Moral hazard as the natural spawn of fractional-reserve banking

By Geoffrey Lawrence

“The bank mania… is raising up a moneyed aristocracy in our country which has already set the government at defiance, and although forced at length to yield a little on this first essay of their strength, their principles are unyielded and unyielding. These have taken deep root in the hearts of that class from which our legislators are drawn, and the sop to Cerberus from fable has become history. Their principles lay hold of the good, their pelf of the bad, and thus those whom the Constitution had placed as guards to its portals, are sophisticated or suborned from their duties.”

— Thomas Jefferson

Federal policy responses to the current recession have increasingly channeled the nation’s productive resources into a handful of government-protected yet inefficient firms while protecting those firms from accountability for their own actions.

Members of Congress and their corporate sponsors have acted to privatize all the gains and socialize the losses of protected firms on Wall Street and elsewhere. As a result, important decisions concerning the wealth and power of the nation are being monopolized by fewer and fewer individuals, including politically connected corporate fat cats and their accomplices in government.

Strict adherence to laissez-faire principles would stifle this growth of state corporatism and empower private individuals to control their own destiny. However, any emergence of true laissez-faire economic policies is remote, given the structure of the American banking system. For reasons discussed below, moral hazard is endemic to fractional-reserve banking under a democratic government and a fiat money system.

The business cycle that naturally results from alternating periods of government-sanctioned credit expansion and contraction produces periods of boom and bust. Fractional-reserve banking allows financial institutions to create currency out of thin air by expanding credit far beyond the amount of real wealth that actually exists.

Initially, this credit expansion can lead to accelerated economic growth. Over time, however, a significant portion of the new loans will necessarily be invested in unsound ventures — ventures lacking enough genuine demand to be truly viable. This happens because the artificially low price of money as reported by interest rates gives investors and entrepreneurs false signals as to the real prices of everything involved in making a business successful over time.

Geoffrey Lawrence is a fiscal policy analyst the Nevada Policy Research Institute.

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