial banks get involved or not It's not really important to that process that the new money comes from the central bank And it has that power over the price level with or without fractional reserve banking Dr. Conkran, I think we can assume that With a system that we have and with the moral hazard of the guarantees insurance and the Fed being the lender of last resort There are less runs on the bank than we had without those those guarantees But does that in itself if we don't see the runs where things have to change and go back to a more Normal system does this then encourage the Building up of more debt would this be the reason why the world is in golf with debt because most people now do Recognize that the world's facing a debt crisis. I mean when people understand it when they look at Greece and these other countries But look at ourselves too, but do you think the fact that there aren't these corrections? We don't have old-fashioned runs on the bank that we end up with a bigger problem Which may be down the road. It takes a little longer to develop that we end up with this huge debt crisis that's a tough question to answer in the context of that but I Think because Joe alluded and Larry alluded with the guarantees that we have we essentially have weakened one of the control sides of prudence on the side is is essentially the lender of funds and people depositing funds into a bank are lenders, okay Had more restraint on deciding at least who and when and how they lended money when they knew the funds Were at risk so with some of these restraints that have been taken away That we have less people paying attention to the safety and soundness of the types of instruments they've invested in and then with the central banking that can create Credit that once you send an interest rate target in many ways. There's Incentive for a bank even if they don't have the funds currently available to extend alone create the deposit and then go out and Either borrow the reserves in the federal funds market and as they borrow in the federal funds market And that would put upward pressure on the federal funds rate then the Federal Reserve has an incentive to go in and create the reserves to Sustain the overextension of credit. So yes, I think there is a Interaction between the fractional reserve banking these restraints are the lack of essentially Risk on the downside for the depositors from the apparent safety that has helped us over leverage I thank you. I now want to yield five minutes to the gentleman from North Carolina. Mr. Jones Mr. Chairman, thank you very much and I Sit here and really appreciate you sharing your intellectual abilities and helping us better understand the pros and cons of fractional reserve banking and Leads me to a number of thoughts First of all a week or so ago. We had Jamie Jamie Diamond up here Trying to explain how he lost two billion dollars in the investments and then you're reading the paper today We wasn't too big. It was not big and I listen to your feelings about fractional Banking and whether this is a sound policy or not a sound policy and how it plays in and I think I'm from Eastern North Carolina and and I think I Listen very carefully to the people I represent Their concerns about our monetary systems and is it strong? Is it challenged? Is it weak and it leads me to a Very simple point that I like your response to When the banks failed in the 30s the Congress passed what they believe was legislation to create some Confidence and some soundness in banking known as Glass-Steagall I Have said many times that the two worst votes I've ever made since I've been in Congress Which is 18 years their rack war and the repeal of Glass-Steagall when I look at all these Boutique type investments that the banks have access to from the selling the credits Defaults from all these different systems and and fractional banking How do you get back to some soundness because it looks like to me that what we're doing is gambling On Wall Street, and I'm talking about the banks as well as in investment banks. I mean How do we get back mr. Paul? We I just think that he's leaving Congress because I think he has been such an expert Whether you agree with all of his positions on the monetary system, but I think we have allowed a system That is not sound at all in fact I think the system is becoming more and more fragile as We continue to move forward and and I do we need to go back to something like Glass-Steagall Do we need to say to the banks that you've got to start banking instead of gambling? Where are we in this process are you all three I? Agree with you that Glass-Steagall was repealing it was was ill-considered It wasn't really deregulation. It only deregulated the banks asset side It allowed SNLs to suddenly begin speculating not just Loaning in mortgages, but but but making loans Risky loans in the oil industry and so on So I agree with you there what I suggest is not to go back to not not to put back in place Glass-Steagall but to Deregulate the liability side. Okay, that is what? the ability of banks bailing out banks and and the deposit insurance was what allowed banks become irresponsible when you Got rid of Glass-Steagall. So I would have kept Glass-Steagall in place and when Congress was ready to repeal deposit insurance and When the too big to fail doctrine was was gotten rid of then I think Banks would become much more careful. They'd operate more like money market mutual funds, which don't go bankrupt Which which don't have any problems which have adjusted to market forces Yeah, I think that the the act passed in the 1930s that has weakened our banking system more than any other is not the Glass-Steagall Act and certainly not to repeal the Glass-Steagall Act, but the FDIC Act and when deposit insurance was very closely limited small amounts and Banks as dr. Salina were looted Couldn't gamble with the money then deposit insurance didn't generate a lot of moral hazard but now sort of everything goes and The big problem with the repeal of Glass-Steagall is that it's extended the subsidy of deposit insurance to risk-taking to very creative risk takers and so the What we need to do to get the genie back in the bottle is find ways to limit the access of risk takers to insured deposits If they want to gamble with their own money, that's fine with me I don't want to put any restrictions on hedge funds. For example, they're not involved in the payment system They haven't been considered too big to fail so far. Let's hope that continues But investment banks sort of fell into this Gray area where traditionally they were not considered part of the Fed's purview even but five years ago the Fed decided that it needed to jump in and Save Bear Stearns from its own foolishness and I think that's been a real mistake and that's led to a and Encouraged a trend that was already underway toward over leveraging so It's not that all leveraging is bad, but clearly we've gone too far We've encouraged banks to go too far and we need to take away those encouragements I think the gentleman now. I recognize the gentleman from Missouri. Mr. Lugema Thank You mr. Chairman Mr. White you've been doing most of the discussing here with regards to deposit insurance. I'm just Come an observation first and then we'll get to a question in 2008 in my district There were a number of runs on banks And people would go in and they take out ten to twenty thousand dollar with a cage But they also would take their money that was above the hundred thousand dollar deposit insurance level and move that to another bank And that's a run of sorts and that it's taking money out of banks and shifting it around all that Didn't go in their pocket and they were in a tin can in their backyard, but Because of the insurance That was in place it did put a floor Under some of this activity and did show that the the consumer had a trust level to that much at least And I guess it was a trust in the government or the deputy. I see insurance backing it up so I Guess you know my question is I understand where you're coming from but I think You know if you open it up make it the Wild Wild West with regards to investments out here And it's up to the individual to do these own research. It's gonna get kind of hairy I know right now, you know and then the past banks have always had to publish a quarterly financial statement And everybody could see what there and it has to be disclosed in the public area So people could see the solvency of the bank But how many of the average consumers in this room today can read a financial statement or stand it? I mean, it's pretty complicated stuff. So I I'm questioning You know if we're going to continue with fractional reserve banking. I think you know deposit insurance certainly Is a part of that and I'm gonna follow a question when you get done with that well, I Think you're right that it would be hairy if we eliminated deposit insurance tomorrow without any preparation because banks have adopted Positions they've taken risks. They put themselves in illiquid positions Knowing that deposit expecting that deposit insurance will be there tomorrow. So it would take some preparation to Even phase it back a little bit even to introduce co-insurance or I Would assume that if you want to get rid of the deposit insurance, you'd want to raise capital requirements So that is that one of the ways you want to go? Well, I would encourage banks to hold more capital I'm not sure I'd do it in the form of a requirement But if we look over the broad sweep of banking history We find very solid banking systems that didn't have deposit insurance and that where the banks held adequate capital because it was in their interest to do so and So that's sort of the goal. I have in mind now getting to that kind of system We kind of have a bomb in front of us. We have to sniff the wires in the right order. I appreciate that It's kind of interesting because I was in discussion this morning with one of the higher-level folks in the Treasury Department and They are advising the Europeans to try and implement deposit insurance So I'm just kind of like you got to be kidding me But anyway, I think you know that you may know the point while ago. I thought was excellent It kind of spurred a thought here with regards to the home mortgage problem that we had during the early 2000s here, you know and part of it was access to money lots of money But the other part of it was the lending loosening lending standards And I think when the Fed throws money out there if they would also think about Restricting lending standards. I think that's another way to control the access to these funds and I think if you see the quality of the new loans being made by the GSE's you can see that suddenly They're their balance sheets look pretty good on the loans They've made since this under new restrictions going back to old lending standards, which would seem to me to think well If we just done this thing right to begin with it wouldn't be in this problem, but I'm kind of curious with regards to the 100% reserve banking You know we have a bank that takes in all the money and all the posits and let's just sit there And it's just a sort of like a piggy bank that goes back and forth and then we have a separate entity That's a loaning bank. Where does the loaning bank get its money from? Well, if it can't lend out the demand deposits checking account dollars It can still lend out savings account dollars So money that it takes in with certificates of deposit would still be available for lending but so it would it would restrict the amount of lending banks could do and The money that people hold so in the words you still make a deposit into your savings account or our certificate of deposit and That's the money then it's loaned out. It's not the not the checking account money. That's right. Are the now account money I might interject the savings deposits would have to be true savings deposits That is they would have to have some sort of 30-day maturity or something like that Today they they technically do you have to supposed to give 30 days notice, but that's been a dead letter since the 1920s Has there ever been in history a system like this? Well, I think the closest the most nearby example is the Canadian banking system up until the First World War They had nationwide branch banking. They had no restriction There were very few restrictions on no tissue by banks on deposit making by banks and there were no Panics in the Canadian banking system. They didn't have a panic of 1907. They didn't have a panic of 1920 30 31 32 no banks failed in Canada during the early years of the Great Depression it's quite remarkable and yet they had no deposit insurance and There wasn't any movement for deposit insurance Very good. Thank you, Mr. Chairman Thank you. I now recognize a gentleman from Arizona. Mr. Schweiker Thank You, Mr. Chairman and I appreciate you all being here because this is one of those I know sometimes it feels a little esoteric, but I want to go a little bit to the side and and sort of Make sure I have my head around part of the global side of Where you see the problem? and It's the is it the expansion of sort of liquidity That that the design now creates correct or I mean is that a simple way to phrase it? Yeah, the loose monetary policy has been a big problem over and that becomes dollars that go in and Create bubbles. That's right Can can we play sort of game theory for a moment? do credit card issuers in some ways with the way they're chartered and issue on credit expansion Do they add to that same sort of? Liquidity out there I Would say no. I mean classic credit card The money that is basically an instant loan so that that the money that you you have That that is lent to to or actually paid to the retailer that you purchase from that money comes from from from a loan It doesn't have to come from a fraction reserve bank Is there a kind? Yeah, an agreement that organizations Organized offer that type of credit How about a store credit or automobile credit or are even a credit line attached to your house? Does that create that same type of multiplier effect of expansion of money supply? If it legitimate loan where someone gives up the amount of money that let's say an equity loan for five years Then they don't have the money to spend and you do have the money to spend that has no effect on prices And that has no effect on interest rates, so it does not cause bubbles and financial crises and so on But because everything is so tied up a fraction reserve banking It ramifies into almost all of these loans You're actually almost went back to credit cards are not money in some circumstances They're a substitute for spending money, but if the total supply of credit is Determined then it it's a matter of what kind of credit is being issued so that that's if it's on the back end is saying Look, there's a total amount of credit that's able to be offered and we as the institution You'll have to have that properly capitalized over here over there Yeah, but but money is an asset to the holder and having an unused credit card line is not an asset So so other than the sort of the ratios of deposit to how much can be lent out Do you see any other types of financial instruments or activity in the American marketplace that also creates that it's sort of expansion of Cash that's out there chasing assets Not in a big way. I mean travelers checks tiny bit. Okay, not very big Travelers checks, so it's basically the Fed fractional reserve banking and then maybe a couple other externalities out there You know the issues of certain lines of credit that do it with very little, you know sort of a hope and pay type of system Right now it's right now. It's the Fed. It's the Fed pumping liquidity into the system in order to prop up these fractional reserve banks which have have extended loans that have gone bad in a massive way so I think that was what dr. Paul referred to as the the sort of Complementarity between the Fed and and fractional reserve banks. Okay. Well in this actually sort of ties back into what our chairman Has touched on many times before let's say we're all sitting here three years from now And the Fed is still buying, you know a massive portion of the US sovereign debt You know we see you'll see the credit expansion. What does our world look like three years from now? Are we in? Debasing massive debasing of the currency. Are we seeing a huge inflationary cycle? What's what each of you I'd love your prediction of what our world looks like 36 months from now if we continued on this path? If we continue on this path and The banks we finally begin to lend money out because we're sitting out on a lot of this liquidity That's been injected into the system by the Fed to have over trillion dollars of excess reserves If that's lent out and we begin to see I think what we're gonna see is first a very rapid depreciation of the exchange rate and With the overhang of foreign ownership of US sovereign debt What we're gonna see happening is a dumping of that debt further exchange rate depreciation Which is going to feed on itself push prices import prices in the US through through the roof and and also Interest rates are going to rise tremendously as people just unload the US debt. Okay, so I see that happening I would tend to echo that that I my biggest fear is not really a total collapse in the currency but a really return to the economic stagnation and inflation that was a Real problem in the mid 70s through the early 1980s and I think is overlooked as In this current crisis where people have jumped back and tried to compare this To the 1930s and our biggest threat is Good and back to a period with significantly high interest rates with inflation premiums and double-digit Inflation and threatening double-digit unemployment With your patience mr. Chairman may have missed right ends You know I have the same concern about the inflation. I don't know at what rate, but we learned in the 70s I thought that you can have rising inflation even while unemployment is high Right that the fact that there's slack capacity in the economy doesn't mean that prices can't start to be bid up For the goods and services that you know people are buying and selling so Now of course the Fed assures us that it will start to pay attention to inflation if it rears its ugly head But there's a lag in recognizing what the problem is and there's a lag in turning that ship around So I worry that inflation will rise substantially Maybe between 5 and 10 percent before they can do anything about it But within that scenario, do you also see literally if you're debasing the currency in that almost a currency war Between sovereigns, I Think we are in a currency war. I think the US has been waging a currency war From the 1960s that is devaluing its currency in order to to help prop up So-called aggregate demand or total spending in the economy to continuously get us out of recessions and so on All right, thank you and thank you for your patience mr. Chairman Thank you, and I believe we'll have time to go on with a second round of questioning. So I yielded myself five minutes You know suggesting that we could move into something like in the 70s with low low growth and prices going up History also shows that you can get inflationary depressions to the depression actually gets worse And and then you also have the destruction of the currency and that's hope we can prevent that from happening But I want to ask the panel and I'll start with dr. Salerno About some of the challenges we get those of us who believe in commodity money or even the gold standard That they always throw the 19th century up to us, you know, and they say well The gold standard was a total failure because we had bank runs. That's why we had to have the Fed And that's why we had to have this system But you know Murray Rothbard wrote about, you know, the booms in the bus in the 19th century He didn't blame the gold standard like they did in the 1930s They said that the gold standard was at fault, but he talked about the pyramiding of debt and and and the deposits and and Would that be Saying that there is some blame for fractional reserve banking for contributing to those crises that we had in the 19th century And it was that rather than the gold standard that caused those problems Yes, I think that's right and that that the fractional reserve banking was really to blame for for most of those Panics and and depressions Particularly after the Civil War when we had the national banking system You had this this pyramiding not only on gold But but but the Wall Street banks pyramid it on gold the gold was concentrated in Wall Street That was one of the points of the legislation and then the country banks pyramid Not on gold. They didn't hold gold. They held held Wall Street Bank Notes as and deposits as as their reserves. So we had this huge unstable Upside-down pyramid, which was ready to topple over at the slightest you know problem or Small or large default on some loan and and that's exactly what the cause was not the commodity money standard itself Now if we were back in the 19th century, what would have been the tool? For preventing those bubbles from forming would there been a Government role in trying to prevent what you just described. Yeah, get rid of get rid of all of the policies that Caused the pyramiding let the banks each stand on their own bottom if they want to have fractional reserve banking Let them hold their own reserves They make a little from another bank that they well, they may be able to go on for a little while That would prevent it You care to make a comment. Let's start to cocker. Yeah, and some of the panics and problems with the banking system at that time were not a result of Banks holding commodity reserves and making loans on that But were actually restrictions put on their note issue that they first had to buy State government debt or with some of the national banking federal government debt And it was the government debt that was supposedly backing their note issue not the commodity reserve so there were some Very very strange symbiosis between Governments using the banking system to help their fiscal situation That were much more responsible for some of the panics and the financial crisis in the Particularly the myth of the wildcat banks Dr. White Yeah, I I would disagree with dr. Salerno a little bit on this I think fractional reserve banking was a necessary condition for bank runs and panics But it's not a sufficient condition and if you look around the world as I said before You find other countries that had sound fractional reserve banking systems where the banks were not artificially hamstrung they were well diversified and They did manage their own reserves as dr. Salerno said they didn't have Interregional banking banks deposits of reserves like country banks into city banks and city banks into New York Because banks were allowed to open their own offices in the financial capital Right, so they didn't have to put their money in the hands of another bank and then create that instability But under the national banking system the the reserve requirements were structured in such a way that it encouraged This kind of interbank depositing But if you look at Canada if you look at Scotland, which is my favorite example If you look at Switzerland if you look at Sweden, you see Systems where banks were on their own two feet They had the penalty of failure in front of them if they failed to keep enough reserves or to invest prudently And the banking systems were competitive and they were solvent. They were solid So that's That's how I would draw the lesson. Thank you. So now you're down to mr. Jones from North Carolina Mr. Chairman thank you, and I couldn't help but think with in some of your answers and So over you've mentioned other countries and their system seems to be relatively sound and and I couldn't help but think well That's because they probably have a different system of raising money for campaigns This country I don't think we could ever Do what's right for the banking system or some other systems as long as we have lobbyists that Both parties raise money and I'm guilty of that too by the way and they have Influenced when people like yourself Who I have great respect for your professionals your intellectuals You this is your area of expertise so to speak You probably could help us write a really good bill That maybe would make some meaningful changes and make the system a little bit more sound and yet You other than hearings like this and other committees you probably That's the limit and I I guess my My my point is that I don't know how we're gonna ever Get the system sound again as long as as the Paid lobbyists come down here and tell us they like this page of the bill They don't like that page of the bill. So you need to change that and you have any thoughts I really take you way all feel so to speak but do you have any thoughts about? You know a system like ours Which really doesn't encourage The honesty and integrity to change things for the good of the system, but also the good of the people I'll just I'll end it that and let you take a shot at I work at a University in New York City a few blocks away from Occupy Wall Street, and I think that things will only change especially in the banking sector When we have a grassroots movement that shares some of these opinions That is like Occupy Wall Street, and that it spreads throughout the constituencies of the US and I think that's one of the things that we should be working to do and I think congressman That think like yourself and dr. Paul that things should be changed Shouldn't should it should encourage these these movements to the extent that you can and the concerns not just limited to banking I think Adam Smith as far back as 1776, which I think also is a significant date for this country really phrased it that That for the economy to operate properly it needs to be an elimination of all systems of privileges and restraints and the lobbying you come in both is necessary because of the Unnecessary restraints we put on market participants, but also them Recognizing that the system that restrains them also can be the system that grants special privileges and and monopolies in the truth sense, which is a government protected Privilege to offer goods and services to the public In the 19th century we had a weak banking system because the small banks had the very powerful lobby and they lobbied for Restrictions on their competitors so that they could stay in business Today 21st century. It's very different the main problem of weakness is caused by privileges And the privileges are being lobbied for by the largest banks and the weakest banks are no longer the smallest banks The weakest banks are now the largest banks and they are the most dependent on these privileges So they're the ones who are going to be Lobbying the most to keep these privileges intact and I don't know how to solve that problem But it's long been a problem that When they're in any area of the economy if there's Privileges and restrictions at stake there are going to be people who are trying to shape legislation around those things so There has to be some kind of greater Attitude toward letting the banking system operate without privileges and without restrictions Can I just add to that? very quickly um Murray Rothbard the Economist once said that the way you get true change is to have Statesmen and and educators who really are interested in the public good reach around the the privileged elites and And and and get their message out to the public Well, I think that Maybe the Citizens United decision might bring some sanity to The system it won't happen in my lifetime, but maybe in our children grandchildren That maybe this would be a system that goes back to being the people's representative instead of the lobbyist representatives and I think it will happen in time I hope to live long enough maybe in a retirement home to see it happen, but I'd love to see that happen But thank you for your comments. I Think the gentleman now I yield to the gentleman from Missouri. Mr. Mukomar. Thank you. Mr. Chairman interesting conversation that was Struck with some of the comments for the gentleman from North Carolina and kind of got me thinking about what if Make you King for the day president for the day congressman for the day, whatever If how would you solve our situation now with the weakness that we have in our system? What what changes do you think we need to be implementing our Working for to get our system back to where it's solid on solid ground and and make it all work How would you ease it into a more? Workable solution Each one of you I think the first step is to get rid of the too big to fail doctrine Whole sale and forthwith do it right now and then phase out I probably would phase out more quickly than Larry the FDIC insurance from you know Within the year or something like that within a year from from from the date that you get rid of the too big to fail doctrine So those are the first important steps So in other words what you would suggest is is to put the honest back on the on the banking system for their own The responsibility for their own decisions their own risk has been taken by themselves not the taxpayer or the FDIC insurance folks and nobody else Okay, because at bottom all they are business firms. They're not special. They should not be special They should not be privileged they should operate on a market bear the burdens of the risks They assume not only them but but any depositors that want want to to put money into a fraction reserve bank. They must Realize what the consequences can be. You know, it's interesting I made the come to the DIN committee that you know I think for first time in several years here people are actually now finding out what banks do They don't just sit there and take deposits make loans. They manage risk That's what they do every day and as a result I think the the consumers and and the citizens of our country are finally figuring out that whoa This is a risky business and they're there. There's there's some responsibility on on somebody's part here to manage that risk And it's determining who who takes the risk who manages that's that's our dilemma right here now of what's going on Dr. Cochran. Yeah, I would echo Joe's Dr. Salerno's comments that the too big to fail doctrine has got to go first and really with it the mentality of that bailouts are going to come in and Across the economy whether it's banking or others and protect people from the risk they undertook Back to the deposit insurances when it appeared that some of the money market funds were going to break the buck we came in and de facto Offered insurance for the deposit on the money market funds, which just again reinforces The deal and then probably on the monetary side. I would look at Eliminating all the restrictions right now that make it difficult for anybody to come in and compete with the system that I think recently we had someone just arrested for coining gold that Could or could not have been used As a medium of change in competition so that we we really don't allow people who would even want to choose to contract in Something payable other than in Federal Reserve notes to write a contract that would be enforceable for payment announces of gold or other mediums of exchange Dr. White In addition to the points that have already been made I would say that The Federal Reserve needs to be constrained So that it doesn't create such an unstable environment and so that it doesn't Issue what became known as the Greenspan put which was the sort of open Suggestion that if the stock market starts to go down will pump in enough money to keep everybody afloat That sort of thing leads to a relaxation of prudential standards And I think that's been a big problem in the banking system now it under this kind of caveat emptor system that we're suggesting it's true people will have to shop around for a bank and People will have to re-educate themselves to how to do that, but people nowadays shop around for a mutual fund They don't understand exactly how mutual funds operate. They get a prospectus. They don't really know what to make of it But they do know who does know right they can read money magazine They can read investment newsletters and they can seek out the advice of experts and people can exercise At least that much prudence when they choose a bank Very good. Thank you. Mr. Chairman. I'll yield back to balance my time Thank you gentlemen. I now recognize mr. Schweikert from Arizona. Thank you, mr. Chairman I'm back to our happy part of the discussion, which is how the world comes to an end Looping back to the discussion of whether it be three years or five years, whatever the time frame is You know, we seem to all have a universal agreement here that with the massive amounts of liquidity. They're out in the system We see inflation we may see a runaway type of inflation. Okay, each of you Just became federal reserve chairman. Congratulations. How would you? Actually, I'll nominate In all sincerity, how would you Guide the ship Monetary policy, how would you pull that excessive liquidity out of the system? You know, what proposals would you make to avoid that ugly scenario? Let's start with this director right, okay well the the same way it went in it can come out that is the Fed can Sell off its mortgage back securities and the Fed can sell its treasury bills back into the market now At the same time the Fed can reduce the incentive of banks Not to lend by scaling back the interest they pay on reserves I mean banks are sitting on more than a trillion in excess reserves in large part because the interest rate the Fed is paying on those Reserves is about the same as the interest rate the banks can earn on T bills Would you also in that same scenario raise reserve requirements at? Chartered lenders Reserve requirements aren't really relevant these days. They're pretty much not binding most banks have more cash in their ATMs And they are required to hold okay total required reserves in the system or something like 80 billion dollars and Banks have more than a trillion dollars in reserves. So reserve requirements are not really going to do the job Yeah, the and one of the things I would echo is that they that you can pull out These excess reserves the way they got in by basically Where you'd purchase now sell them? one of the dangers Going in is that as they've changed their balance sheet from short-term securities to longer-term Securities that the value of those securities the mortgage back another they're much more susceptible decline in value to rising interest rates. So there is a Damming in there. I do think that given the amount of excess reserves that are in the system that a Possible way to avoid this besides reducing As you reduce the interest that they're paying on these exit excess reserves that It is possible that a consideration of a significant increase in the required reserve ratio could be an effective tool as You take more time to pull and sell off some of these assets, but okay And once the this all was reversed the excess reserves were sucked out of the system I would then if I were the Federal Reserve chair Just stop open market operations at that point stop printing up reserves and purchasing government securities And then that would stop the the the the next influx of liquidity into the system that would would get the whole thing started again Okay, you you're you're more optimistic than than I am I guess mechanically so but I have one of you It doesn't think raising reserve requirements it would be affected just because of how much margin there is there and You actually believe that would be one of the tools I Think it should be a Consideration it would be not a first tool, but it could be a tool that Could allow more of a phased sale of the securities without allowing the reserves To start flooding excess Lending into the system. Okay, not right you looked anxious there Well if it is possible to make reserve requirements binding if you're really determined to do so But you know banks have gotten very good with computers at sweeping the reservable deposits off the books at the end of the day And that makes it very hard to enforce reserve requirements. Okay, mr. Chairman. Thank you. I Think the gentleman and I want to thank our witnesses for appearing today As I said at the opening I believe these are very important hearings and I appreciate very much you being here This hearing is now adjourned