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FRACTIONAL RESERVE BANKING AND THE 

FEDERAL RESERVE: THE ECONOMIC 

CONSEQUENCES OF HIGH-POWERED MONEY 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

DOMESTIC MONETARY POLICY 

AND TECHNOLOGY 

OF THE

COMMITTEE ON FINANCIAL SERVICES 

U.S. HOUSE OF REPRESENTATIVES 

ONE HUNDRED TWELFTH CONGRESS 

SECOND SESSION 

JUNE 28, 2012 

Printed for the use of the Committee on Financial Services 

Serial No. 112–141 

( 

(II) 

HOUSE COMMITTEE ON FINANCIAL SERVICES 

SPENCER BACHUS, Alabama, Chairman 

JEB HENSARLING, Texas, Vice Chairman 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

RON PAUL, Texas 

DONALD A. MANZULLO, Illinois 

WALTER B. JONES, North Carolina 

JUDY BIGGERT, Illinois 

GARY G. MILLER, California 

SHELLEY MOORE CAPITO, West Virginia 

SCOTT GARRETT, New Jersey 

RANDY NEUGEBAUER, Texas 

PATRICK T. MCHENRY, North Carolina 

JOHN CAMPBELL, California 

MICHELE BACHMANN, Minnesota 

THADDEUS G. McCOTTER, Michigan 

KEVIN McCARTHY, California 

STEVAN PEARCE, New Mexico 

BILL POSEY, Florida 

MICHAEL G. FITZPATRICK, Pennsylvania 

LYNN A. WESTMORELAND, Georgia 

BLAINE LUETKEMEYER, Missouri 

BILL HUIZENGA, Michigan 

SEAN P. DUFFY, Wisconsin 

NAN A. S. HAYWORTH, New York 

JAMES B. RENACCI, Ohio 

ROBERT HURT, Virginia 

ROBERT J. DOLD, Illinois 

DAVID SCHWEIKERT, Arizona 

MICHAEL G. GRIMM, New York 

FRANCISCO R. CANSECO, Texas 

STEVE STIVERS, Ohio 

STEPHEN LEE FINCHER, Tennessee 

BARNEY FRANK, Massachusetts, Ranking 

Member 

MAXINE WATERS, California 

CAROLYN B. MALONEY, New York 

LUIS V. GUTIERREZ, Illinois 

NYDIA M. VELA ́ ZQUEZ, New York 

MELVIN L. WATT, North Carolina 

GARY L. ACKERMAN, New York 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

MICHAEL E. CAPUANO, Massachusetts 

RUBE ́ N HINOJOSA, Texas 

WM. LACY CLAY, Missouri 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

DAVID SCOTT, Georgia 

AL GREEN, Texas 

EMANUEL CLEAVER, Missouri 

GWEN MOORE, Wisconsin 

KEITH ELLISON, Minnesota 

ED PERLMUTTER, Colorado 

JOE DONNELLY, Indiana 

ANDRE ́ CARSON, Indiana 

JAMES A. HIMES, Connecticut 

GARY C. PETERS, Michigan 

JOHN C. CARNEY, JR., Delaware 

JAMES H. CLINGER, Staff Director and Chief Counsel 

(III) 

SUBCOMMITTEE ON DOMESTIC MONETARY POLICY AND TECHNOLOGY

RON PAUL, Texas, Chairman 

WALTER B. JONES, North Carolina, Vice 

Chairman 

FRANK D. LUCAS, Oklahoma 

PATRICK T. MCHENRY, North Carolina 

BLAINE LUETKEMEYER, Missouri 

BILL HUIZENGA, Michigan 

NAN A. S. HAYWORTH, New York 

DAVID SCHWEIKERT, Arizona 

WM. LACY CLAY, Missouri, Ranking 

Member 

CAROLYN B. MALONEY, New York 

GREGORY W. MEEKS, New York 

AL GREEN, Texas 

EMANUEL CLEAVER, Missouri 

GARY C. PETERS, Michigan 

(V) 

C O N T E N T S 

Page 

Hearing held on: 

June 28, 2012 .................................................................................................... 1 

Appendix: 

June 28, 2012 .................................................................................................... 23 

WITNESSES 

THURSDAY, JUNE 28, 2012 

Cochran, John P., Ph.D., Emeritus Professor of Economics and Emeritus 

Dean of the School of Business, Metropolitan State College of Denver .......... 5 

Salerno, Joseph T., Ph.D., Professor of Economics, Lubin School of Business, 

Pace University .................................................................................................... 3 

White, Lawrence H., Ph.D., Professor of Economics, George Mason University 7 

APPENDIX 

Prepared statements: 

Paul, Hon. Ron .................................................................................................. 24 

Cochran, John P. .............................................................................................. 27 

Salerno, Joseph T. ............................................................................................ 44 

White, Lawrence H. .......................................................................................... 54 

(1) 

FRACTIONAL RESERVE BANKING AND THE 

FEDERAL RESERVE: THE ECONOMIC 

CONSEQUENCES OF HIGH-POWERED MONEY 

Thursday, June 28, 2012 

U.S. HOUSE OF REPRESENTATIVES, 

SUBCOMMITTEE ON DOMESTIC MONETARY

POLICY AND TECHNOLOGY, 

COMMITTEE ON FINANCIAL SERVICES, 

Washington, D.C. 

The subcommittee met, pursuant to notice, at 2:30 p.m., in room 

2128, Rayburn House Office Building, Hon. Ron Paul [chairman of 

the subcommittee] presiding. 

Members present: Representatives Paul, Jones, Luetkemeyer, 

and Schweikert. 

Chairman PAUL. This hearing will come to order. 

I now recognize myself for 5 minutes to make an opening statement. 

I thank all the Members attending today, and I thank the panel 

for being here today. I will make a brief statement because we are 

anxious to get to the testimony. 

I find today a very interesting day in our history because there 

is lots in the news today. There is a contempt vote in the House 

that will be voted on, as well as there was a major Supreme Court 

ruling today which has caught the attention of not only people in 

Washington, but everybody around the country. 

But I would like to suggest that the hearing we are holding today 

is not to be dismissed as insignificant, because we are dealing with 

a subject that is rarely thought about but has a major impact on 

our economy, on how deficits are financed, how government grows, 

and how financial bubbles are formed, and why we have crises, 

which are the corrections and the depressions. So, for this reason, 

I think this emphasis today on fractional reserve banking is very 

apropos, because without the understanding of this and the understanding of the nature of money, we really can’t get to the bottom 

of the business cycle. 

There are certainly those who argue that fractional reserve banking is something that is advantageous, it facilitates the market, it 

makes credit easy, it causes economic growth. Others would choose 

to say that there is also a downside for fractional reserve banking 

because there is an encouragement of those who can find credit 

rather easily, not coming from savings but from a computer or a 

printing press or fractional reserve banking, causes problems. It 

causes problems because it does affect interest rates, it sends out 

2 

bad signals, it causes malinvestment and overinvestment that, indeed, the marketplace requires that these mistakes be corrected. 

And this is the reason why we are having these hearings today, 

because much has been talked about in the last several years about 

the influence of the Federal Reserve itself, how it can increase the 

monetary base and high-powered money, but it doesn’t end there. 

Money continues to expand with the cooperation of the banks with 

what we call fractional reserve banking. But we also have to deal 

with and think about exactly where capital comes from in a free 

market system. 

My understanding is that capital should come from work, hard 

effort, and having a savings; don’t consume everything you earned. 

If you can’t save, you can’t invest. And that is a big difference if 

you understand that capital comes from hard work and savings and 

then investment and it be distributed by the marketplace by the 

so-called price or the interest rates; compared to saying, savings 

are unnecessary, don’t ever worry, we can always provide the liquidity and the credit either directly from the Fed or indirectly 

through fractional reserve banking. So if we indeed think about 

fractional reserve banking, we have to think about actually where 

capital comes from and where the mistakes come from and what 

causes them. 

But fractional reserve banking is a major contributing factor to 

the ease with which governmental bodies accumulate debt. And we 

can also emphasize the importance and nature—and we will talk 

more about this today—of worry that there is a moral hazard connected to this. So if there is risky financial behavior with the monetary system we have, it is compounded by the fact that there are 

going to be guarantees in the system, the lender of last resort, the 

insurance that says that people can be taken care of and actually 

be rewarded for the mistakes that they made. 

It seems to me that the system seems to work on one part of the 

cycle and it is a total disaster on the downturn of the cycle. And 

that is something I think every American, every Congressman, everybody who cares about their fellow man and about a healthy 

economy should think about and consider. Because if, indeed, the 

business cycle is caused in this manner, there is actually an answer for us and there is something that we can do about it, rather 

than the demagoguing and the politicizing of these issues as goes 

on so often. 

So I want to pause there and make sure there are no other Members who have an opening statement. And if not, we will proceed 

to the witnesses. 

The first witness I would like to introduce is Dr. Joseph Salerno, 

who is a professor of economics and chair of the economics graduate degree program at Pace University in New York City. He is 

also academic vice president of the Ludwig von Mises Institute in 

Auburn, Alabama; research associate of the Foundation of the Market Economy at NYU; and policy expert for The Heritage Foundation. He has written extensively on monetary policy theory and 

banking and comparative economic systems. He finished his undergraduate study at Boston College and received his M.A. and Ph.D. 

in economics from Rutgers University. 

3 

Also with us today, we have Dr. John Cochran, emeritus professor of economics and emeritus dean of the School of Business at 

Metropolitan State College of Denver and a senior scholar of the 

Ludwig von Mises Institute. He has published numerous scholarly 

articles on the refinement and development of the Mises/Hayek 

Austrian theory of the business cycle. He received his Ph.D. in economics from the University of Colorado Boulder. 

Dr. Lawrence White is professor of economics at George Mason 

University, where he specializes in the theory and history of money 

and banking. Dr. White is one of the leading experts on free banking and is a member of the Financial Markets Working Group at 

the Mercatus Center. He has been published in the American Economic Review and the Journal of Monetary Economics and has also 

authored three books on monetary matters, including, ‘‘The Theory 

of Monetary Institutions.’’ He received his Ph.D. in economics from 

UCLA and his undergraduate degree in economics from Harvard. 

Without objection, your written statements will be made a part 

of the record. You will now each be recognized for a 5-minute summary of your testimony. 

Dr. Salerno? 

STATEMENT OF JOSEPH T. SALERNO, PH.D., PROFESSOR OF 

ECONOMICS, LUBIN SCHOOL OF BUSINESS, PACE UNIVERSITY 

Mr. SALERNO. Chairman Paul and members of the subcommittee, 

I am deeply honored to appear before you to testify this morning 

on the momentous topic of fractional reserve banking. Thank you 

for your invitation and attention. 

In the short time I have, I will give a brief description of fractional reserve banking, identify the problems it presents for the 

economy, and suggest a solution. 

A bank is simply a business firm that issues claims to a fixed 

sum of money in receipt for the deposit of ready cash. These claims 

are cashable on demand and without cost to the depositor. In today’s world, these claims may take the form of checkable deposits 

that are transferred to a third party by writing out a check. They 

may also take the form of so-called savings deposits that require 

withdrawal in person at one of the bank’s branches or at an ATM 

machine. 

In the United States, the cash for which the claim is redeemable 

consists of Federal Reserve Notes, the dollar bills that we all are 

familiar with. Fractional reserve banking occurs when the bank 

lends or invests some of its deposits payable on demand and retains only a fraction in cash reserves, hence the name ‘‘fractional 

reserve banking.’’ All U.S. banks today engage in fractional reserve 

banking. 

Let me illustrate how fractional reserve banking works with a 

simple example. Assume that a bank’s deposits of $1 million make 

$900,000 of loans and investments. If we ignore for simplicity the 

capital paid in by its owners, this bank is holding a cash reserve 

of 10 percent against its deposit liabilities, the assets of the bank 

or its cash reserves, and various noncash assets. The noncash assets include business loans, credit card loans, mortgage loans, and 

securities issued by the U.S. Treasury and other financial authoriVerDate Nov 24 2008 18:25 Oct 09, 2012 Jkt 076112 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 K:\DOCS\76112.TXT TERRIE
4 

ties. These assets are titles to cash receivable only in the near or 

distant future. 

The key to understanding the nature of fractional reserve banking and the problems it creates is to recognize that a bank deposit 

is not, itself, money. It is, rather, a money substitute—that is, a 

claim to standard money or dollar bills—widely regarded as perfectly secure. Bank deposits will be routinely paid and received in 

exchange in lieu of money only as long as the public does not have 

the slightest doubt that the bank which creates these deposits is 

willing and able to redeem them without delay or expense. When 

this is the case, bank deposits are regarded as indistinguishable 

from cash itself. 

The very nature of fractional reserve banking, however, presents 

a problem for the bank. On the one hand, all of the bank’s deposit 

liabilities mature on a daily basis because it has promised to cash 

them in on demand. On the other hand, only a small fraction of its 

assets is available at any moment to meet these liabilities. The rest 

of the bank’s liabilities will only mature after a number of months, 

years, or even decades. 

In the jargon of economics, fractional reserve banking always involves ‘‘term structure risk,’’ arising from a mismatching of the maturity profile of its liabilities with that of its assets. In layman’s 

terms, banks borrow short and lend long. 

The inherent problem is revealed when the withdrawal of deposits exceeds a bank’s existing cash reserves. The bank is then compelled to hastily sell off some of its longer-term assets, many of 

which are not readily saleable. Thus, it will incur big losses. This 

will cause a panic among the rest of its depositors, who will scramble to withdraw their deposits before they become worthless. A 

classic bank run will ensue, and the bank will fail. 

But the failure of fractional reserve banking is only a minor 

problem. Its effects are restricted to the bank’s stockholders, creditors, and depositors, who voluntarily assume the peculiar risks involved in this kind of business. 

More important are the harmful effects that fractional reserve 

banking has on the overall economy. First, fractional reserve banking is inherently inflationary. The issue of money substitutes 

unbacked by cash expands the money supply and drives up prices. 

Second, the lending of unbacked money substitutes artificially reduced interest rates below market equilibrium rates. This causes 

businesses to make unwise and wasteful investments and households to indulge in overconsumption. It destroys wealth, and it creates financial bubbles that end in recession and financial crises. 

The inflation and business cycles generated by fractional reserve 

banking are greatly intensified by Federal Reserve and U.S. Government interference in the banking industry. The most dangerous 

forms of such interference are the power of the Federal Reserve to 

create bank reserves out of thin air via open market operations, its 

uses of these reserves to bail out failing banks in its role as the 

lender of last resort, and Federal insurance of bank deposits. 

In the presence of such policies, the deposits of all banks are perceived and trusted by the public as one homogeneous brand of 

money substitute, fully guaranteed by the Federal Government and 

backed up by the Fed’s power to print up bank reserves and bail 

5 

out insolvent banks. Under such a monetary regime, there is absolutely no check on the inherent propensity of fractional reserve 

banks that borrow short and lend long to issue unbacked money 

substitutes, to expand the money supply, and to artificially depress 

interest rates. 

The solution to the problem is to treat banking as any other business and permit it to operate in a market completely free of government guarantees of bank deposits and assurance of Fed bailouts. 

In order to achieve this ideal, the Fed would have to be permanently and credibly deprived of its legal power to create reserves 

from nothing. The best way to do this is to establish a genuine gold 

standard, in which gold coins would circulate as cash and serve as 

bank reserves. At the same time, the Fed must be stripped of its 

authority to issue notes and conduct open market operations. Also, 

banks would once again be legally permitted to issue their own 

competing brands of notes, as they were throughout the 19th Century and even into the 20th Century. 

To conclude, in fact, on the banking market as I have described 

it, I foresee the ever-present threat of insolvency lurking over fractional reserve banks to compel banks to refrain from further lending of their deposits on demand. They would retain in their vaults 

and ATM machines the full amount of the cash deposits. This 

means that if a bank wished to make loans of a longer or shorter 

maturity, it would only do so by issuing credit instruments whose 

maturities matched their loans. Thus, for short-term business lending, they would issue certificates of deposit with maturities of 3 or 

6 months; to finance car loans, they might issue 3- or 4-year short 

bonds. Mortgages would take the form of 5- to 10-year balloon 

loans, as they did in the 1930s, and be financed by bonds of 5 or 

10 years. 

In short, on a free market, fractional reserve banking, with all 

its inherent problems, would slowly wither away. 

Thank you. 

[The prepared statement of Dr. Salerno can be found on page 44 

of the appendix.] 

Chairman PAUL. Thank you. 

Dr. Cochran? 

STATEMENT OF JOHN P. COCHRAN, PH.D., EMERITUS PROFESSOR OF ECONOMICS AND EMERITUS DEAN OF THE 

SCHOOL OF BUSINESS, METROPOLITAN STATE COLLEGE OF 

DENVER 

Mr. COCHRAN. Chairman Paul and members of the subcommittee, thank you for this opportunity to discuss fractional reserve banking, central banking, and its relationship to economic 

and financial instability. 

Fractional reserve banking has historically been viewed by some 

economists and most monetary cranks as a panacea for the economy, a source of easy credit, and new purchasing power to quicken 

trade. Better economists, however, recognize fractional reserve 

banking, with its ability to create credit, as a major source of financial and economic instability. 

Credit created by fractional reserve banks—credit extended beyond what could be supported by actual savings—while initially apVerDate Nov 24 2008 18:25 Oct 09, 2012 Jkt 076112 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 K:\DOCS\76112.TXT TERRIE
6 

pearing beneficial, output and employment increase in areas supported by the expanding credit is unsustainable and will end in a 

bust. A secondary consequence of the bust is a financial and banking crisis, the bank run and associated panic. 

The establishment of a central bank was often, when not driven 

by fiscal priorities of a government, an attempt to achieve the first 

while mitigating or eliminating the second. For the United States 

in particular, the effort was misguided. Per Vera Smith, ‘‘A retrospective consideration of the background and circumstances of the 

foundation of the Federal Reserve System would seem to suggest 

that many, perhaps most, of the defects of American banking could, 

in principle, have been more naturally remedied otherwise than by 

the establishment of a central bank; that it was not the absence 

of a central bank per se that was the root of the evil.’’ 

Recent research supports her conclusion. Compared to the preFederal Reserve era, the Fed has failed to provide the promised 

stability and the Fed has guided a significant decline in the purchasing power of the dollar. The dollar currently has a purchasing 

power of less than 5 percent of the 1913 dollar. 

Fractional reserve banks developed from two separate business 

activities: banks of deposit, or warehouse banking, where banks offering transaction service for a fee; and banks of circulation or financial intermediaries. Circulation banking, if clearly separated 

from deposit banking, reduces transaction costs and enhances the 

efficiency of capital markets, leading to more savings, investment, 

and economic growth. Fractional reserve banking combined these 

two types of banking institutions into one: a single institution offering both transaction services and intermediation services. 

With the development of fractional reserve banking, money creation—either through note issue or deposit expansion—and credit 

creation became institutionally linked. Banks create credit if credit 

is granted out of funds especially created for this purpose. As a 

loan is granted, the bank prints bank notes or credits the depositor 

on account. It is a creation of credit out of nothing. Created credit 

is credit granted independently of any voluntary abstinence from 

spending by holders of money balances. 

The existence of a central bank, with its ability to create highpowered or base money, is a necessary prerequisite for excessive 

credit creation and the resultant boom-bust cycle. While 100 percent reserves could eliminate or reduce the boom-bust cycle and 

eliminate the threat of bank runs and panics, boom-bust business 

cycles are really a phenomenon of central banking, not fractional 

reserve banking per se. Without a central bank, credit creation by 

fractional reserve banks would be limited in extent. Large misdirections of production caused by credit creation require either 

newly created base money or the promise to create new base money 

in the event of a crisis by a central bank. 

During the period known as ‘‘the great moderation,’’ roughly 

1982 to 2000, the U.S. economy experienced a period of apparent 

relative stability and prosperity. The U.S. economy was then buffeted by two boom-bust cycles tied directly to credit expansion and 

low interest rates. While much of the discussion following the recent crisis focused on why the recovery has been so slow, a lesson 

that should have been learned is that credit-driven artificial booms 

7 

cannot last. High-powered, money-driven credit expansion, enhanced by the money multiplier of fractional reserves, is a major 

destructive power that misdirects production, falsifies calculation, 

even in a period of relatively stable prices, and destroys wealth. 

Policy-induced booms tend to piggyback on whatever economic development is under way. The interest rate break, which normally 

would stop the event before they turn into bubbles and booms, is 

effectively neutered by credit creation. 

Central bank response to the most recent crisis has moved in the 

direction of greater, not lesser, central bank involvement in the 

economy. Recent trends are troubling. John Taylor recently reported that the Federal Reserve purchased 77 percent of the net increase in the debt by the Federal Government in 2011. The Fed is 

moving from a monetary policy to a ‘‘mondustrial’’ policy, a policy 

environment that is not a monetary framework; it is an intervention framework financed by money creation. These trends make a 

return to sound money, which involves abolishing the central bank 

and paper fiat money and restoring a commodity money chosen by 

the market and totally subject to the market, imperative. 

Fractional reserve banking supported by a central bank is a 

cause of the boom-bust cycle, both the dot-com and the 2007 financial crisis and great recession. Elimination of the source of instability requires monetary reform, such as H.R. 1094, which is most 

consistent with the reforms in the written testimony. H.R. 4180 

would be a strong improvement over current Fed operations, as 

would H.R. 245, but both of these, while improving monetary policy, would still leave the economy subject to boom-bust cycles. 

[The prepared statement of Dr. Cochran can be found on page 27 

of the appendix.] 

Chairman PAUL. Thank you. 

And now, I will recognize Dr. White. 

STATEMENT OF LAWRENCE H. WHITE, PH.D., PROFESSOR OF 

ECONOMICS, GEORGE MASON UNIVERSITY 

Mr. WHITE. Thank you, Chairman Paul, and members of the subcommittee. 

I want to second what has been said by Dr. Salerno and Dr. 

Cochran. The problem is not fractional reserve banking per se, but 

the lack of constraints on fractional reserve banking which have 

been created by: one, the Federal Reserve system; two, our system 

of deposit insurance combined with ‘‘too-big-to-fail;’’ and three, 

other restrictions and privileges placed upon banks. 

In my statement, I offer some historical background on the origins of fractional reserve banking, and talk a little about the effect 

of fractional reserve banking on the money supply. But I think the 

important issue here is to focus on the problems of bank runs and 

financial instability and the reforms needed to improve our banking system, so let me focus on that. 

Undoubtedly, the leading argument made in favor of government 

regulation of banks, at least since the 1930s, has been the argument claiming that fractional reserve banking is inherently fragile, 

and so it needs a lender of last resort; it needs deposit insurance 

to prop it up. I find that is actually not correct. Uninsured fractional reserve banking is not, in fact, inherently prone to runs; it 

8 

is not inherently prone to panics. The runs and panics that were 

a problem in the United States in the late 19th Century and in the 

Great Depression were due to weakness that was specific to the 

United States and created by the legal restrictions and privileges 

that I have mentioned. 

It is true that runs have harmful effects, I don’t think there is 

much disagreement about that, at least when a run takes place on 

a bank that is actually solvent. In a sense, the depositors think 

there is not enough to go around, but there really is. We would all 

like to prevent that. But banks would like to prevent that, too, and 

I will talk about how they can do that. 

And the supposed remedy of deposit insurance, although it does 

reduce the number of runs, it does so at a cost that is probably 

greater than the—I think almost surely greater than the benefit 

that it provides by doing so, because it not only eliminates the tragic runs but it also eliminates the runs that are healthy, the ones 

that eliminate insolvent banks. And in the absence of that kind of 

mechanism, we rely on the good graces of the bank regulators to 

close banks when they begin to get insolvent, and we have found 

that they are not actually very good at it. They tend to delay closure, and that creates great moral hazard problems. 

So if a fractional reserve bank makes promises to pay on demand 

more than it has in its vault, then it is possible that enough people 

will claim their money back that the bank can’t pay everyone. And 

if that happens, as Dr. Salerno said, the bank is forced into hasty 

liquidation of assets. That is certainly possible. It typically happened, historically, when a bank was already insolvent, so it actually—the run closed the bank that ought to be closed. But it could 

happen even against a solvent bank. 

And because that is a possibility, some economic theorists have 

jumped to the conclusion that banks in practice are actually fragile. 

But if we look at the historical record and especially if we look outside the United States, we find that that is not what prompted 

bank runs. What prompted bank runs was a justifiable fear that 

a bank was already insolvent. 

And that explains the pattern of bank runs over the season, over 

the business cycle, and it explains why bank runs were more of a 

problem in the United States than they were in, say, Canada, because the United States had a weak banking system in ways that 

Canada didn’t. And the United States system was weak because we 

restricted branching for so many years and because we restricted 

notes issued by banks under the national banking system in ways 

that made them unable to meet peak demands for currency. 

There are two way banks can protect themselves from runs. One 

is to have a clause in their accounts that says, ‘‘If necessary, we 

can delay redemption until we have enough time to liquidate assets 

in an orderly manner.’’ That was used by some trust companies in 

the United States. But, most importantly, banks have to assure 

their customers that they are solvent, and they have to behave in 

such a prudent way that there is no doubt about their solvency. 

And before deposit insurance, banks did that. They held large 

capital positions; 20 percent capital was typical. But when the 

FDIC Act came along, the banks hired—banks used to actually 

paint in their window, ‘‘This bank has $5 million in capital.’’ When 

9 

the FDIC Act passed, they hired someone to go scrape that paint 

off the window and put in the FDIC sticker. All right? So, FDIC 

protection took the place of what should be protecting depositors, 

namely bank capital. Since then, banks have held as little capital 

as the FDIC will let them get away with. And the FDIC is not particularly good at monitoring bank capital or discovering when 

banks have bigger liabilities than they admit on their balance 

sheets. 

So I think our biggest problems today—let me talk about very 

briefly, in conclusion, about what we need to do. We need to find 

some way of rolling back and ultimately ending deposit insurance 

at the Federal level. We need to certainly end immediately the toobig-to-fail doctrine because that compounds the problem and means 

that even uninsured depositors are not shopping around for a safe 

bank, so nobody is monitoring banks for prudent behavior. So, 

some way of ending that needs to be found immediately. 

Thank you. 

[The prepared statement of Dr. White can be found on page 54 

of the appendix.] 

Chairman PAUL. Thank you. 

I now yield myself 5 minutes for questioning. 

I am going to direct this question to Dr. Salerno, but, the rest 

of the panel, feel free to also answer it. 

I wanted to talk a little bit about how, under today’s circumstances when we have the Fed doing what they are doing and 

we are concerned about fractional reserve banking, we know the 

Fed had an effect on interest rates and an inflationary impact, certainly on the monetary as well as price inflation. 

But is there any way to just roughly maybe separate the two: 

How much of an impact does fractional reserve banking have on interest rates, and how much does it have an impact on actually the 

inflationary impact which ends up with prices going up? Is this a 

major contributing factor or not too relevant because the Fed is to 

be blamed for everything? Can you put that into a proper perspective? 

Mr. SALERNO. Yes. 

On a free market, as I said, I don’t think fractional reserve banking would be too problematic. It would eventually, I think, wither 

away. I disagree with Larry on that. 

But when there is the Fed, a lender of last resort, somebody who 

can print up reserves out of thin air, there is really a symbiotic relationship between the two. The Fed needs fractional reserve banking, and fractional reserve banking needs the Fed. 

So when fractional reserve banking, which I believe is inherently 

stable, gets into trouble, as when Washington Mutual failed overnight, you then have the Fed intervening, of the too-big-to-fail doctrine. And it is the very fragility of fractional reserve banking that 

caused the Fed, then, to engage in Quantitative Easing 1 and 2. 

Without fractional reserve banking, we would not have had these 

unconventional ways of injecting money into the system. So I think, 

yes, fractional reserve banking does contribute a great deal to the 

problem. 

Chairman PAUL. But does it affect the interest rates per se? 

10 

Mr. SALERNO. Yes, actually, if the government just printed 

money and issued it, it wouldn’t affect interest rates. If the government just printed up money and spent it, it wouldn’t affect interest 

rates. It needs to have fractional reserve banking in order to put 

down pressure on interest rates and, therefore, cause bubbles and 

recessions. 

Chairman PAUL. Do either of the others have a comment? 

Mr. WHITE. Yes, I think the Fed, even in a world without fractional reserve demand deposits, could affect interest rates by going 

out and buying a huge quantity of government bonds. That kind of 

open market operation will push up the price of bonds, and push 

down the yields on bonds. So it is true that fractional reserve banking gives the Fed, in a sense, more leverage. 

When it comes to the price level, if the Fed expands the money 

supply by 10 percent, quantity theory of money tells us—at least, 

it is an approximation for the long run—the price level will rise 10 

percent. And that is true whether you have 100 percent reserve 

banking or fractional reserve banking. 

So the Fed can raise the price level by a given percentage by expanding its own liabilities by that percentage, and whether the 

commercial banks get involved or not is not really important to 

that process. The new money comes from the central bank, and it 

has that power over the price level with or without fractional reserve banking. 

Chairman PAUL. Dr. Cochran, I think we can assume that with 

the system that we have and with the moral hazard of the guarantees insurance and the Fed being the lender of last resort, there 

are less runs on the bank than we had without those guarantees. 

But does that, in itself—if we don’t see the runs, where things 

have to change and go back to a more normal system, does this 

then encourage the building up of more debt? 

Would this be the reason why the world is engulfed with debt? 

Because most people now do recognize that the world is facing a 

debt crisis. People understand it when they look at Greece and 

these other countries, but look at ourselves, too. 

But do you think the fact that there aren’t these corrections, we 

don’t have old-fashioned runs on the bank, that we end up with a 

bigger problem which may be down the road, it takes a little longer 

to develop, but we end up with this huge debt crisis? 

Mr. COCHRAN. That is a tough question to answer in the context 

of that, but I think, as Joe alluded and Larry has alluded, with the 

guarantees that we have, we essentially have weakened—one of 

the control sides—prudence on the side is essentially the lender of 

funds—and people depositing funds into a bank are lenders, okay— 

had more restraint on deciding at least who and when and how 

they lended money when they knew the funds were at risk. 

So with some of these restraints that have been taken away, that 

we have less people paying attention to the safety and soundness 

of the types of instruments they have invested in, and then with 

the central banking that can create credit, that once you set an interest rate target, in many ways there is incentive for a bank, even 

if they don’t have the funds currently available, to extend a loan, 

create the deposit, and then go out and either borrow the reserves 

in the Federal funds market, and as they borrow in the Federal 

11 

funds market—and that would put upward pressure on the Federal 

funds rate—then the Federal Reserve has an incentive to go in and 

create the reserves to sustain the overextension of credit. 

So, yes, I think there is an interaction between the fractional reserve banking, these restraints, or the lack of, essentially, risk on 

the downside to the depositors from the apparent safety, that has 

helped us overleverage. 

Chairman PAUL. Thank you. 

I now want to yield 5 minutes to the gentleman from North 

Carolina, Mr. Jones. 

Mr. JONES. Mr. Chairman, thank you very much. 

As I sit here and listen, I really appreciate you sharing your intellectual abilities and helping us better understand the pros and 

cons of fractional reserve banking. And it leads me to a number of 

thoughts. 

First of all, a week or so ago, we had Jamie Dimon up here try- ing to explain how he lost $2 billion in investments. And then, you 

read in the paper today that it wasn’t $2 billion, it was $9 billion. 

And I listen to your feelings about fractional banking and whether this is a sound policy or not a sound policy and how it plays in. 

And I think—I am from eastern North Carolina, and I think I listen very carefully to the people I represent, their concerns about 

our monetary systems and is it strong, is it challenged, is it weak. 

And it leads me to a very simple point that I would like your response to. 

When the banks failed in the 1930s, the Congress passed what 

they believed was legislation to create some confidence and some 

soundness in banking known as the Glass-Steagall Act. I have said 

many times that in the 18 years I have been in Congress, the two 

worst votes I ever made were the Iraq war and the repeal of GlassSteagall. 

When I look at all these boutique-type investments that the 

banks have access to, from the selling of credit defaults, from all 

these different systems, and fractional banking, how do you get 

back to some soundness? Because it looks like to me that what we 

are doing is gambling on Wall Street. And I am talking about the 

banks as well as the investment banks. 

How do we get back? Chairman Paul—I hate to think that he is 

leaving Congress because I think he has been such an expert, 

whether you agree with all of his positions on the monetary system. But I think we have allowed a system that is not sound at 

all. In fact, I think the system is becoming more and more fragile 

as we continue to move forward. 

Do we need to go back to something like Glass-Steagall? Do we 

need to say to the banks that you have to start banking instead 

of gambling? Where are we in this process? 

I would like all three of you to respond, please. 

Mr. SALERNO. I agree with you that repealing Glass-Steagall was 

ill-considered. It wasn’t really deregulation. It only deregulated the 

banks’ assets side. It allowed S&Ls to suddenly begin speculating, 

not just loaning mortgages but making risky loans in the oil industry and so on. So I agree with you there. 

What I suggest is not to put back in place Glass-Steagall but to 

deregulate the liability side, okay? That is, the ability of banks— 

12 

bailing out banks and the deposit insurance was what allowed 

banks to become irresponsible when you got rid of Glass-Steagall. 

So I would have kept Glass-Steagall in place, and when Congress 

was ready to repeal deposit insurance and when the too-big-to-fail 

doctrine was gotten rid of, then I think banks would become much 

more careful. They would operate more like money market mutual 

funds, which don’t go bankrupt, which don’t have any problems, 

which have adjusted to market forces. 

Mr. WHITE. Yes, I think that the Act passed in the 1930s that 

has weakened our banking system more than any other is not the 

Glass-Steagall Act, and certainly not the repeal of the GlassSteagall Act, but the FDIC Act. 

And when deposit insurance was very closely limited, small 

amounts and banks, as Dr. Salerno alluded, couldn’t gamble with 

the money, then deposit insurance didn’t generate a lot of moral 

hazard. But now, sort of, everything goes. 

And the big problem with the repeal of Glass-Steagall is that it 

has extended the subsidy of deposit insurance to risk-taking to very 

creative risk-takers. And so what we need to do to get the genie 

back in the bottle is to find ways to limit the access of risk-takers 

to insured deposits. If they want to gamble with their own money, 

that is fine with me. I don’t want to put any restrictions on hedge 

funds, for example. They are not involved in the payment system. 

They haven’t been considered too-big-to-fail so far; let’s hope that 

continues. 

But investment banks sort of fell into this gray area, where traditionally they were not considered part of the Fed’s purview even, 

but 5 years ago, the Fed decided that it needed to jump in and save 

Bear Stearns from its own foolishness. I think that was a real mistake, and it has led to and encouraged a trend that was already 

under way toward overleveraging. 

So it is not that all leveraging is bad, but, clearly, we have gone 

too far. We have encouraged banks to go too far, and we need to 

take away those encouragements. 

Chairman PAUL. I thank the gentleman. 

Now, I recognize the gentleman from Missouri, Mr. Luetkemeyer. 

Mr. LUETKEMEYER. Thank you, Mr. Chairman. 

Mr. White, you have been doing most of the discussing here with 

regards to deposit insurance. And I have just kind of an observation first, and then we will get to a question. 

In 2008, in my district, there were a number of runs on banks. 

And people would go in and they would take out $10,000, $20,000 

worth of cash, but they also would take their money that was above 

the $100,000 deposit insurance level and move that to another 

bank. And that is a run of sorts, in that it is taking money out of 

banks and shifting it around, although it didn’t go into their pocket 

or in a tin can in the backyard. 

But because of the insurance that was in place, it did put a floor 

under some of this activity and did show that the consumer had 

a trust level to that much, at least. And I guess it was a trust in 

the government, with FDIC insurance backing it up. 

So I guess my question is, I understand where you are coming 

from, but I think if you open it up, make it the wild, wild west with 

13 

regards to investments out here and it is up to the individual to 

do his own research, it is going to get kind of hairy. 

I know right now—in the past, banks have always had to publish 

a quarterly financial statement, and everybody could see what 

their—and it has to be disclosed in the public area so people could 

see the solvency of the bank. But how many of the average consumers in this room today can read a financial statement or understand it? It is pretty complicated stuff. 

So I am questioning, if we are going to continue with fractional 

reserve banking, I think deposit insurance certainly is a part of 

that. 

And I have a follow-up question when you get done with that. 

Mr. WHITE. I think you are right that it would be hairy if we 

eliminated deposit insurance tomorrow without any preparation, 

because banks have adopted positions, they have taken risks, they 

have put themselves in illiquid positions knowing that deposit—or, 

expecting that deposit insurance will be there tomorrow. So it 

would take some preparation to even phase it back a little bit, even 

to introduce coinsurance or— 

Mr. LUETKEMEYER. I would assume that if you want to get rid 

of deposit insurance, you would want to raise capital requirements. 

Is that one of the ways you want to go? 

Mr. WHITE. I would encourage banks to hold more capital. I am 

not sure I would do it in the form of a requirement. 

But if we look over the broad sweep of banking history, we find 

very solid banking systems that didn’t have deposit insurance, 

where the banks held adequate capital because it was in their interest to do so. So that is sort of the goal I have in mind. 

Now, getting to that kind of system, we kind of have a bomb in 

front of us and we have to snip the wires in the right order. I appreciate that. 

Mr. LUETKEMEYER. It is kind of interesting because I was in a 

discussion this morning with one of the higher-level folks in the 

Treasury Department, and they are advising the Europeans to try 

and implement deposit insurance. So I am just kind of like, you 

have to be kidding me. 

But, anyway, I think you made a point a while ago that I 

thought was excellent. It kind of spurred a thought here, with regards to the home mortgage problem that we had during the early 

2000s. And part of it was access to money, lots of money. But the 

other part of it was the lending, loosening the lending standards. 

And I think when the Fed throws money out there, if they would 

also think about restricting lending standards, I think that is another way to control the access to these funds. 

And I think if you see the quality of the new loans being made 

by the GSEs, you can see that suddenly their balance sheets look 

pretty good on the loans they have made since this, under new restrictions, going back to the old lending standards, which would 

seem to me, if we had just done this thing right to begin with, we 

wouldn’t be in this problem. 

But I am kind of curious with regards to the 100 percent reserve 

banking, where you have a bank that takes in all the money and 

all the deposits and lets it sit there and it is just sort of like a piggyback that goes back and forth, and then we have a separate entiVerDate Nov 24 2008 18:25 Oct 09, 2012 Jkt 076112 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 K:\DOCS\76112.TXT TERRIE
14 

ty that is a loaning bank. Where does the loaning bank get its 

money from? 

Mr. WHITE. If it can’t lend out demand deposits, checking account dollars, it can still lend out savings account dollars. So 

money that it takes in with certificates of deposit would still be 

available for lending. But it could restrict the amount of lending 

banks could do, and the money that people hold— 

Mr. LUETKEMEYER. In other words, you still make a deposit into 

your savings account or certificate of deposit, and that is the 

money, then, that is loaned out; it is not the checking account 

money. 

Mr. WHITE. That is right. 

Mr. SALERNO. If I might interject, the savings deposits would 

have to be true savings deposits. That is, they would have to have 

some sort of 30-day maturity or something like that. Today, they 

technically do, that you are supposed to give 30 days’ notice, but 

that has been a dead letter since the 1920s. 

Mr. LUETKEMEYER. Has there ever been in history a system like 

this? 

Mr. WHITE. I think the closest, the most nearby example is the 

Canadian banking system. Up until the first world war, there was 

nationwide branch banking, they had very few restrictions on note 

issue by banks, on deposit making by banks, and there were no 

panics in the Canadian banking system. They didn’t have a panic 

of 1907. They didn’t have a panic of 1930, 1931, or 1932. No banks 

failed in Canada during the early years of the Great Depression. 

It is quite remarkable. And yet, they had no deposit insurance, and 

there wasn’t any movement for deposit insurance. 

Mr. LUETKEMEYER. Thank you, Mr. Chairman. 

Chairman PAUL. Thank you. 

I now recognize the gentleman from Arizona, Mr. Schweikert. 

Mr. SCHWEIKERT. Thank you, Mr. Chairman. 

And I appreciate you all being here because this is one of those— 

I know sometimes it feels a little esoteric. 

But I want to go a little bit to the side and sort of make sure 

I have my head around part of the global side of where you see the 

problem. Is it the expansion of liquidity that the design now creates? Is that the simple way to phrase it? 

Mr. WHITE. Yes, that loose monetary policy has been a big problem over the last— 

Mr. SCHWEIKERT. And that becomes dollars that go in and create 

bubbles? 

Mr. WHITE. That is right. 

Mr. SCHWEIKERT. Can we play, sort of, game theory for a moment? Do credit card issuers in some ways, with the way they are 

chartered and issue credit expansion, do they add to that same sort 

of liquidity out there? 

Mr. SALERNO. I would say ‘‘no.’’ A classic credit card, that money 

is basically an instant loan, so that the money that is lent to—or, 

actually, paid to the retailer that you purchased from, that money 

comes from a loan. It doesn’t have to come from a fractional reserve 

bank. 

Mr. SCHWEIKERT. Is there an agreement that organizations organized off of that type of credit—how about a store credit or autoVerDate Nov 24 2008 18:25 Oct 09, 2012 Jkt 076112 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 K:\DOCS\76112.TXT TERRIE
15 

mobile credit or even a credit line attached to your house? Does 

that create that same type of multiplier effect of the expansion of 

money supply? 

Mr. SALERNO. A legitimate loan, where someone gives up the 

amount of money, let’s say, an equity loan for 5 years, they don’t 

have the money to spend, and you do have the money to spend. 

That has no effect on prices and that has no effect on interest 

rates, so it does not cause bubbles and financial crises and so on. 

But because everything is so tied up with fractional reserve banking, it ramified into almost all of these loans. 

Mr. WHITE. Credit cards are not money. In some circumstances, 

they are a substitute for spending money. But if the total supply 

of credit is determined, then it is a matter of what kind of credit 

is being issued. 

Mr. SCHWEIKERT. So if it is on the back end, is saying, look, there 

is a certain amount of total credit that is able to be offered, and 

we as the institution have to have that properly capitalized over 

there. 

Mr. WHITE. Right. Yes. But money is an asset to the holder, and 

having an unused credit card line is not an asset. 

Mr. SCHWEIKERT. So, other than, sort of, the ratios of deposit to 

how much can be lent out, do you see any other types of financial 

instruments or activity in the American marketplace that also creates that sort of expansion of cash that is out there chasing assets? 

Mr. WHITE. Not in a big way—traveler’s checks, a tiny bit, not 

very big. 

Mr. SCHWEIKERT. Traveler’s checks. So it is basically the Fed, 

fractional reserve banking, and then maybe a couple of other 

externalities out there, issuers of certain lines of credit that do it 

with very little—sort of a hope-and-pay type of system. 

Mr. SALERNO. Right now, it is the Fed. It is the Fed pumping liquidity into the system in order to prop up these fractional reserve 

banks that have extended loans that have gone bad in a massive 

way. So I think that was what Dr. Paul referred to as the, sort of, 

complementarity between the Fed and fractional reserve banking. 

Mr. SCHWEIKERT. Okay. And this actually sort of ties back into 

what our chairman has touched on many times before. Let’s say we 

are all sitting here 3 years from now and the Fed is still buying 

a massive portion of U.S. sovereign debt, we see a credit expansion. 

What does our world look like 3 years from now? Are we in a massive debasing of the currency? Are we seeing a huge inflationary 

cycle? Each of you, I would love your prediction of what our world 

looks likes 36 months from now if we continued on this path. 

Mr. SALERNO. If we continue on this path and the banks finally 

begin to lend money out—because they are sitting on a lot of this 

liquidity that has been injected into the system by the Fed. They 

have over a trillion dollars of excess reserves. If that is lent out, 

then we begin to see—I think what we are going to see is, first, 

a very rapid depreciation of the exchange rate. 

And with the overhang of foreign ownership of U.S. sovereign 

debt, what we are going to see happening is the dumping of that 

debt, further exchange rate depreciation, which is going to feed on 

itself, push import prices in the United States through the roof, 

16 

and, also, interest rates are going to rise tremendously as people 

just unload U.S. debt. 

Mr. SCHWEIKERT. Okay. 

Mr. SALERNO. I see that happening. 

Mr. COCHRAN. I would tend to echo that, that my biggest fear is 

not really a total collapse in the currency but really, a return to 

the economic stagnation and inflation that was a real problem in 

the mid-1970s through the early 1980s, and I think is overlooked 

in this current crisis, where people have jumped back and tried to 

compare this to the 1930s, and our biggest threat is getting back 

to a period with significantly high interest rates, with inflation premiums, and double-digit inflation and threatening double-digit unemployment. 

Mr. SCHWEIKERT. With your patience, Mr. Chairman, may I have 

Mr. Wright answer? 

Mr. WHITE. Yes, I have the same concern about inflation. I don’t 

know at what rate, but we learned in the 1970s, I thought, that 

you can have rising inflation even while unemployment is high. 

The fact that there is slack capacity in the economy doesn’t mean 

that prices can’t start to be bid up for the goods and services that 

people are buying and selling. 

Now, of course, the Fed assures us that it will start to pay attention to inflation if it rears its ugly head, but there is a lag in recognizing what the problem is and there is a lag in turning that ship 

around. So I worry that inflation will rise substantially, maybe between 5 and 10 percent, before they can do anything about it. 

Mr. SCHWEIKERT. Within that scenario, do you also see, literally, 

if you are debasing the currency in that, almost a currency war between sovereigns? 

Mr. SALERNO. I think we are in a currency war. I think the 

United States has been waging a currency war from the 1960s— 

that is, devaluing its currency in order to help prop up so-called aggregate demand or total spending in the economy to continuously 

get us out of recessions and so on. 

Mr. SCHWEIKERT. All right. Thank you. 

And thank you for your patience, Mr. Chairman. 

Chairman PAUL. Thank you. 

I believe we will have time to go on with a second round of questioning. So I will yield myself 5 minutes. 

Suggesting that we could move into something like in the 1970s 

with low growth and prices going up, history also shows that you 

can get inflationary depressions, too. The depression actually gets 

worse, and then you also have a destruction of the currency. And 

let’s hope we can prevent that from happening. 

But I wanted to ask the panel, and I will start with Dr. Salerno, 

about some of the challenges we get, those of us who believe in 

commodity money or even the gold standard, that they always 

throw the 19th Century up to us, and they say that the gold standard was a total failure because we had bank runs; that is why we 

had to have the Fed, and that is why we had to have this system. 

But, Murray Rothbard wrote about the booms and the busts in 

the 19th Century, and he didn’t blame the gold standard like they 

did in the 1930s. They said that the gold standard was at fault. 

But he talked about the pyramiding of debt and the deposits. 

17 

Would that be saying that there is some blame for fractional reserve banking for contributing to those crises that we had in the 

19th Century, and it was that rather than the gold standard that 

caused those problems? 

Mr. SALERNO. Yes, I think that is right, that fractional reserve 

banking was really to blame for most of those panics and depressions. Particularly after the Civil War, when we had the national 

banking system, you had this pyramiding not only on gold, but— 

Wall Street banks pyramided on gold. Gold was concentrated on 

Wall Street. That was one of the points of the legislation. And then 

the country banks pyramided not on gold, they didn’t hold gold, 

they held Wall Street bank notes and deposits as their reserves. 

So we had this huge, unstable, upside-down pyramid which was 

ready to topple over at the slightest problem or small—or large default on some loan. And that is exactly what the cause was, not the 

commodity money standard itself. 

Chairman PAUL. Now, if we were back in the 19th Century, what 

would have been the tool for preventing those bubbles from forming? Would there have been a government role in trying to prevent 

what you just described? 

Mr. SALERNO. Yes, get rid of all of the policies that caused the 

pyramiding. Let the banks each stand on their own bottom. If they 

want to have fractional reserve banking, let them hold their own 

reserves. If they can get a loan from another bank, they may be 

able to go on for a little while. But that would prevent it. 

Chairman PAUL. Do you care to make a comment, Dr. Cochran? 

Mr. COCHRAN. Yes. Some of the panics and problems with the 

banking system at that time were not a result of banks holding 

commodity reserves and making loans on that, but were actually 

restrictions put on their note issue that they first had to buy State 

government debt or, with some of the national banking, Federal 

Government debt. And it was the government debt that was supposedly backing their note issue, not the commodity reserves. 

So there was some very, very strange symbiosis between governments using the banking system to help their fiscal situation that 

were much more responsible for some of the panics and the financial crisis, particularly the myth of the wildcat banks. 

Chairman PAUL. Dr. White? 

Mr. WHITE. Yes, I would disagree with Dr. Salerno a little bit on 

this. I think fractional reserve banking was a necessary condition 

for bank runs and panics, but it is not a sufficient condition. And 

if you look around the world, as I said before, you find other countries that had sound fractional reserve banking systems where the 

banks were not artificially hamstrung; they were well-diversified, 

and they did manage their own reserves, as Dr. Salerno said. They 

didn’t have inter-regional banks’ deposits of reserves, like country 

banks into city banks and city banks into New York, because banks 

were allowed to open their own offices in the financial capital. So 

they didn’t have to put their money in the hands of another bank 

and then create that instability. But under the national banking 

system, the reserve requirements were structured in such a way 

that it encouraged this kind of interbank depositing. 

But if you look at Canada, if you look at Scotland—which is my 

favorite example—if you look at Switzerland, if you look at Sweden, 

18 

you see systems where banks were on their own two feet, they had 

the penalty of failure in front of them if they failed to keep enough 

reserves or to invest prudently, and the banking systems were competitive and they were solvent, they were solid. So that is how I 

would draw the lesson. 

Chairman PAUL. Okay. Thank you. 

I now yield to Mr. Jones from North Carolina. 

Mr. JONES. Mr. Chairman, thank you. 

And I couldn’t help but think—in some of your answers, several 

of you have mentioned other countries and their systems seem to 

be relatively sound. And I couldn’t help but think that is because 

they probably have a different system of raising money for campaigns. This country—I don’t think we could ever do what is right 

for the banking system or some other systems as long as we have 

lobbyists. Both parties raise money—and I am guilty of that too, 

by the way—and they have influence. 

When people like yourself, for whom I have great respect—you 

are professionals, you are intellectuals, this is your area of expertise so to speak, you probably could help us write a really good bill 

that maybe would make some meaningful changes and make the 

system a little bit more sound. And yet you, other than hearings 

like this and other committees, you probably—that is the limit. 

And I guess my point is that, I don’t know how we are going to 

ever get the system sound again as long as the paid lobbyists come 

down here and tell us they like this page of the bill, and they don’t 

like that page of the bill, so you need to change that. 

Do you have any thoughts? I really have taken you way off field, 

so to speak, but do you have any thoughts about a system like 

ours, which really doesn’t encourage the honesty and integrity to 

change things for the good of the system but also the good of the 

people? I will end at that and let you take a shot at it. 

Mr. SALERNO. I work in New York. I work at a university in New 

York City a few blocks away from ‘‘Occupy Wall Street.’’ And I 

think that things will only change, especially in the banking sector, 

when we have a grassroots movement that shares some of these 

opinions, that is like ‘‘Occupy Wall Street,’’ in that it spreads 

throughout the constituencies of the United States. 

I think that is one of the things that we should be working to 

do. And I think Congressmen who think—like yourself and Dr. 

Paul—that things should be changed should encourage these movements to the extent that you can. 

Mr. COCHRAN. And the concern is not just limited to banking. I 

think Adam Smith, as far back as 1776, which I think also is a significant date for this country, really phrased it that, for the economy to operate properly, there needs to be an elimination of all systems of privileges and restraints. And the lobbying comes in both 

as necessary because of the unnecessary restraints we put on market participants, but also them recognizing that the system that restrains them also can be the system that grants special privileges 

and monopolies in the true sense, which is a government-protected 

privilege to offer goods and services to the public. 

Mr. WHITE. In the 19th Century, we had a weak banking system 

because the small banks had the very powerful lobby, and they lobbied for restrictions on their competitors so that they could stay in 

19 

business. Today, in the 21st Century, it is very different. The main 

problem of weakness is caused by privileges, and the privileges are 

being lobbied for by the largest banks. And the weakest banks are 

no longer the smallest banks; the weakest banks are now the largest banks. And they are the most dependent on these privileges, so 

they are the ones who are going to be lobbying the most to keep 

these privileges intact. 

And I don’t know how to solve that problem, but it has long been 

a problem that when there—in any area of the economy, if there 

are privileges and restrictions at stake, there are going to be people 

who are trying to shape legislation around those things. So there 

has to be some kind of greater attitude toward letting the banking 

system operate without privileges and without restrictions. 

Mr. SALERNO. Can I just add to that very quickly? 

Murray Rothbard, the economist, once said that the way you get 

true change is to have statesmen and educators who really are interested in the public good reach around the privileged elites and 

get their message out to the public. 

Mr. JONES. I think that maybe the Citizens United decision 

might bring some sanity to the system. It won’t happen in my lifetime, but maybe in our children or grandchildren’s lifetime, that 

maybe this would be a system that goes back to being the people’s 

representatives instead of the lobbyist’s representatives. And I 

think it will happen in time. I hope to live long enough, maybe in 

a retirement home, to see it happen, but I would love to see that 

happen. 

But thank you for your comments. 

Chairman PAUL. I thank the gentleman. 

Now, I yield to the gentleman from Missouri, Mr. Luetkemeyer. 

Mr. LUETKEMEYER. Thank you, Mr. Chairman. 

Interesting conversation. I was struck with some of the comments by the gentleman from North Carolina. And it kind of got 

me thinking about, if we make you king for the day, President for 

the day, Congressman for the day, whatever, how would you solve 

our situation now with the weakness that we have in our system? 

What changes do you think we need to be implementing or working 

for to get our system back to where it is on solid ground and make 

it all work? How would you ease it into a more workable solution? 

Each one of you? 

Mr. SALERNO. I think the first step is to get rid of the too-bigto-fail doctrine wholesale and forthwith. Do it right now. And then 

phase out—I probably would phase out more quickly than Larry— 

the FDIC insurance, within the year or something like that, within 

a year from the date that you get rid of the too-big-to-fail doctrine. 

Mr. LUETKEMEYER. So, in other words— 

Mr. SALERNO. I think those are the first important steps. 

Mr. LUETKEMEYER. So, in other words, what you would suggest 

is to put the onus back on the banking system for their own—the 

responsibility for their own decisions. Their own risk has been 

taken by themselves, not the taxpayer or the FDIC insurance folks 

and nobody else. 

Mr. SALERNO. Right. 

Mr. LUETKEMEYER. Okay. 

20 

Mr. SALERNO. Because at bottom, all they are, are business 

firms. They are not special. They should not be special. They 

should not be privileged. They should operate on the market, bear 

the burdens of the risks they assume—not only them, but any depositors who want to put money into a fractional reserve bank. 

They must realize what the consequences can be. 

Mr. LUETKEMEYER. It is interesting, I made the comment the 

other day in committee that I think for the first time in several 

years here, people are actually now finding out what banks do. 

They don’t just sit there and take deposits and make loans. They 

manage risk. That is what they do every day. And, as a result, I 

think the consumers and the citizens of our country are finally figuring out that, whoa, this is a risky business, and there is some 

responsibility on somebody’s part here to manage that risk. And it 

is determining who takes the risk, who manages it, that is our dilemma here right now of what is going on. 

Dr. Cochran? 

Mr. COCHRAN. Yes, I would echo Dr. Salerno’s comments that the 

too-big-to-fail doctrine has to go first and, really, with it, the mentality that bailouts are going to come in across the economy, whether it is banking or others, and protect people from the risk they undertook. 

Back to the deposit insurance, when it appeared that some of the 

money market funds were going to break the buck, we came in and 

de facto offered insurance for the deposit on the money market 

funds, which just again reinforces the deal. 

And then probably on the monetary side, I would look at eliminating all the restrictions right now that make it difficult for anybody to come in and compete with the system. I think recently, we 

just had someone arrested for coining gold that could or could not 

have been used as a medium of exchange in competition. So that 

we really don’t allow people who would even want to choose to contract in something payable other than in Federal Reserve Notes to 

write a contract that would be enforceable for payment in ounces 

of gold or other mediums of exchange. 

Mr. LUETKEMEYER. Dr. White? 

Mr. WHITE. In addition to the points that have already been 

made, I would say that the Federal Reserve needs to be constrained so that it doesn’t create such an unstable environment and 

so that it doesn’t issue what became known as the ‘‘Greenspan 

Put,’’ which was the, sort of, open suggestion that if the stock market starts to go down, we will pump in enough money to keep everybody afloat. That sort of thing leads to a relaxation of prudential standards, and I think that has been a big problem in the 

banking system. 

Now, under this kind of caveat emptor system that we are suggesting, it is true that people will have to shop around for a bank 

and people will have to reeducate themselves as to how do that. 

But people nowadays shop around for a mutual fund. They don’t 

understand exactly how mutual funds operate. They get a prospectus, and they don’t really know what to make of it. But they 

do know who does know, right? They can read Money magazine, 

they can read investment newsletters, and they can seek out the 

21 

advice of experts. And people can exercise at least that much prudence when they choose a bank. 

Mr. LUETKEMEYER. Very good. 

Thank you, Mr. Chairman. I yield back the balance of my time. 

Chairman PAUL. I thank the gentleman. 

I now recognize Mr. Schweikert from Arizona. 

Mr. SCHWEIKERT. Thank you, Mr. Chairman. 

Back to our happy part of the discussion, which is how the world 

comes to an end, looking back to the discussion of, whether it be 

3 years or 5 years, whatever the timeframe is, we seem to all have 

a universal agreement here that with the massive amount amounts 

of liquidity that are out in the system, we see inflation, we may see 

a runaway type of inflation. 

Okay, each of you just became Federal Reserve Chairman. Congratulations. How would you—actually, I will nominate you. In all 

sincerity, how would you guide the ship of monetary policy? How 

would you pull that excessive liquidity out of the system? What 

proposals would you make to avoid that ugly scenario? 

Let’s start with Dr. White. 

Mr. WHITE. Okay. The same way it went in, it can come out. 

That is, the Fed can sell off its mortgage-backed securities, and the 

Fed can sell its Treasury bills back into the market. 

Now, at the same time, the Fed can reduce the incentive of 

banks not to lend by scaling back the interest they pay on reserves. 

Banks are sitting on more than a trillion dollars in excess reserves, 

in large part because the interest rate the Fed is paying on those 

reserves is about the same as the interest rate the banks can earn 

on T-bills. 

Mr. SCHWEIKERT. Would you also, in that same scenario, raise reserve requirements at chartered lenders? 

Mr. WHITE. Reserve requirements aren’t really relevant these 

days. They are pretty much not binding. Most banks have more 

cash in their ATMs than they are required to hold. 

Mr. SCHWEIKERT. Okay. 

Mr. WHITE. Total required reserves in the system are something like $80 billion, and banks have more than a trillion dollars in reserves. So reserve requirements are not really going to do the job. 

Mr. SCHWEIKERT. Doctor? 

Mr. COCHRAN. Yes. And one of the things I would echo is that 

you can pull out these excess reserves the way they got in by basically, where you purchased, now sell them. One of the dangers 

going in is that, as they have changed their balance sheet from 

short-term securities to longer-term securities, that the value of 

those securities, the mortgage-backed and others, are much more 

susceptible to decline in value to rising interest rates. 

I do think that, given the amount of excess reserves that are in 

the system, that a possible way to avoid this, besides reducing— 

as you reduce the interest that they are paying on these excess reserves, that it is possible that a consideration of a significant increase in the required reserve ratio could be an effective tool as you 

take more time to pull and sell off some of these assets. 

Mr. SCHWEIKERT. Okay. 

Mr. SALERNO. And once this was reversed, once the excess reserves were sucked out of the system, I would then, if I were the 

22 

Federal Reserve Chair, just stop open market operations at that 

point, stop printing up reserves and purchasing government securities. And then, that would stop the next influx of liquidity into the 

system that would get the whole thing started again. 

Mr. SCHWEIKERT. Okay. You are more optimistic than I am, I 

guess mechanically so. 

But one of you doesn’t think raising the reserve requirements 

would be effective, just because of how much margin there is there? 

And you actually believe that would be one of the tools? 

Mr. COCHRAN. I think it should be a consideration. It would not 

be a first tool, but it could be a tool that could allow more of a 

phased sale of the securities without allowing the reserves to start 

flooding excess lending into the system. 

Mr. SCHWEIKERT. Okay. 

And, Dr. White, you looked anxious there. 

Mr. WHITE. Well, it is possible to make reserve requirements 

binding if you are really determined to do so. But, banks have gotten very good with computers at sweeping the reservable deposits 

off the books at the end of the day, and that makes it very hard 

to enforce reserve requirements. 

Mr. SCHWEIKERT. Okay. 

Mr. Chairman, thank you. 

Chairman PAUL. I thank the gentleman. 

And I want to thank our witnesses for appearing today. As I said 

at the opening, I believe these are very important hearings, and I 

very much appreciate you being here. 

The Chair notes that some Members may have additional questions for this panel, which they may wish to submit in writing. 

Without objection, the hearing record will remain open for 30 days 

for Members to submit written questions to these witnesses and to 

place their responses in the record. 

This hearing is now adjourned. 

[Whereupon, at 3:42 p.m., the hearing was adjourned.] 

(23) 

A P P E N D I X 

June 28, 2012 

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