“Mt. Gox Problems Mount” is the fourth article in a series about Mt. Gox, bitcoin, and fractional reserve banking written by David Howden.
Here, Howden shows how new revelations about Mt. Gox’s operations strengthen his conclusion that it was operating as a fractional reserve bank. Howden reminds us that fractional reserve banking is inherently fraudulent and doomed to failure in the absence of government intervention. This is important as there are self proclaimed advocates of the Austrian school of economics who believe that free banking can mitigate problems associated with fractional reserve banking.
‘Here we have another case where free banking theory is, unfortunately, demonstrated to be true in practice. The free banking literature says that any liquidity problem faced by a member bank can be solved by asking for lines of credit and concessions from other banks. As long as the illiquid bank is fundamentally solvent there should be some deal struck to extend it credit to get it through its time of trouble until it regains its footing. Mt. Gox is seeking the help of other “Bitcoin main players” to assist it in injecting new bitcoins onto its books.‘
‘For five years Mt. Gox seemingly functioned with an ever lower reserve ratio and no one noticed. An epiphany happened when the reserve got so low that the company was unable to make good on the withdrawal requests of its clients. It tried to hide this outcome through a series of ever more desperate policies, all used previously by other liquidity-constrained fractional-reserve banks (and which I documented here and here).
Previously I noted that there is an important lesson to take from all this. It is one thing to have a currency that is not centrally controlled, and bitcoin ably shows how the market can create a money without the “helping hand” of government. The banking system matters too though. Having a fractional-reserve banking system leaves depositors open to problems even if the underlying money deposited is sound. Those empty-handed depositors of Mt. Gox are learning this painful lesson now.
There is one more lesson we can all take from this: fractional-reserve banks function until they don’t. For many years Mt. Gox survived because no one doubted its solvency. Then in a short period of time disaster struck and the bank was exposed for what it was. This pattern of fractional-reserve bank surviving for a time while they sow the seeds of their own demise has happened many times throughout history. These episodes have always ended with tears shed over insolvent banks, or government help being called for by both bankers and depositors interested in saving their financial interests. Let’s hope the demise of Mt. Gox is taken as a warning by the bitcoin community and that this same fate doesn’t befall other bitcoin banks.‘
Once again we see the practical importance of understanding Austrian school economics. Those who lost money dealing with Mt. Gox never bothered to realize that Mt. Gox was actually operating as a fractional reserve bank and thus were ignorant about the risks of suspension of redemption. Hopefully those who are using other bitcoin deposit and exchange companies have learned important lessons from the Mt. Gox situation and will take steps to verify that these companies are not fractional reserve banks.