By means of monetary policy, which is also termed the reserve management of the banking system, the central bank permits the existence of fractional-reserve banking and thus the creation of money out of thin air.
The modern banking system can be seen as one huge monopoly bank that is guided and coordinated by the central bank. Banks in this framework can be regarded as "branches" of the central bank.
For all intents and purposes the banking system can be seen as being comprised of one bank. (Note that a monopoly bank can practice fractional-reserve banking without running the risk of being "caught.")
Through ongoing monetary management — i.e., monetary pumping — the central bank makes sure that all the banks engage jointly in the expansion of credit out of thin air. The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out. By means of monetary injections the central bank makes sure that the banking system is "liquid enough" so banks will not bankrupt each other.
Shostak then argues in favor of the Volcker Rule and more regulations on banks:
According to some commentators, the huge $2 billion loss by JPMorgan Chase, caused by the risky bets placed using the bank's money, raises the need to implement the Volcker rule — more controls on banks' activities. Critics of the Volcker rule are of the view that it will only make things much worse by stifling the efficient allocation of scarce real resources. Our analysis holds that as long as we have a central bank, in order to minimize the damage its policies inflict, it makes sense to impose tighter controls on banks. It is the central bank that enables banks to practice fractional-reserve banking, thereby polluting the economy with money out of thin air. A better alternative is of course to have genuine free banking without the central bank.Shostak has a point in trying to smother the Fed controlled banking system. And, although, at first it appears that is what the Volcker Rule does, the Rule is in fact quite evil in that it drives bankers from dealing in the private sector and causes them to conduct more activity in the government Treasury market.
Here's the powerhouse Wall Street law firm Skadden, Arps, Slate, Meagher & Flom on the Volcker Rule:
The “Volcker Rule” prohibits an insured depository institution and its affiliates from:
• engaging in “proprietary trading”;
• acquiring or retaining any equity, partnership, or other ownership interest in a hedge fund or private equity fund; and
• sponsoring a hedge fund or a private equity fund...
The Volcker Rule would prohibit any insured depository institution and its affiliates from engaging in “proprietary trading” of debt and equity securities, commodities, derivatives, or other financial instruments. “Proprietary trading” is defined as engaging as a principal for the trading account of a banking organization or supervised nonbank financial company in any transaction to purchase or sell, or otherwise acquire or dispose of:
• any security;
• any derivative;
• any contract of sale of a commodity for future delivery;
• any option on any such security, derivative, or contract; or
• any other security or financial instrument that the appropriate federal banking agencies, the SEC, and the CFTC (the “Regulators”) may determine by rule.But here's Skadden on what VR allows (my bold):
The Volcker Rule also specifically permits trading transactions:• in government securities;• in connection with underwriting or market-making, to the extent that either does not exceed nearBottom line, what the Volcker Rule does is drive banking from the private sector and toward the government sector. Thus, this rule, rather than limiting credit, simply pushes banks to use funds to invest in and provide more liquidity for the government sector.
term demands of clients, customers, or counterparties;
• on behalf of customers; or
• by an insurance business for the general account of the insurance company.
If credit is to be created by the Fed, I would rather have those funds directed to the private sector, or see banks blow themselves up with synthetic instruments, than have the funds directed toward more investments in the government sector, which will do nothing but allow the state to grow. Thus, the Volcker Rule is a bad idea.
Of course, as Shostak concludes, " a better alternative is of course to have genuine free banking without the central bank."