Mankind is in a constant search to identify the causes of its ailments, so it can find cures.  When it gets the cause wrong, the “cure: can be disastrous.  History is replete with examples of mistaken “cures” resulting in thousands of deaths.

In economics the results of mistaken diagnosis include unemployment, breadlines, bankruptcies, destruction of assets and war.

Almost all economists believe that the root of the problem is a lack of bank credit.  In fact, around the world, the consensus view holds that no modern economy can function without commercial banks and their system of fractional-reserve banking.  Economists take fractional-reserve banking as indispensable to progress and prosperity.

Is it?  Any investor that wants to survive and prosper would be wise to questions this premise.  Look carefully and you should conclude that the primary cause of the economic woes for the past two centuries has been fractional-reserve banking.  As Murray Rothbard so bluntly put it in The Mystery of Banking: “It should be clear that modern fractional-reserve banking is a shell game, a Ponzi scheme, a fraud in which fake warehouse receipts are issued and circulate as equivalent to the cash supposedly represented by the receipts.”

He goes on to point out that since the bank has promised the depositor can withdraw his deposit at any time, “. . .a bank is always inherently bankrupt and would actually become so if its depositors all woke up to the fact that the money they believe to be available on demand is actually not there.”

Consequences of the Fraud

The fraud of fractional-reserve banking results in two additional and more destructive consequences.  The most obvious is price inflation.  Fractional-reserve banking increases the money supply by multiples of the initial deposits.  The purchasing power of money is destroyed as more money is used to chase the same number of goods.

The second consequence is more subtle, less obvious and more destructive.  Create money out of thin air and individuals feel richer than they really are.  This encourages them to increase their consumption and their standard of living.  They buy bigger cars and houses, dine at fancier restaurants, travel more, and stay at better hotels and resorts.

Yet their individual output has not increased.  As demand rises for luxuries, businesses expand production of luxury goods.  All is fine until some “black swan” event disturbs the process, and the credit expansion ends and contraction begins.  This contraction, known as deflation, is where we are now as lenders refuse to lend and borrows are reticent to borrow.

The Road to Stability

No doubt you have read about the luxury hotel and resort projects that are going bankrupt everywhere from Las Vegas to Dubai.  Clearly, the investors in these projects did not understand the consequences of fractional-reserve banking.

Doing away with fractional-reserve banking is the only way any nation will ever create a stable, permanent and prosperous economy.  All loans should come from saved capital, not from fraudulent paper promises.

It becomes obvious that those in power don’t (or won’t) understand the cause of economic cycles.  We do.  Here at The Sovereign Society, all of the strategies outlined in this issue, including Eric Roseman’s recommendation of the PIMCO Bond Fund and Elvaldo Albuquerque’s choice of alternative ways to hold cash, rest on a thorough understanding of the cause of the current world dilemma.

John Pugsley founded the Bio-Rational Institute
www.biorationalinstitute.com