In recent weeks, the financial world has been rocked by a scandal involving professional investor Bernie Madoff. Madoff lost as much as $50 billion of his investors’ money and even caused a few nonprofit associations to close their doors. Madoff’s embezzlement scheme, however, pales in comparison with the $7 trillion scheme being perpetrated by the U.S. government via the fraudulent bank loaning policy known as fractional-reserve banking. In fractional-reserve banking, bank managers are constantly deceiving their clients, buying property and other assets with what amounts to counterfeit money.

There are essentially two roles for banks: making loans and acting as warehouses to store money. A fractional-reserve bank will only keep a portion of your money in your account and will loan out the rest. The basic reason why this is an illegitimate form of business is because the banker attaches a false receipt to your money. It is akin to a person paying me to draw them a square circle. This being impossible, I’m not delivering on their request as promised and have therefore committed fraud.

In a normal business, the owners know approximately when they have to pay workers and when they will receive payments from clients. If owners owe $1 million on a certain date, they will try to rearrange their funds so that they can pay off their debts. With fractional-reserve banking, this strategy is impossible. Although the assets come in regularly in the form of loan payments, the bank deposits can’t be anticipated. The problem arises when I can’t go to the bank and claim my own money.

When you buy a stock or bond, you exchange an available good — money — for the expectation of a future good. In order to claim money from your asset, you have to find a willing buyer. But with bank deposits, you never exchange anything with the bank. The money is still your property, and the bank simply guards it for you or facilitates transactions. If everyone were to claim their property, there would not be enough money to satisfy the demand.

In the Madoff scandal, investors were being paid using deposits from later investors. As long as there remained a constant flow of new funds, the pyramid scheme kept working. But when the current financial crisis hit the economy, many investors withdrew their funds and the system collapsed.

Fractional-reserve banking works the same way, using guarantees from the Treasury Department and societal pressure to retain faith in banks and preserve the existing system. This deception is just as fraudulent as Madoff’s scheme. As soon as people lose faith or withdraw their funds, the system collapses.

The typical argument in favor of fractional-reserve banking goes as follows. Suppose an entrepreneur builds a bridge and he sells access to the bridge to 1000 people, even though only 100 people can cross at any one time. But since only 50 travelers cross each day on average, there’s no traffic problem. If, however, some treacherous Visigoths were to attack and everyone attempted to flee, the bridge’s 100-man capacity would not be sufficient to satisfy demand. Since banks know roughly how much money will be taken out and are not afraid of Visigoths, they can estimate how much money they need to have at all times.

But the difference between this example and fractional-reserve banking is that with the bridge you are paying for access, not ownership. I can’t go and claim 300 bricks of the bridge. When you pay a cover charge to a bar, you don’t own some section of the bar. Use and ownership are two different things, and this method of banking constitutes fraud.

The alternative and superior system is to have 100 percent reserve banking. The two functions of banks, under this setup, will be kept separate. If a person wishes to save money, they would invest in something resembling a certificate of deposit. This would be an investment because the saver cannot claim his actual good before a certain amount of time has elapsed. In order to purchase goods, there would be a separate checking account where you would pay for the bank to hold your money. One hundred percent reserve banking may seem more complicated than fractional-reserve banking, but it’s the only good way to protect against crises where everyone tries to withdraw their investments.

Fractional reserve bankers are essentially counterfeiters. They buy more goods than they can pay for under the pretense of government-sponsored stability. Traditionally, counterfeiters would be on the run from the U.S. Treasury Department. With fractional-reserve banking, though, it’s the Treasury committing the crime.

Vincent Patsy can be reached at vapatsy@umich.edu.

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