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Fractional Reserve Banking versus Ayn Rand's Ethics

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Paul McKeever
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I agree with what everyone has said about it not being fraud, however, I don't think anyone has really addressed whether or not FRB causes inflation. If FRB causes inflation, thereby diminishing the real value of currency, then it is theft. I am not sure I understand the concept well enough though to judge whether or not it does have the effect of inflation on the economy, can someone clarify this?

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My thought was that the expansion of the money supply caused by FRB loans is not inflationary as long as the value in goods and services created by the loans also expands. If the loans were bad loans then there is some inflation.

As the loan is paid back with interest in the form gold or the bank's own notes the bank now owns outright some portion of gold which it did not before. Either the gold supply increased with new gold, or the bank retires its' own note, decreasing the amount of notes in circulation. If all loan payments were in the form of notes then when the loan is completely paid off there would be less notes in circulation than before the loan was made, the difference being the interest paid. So good loans are actually a little bit deflationary, and the value of gold has appreciated.

The bank's gold gets partly distributed to those who have deposits in interest bearing accounts, and any excess is the bank's profit. The bank owner can then spend it all on a marble lobby or lend it all out or give it away, his choice.

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There seems to be a general conflation of two distinct concepts here and in the video: Fractional Reserve Gold Standard, and Fractional Reserve Banking.

Fractional Reserve Gold Standard occurs when a bank prints more currency than can be backed by the assets (gold) deposited in its safe. It is a form of theft, in which the bank profits from the use of the deposited gold, as if it were owned by the bank. In the case of early banks, that use was usually limited to loaning some of the value of deposited gold out, and pocketing the interest on those loans. In the case of government banks, the use is often simply printing extra money and spending it on government programs, in the hope that they never get found out. (If they do, they simply revalue the currency to a lower value of gold, as the U.S. did in 1934, going from $20.67/oz to $35/oz, and eventually, to a fiat - unvalued - currency)

Fractional Reserve Banking is the loaning of deposited money, and entails the securing of collateral to back those loans, and payment to depositors of a portion of the interest earned. Fractional reserve banking can be moral if the bank makes the terms of deposits clear, and, if the bank effectively secures collateral greater in value (and potential value) than the amount of money loaned. When you get a mortgage on a house, you deposit the deed to the house in the bank, in return for a loan of part of the value of the home. Banks typically require 10-20% of the value of the house as a down-payment, to establish a margin of value above the value of the loan. In this way, the bank, in effect, puts your home (or factory, or business or car) "in the vault" and issues currency based on that deposit, and therefore maintains reserves in collateral greater than the amount of money issued. Fractional reserve banking allows the banks to expand the money supply by an amount roughly equal to the reciprocal of the reserve fraction (that is, if the reserve fraction is 10%, the money supply increases tenfold), but always with an increase in the amount of assets backing the money. But this increase in the money supply does not mean an increase in the amount of currency "out there" chasing goods. In fact, the amount of currency on the street decreases through FRB deposits until the interest paid by those deposits just equals the value of outstanding currency to facilitate commerce, thus providing a measure of currency regulation. (as long as changes occur gradually)

Therefore, Fractional Gold Standard is immoral, because it makes fraudulent claims as to the value of assets backing the currency issued, while fractional reserve banking can be moral, as long as the currency issued is backed by assets (gold and collateral) of at least as great a value, including a margin for potential devaluation of the collateral.

The problem in the credit crisis is that banks (and, more importantly, MBS bundlers, primarily Fannie Mae and Freddie Mac) were using recent performance to establish a rule of thumb for potential loss of real estate value, and ignored the gross overvaluation induced by rampant government credit, and targeted home-ownership policies. Had they listened to Dr. Shiller, they would have insisted on real estate collateral margins consistent with the Case-Shiller index, and the additional down-payment requirements would have stopped the bubble before it started.

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Personally, I look at fractional reserve banking in the same way I look at religion. I disapprove of it, but would do nothing to stop it legally. I would prefer to use a 100% full reserve bank because I'm a frugal person and I'm picky about my savings, but the issue nonetheless is a matter of practicality, not of morals.

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Personally, I look at fractional reserve banking in the same way I look at religion. I disapprove of it, but would do nothing to stop it legally. I would prefer to use a 100% full reserve bank because I'm a frugal person and I'm picky about my savings, but the issue nonetheless is a matter of practicality, not of morals.

We have 100% full reserve banking in the U.S. It's called "safe deposit box." You can store all of your money and gold in the bank vault, and you can withdraw it any time you want. Just don't expect any interest, and don't balk at the yearly storage fee. :)

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Yeah, that's the problem with people who condemn fractional reserve banking--how the hell ELSE can you earn interest?

I phrased this harshly and should retract it as written. Nevertheless, the question remains: If you cannot have fractional reserve banking, how can banks lend money out (i.e., invest it) and without them investing it, how can it earn interest?

Without FRB, the only services a bank can offer would be safe deposit boxes, warehousing of money, and checking, and those would all have to be charged for since the bank would have no other source of income.

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Without government involvement in the banking system I would say that a market alternative to Federal deposit insurance would quickly appear. This would allow Factional Reserve Banking to take place without (should one purchase the insurance) the worry of loosing everything in a run on the bank.

If you uphold the idea of no FRB then the bank becomes a vault, and the money in it becomes stagnant, which would lead to the same result for the economy.

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Someone mentioned earlier that Fractional Reserve Banking would lead to inflation, but it won't if it is done correctly. Let's say you have 100 ounces of gold and you want to deposit it into a bank. The bank could create bills (gold notes) splitting up that 100 ounces into more manageable units -- let's say, to make it easy, that 1 gold note equals 1 ounce of gold, and anyone having this gold note could lay claim to 1 ounce of gold at any time by going to the bank and exchanging their 1 gold note for 1 ounce of gold. If the bank is not free to use that gold for loans, then making 100 gold notes and giving it to the owner of the gold would prevent inflation. Likewise, if the owner of the gold decided to let the bank use the gold for loans, then the owner would not receive all of the gold notes, since the gold notes is a claim on the gold held in the bank. The owner of the gold would have to decide ahead of time if he will receive all of the gold notes or let the bank utilize some fraction of those gold notes to make loans with the owner of the gold getting a percentage cut of the profits. At no time can the bank make more than 100 gold note each representing or laying claim to 100 ounces of gold that the owner has deposited into the bank, but given the contractual agreement between the gold owner and the bank, the gold owner, insofar as he has agreed to let the bank use a percentage of the gold, cannot lay claim to 100% of the gold in the vaults at any given time.

In other words, let's say the gold depositor agrees that the bank can use 50% of the gold for making loans, then the gold owner has agreed that at any time at his discretion, he will only have demand access to 50% of the gold, rather than 100% of the gold. In this manner, the bank is free to loan out the gold (in notes or actual gold), but a run cannot occur because the depositor has agreed ahead of time that 50% is reserved for loans (where he shares in the profits).

So, I don't see a problem with fractional reserve banking, so long as it is done rationally, and so long as depositors know ahead of time that they may not have access to all of their money at any given time. As it is done today, without this spelled out explicitly, one expects to be able to lay claim to 100% of one's deposits because it is your money and not the bank's, but under capitalism, their could be agreements that if you make a deposit and agree to let the bank loan out your money, then you cannot have access to 100% of your money if you are expecting to make interest profit from that deposit since that implies the bank can use a portion of your money to make loans.

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Without government involvement in the banking system I would say that a market alternative to Federal deposit insurance would quickly appear. This would allow Factional Reserve Banking to take place without (should one purchase the insurance) the worry of loosing everything in a run on the bank.

FRB worked prior to the FDIC through voluntary cooperation between banks. One method was a fund which all banks pledged to and which any bank could draw on when faced with a run. This was sometimes done in an ad hoc manner, with liquid banks voluntarily lending cash to the run-on bank to calm the fears of depositors. Suspension of payments was used when a bank run spread beyond a small number of banks. It worked by allowing withdrawals only by check, and used ledger entries to transfer money between bank accounts, thus forcing the use of bank cheques in place of cash exchanges. All of these work up to a point, but the key to all of them is sound lending principles, that is, maintaining a loan-to-asset ratio significantly below 100%. During bubbles, the ratio should drop significantly (according to the Case Shiller index, the ratio should have been <50% at the peak of the housing bubble, reflecting the fact that real housing prices were more than twice their historic levels).

If banks can clearly see that the assets owned by a troubled bank are greater than its outstanding deposit liabilities, they will have no hesitation lending to that bank. Likewise, if a depositor can clearly see that his deposits are backed by adequate assets, he will be less inclined to panic during a short term liquidity crisis. Insurance would therefore require transparency of loan details.

One of the great causes of the current crisis is that the government, which should have been monitoring asset-to-loan ratios adjusted by an objective measure (Case-Shiller), instead got caught up in the bubble, because of the fantastic profits it was making from Fannie and Fred, and failed in its primary responsibility. In fact, the situation is much worse than that, as the FHA approved 0-down loans (i.e., loan-to-asset ratio = 100%), in order to maintain mortgage levels to keep Fan & Fred profitability rising - exactly the opposite of what they should have been doing, which is requiring larger down-payments (lower asset-to-loan ratios) as the bubble expanded.

Being the sponsors of more than half of MBS, the federal gov't should have known explicitly that those assets, which backed a large amount of bank deposits, and served as collateral for a wider and wider circle of credit, were fundamentally overvalued and unsound. If anyone in gov't can be shown to have known any of this, they should be treated exactly as private citizens are treated for the same behavior, that is, thrown in jail. (sorry, /soapbox)

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As it is done today, without this spelled out explicitly, one expects to be able to lay claim to 100% of one's deposits because it is your money and not the bank's.

Check your fine print. I believe most savings accounts stipulate that the bank may at its discretion, delay withdrawals by up to 60 days. By suspending loans, a typical bank can reduce its outstanding loan value by about 1% per month, so 60 days buys them significant liquidity, and also enforces a cooling-off period for short term panics.

So, to paraphrase Lincoln, you can get all of your money some of the time, and some of your money all of the time, but you can't get all of your money all of the time. It says so right there in your account agreement.

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Mr. McKeever's main complaint against private FRB is that by issuing currency which does not represent actual wealth, that bank is stealing the wealth of everyone else in the nation (via inflation). What he fails to realize is that he is looking at the issue through a very contemporary lens. One in which the inflation of the money supply - by a government run central bank - does constitute theft.

However, in a free economy - one in which banks issue their own currency - it quite literally is none of my business what two other people (the banker and his creditor) do. If I do not hold currency issued by that bank, the wealth which I possess (possibly in the form of currency issued by another bank) is not affected in the least.

To me, that seems to be most obvious flaw in his argument.

I like Mr. McKeever and I wanted to agree with him as I so often do. But unfortunately on this issue I cannot.

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Mr. McKeever's main complaint against private FRB is that by issuing currency which does not represent actual wealth, that bank is stealing the wealth of everyone else in the nation (via inflation).

No, he said the bank steals from everyone who holds one of the bank's notes when it inflates, not from the third parties or the entire nation.

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No, he said the bank steals from everyone who holds one of the bank's notes when it inflates, not from the third parties or the entire nation.

Yes, he said that. He also said (at least implicitly) that the bank steals from everyone. He said that when he advocated a prohibition on FRB on the basis of it being theft. If the depositors consent to be "stolen" from, then if not them, someone else must be the victim for it to still constitute theft.

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Actually, under capitalism, it would be illegal to inflate the money supply because that would constitute fraud. Fraud is an indirect form of the initiation of force, because some of those gold notes that I mentioned before cannot be redeemed for gold if the money supply is inflated. Let's say that given the example I gave that someone brings in 100 ounces of gold and the bank prints out 200 1 ounce gold notes redeemable for 1 ounce of gold. Obviously, there isn't enough gold to go around to cover those notes, so some of the people holding those notes are actually holding worthless pieces of paper. It would be like you writing a check with no money in your account to cover it, which is clearly fraud. Like a bad check, the holder of those bad gold notes could go to a store and purchase goods or services, and even though he exchanges gold notes for those goods and services, he hasn't actually paid for them. So there would definitely be a role for the government to play in terms of the standards of weights and measures to insure that however many gold notes are printed out are actually redeemable for gold. Otherwise, one could get a printing press and print out worthless gold notes and go on a spending spree, just as you could write a check for more money than is in your account. Cracking down on fraud is one of the legitimate functions of government. The person who writes a check for more than he has in his account is initiating force, just as a bank would if it printed out more gold notes than can be redeemed for gold.

In other words, the Federal Reserve, insofar as it prints money with nothing backing it up, is committing fraud and therefore is committing the initiation of force. Only with the Federal Reserve, one has to accept the currency as a medium of exchange because any competing currency is forbidden by corrupt law.

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In other words, the Federal Reserve, insofar as it prints money with nothing backing it up, is committing fraud and therefore is committing the initiation of force. Only with the Federal Reserve, one has to accept the currency as a medium of exchange because any competing currency is forbidden by corrupt law.

I'm not so sure that's true. The premise behind fiat currency is that the currency itself has intrinsic value due to its capacity to facilitate trade. Given that there is no guarantee on the part of the government to hold the value of money constant, it can use any excuse it pleases to inflate the money supply, including the rationale that a positive rate of inflation incentivizes borrowing (because the value of the principal, and thus the servicing payment, decreases over time), which stimulates growth. What "backs up" currency is the guarantee that it will be accepted by all businesses as a means of transacting value for value. Without that guarantee, the currency would be worthless.

The initiation of force comes in when the government uses actual force to prevent the use of competing currencies in its jurisdiction. Thus it is the guarantee, the thing that backs the value of currency, which constitutes the use of force. This makes the charge of fraud a little thorny, because the gov't can argue that only direct control over currency can allow it to effectively prevent fraud (by banks and/or counterfeiters) from occurring. Of course, it could use that same rationale to dictate government control of any area of commerce.

Like loans... banking... investment services... automobile manufacturing...

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Likewise, if the owner of the gold decided to let the bank use the gold for loans, then the owner would not receive all of the gold notes, since the gold notes is a claim on the gold held in the bank. The owner of the gold would have to decide ahead of time if he will receive all of the gold notes or let the bank utilize some fraction of those gold notes to make loans with the owner of the gold getting a percentage cut of the profits.

The owner wouldn't receive the gold notes? Then how would the owner of the gold lay claim to his gold? Surely he would have to get a receipt of some kind, a written contract acknowledging that he deposited gold to say the least. Without that, he would be relying on the "Banker Joe knows what I look like, so he'll remember I deposited gold" story, which won't hold up so well in court. The point of FRB is that the depositor does get 100 notes, while the bank simultanously retains the right to print a certain amount 100+X notes (according to reserve ratios), and loan X notes to borrowers.

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The owner wouldn't receive the gold notes? Then how would the owner of the gold lay claim to his gold? Surely he would have to get a receipt of some kind, a written contract acknowledging that he deposited gold to say the least. Without that, he would be relying on the "Banker Joe knows what I look like, so he'll remember I deposited gold" story, which won't hold up so well in court. The point of FRB is that the depositor does get 100 notes, while the bank simultaneously retains the right to print a certain amount 100+X notes (according to reserve ratios), and loan X notes to borrowers.

If someone deposits a certain amount of gold into the bank, yes he would get a receipt, but no the bank could not be permitted to print out more gold backed notes than it has in its vault, and no if the bank is going to use some of that gold for loans, then it could not give all of the gold notes to the owner of the gold. Those gold notes are claims for that gold in the vault, and to print up more notes than would cover the gold would be fraud. If fractional reserve banking is based upon printing up more gold backed notes than there is gold to cover it, then that is fraud and that would be counter to the Objectivist ethics, which was the claim made back at the beginning of this thread. For the same reason one cannot write a check for the total amount of money one has in the bank plus a little extra, Fractional Reserve Banking cannot be based on printing up more notes than can be covered by the gold deposits.

In a rational banking system, those monetary notes printed by banks must be backed by something, some commodity. In other words, the Federal Reserve Notes that we use for money are only valid to the extent that one can freely exchange them for commodities held by the Federal Reserve. By claiming the money is sound because you can take it to the grocery store to buy groceries is to reverse the meaning of money -- i.e. that the holder of the note has a claim (in terms of commodities) on the bank it was issued from (who has those commodities). Currently there are no commodities behind the Federal Reserve notes, not even the gold in Fort Nox, and therefore it is fraudulent as money. People still accept it, so it is good for buying goods and services, but it is actually just paper that no one has bothered checking to see if it is a claim on anything from the Federal Reserve.

Back before the Feds stole the gold from the American people, all money was back by either gold or some other commodity held by the bank that issued the notes. For a little while after the gold was taken, it was implied that this gold backed the US dollar, but since then, all such ties have been broken. In other words, your cash is good so long as you can find people to accept it, but note that in Galt's Gulch such Federal Reserve notes were meaningless and a millionaire like Dagny was literally penniless. If better money was legally permitted, then the Federal Reserve Note would be almost useless, except insofar as one could convert it into gold (if accepted in exchange) and then exchanged into the better money. This is why the Feds do not permit the coining of money from gold or silver or permit the printing of gold or silver notes to be used as money -- because it would show their fraud.

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If you cannot have fractional reserve banking, how can banks lend money out (i.e., invest it) and without them investing it, how can it earn interest?

The bank lends out funds that depositors have lent to it - not the funds held in on-demand checking accounts. If you deposit 10 oz in your checking account, the bank can lend 0 oz. If you deposit 10 oz in a 1 month 0,5% yield fund, the bank can lend out those 10 oz for one month and make money on the spread. And you can't use that same money while it is lent out.

Someone mentioned earlier that Fractional Reserve Banking would lead to inflation, but it won't if it is done correctly. Let's say you have 100 ounces of gold and you want to deposit it into a bank. The bank could create bills (gold notes) splitting up that 100 ounces into more manageable units -- let's say, to make it easy, that 1 gold note equals 1 ounce of gold, and anyone having this gold note could lay claim to 1 ounce of gold at any time by going to the bank and exchanging their 1 gold note for 1 ounce of gold.

That is not fractional reserve banking Thomas, that is 100% reserve banking. Fractional reserve banking means that the reserve is only a fraction of the outstanding notes, not that the notes pertain to fractions of the gold deposited (but add up to the deposited total).

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That is not fractional reserve banking Thomas, that is 100% reserve banking. Fractional reserve banking means that the reserve is only a fraction of the outstanding notes, not that the notes pertain to fractions of the gold deposited (but add up to the deposited total).

Ok, but I think this is the point of contention. How can a bank loan out more money than it has in reserve in their vaults and do that rationally (i.e. morally)? I suppose they could say that given the money they are making on loans they can say that their reserves will build up and maybe can make loans based on money coming in from loans, but even that would have limitations. That is, say if they know from outstanding loans they will bring in 100 ounces of gold a month, then they could loan that out as it comes in, but otherwise, I'd say it is immoral. Unless someone can explain this to me, then it sounds like the bank is creating loanable money out of nothing.

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Ok, but I think this is the point of contention. How can a bank loan out more money than it has in reserve in their vaults and do that rationally (i.e. morally)?

That's the point of this discussion, which is why I called you on the contradiction.

FRB banking entails taking a deposit for 100 ounces of gold and printing 100+X notes. That is the definition of fractional reserve banking. Printing a receipt for a depositor entails printing a gold backed note. That is the definition of a banknote.

The bank is not loaning out more money than it has in the vault, because the supply of money is static. What they are loaning out is paper claims to gold at some future redemption date (or they can loan out the gold and give the depositor the bank notes, it doesn't make a difference). The bank can do this rationally because it mitigates losses by calculating the probability that all depositors will show up at the bank at one time to redeem all the printed notes in circulation. Insurance companies also conduct business in this manner. For instance, if every car owner insured by Geico got into a car accident tomorrow and totaled their car, Geico would be insolvent, and also probably wouldn't pay you at all.

Under FRB, the note is not worth its face value unless the bank is solvent. During periods of insolvency, the note is obviously worth much less than its face value, or it can even be totally worthless.

Edited by adrock3215
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Ok, but I think this is the point of contention. How can a bank loan out more money than it has in reserve in their vaults and do that rationally (i.e. morally)?

First, by not loaning out the amounts held in demand deposits and checking accounts. As long as all withdrawal and redemption requests can be met and no one shows up to demand the cash that is on loan (because that cash came from term deposits such as multi-year CDs) then there is no problem.

Second, by securing collateral equal to the value of the loan which the bank gains control of should a loan default.

There is no difference in principle between loaning out more money than it has in reserve or loaning out less money than it has in reserve. What matters is the quality of the individual loans and the value of their collateral.

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I think we are talking past one another to some degree. I think so long as a bank authorizes, say, a 10 year CD at 5% interest, then sure the bank can only make money if it loans out that money deposited for more than 5%. It cannot hold onto that money at the same time it is loaning it out, but the purchaser of the CD understands ahead of time that he will not have access to that CD money until the term expires. So, in effect, then bank can use that money for 10 years, earn interest on it via loaning it out, and so long as when the CD owner shows up to receive his, say $10,000 +5% interest, and the bank has it, then there is no problem. But, if the CD holder brings in $10,000 for a CD, the bank cannot loan out money that it does not have -- say $20,000, because it doesn't have the money to loan out. I mean, it can't loan out money it does not have access to, and so long as the depositors understand that they do not have access to their money until the term expires, there is no problem and this is moral, provided everyone gets paid in the end.

What I'm against is the idea that, say, someone brings in 100 ounces of gold and the bank issues notes for more than 100 ounces of gold (whatever denomination), because that would be fraud.

Now, I do understand that banks have money coming in and out all of the time, and so it becomes a balancing act for the given transactions, but it cannot either print more notes than money it controls, nor loan out more money than it controls. I cannot take the $100 in my pocket and loan out $500 to whomever agrees with my terms -- I don't have $500 to loan out, I only have $100 to loan out. Now if I had outstanding loans that were being paid off I might at any given time have access to $500, that I could then loan out, but I am not printing money out of thin air the way the Federal Reserve does.

So, I guess it comes down to what is fractional reserve banking? Is it managing loans and debts in such a way (dynamically) so that one can loan out more than one has control of? I don't see how. And if more gold bank notes are printed than what covers the gold, then that is fraud.

In other words, say I had a money printing press and began printing out money notes and loaning them out, that would be fraud because it is not real money -- it is counterfeit, and that is both immoral and illegal.

Sorry if I seem think on this and I am not trying to hold any contradictions, but printing out more money than gold reserves is fraud, and loaning out more money than one controls would be the same thing. Unless someone can explain to me how I can loan out more money than I have or control.

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Hrmm. I'm trying to wrap my head around this, and I don't have a great understanding of banking and intricacies so I'm still unsure.

The main issue Paul talks about isn't fraud, which is mostly being discussed in this topic. In fact he dismisses the idea of fraud quickly in that link. If I'm understanding him right, his point is that inflation of credit (as opposed to inflation of physical money supply/gold) is wrong, because it devalues everyone's buying power. In effect stealing that value without consent of those others. Just the same as it is wrong for the government to crank out racks of paper money and devalue the currency. He also addresses the issue of the role of banks if they are required to keep 100% reserves

One thing that is confusing me here is that the different banks under the gold standard before central banking came to America printed their own separate currency for their own bank. And so in creating credit (which potentially could and would be the banks paper money correct?) if it causes inflation, doesn't it only apply to the banks own currency? Or is purchasing power universal where all banks are effected by all the others? I'm muddled on this point.

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