A Fetid Fable of Fractional Reserve Banking

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Once upon a time in a town very much like yours there was a casino. Actually, several casinos. But not too many. Just enough to make a nice living entertaining the local gentry.

Tradesmen in town watched the well-heeled come and go from the casinos wishing they could be like them.

Casino owners, never satisfied, lamented at their regular Sunday luncheon. "Making a living off the gentry is fine but there are too few of them. How do we get the many tradesmen in town to come to our casinos?"

One of them hit on a plan. "Why don't we pay our servants in chips? We can put their wages into the kitty to ensure they can cash them but perhaps a few might linger at the tables?"

Lo and behold, this worked. Most servants had never set foot in a casino but few could resist the allure of wagering a few chips before exchanging the rest for wages. Smart casino owners learned that if they clustered their low stakes tables near the exchange booth even more would play. Like the gentry, everyone who played carried vivid memories of their winnings and conveniently forgot about their losses.

The casinos expanded and all was well.

One payday a servant ran out of money while shopping, though he had a pocket full of chips. The grocer, who had never been to a casino, was happy to take them. He and his wife had a grand time. Before long chips were circulating all over town.

The casinos expanded and all was well.

Then one casino owner noticed that with so many chips in circulation there was no need to keep an equal amount of real money in the kitty to redeem them. Why not lend some of that real money out at interest? Who would ever know? Another casino owner realized that if he paid his servants in chips but only put half their wages in the kitty, none would be the wiser. A third found that it cost him nothing to express his gratitude to the mayor with a bag of chips after the mayor helped him with a zoning problem. The mayor, who never seemed short of chips, found that spreading these around to supporters worked wonders on Election Day.

Before long all of the real money in all of the casinos' kitties only covered ten percent of the chips circulating.

All was well until a terrible storm knocked down many homes in the town. Long lines of tradesmen formed at every casino looking to cash in their chips so they could afford to make repairs. But there wasn't enough money on hand to pay them all. What to do?

Casino owners gathered in the town hall. As crowds outside grew angry and the mayor cowered under his desk the richest casino owner stood up. "My friends," he said. "We must hang together or we will surely hang separately. Each of you must reach into your own pockets and come up with money to redeem these chips. I would be happy to cover any of you that are short in return for a mortgage on your casino."

And so the crisis passed. In time the big casinos gobbled up the little casinos, and all was well.

It turns out that many towns across the land had casinos just like this town, with owners just as clever and chips just as bountiful. When they learned of the run on the casinos' exchange windows they realized that the same thing could happen to them. So the largest and most powerful casino owners arranged a secret meeting on a secluded island.

"It's all well and good that a few wealthy casino owners had both the will and the resources to weather the chip run. But what if it happens on a larger scale? Only a national solution will keep all of our casinos solvent in times of panic. Gather up your chips, boys, it's time to visit our friends in the capital."

And so a National Casino Reserve was formed to assure the people that a lender of last resort always stood behind every casino guaranteeing that their chips could be redeemed. The government also proclaimed that all taxes must be paid in chips instead of real money, passing a modest new tax on the incomes of only the most wealthy. Chip use exploded.

To protect people from fraud a law was passed making it illegal for casinos to manufacture their own chips. Only the National Casino Reserve Board could do that. The total number of chips in circulation would be controlled by the National Casino Reserve Board Chairman, who would also tell every casino how much real money they had to keep on hand to redeem chips.

A wise and prudent National Casino Reserve Board Chairman was chosen who swore a mighty oath guaranteeing that there would always be plenty of chips to keep every tradesman employed, every casino owner wealthy, and every politician happy. And they all lived happily ever after.

If you believe that, you deserve what's coming to you.

Bill Frezza is a fellow at the Competitive Enterprise Institute, and a Boston-based venture capitalist. You can find all of his columns, TV, and radio interviews here.  If you would like to have his weekly columns delivered to you by e-mail, click here or follow him on Twitter @BillFrezza.

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