Customer Reviews

The Mystery of Banking

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I found this book to be the most interesting and revealing book I have ever read about the banking system and the Federal Reserve. Rothbard has a very different perspective than most conventional economists, but his explanations are very clear and compelling. He explains how fractional reserve banking makes banks inherently prone to bankruptcy, how the Federal Reserve and other central banks create inflation, and how money has evolved and been debased. Gene Epstein, the Barron's columnist, recently recommended The Mystery of Banking as the best book to read for anyone interested in understanding how our banking system works.

I just finished reading this book and found that it filled in many inconsistencies that I have noted in my mainstream economic study. The author explains clearly and concisely the origins of and money and its importance to any economic system. He proceeds to describe the evolution of banking to its current inflationary state. He clearly shows that this inflationary states results from a combination of fractional reserve banking, the government's grant of monopoly powers through a cental bank (the U.S. Federal Reserve in the case of the U.S.), and the central banks open market operations to manipulate bank reserves (e.g., monetizing debt). Finally, Rothbard makes it clear that the banking industry's inflationary policies are beneficial to the banking industry itself and leave the reader no doubt that this industry has a vested interest in the status-quo.

Murray Rothbard writes clearly and yet with a technician's precise knowledge of the operation of money and banking. This book should be read by any who truly desire to understand these important aspects of the ecoonomy. And, oh, by the way, you don't really have to fork over $98 bucks for this important book. Resourceful readers can locate it for free online. Who says there's no such thing as a free lunch?

The first 100 pages of this book read like a review of standard Austrian theory on things like price theory when it comes to money. I've read better explanations from Ludwig von Mises. However, beginning with the chapter on Loan Banking, Rothbard's work comes into its own, demystifying modern banking. If you ever wondered why there is a business cycle or how bank runs work, this is the book for you. Unlike most modern writers, his book builds upon itself - it is all one long argument with each chapter depending on the one before to establish its arguments. Skimming is not recommended.

The serious flaw deals with free banking, his ideal model. In the main text, he provides Scotland in the early 1800s as his only real-world example. Then, in an appendix, he admits that he was duped by poor research and that the Scottish system was not free after all. Fine and good, but he does not then provide a better example to prove his hypothesis. One is left to assume that free banking has either never been tried (quite likely) or never worked in the way his theories suggest.

This book is especially timely with the recent financial issues facing the US.

You can read this book as a pdf at http://mises.org/Books/mysteryofbanking.pdf. Just Google: Mystery of Banking. Very informative and enlightening book.

I have to say, this is a gem of a book, even if it does come from the Ludwig von Mises Institute. I would normally give publications from this stable a very wide berth, and there are indeed numerous gratuitous sideswipes at various liberal policies in the book. However, if you can bite your tongue and roll with the punches what you get is more than worth it. If you really want to understand the mystery of how money is created, what inflation is, and how the modern banking system evolved, you will not be disappointed. Rothbard's basic objective is to do a hatchet job on fractional reserve banking and fiat money, and by God, he almost pulls it off. My only quibble is that although his critique is indeed devastating he never really explains the other side of the argument. Yes, Governments routinely (as a matter of policy) debase the currency by insisting that the money supply grows more quickly than the quantity of goods and services. Yes, banking is a scandalous oligopoly which makes extraordinary profits by creating and lending newly created money at interest (they win twice, once through being protected from competition and insolvency and twice by being the first to benefit from newly created money before its inflationary effects have cascaded through the economy). Nevertheless, many would argue that in spite of its inflationary effects fractional reserve banking still makes sense, as the creation of money results in greater economic activity (ie. increases in the money supply lead to the production of more goods and services because it creates new incentives where they would otherwise be lacking). So, the argument goes, the residual inflationary impact is a price worth paying for the resulting increase in economic value. Whether this argument is valid or not is a moot point - Rothbard simply fails to engage with it.

However, what is really interesting about the book is that it brought home to me the fundamental convergence of green-left and free-market-right opinion on the iniquities of fractional reserve banking (although for fundamentally different reasons). The free-market-right objects to the fact that fractional reserve banking diminishes the utility of money as a store of value, hence the traditional call for a return to the gold standard. The green-left on the other hand points out that the continual (exponential) creation of new money at compound interest can only be sustained by a corresponding exponential growth of resource throughput in the physical world, which in turn can only result in catastrophic consequences. In addition, both strongly object to the privileged position of private banks that generate outrageous profit from seigniorage, and the implicit guarantee they receive from Government. So never let it be said that bankers are great believers in free markets - they are actually great believers in the power of Government to sustain their protected position, and Rothbard does a fine job in clearly exposing this outrageous scandal.

In a brilliant and interesting manner, Murray starts off with some basic economic science concepts, which he then proceeds into explaining the theory of operation behind this monster that is now revealing itself to all of us in great confusion. This book was written in the early 80's and I bet anyone who had read this book back then is not surprised by the current financial crisis.
Some of the main questions he explores are: What is money? What is the money supply and how much of it do we really need? How do modern commercial banks work? What is the purpose of the central bank and how does it operate? And how did all of this evolve into the current system that we have today, which itself was only possible with the power of government. Murray also explains the nature of the business cycle(boom and bust), and how the business cycle is a direct result of the inherent nature of the banking system, and not the result of free markets or capitalism like everyone assumes. Murray filters out all of the financial and economic jargon used in the media that only confuse the wide public, as well as many economists themselves.
I think most readers will be shocked to learn how a modern bank works and will immediately feel the urge and need to spread the information to others. I think many bankers themselves will be shocked to learn how the broad theory of operation itself is actually hidden from the common bank employee. In the context of the current financial turmoil, the reader will immediately grasp the vast ignorance among the public, politicians, and many so called experts. This is simply a must read for the ordinary person, the banker, as well for the professional economist.

The state can tax you now, or borrow and tax your children, or it can inflate the money supply, use the new money first and rob you of the purchasing power of your savings. The third alternative is a favorite of the state. This book makes it plain that there has always been an unholy alliance between banks and the state. The events of 2008 were nothing new, and the piddly legislation that congress is bantering about doesn't even come close to "making sure this won't happen again." On the contrary, it is almost a certainty that it will happen again and again until we return to sound money and banking.

Murray Rothbard takes a complex topic, perhaps one more complex than most of us imagine, but provides a clear, crisp and detailed explanation. The writing style is excellent and it should be accessible to any reader who can navigate the Op-ed page of a 'quality' newspaper.

Having said that, yet as someone who finds even the most simple balance sheet a puzzle, I must confess that some of the process is still something of a mystery to me, despite Rothbard's clarity. I feel like I need to read the book again to fully assimilate it. Perhaps because I have more of a historical bent, Rothbard's outline of the history of the banking system excellent. Especially good was his concise and clear treatment of the role of the Federal Reserve's Benjamin Strong and the Bank of England's Montagu Norman in precipitating the boom of the 1920s and the bust of the 1930s.

Rothbard is an opponent of Fractional Reserve Banking (FRB) and an advocate of 100% reserve deposit banking. His argument is primarily economic but also ethical. He sees the absence of these institutions as the root cause of the business cycle, but he also argues that FRB is essentially fraudulent. As such he opposes many fellow free market economists who support FRB via "free banking". Although Rothbard deals
extensively with the main real world example of free banking, the Scottish experience in the late 18th and early 19th centuries in a addendum added to the 2008 edition, I'm not convinced Rothbard has completely disposed of his rivals' argument.

Especially with his ethical claim that FRB is fraud. There is certainly a misleading element to FRB, the popular belief that banks profit by "lending out" deposits is at best "a half truth". Banks create deposits as well as lend them and only a small percentage of the public comprehend this. Still the fraud claim may be too strong. Even bank depositors who know that their bank could not possibly redeem all deposits at the same time, continue to use their bank. So perhaps Rothbard's ethical argument is overstated.

Despite this quibble, although the book does not deal with the recent financial crises, the book provides an excellent primer.

I bought this book because I wanted to learn how fractional reserve banking works. Rothbard's book is the best source I have found in this regard; perhaps this is because he delineates the history of it (its origins found in the separated loan banking and deposit banking industries), tracing its arc all the way up to its transactional nature within a central banking organization (which, by the way, is how the whole of the world's commerce is transacted; virtually all nations currently use fiat money and have a central bank). The Mystery of Banking has done more to actually explain how banking works than literally any finance or banking textbook that I have read. And yes, he fully illustrates that fractional reserve banking creates money out of thin air when it is lent out, thereby manipulating the supply of money.

It is important to remember that Rothbard does this for a reason. He has a point to prove: fractional reserve banking and central banking operations are illegitimate, and the fiat money they issue is counterfeit (which by definition it is). All of these things he establishes on a point-by-point basis, building his thesis for the reader so that you can see where he is coming from and why he is factually correct.

This being said, it leaves the independent thinker to ponder the implications of such ideas as a means for creating alternate policies. Obviously, Rothbard and other Austrian economists would argue that the obvious alternative is a hard money standard backed by gold and silver. It does seem like an obvious alternative to what we have today, where the Fed's "reserves" are merely our government's promises to pay out interest in the same federal reserve notes that are backed by it.

In the end, however, I think that for all that Rothbard says in regard to the ills of the present system, he loses the forest for the trees. One must remember the *purpose* of money. For all that Austrians such as Rothbard and even Ron Paul exalt gold as a way for the hardworking individual to find a store of value for his labor in a durable metal that retains its purchasing power, *this is not the purpose of money*. Money is, and has always been, a tool for people to facilitate exchange. The idea of money as a store of value, a battery if you will, only came along much later with a use of gold as the tool of exchange (money), and at the expense of its ability to be easily transferred from one person to another (due to the weight of the metal).

Money is primarily meant to provide for interperson transaction, to facilitate economic activity. One person's production of one good is not the same as another's, so money allows them both to exchange their labor at an agreed-upon amount, creating value for both parties. In this regard, able-bodied persons and fleet-footed companies are inherently valued in their ability to *create* value in the present. This most clearly follows what an economy is all about: the creation of wealth (value) in the present. A person sitting on a horde of their stored-up labor via a hard money-based currency, a la Scrooge McDuck, creates no present value. And a person wanting to find a true store for excess capital that is created through production should reinvest this in his operation(s). This is capitalism. Simply sitting on hordes of stored-up, undeployed production is feudalistic.

I'm not saying that I think it is great that our central bank (the Fed) can devalue our dollar or potentially create massive inflation, but rather that the cure for the individual in this regard is to have one's capital deployed in productive businesses that can raise prices as needed. In the end, the manipulation of the money supply shouldn't matter for the business owner or the productive worker. It merely changes with regard to its signification of value. A house you own could be worth $200,000 instead of $175,000, for example, or corn flakes at the grocery store might be $4.00 instead of $2.75. This is okay though (provided it is not hyper-inflationary activity), because things like wages and corporate earnings also move with changes in the money supply. The only person who is truly *punished* is the person who sits on the horde of money and does nothing with it.

Regarding a hard-money alternative, let's be honest. The idea of free banking and its benefits as Rothbard puts forth has never existed. It says as much in the prologue of The Mystery of Banking. The closest thing I would use instead is the United States after Andrew Jackson broke the Bank of the United States, where booms and busts still persisted, but occurred in a different fashion (speculative activity on the part of individuals engaging in commerce versus flooded money trying to find a home).

All of this aside, everyone should read this book if they want to understand how banks work. Just don't drink the Kool-Aid unnecessarily.

P.S. - Anyone really wanting to get down to the nuts and bolts of this argument can simply compare the arguments for Warren Buffett, who I suppose you could classify as a Keynesian, and his father Howard Buffett, who was and still is remembered as a passionate hard-money advocate:

Howard Buffett on gold:

"...unless you are willing to surrender your children and your country to galloping inflation, war and slavery then this cause demands your support. for if human liberty is to survive in America, we must win the battle to restore honest money. There is no more important challenge facing us than this issue -- the restoration of your freedom to secure gold in exchange for the fruits of your labors."

Warren Buffett on gold:

"It gets dug out in Africa or some place. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

Indeed.