[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



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