    [House Hearing, 112 Congress]
    [From the U.S. Government Publishing Office]

                       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

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                     HOUSE COMMITTEE ON FINANCIAL SERVICES

                       SPENCER BACHUS, Alabama, Chairman

    JEB HENSARLING, Texas, Vice          BARNEY FRANK, Massachusetts,
        Chairman                             Ranking Member
    PETER T. KING, New York              MAXINE WATERS, California
    EDWARD R. ROYCE, California          CAROLYN B. MALONEY, New York
    FRANK D. LUCAS, Oklahoma             LUIS V. GUTIERREZ, Illinois
    RON PAUL, Texas                      NYDIA M. VELAZQUEZ, New York
    DONALD A. MANZULLO, Illinois         MELVIN L. WATT, North Carolina
    WALTER B. JONES, North Carolina      GARY L. ACKERMAN, New York
    JUDY BIGGERT, Illinois               BRAD SHERMAN, California
    GARY G. MILLER, California           GREGORY W. MEEKS, New York
    SHELLEY MOORE CAPITO, West Virginia  MICHAEL E. CAPUANO, Massachusetts
    SCOTT GARRETT, New Jersey            RUBEN HINOJOSA, Texas
    RANDY NEUGEBAUER, Texas              WM. LACY CLAY, Missouri
    PATRICK T. McHENRY, North Carolina   CAROLYN McCARTHY, New York
    JOHN CAMPBELL, California            JOE BACA, California
    MICHELE BACHMANN, Minnesota          STEPHEN F. LYNCH, Massachusetts
    THADDEUS G. McCOTTER, Michigan       BRAD MILLER, North Carolina
    KEVIN McCARTHY, California           DAVID SCOTT, Georgia
    STEVAN PEARCE, New Mexico            AL GREEN, Texas
    BILL POSEY, Florida                  EMANUEL CLEAVER, Missouri
    MICHAEL G. FITZPATRICK,              GWEN MOORE, Wisconsin
        Pennsylvania                     KEITH ELLISON, Minnesota
    LYNN A. WESTMORELAND, Georgia        ED PERLMUTTER, Colorado
    BLAINE LUETKEMEYER, Missouri         JOE DONNELLY, Indiana
    BILL HUIZENGA, Michigan              ANDRE CARSON, Indiana
    SEAN P. DUFFY, Wisconsin             JAMES A. HIMES, Connecticut
    NAN A. S. HAYWORTH, New York         GARY C. PETERS, Michigan
    JAMES B. RENACCI, Ohio               JOHN C. CARNEY, Jr., Delaware
    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

               James H. Clinger, Staff Director and Chief Counsel
            Subcommittee on Domestic Monetary Policy and Technology

                           RON PAUL, Texas, Chairman

    WALTER B. JONES, North Carolina,     WM. LACY CLAY, Missouri, Ranking
        Vice Chairman                        Member
    FRANK D. LUCAS, Oklahoma             CAROLYN B. MALONEY, New York
    PATRICK T. McHENRY, North Carolina   GREGORY W. MEEKS, New York
    BLAINE LUETKEMEYER, Missouri         AL GREEN, Texas
    BILL HUIZENGA, Michigan              EMANUEL CLEAVER, Missouri
    NAN A. S. HAYWORTH, New York         GARY C. PETERS, Michigan
    DAVID SCHWEIKERT, Arizona

                                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

                       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 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.
        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 authorities. 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 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 appearing 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
    pre-Federal 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
    high-powered 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 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 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 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 too-big-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?
        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 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
    trying 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 Glass-Steagall.
        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--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
    Glass-Steagall 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 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 entity 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 automobile 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, 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.
        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, 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 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-big-to-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.
        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 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 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.]

                                A P P E N D I X

                                 June 28, 2012
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