On Friday, May 1, 2012, JPMorgan Chase said it suffered a $2 billion trading loss. Some commentators have suggested that the huge loss emanates from so-called proprietary trading or placing risky bets using the bank’s money. The loss raised the credibility of the Volcker rule, which restricts banks from trading their own money. Despite JPMorgan Chase’s large loss, the opponents of the Volcker rule are of the view that the rule, if it is introduced, will only destabilize the financial markets and make things much worse. Hence they would like to allow market forces to do their job.
Do Fewer Banking Controls Always Equate with a Free Market?
The proponents for less control in the banking industry hold that fewer restrictions imply a better use of scarce resources, which leads to the generation of more real wealth.
It is true that a free banking environment is an agent of wealth promotion through the efficient use of scarce real resources, while controlled banking stifles the process of real wealth formation. However, it is overlooked by the opponents of the Volcker rule that the present banking system has nothing to do with free banking and thus a free market.
What we have at present is a banking system within the framework of the central bank, which promotes monetary inflation and the destruction of the process of real wealth generation through fractional-reserve banking. In the present system, the more unrestricted the banks are, the more money “out of thin air” can be generated and hence greater damage inflicted on the wealth-generation process. This must be contrasted with genuine free banking, i.e., the absence of a central bank, where the potential for the creation of money out of thin air is minimal.
Elsewhere we have shown that in a free-banking environment with many competitive banks, if a particular bank tries to expand credit by practicing fractional-reserve banking, it runs the risk of being “caught.” So it is quite likely that in a free-market economy the threat of bankruptcy would bring to a minimum the practice of fractional-reserve banking.
The Existence of a Central Bank Encourages Fractional-Reserve Banking
This is, however, not so in the case of the existence of the central bank. By means of monetary policy, which is also termed the reserve management of the banking system, the central bank permits the existence of fractional-reserve banking and thus the creation of money out of thin air.
The modern banking system can be seen as one huge monopoly bank that is guided and coordinated by the central bank. Banks in this framework can be regarded as “branches” of the central bank.
For all intents and purposes the banking system can be seen as being comprised of one bank. (Note that a monopoly bank can practice fractional-reserve banking without running the risk of being “caught.”)
Through ongoing monetary management — i.e., monetary pumping — the central bank makes sure that all the banks engage jointly in the expansion of credit out of thin air. The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out. By means of monetary injections the central bank makes sure that the banking system is “liquid enough” so banks will not bankrupt each other.
The Myth of Financial Deregulation…