1. Skip to navigation
  2. Skip to content
  3. Skip to sidebar
Source link: http://archive.mises.org/12957/the-fractional-reserve-banking-question/

The Fractional-Reserve Banking Question

June 14, 2010 by

I offer this article to explain why fractional-reserve banking is just plain weird. Weirdness is not in itself proof of dubiousness, let alone fraud, but bankers who engage in fractional-reserve banking really do “create money out of thin air.” FULL ARTICLE by Robert Murphy

{ 219 comments }

scineram June 14, 2010 at 7:08 am

Step 2 does not make sense to me. When did Sally opened her checking account? As far as I can see assets should be $100 in vault and $900 plus interest due in 12 months, liabilities should be Billy’s $1000 checking account only.

J. Murray June 14, 2010 at 7:50 am

Many banks require you to be a customer of the bank to get the loan, which is immediately “deposited” in the bank itself.

scineram June 14, 2010 at 8:47 am

Maybe, maybe not. But this is not “how fractional reserve banking works”.

george t morgan June 15, 2010 at 8:45 pm

is it an asset if the bank doesnt have sallys repayment??

if two months have passed and sally has made two payments does the bank actually have a full asset???

george t morgan June 15, 2010 at 9:04 pm

as of now, do banks keep roughly 10 percent of their total deposits in paper/coins at their various branches with the rest of their paper/coins to match the deposit amounts at the federal reserve???

J. Murray June 14, 2010 at 8:06 am

Don’t those interbank transfers go through the regional Federal Reserve branches? Meaning that the regional bank provides the $9,000 in cash to the recipient bank without actually requiring Bank A to pony up the $9k that Sally borrowed until a later date? I was under the impression that the original $1,000 pretty much stays at Bank A and the regional bank takes “ownership” of the $9,000 loan asset to be paid back by the bank, usually backed by a $9,000 loan at the prime rate from the regional bank itself.

Here is how I always thought it worked:

$1,000 is deposited into Bank A.

Bank A makes $9,000 loan to Sally.

Sally spends the $9,000 and Bank B asks for money.

Regional Fed Bank prints up $9,000 and sends to Bank B, creating loan for Bank A at prime rate.

Bank A continually rolls over $9,000 at current prime rates (fluctuating), paying back principle and interest as Sally pays back her loan.

Bank A completes transaction, pays the Regional Fed Bank back, and keeps the spread between the rate charged to Sally and that paid to the Regional Fed. The difference being the money actually created from nothing.

This is how I always thought it worked and why I thought the system was so destructive since the Fed was basically backstopping loans by printing up money to inject into the system via interbank transfers and loans to cover those transfers. Am I incorrect on this?

Dick Fox June 14, 2010 at 8:11 am

Bob,

What if in your example Billy invested the $1,000 directly with Sally and she then used the $1,000 as a down-payment on $10,000 of manufacturing equipment to be paid back in installments? Would you consider this creating money out of thin air?

J. Murray June 14, 2010 at 8:18 am

It’s not. The $9,000 that Sally is out can not be used for other purposes. She is simply down $9,000. That’s an account recievable line. Once the $9k is out, that’s it, activity has ceased. She can sell it to someone, but no one will accept it as trade.

This is not the case with a bank. The bank is using its own internal credit as actual money, not temporarily giving up owned assets. Whereas Sally actually had $10,000 in real assets, the bank simply invented the $9,000 difference.

Sally gave up $10,000 in equipment for $1,000 in cash and a promise to pay of $9,000 plus interest later. The basic laws of physics have not been violated. Nothing created, nothing destroyed. The bank gave up nothing and handed over $9,000 in invented assets. The basic laws of physics have been violated, money is created.

There is a huge difference between the two.

Dick Fox June 14, 2010 at 10:25 am

J. Murray,

OK, what if Sally then used her new business to secure a signature line of credit. Would the credit she used be creating money?

My point is that there are many permutations to this “creating money” scenario. The important thing is that there be full disclosure then let the free market decide.

If Billy knows he is making an investment for a higher return in a FRB then he should be allowed. Because currency is a medium of exchange the economy will quickly value such transactions and stabilize the currency. FRB has no more impact on the quality of money than any other investment.

J. Murray June 14, 2010 at 10:41 am

No, it wouldn’t be creating money, so long as the lender is not actually adding an asset on a balance sheet that doesn’t otherwise exist. If Sally took out a $9,000 loan, someone else is giving up $9,000 that they can use today for a return later. Money is not created at any point since the lending party didn’t create $9,000 it otherwise didn’t have. Except if Sally got that line of credit from a bank, in which case, money really is created and it only moves along perfectly with this article.

It is highly unlikely that Sally will be able to create her own money that is accepted by the community at large. There is pretty much no scenario that Sally can create money. Only in that scenario would Sally actually be creating money if the transaction didn’t involve a modern banking establishment.

However, I do agree that the free market should decide, including free and open competition with money. That kind of open monetary competition would pretty much keep the whole creation of money problem in check since businesses and individuals would have the option of rejecting the money if they knew the issuer was lavishly printing to enjoy a high lifestyle, something we can’t do today due to legal tender law.

Fred June 14, 2010 at 8:16 am

Dick,
When Billy invested (loaned money) with Sally, she surely would have insisted on a term for the loan. When Billy deposited his money at the bank it was available to him on demand. What if Billy wrote a check for $500 after Sally had cleared her account?

scineram June 14, 2010 at 8:49 am

Well, yes. That is how financial institutions improve the economy through innovation. Making new options available.

iain June 14, 2010 at 10:34 am

In Fred’s example the answer is that the bank would be unable to pay Billy four of the five hundred dollars and would be bankrupt, leaving Billy and whoever got his check out of pocket.I struggle to see this as beneficial innovation or an improvement to the economy.

Dennis June 14, 2010 at 11:03 am

Well, that’s a worst-case scenario. What the bank has to do is liquidate the loan, probably by selling it to someone else. If the loan is sound, they should be able to recoup their “investment.” If not, they’ll take a loss. They may still be able to cover Billy’s check, but now have fewer reserves than Billy’s remaining balance. If Billy decides to withdraw the whole amount, then the bank may fold and Billy will be out some residual amount, unless insured.

iain June 14, 2010 at 3:22 pm

Granted, but it is the case that the bank can lend out something it doesn’t have. I’m yet to be convinced that this is beneficial to society as a whole, or productive. I’ve never seen a clear argument to that effect.

Instead, I’m more convinced it redistributes resources to the bank and the people it lends to (in the short term at least) without creating anything. It is clear that it can sometimes lead to banks being unable to honour their debts. Fraud? I’m not so sure – surely that should depend on the contract between bank and their client? It does increase prices. Government / central banks making this price rise indefinite is a Bad Thing (and not going to work forever). The fact that banks under our present system need and get government assistance shows that system, is, well, F*****G STUPID. (just kidding, it’s totally cool – they so know what they’re doing and they’re doing it for EVERYBODY – LMAO). Oooo, did i loose it towards the end? It happens.

J. Murray June 14, 2010 at 10:58 am

What you have, Fred, is exactly what happened in the real estate meltdown. The FRB system is highly reliant on people never actually spending any of the original deposit or fully paying off loans. It’s bad for the FRB system if people actually paid down their debt because now it means more people are spending from the pool of physical assets and for every $1 spent from physical assets means that the bank has to pull back $10 of loans to remain functional. The system prefers people trade their bank credit between institutions (debit and credit cards for example) and not use real cash. The FRB system wants the total debt load to increase indefinitely (it’s the only way it can work), which is an impossible task of Ponzi proportions.

Current June 14, 2010 at 8:54 am

> As our hypothetical example[1] makes clear, with the power of fractional-reserve banking,
> bankers can apparently earn income out of nothing! So long as Billy leaves his money in
> the bank, and so long as Sally is able to earn enough revenues from her business to
> avoid defaulting on her loan, the bank’s shareholders end up with $45 of the community’s
> cash, free and clear.

In this scenario the bank has earnt income from providing banking services. If the bank provided no services then Billy would not put his $1000 in the bank in the first instance. And, Sally would not be able to borrow $900 from the bank.

> But perhaps the bank in our updated scenario is running afoul of the 10-percent
> reserve requirement enforced by the Fed? Again, no — as of the moment of the new
> loan to Sally, the bank’s total customer checking account balances are $10,000, and
> the bank has $1,000 in physical currency in its vault, “backing up” those accounts.
> So the bank is satisfying the 10-percent reserve requirement.

Yes, but there isn’t *just* that, there is also the loan. As you wrote earlier modern banks provide “debt money”. They don’t create money out of thin air, they create money out of debt.

Consider an Australian commercial bank which has *no* reserve requirement. It can provide bank balances $ for $ with the loans that it can acquire. Acquiring good loans is the limitation.

As Beefcake and I discussed in the other thread the crux of the matter is how much the banks can influence the price of debt. The British Banking school argued that both commercial banks and central banks are passive and neither can determine the quantity of money or bills. They argued that the amount grows and contracts organically. We all disagree with them.

The issue is about how far we disagree though. The view of the fractional-reserve free-banking school is that a central bank can heavily influence the price of debt through note issues. But, a set of free commercial banks could not do this trick (or an unlikely sort of cartel would be needed to pull it off).

Eric June 14, 2010 at 11:23 am

Yes, the bank provides a service to Billy. They keep his money safer than if he hid it under the bed. They also provide check-clearing services. But in the example, Billy doesn’t pay for the services. The $45 is paid by someone else.

Billy, however, is at risk. He thinks his $1000 is safe in the bank ready for him to spend at any time. But it’s not there, since (in the first example) $900 has been lent out. This risk is today covered by FDIC, but not fully, since the FDIC doesn’t have enough “insurance reserves” to pay off all claims should they all come due at the same time. This shortage is covered by the government who simply borrows money from the FED to pay off any claims. It’s a slick system.

Should Billy decide to write a check, he is then withdrawing money that is no longer at the bank. How do they pay him if his $900 of his $1000 has been loaned out for 1 year? They assume that other depositors haven’t withdrawn their deposits and so Billy is covered by the 10% reserves of others like Billy.

So, the Bank keeps a pool of money available, to use for all the Billy’s that might withdraw their funds before the loans are repaid. This pool is insufficient to pay off all the depositors and so they use the FEDs ability to loan them money if they run short. The FED then creates money to lend the banks (or the banks lend each other money) to handle a shortfall. As the author noted, few Austrians would argue that the FED does not create money out of thin air. They typically create money from government debt. Theoretically, the money is destroyed when the government debt is repaid. But governments never repay, they always borrow more to pay the older debt. This is also sometimes called a Ponzy scheme.

Now, over the years, the FED creates more money than it destroys. So over time the amount of money created by the FED increases. This does NOT have to happen in theory, but historical evidence is there to show that the FED has systematically increased the money supply. They don’t even deny it.

This ever-increasing supply of money causes prices to rise. Holders of cash lose purchasing power. So, it is this loss that was the source of the $45 of earnings on interest that the bank received, not income earned from Billy for providing the services of the checking account. Those services are not very expensive for the bank, otherwise they would have to charge for them, as indeed they once did, and still do if you don’t have a large enough balance. Clearly, their services don’t cost anywhere near the $45 or the bank would be losing money, not making profits.

So, in a round about way, we see how the bank “earns” money by lending out money it does not have. It, in effect, steals money from the cash holding public. There are enough twists and turns and indirection to hide the true source of their “earnings” that the public doesn’t know their being robbed. This, plus government laws, is what allows them to get away with it.

Current June 14, 2010 at 11:41 am

No, the bank makes profits principally by lending out Billy’s money. It provides banking services to Billy to encourage him to loan to the bank, it can then lend out the money elsewhere. The banking services provide the incentive for Billy to loan to an organization that doesn’t pay interest, rather than lending directly to Sally himself. Monetary expansion isn’t the only possible source of profits, but I agree it can be a source of profits.

The Fed certainly back the banking system using money they “create out of thin air”. However, that doesn’t mean that a fractional reserve banking system must have a central bank. The patterns of redemptions are easy enough to predict that a free bank can use fractional reserves too.

DD5 June 14, 2010 at 2:26 pm

“If the bank provided no services then Billy would not put his $1000 in the bank in the first instance. And, Sally would not be able to borrow $900 from the bank.”

You simply cannot make this [implied productivity] claim without resorting back to the fallacy of “hoarding is detrimental” You and other ME/FB advocates are so inconsistent, it blows my mind off.

Hoarding $1000 under the mattress is less productive then directly investing it. That’s what you said. NO buts

Current June 14, 2010 at 2:36 pm

The FRFB point isn’t that “hoarding is detrimental” it’s that FRB is a better option than hoarding.

Let’s say I have 100 ounces of gold coins. I keep those at home and they provide me with the “uncertainty hedge” yield that money provides.

Now, I take those gold coins and I loan them to an FR Free bank. That bank then gives me a balance of 100 ounces of gold. Since the banks balances are money-substitutes this is just as good as me having the coins. But, the bank can make loans which are useful to others.

So, holding or “hoarding” money is not socially detrimental. But, investing it in an FR free bank is better for all concerned.

DD5 June 14, 2010 at 4:24 pm

Current,

So now you’re resorting to another fallacy (just as bad) to avoid the first one. Somehow, real capital was created (or freed) on account of the bank deposit, which would not have been created (or freed) by just hoarding.
Now, just to warn you, don’t start lecturing me about ME now. “smoother” transitions to accommodate increase or decrease in demand to hold money is completely unrelated to the fallacious reason you provided to justify the “productivity” claim. And anyway, ME theorizes about a general pervasive change in demand to hold money. It doesn’t apply to the isolated example of somebody finding $1000 in his basement and cashing it in. No (I say fallacious)”prisoner paradox” applies.

Current June 14, 2010 at 4:35 pm

> Somehow, real capital was created (or freed) on account of the bank deposit,
> which would not have been created (or freed) by just hoarding.

Yes. This is Adam Smith’s famous argument about “wagons through the air”.

If there is FRB then money is backed by reserves and by debt. Debt performs a useful function in the economy. If you look at it the other way around it allows less gold to be used as money and more for other purposes.

Ireland June 14, 2010 at 10:05 am

The case could be fine-tuned to have Billy putting the money in a demand deposit account vs. time deposit. If Billy uses time deposit, he cannot claim it back before Sally repays, and all checks out.

However with demand deposit, and Sally yet to repay the spent loan, our Bank is on the hook should Billy come and demand his deposit back. They only have $100 of it, while pretending there’s $1000 in full. Trying that with any other commodity gets you busted big time for fraud, and rightfully so.

Money is a commodity too, only banksters managed to bribe politicians to let them get away with it. It’s up to us to understand this sleight of hand and put an end to the legality of such practice.

joebhed June 15, 2010 at 9:13 am

central government planner here.
seems to me that if banks lent out only time deposit money, then you would have full-reserve banking.
which is what we should have.
i thought we all agreed.

Abhilash Nambiar June 14, 2010 at 10:19 am

It seems to me that in the two cases, the 10% reserve requirements are calculated differently. In the first case it is calculated at step 1

I. Bank’s Balance Sheet after Billy’s Deposit

Assets|Liabilities + Shareholder’s Equity
$1,000 in vault cash|$1,000 (Billy’s checking account balance)

So 10% of $1000 is $900, which gets lent out.

In the second case the 10% reserve is calculated in step 2

II. Bank’s Balance Sheet after Loan Granted to Sally

Assets|Liabilities + Shareholder’s Equity

$1,000 in vault cash |$9,000 loan to Sally at 5% for 12 months
$9,000 (Sally’s new checking account)

That is not an apples to apples comparision. Who decides at which instance of the transaction the 10% requirement needs to be met? Is it a 10% reserve requirement at all times?

Is so within this simple scenario, the bank will not make a $9000 loan. As it would inevitably lead to this.

III. Bank’s Balance Sheet after Sally Spends Her Loan on Business Supplies

Assets| Liabilities + Shareholder’s Equity

($8,000) in vault cash|$1,000 (Billy’s checking account balance)

$9,000 loan to Sally at 5% for 12 months| $0 (Sally’s checking account balance)

In the first case, the reserve is at least 10% if not more throughout. Banks would try to stick with case one would they not?

Bob Murphy June 14, 2010 at 10:27 am

Shoot I should have spelled this point out. It seems there are two different calculations going on, but they are the same: In the first scenario, the bank at Step One calculates that is has $900 in excess reserves.

So most people assume that means the bank can only lend out $900 because of reserve requirements.

This is wrong.

The bank can lend out $9,000 on the basis of $900 in excess reserves. That’s because each $10 in new loans only “absorbs” $1 in excess reserves.

The confusion arises from picturing the bank physically handing $900 in currency to the loan applicant. But in reality the bank can credit the person’s checking account with the new funds, without touching the cash in the vault. It’s true, this strategy will backfire if/when the loan applicant spends the money and the bank gets hit with a claim on its reserves, but that’s a matter of prudence, not of the reserve requirement.

J. Murray June 14, 2010 at 10:45 am

A more simplified explanation -

A bank redeposits that $900 loan as an asset and can now lend out $810 from that. The $810 is redeposited and from that is loaned $729 which continues until the 10% is less than a penny. If you do this manually (I suggest using Excel), you’ll find the total amount of assets will be equal to $10,000.

James W. McGillivray December 18, 2010 at 11:18 pm

You can do this also, in one step by using the binomial theorum. Ask a high school mathematics teacher to do it for you.

Wildberry June 14, 2010 at 12:22 pm

Bob,
By the way, nice appearance on Glen Beck promoting Road to Serfdom. That is the second time Fox News has mentioned the book. Laura Ingrim also mentioned it in a segment with Bill O’Riely a few months back.

On your article, it is a good illustration of banking practice. On the “matter of prudence”, much of the risk is leveled out by interbank and central bank loans. A “temporary” blip in the excess reserves can be borrowed in at very favorable rates until assests can be sold or new depositors offset the withdrawals.

As you know better than most, a tremendous amout of energy has been invested in the banking system since 1915 to insure that banks can live on the edge of the reserve requirements, while pumping as much money into the commercial stream as possible. In fact the Feds can “fine tune” the money supply by adjusting the reserve requirements, something that seems unnecessary in these time of ballooning bank reserves. If investors ever found anything worth borrowing for, there would be a flood of this excess reserves coursing throught the economy. Hello hyperinflation! I believe keeping this banking engine going is one of many reasons the government and the banks are so interested in proping up prices and supporting wages through collusion witht he unions, and buying labor at “government rates”, which are far outpacing those in the private sector.
The only thing worse than spending the loan funds is to spend it on something that drops in price, making it attractive to default on the loan. The default rate for mortgages if housing prices were allowed to fall to market values must keep bankers up at night!

Abhilash Nambiar June 14, 2010 at 1:08 pm

Thanks Prof. Murphy, Thanks J Murray.

I tried it out on Excel. This is truly amazing to look at. A $1000 dollar deposit can be pyramided into a $10,000 dollar deposit with $9000 in loans. I never fully realized that the implications of fractional reserve banking were so far reaching. Talk about over leveraging!! That clears things up so wonderfully.

But it poses so many new questions. Somehow this must relate to the move towards a cashless society, the overuse of credit cards and the over emphasis on electronic transactions. Not only does it decrease the demand on the limited reserves, it makes manipulation very hard to detect and even harder to understand once detected.

I mean, suppose the people who Sally is spending the $9000 on are also clients of the same bank, they can debit $9000 from her account and credit it to the account of all those that she is spending it on. The reserves remain untouched right?

The bank’s balance sheet may look like this

Before Sally bought stuff

Assets |Liabilities + Shareholder’s Equity
$1,000 in vault cash |$1,000 (Billy’s checking account balance)
$9,000 loan to Sally at 5% for 12 months |$9,000 (Sally’s new checking account)
|$0 (Accounts of people that sell stuff)

After Sally bought stuff

Assets |Liabilities + Shareholder’s Equity
$1,000 in vault cash |$1,000 (Billy’s checking account balance)
$9,000 loan to Sally at 5% for 12 months |$0 (Sally’s checking account balance)
($9,000) towards people Sally bought stuff from |$9000 (Accounts of people that sell stuff)

The numbers add up, the reserves remain untouched. The bank’s total customer checking account balances are still $10,000 and the bank has $1,000 in physical currency “backing it up”.

If there are many banks involved, they can maintain running totals and have it cleared at the end of the day. So there are fewer claims on the reserves.

Abhilash Nambiar June 14, 2010 at 10:29 am

Let me take time to think and respond. Thanks for taking the time.

Abhilash Nambiar June 14, 2010 at 10:25 am

It seems to me that in the two cases, the 10% reserve requirements are calculated differently. In the first case it is calculated at step 1

I. Bank’s Balance Sheet after Billy’s Deposit

Assets|Liabilities + Shareholder’s Equity
$1,000 in vault cash|$1,000 (Billy’s checking account balance)

So 10% of $1000 is $900, which gets lent out.

In the second case the 10% reserve is calculated in step 2

II. Bank’s Balance Sheet after Loan Granted to Sally

Assets|Liabilities + Shareholder’s Equity

$1,000 in vault cash |$1,000 (Billy’s checking account balance)
$9,000 loan to Sally at 5% for 12 months|$9,000 (Sally’s new checking account)

That is not an apples to apples comparision. Who decides at which instance of the transaction the 10% requirement needs to be met? Is it a 10% reserve requirement at all times?

Is so within this simple scenario, the bank will not make a $9000 loan. As it would inevitably lead to this.

III. Bank’s Balance Sheet after Sally Spends Her Loan on Business Supplies

Assets| Liabilities + Shareholder’s Equity

($8,000) in vault cash|$1,000 (Billy’s checking account balance)

$9,000 loan to Sally at 5% for 12 months| $0 (Sally’s checking account balance)

In the first case, the reserve is at least 10% if not more throughout. Banks would try to stick with case one would they not?

Wildberry June 14, 2010 at 1:25 pm

Am I missing something, or is this simple math? 10% reserve means that 90% of total liabilities my be in the form of loans, while 10% is held in reserve.
If I have $10,000 in deposits, I may loan $9,000 if I keep the $1,000 in reserve. To meet my reserve requirement at the close of each day, I am entitled to borrow money from the Federal Reserve or other Banks to correct shortfalls until the next business day, when I can attract new depositors or sell assets, etc.
The problem comes with systemic shortfalls where the only bank willing to “lend” is the Fed. Can you say “Bailout”?

Abhilash Nambiar June 14, 2010 at 1:56 pm

Wildberry,

Read Dr. Murphy’s and J. Murray’s clarification above. $1000 deposit can be ‘magically’ made into $10,000 deposit in fractional reserve banking. I seem to have made the same entry twice.

J. Murray June 15, 2010 at 5:57 am

You have it backwards. Loans can be made until the physical assets on the books are 10% of the total liabilities. The loaned money doesn’t leave the asset account at the bank, it remains in the bank and can be reloaned out again because that $900 loan is “deposited” back in the bank and it can then continue the cycle.

Or in another term, of all the assets the bank holds in demand accounts, it can create 9 times as many credit assets to loan out. Assets the bank literally does not have, yet is creating a claim against. Since all of the banks in our nation are effectively required to be part of the Federal Reserve system, these credit-created assets are traded between banks as actual money.

As for how the Fed gets involved, when a bank “borrows” $1,000 from the Federal Reserve, it can now make $10,000 worth of loans.

Mike Sproul June 14, 2010 at 10:26 am

The bank would only lend $900 to Sally if she posted collateral (e.g., land) worth at least $900. The bank is merely coining that land into money, and the effect on prices is no different than if Sally had brought in $900 worth of silver and had it stamped into coins.

Russell June 14, 2010 at 11:23 am

Mike Sproul is correct. A direct loan to Sally would be for collateral. The problem with the bank lending out any of Billy’s money is that he has no agreement from Billy to do so. The bank has no right to loan Billy’s demand deposit as evidence by the fact that Billy can demand his $1,000 the next day and, unless the bank has capital to cover the deficiency created by its loan of $900 to Sally, the bank is bankrupt.

Now, the correct way to do it is to get Billy’s agreement to leave his $1,000 in the bank long enough to for the bank to make and collect on Sallies loan. Of course, Billy may not want to risk not getting his money back. If Billy does not want to do that, that bank can charge Billy for the banking services.

The real problem created by allowing fractional reserve banking is that it inflates the money supply allowing someone, the bank, to create additional money out of thin air that can then be used to buy goods and services. If the money Billy deposited was earned by Billy who added goods and servces to the economic pie, then his spending or savings or lending or investment of money reflects the use of money that is the result of an increase in the economic pie. Holders of money all benefit from this. And the spending of money resulting from the creation of goods and servces sends a demand signal to the market that someone who is or has actively increased the size of the economic pie wants something.

This is not the case when the bank lends out part of demand deposit. It creates money (or equivalent, credit in a checking account) out of thin air and gives it to someone to spend and compete in the marketplace for goods and services. This money does not represent money earned by the addition of goods or services. If Billy withdraws his $1000 before Sally repays the loan, the bank cannot repay it. Thus fractional reserve banking is inherently inflationary in the sense that it allows the banks to create and lend money or credit that neither they nor anyone else earned. That would not be the case if Billy agreed to lend the money to the bank until Sally repaid her loan.

This inflationary credit competes in the marketplace to purchase goods and services with money held by those who worked for it, drives up the prices for everyone and dilutes the value of money saved by the savers.

Worse, it distorts the demand signals in the economy making appear that there is more demand from people who first added goods or services to the economic pie than there is. Resources are invested to satisfy this apparent demand, as in the subprime housing debacle, and ultimately wasted because the demand not real, not by someone who added goods or services to the economic pie commensurate to the money he is spending.

Bottom line is that fractional reserve banking interfere’s with the supply and demand signals generated by those who have contributed to have contributed to the economic pie. It allocates resources to those who have previously added nothing to the economy. In the long run, this results in much more waste than would otherwise be the case. It discourages those who work and save on the gamble that something good will come of it.

Stephen Grossman June 16, 2010 at 10:11 am

>when the bank lends out part of demand deposit. It creates money (or equivalent, credit in a checking account) out of thin air and gives it to someone to spend and compete in the marketplace for goods and services. This money does not represent money earned by the addition of goods or services.

FR does not create money, ie, a medium for exchanging goods and services. Only the market creates money and then only from something w/prior market value ,eg, fishhooks, as Rothbard notes. FR counterfeits money and bank credit. Legal tender and FR bank credit are not money. They are counterfeit. The Fed does not inflate the money supply. The (US) money supply is in Fort Knox. Its a real money warehouse (or museum). ;<) Unfortunately "depositors" cannot get their money back. But the US Army is guarding it until the public wakes up. The Fed inflates the supply of counterfeit money (and bank credit).

Daniel April 27, 2011 at 3:56 pm

I am no expert on banking or economics, so this is as much a request for correction as it is an argument.

I think they key sentence in Russell’s assessment (which seems to be a good representation of the rest of the anti FR banking proponents who have commented so far) is “If Billy withdraws his $1000 before Sally repays the loan, the bank cannot repay it.”

The fact that the $900 in physical assets would remain in Sally’s hands if Billy attempted to withdraw them demonstrates that the bank is not actually adding to the circulating money supply. The money that shows as being in his account, notwithstanding Sally’s use of them, is purely illusory. The circulating money supply is the same. What has changed is that the bank now has $900 in unfunded liabilities that exactly matches the $900 in physical assets Sally now possesses. These two cancel each other out.

Whether loaning deposited funds violates and implicit agreement between the bank and the depositor is another issue entirely, but it seems fairly obvious that people know how banks work by now and accept the fact that their money is being loaned out in return for interest payments. This is an arrangement they obviously favor or, as someone has already pointed out, they would not engage in it.

But banks loaning money that they DON’T have by simply changing their ledgers is a fundamentally different problem. Inasmuch as FR banking opponents oppose this aspect of modern banking, they are not really objecting to FR banking but to fraud in its truest sense. As far as I am aware (and again, I am no expert) regular banks cannot create money in this way. If that were the case there would be little sense in even having a reserve ratio. If a bank is loaning notional money, then the borrower, or whoever he uses the notional money to pay with it, will be depositing notional money in another bank account. If that money is purely notional, then this new depositor has no claim to real physical assets in return. Any money a regular bank loans out, therefore, MUST be in the form of physical assets at bottom, otherwise none of us would be able to withdraw physical assets from a bank based on an electronic deposit. At the end of a business day, actual physical assets representing fractions of deposits must change hands among banks clearing notional transactions so that they will meet the reserve ratio requirements.

The only bank that can manufacture money by simply changing ledgers is the Federal Reserve. This only “works” because the Federal Reserve will never try to redeem real physical money based on the notional loans it has made to member banks. The real enemy then is not fractional reserve banking but central banking.

FR banking, on the other hand, provides a valuable service to individuals by allowing depositors to realize the benefits of investment without giving up liquidity. It also benefits the economy as a whole because it makes funds available for investment that would not otherwise be available due to individual preference for liquidity.

The Kid Salami June 14, 2010 at 11:41 am

Oh Mike not again with the collateral and coining assets stuff – and now you’ve got people cheerleaders (“Mike Sproul is correct”!). It is NOT the same as if Sally had coined some silver. It is not personal, I bear no ill will against you or your kin, but I do bear ill will towards idoitic ideas. I asked you simple questions about your theory and then showed that your answers were contradictory – your “theory” is nonsense. I will not stop asking you this question so long as you keep spouting this “theory”.

Please either answer my question or stop adding noise to the discussions.

http://blog.mises.org/12367/should-the-quantity-of-money-be-increased/comment-page-1/#comment-683011

Russell June 14, 2010 at 12:08 pm

I read your question but an a bit confused about your point. Any commodity can serve as money if people will accept it. But some commodities work better than others as money because they are more stable. Gold and silver of both more stable than wheat or shells.

Money usually starts out to be something that has intrinsic subjective value to people in the market place like gold pr silver. Of course, adding to the gold supply reduces the market value of gold and adding to the silver supply reduces the value of silver.

When they are being used as intermediates to facilitate exchange other goods we call that money. The value of other goods will go up as the quantity of gold or silver goes up (all other things being equal). Taht would be true in a barter system as well. It is simple supply and demand. Money is simply another commodity whose function is to facilitate exchanging other goods and services.

In effect money is a marker that entitle the holder to his or her allocate shore of goods and services that are present in the marketplace. The allocation depends on how much people want to spend and how much they want to save for a rainy day. The price of a particular product is determined by how many people want a particular product and how many of their markers they are willing to exchange for it.

If you want to encourage the production of new goods and services, you don’t give out the marker for free. You make people work for them. If you give markers or money out for free, it takes away the incentive to work for the money and to increase the size of the economic pie. It encourages freeloading and reduces the value of the markers in cirulation. That is the effect of fractional reserve banking.

The Kid Salami June 15, 2010 at 4:16 am

Russel – are you responding to me and the question I put to Mike Sproul on the other thread? If so, I don’t really understand the relevance.

I used Mike Sproul’s own words to show that his theory predicts that, in the restricted scenario we discussed where money is gold, finding easy to mine gold raises prices while finding easy to mine silver doesn’t. This doesn’t make any sense and so I asked him to explain it. He can’t. If you want to explain this, please do.

Russell June 15, 2010 at 6:36 am

Ok The Kid Salami. Maybe I misunderstood the dispute because the situation is pretty straight forward. If you only use gold as money and not silver and you add gold to the money suppy via mining (or alchemy for that matter), then the increase in the supply of gold makes the ratio of gold to all other commodities lower (all other things being equal) and decreases the value of gold vis a vis these other commodities. Of course, as your question implies, the same is true of silver but in your special case, you are not using silver as money but apparently only for jewelry or industrial use. Silver’s value will drop vis a vis other commodities including money (here gold) but the value of other commodities vis a vis money (here gold) will not change. I hope this helps. Russell

The Kid Salami June 17, 2010 at 4:57 am

Russell – there was a bit of back and forth before that exchange with Mr Sproul, so if you didn’t read that (and I can’t blame you for this) then I was trying to construct the most succinct and concentrated (if contrived) scenario in which Sproul’s “theory” would be shown as stupid, and he walked right into it.

His theory is fundamentally this: if gold was money and we were using paper property titles to the gold instead of the gold itself in daily transactions, then Sproul says that you can add to this money supply and you will NOT get price increases provided that the paper you add is an IOU for existing property. So, as I got him to say clearly, you can essentially “coin” your assets and he says there will be no price increases. He does not understand that the very price of the asset he is “coining” is based upon the supply of money and the other market information etc. He just doesn’t get it. I thought carefully about how to prove him wrong because he pollutes every thread about banking with this rubbish.

He ignores my question and just continues on other threads like nothing happened. I’ve asked about 5 times for an answer, he won’t. He can’t. He is a bluffer.

Eric June 14, 2010 at 12:04 pm

If the banks loan $900 to Sally backed by land, then the effect would be to increase the money supply by $900. But, while the loan is in force, the land cannot be sold, since it is acting as money. So there is now $900 more money floating around, and $900 less in land to be bought. More money chasing fewer goods raises prices. But things don’t happen all at once. It is not the helicopter effect of Milton Friedman.

While the loan is still in force, the money supply is slightly larger. There is a transfer of wealth away from cash holders (who lose purchasing power) that eventually finds its way back to Sally (who for example was able to spend $900 before prices went up). So, Sally gained at the expense of others. This partially accounts for the money she accumulates to pay the interest on the loan.

In reality, new loans continue to exceed the number of loans paid off, and so the money supply continues to increase over time. There is not just one Sally, but millions of Sally’s. The banks benefit and Sally benefits, but at the expense of people holding onto cash.

Richard Moss June 14, 2010 at 12:19 pm

Mike,

The land Sally may post as collateral is not money. The silver coins in this example are money because they are the most marketable commodity. Land (in this case) is not.

It seems to me that what you are advocating is nothing more than a system of monetized barter. People people pledge “notes” against things they own (like land) and these notes are supposed to circulate as a means of payment. Fundamentally, how is this different from barter?

Fred June 14, 2010 at 12:48 pm

Mike,

What is happening in the US mortgage market with loans collateralized against land and buildings?

Mike Sproul June 14, 2010 at 12:56 pm

Fred:

When loans are collateralized that way, then the lending bank issues 100 new checking account dollars, and backs them with at least $100 worth of real estate. If that real estate falls in value to $90, then those 100 checking account dollars will be worth on 90 paper dollars.

fundamentalist June 14, 2010 at 10:41 am

Hayek shows that even if the creation of money out of thin air doesn’t happen in the same bank, it inevitably happens across banks in his “Monetary Theory and the Trade Cycle.”

Sproul, you’re completely right. An increase in the money stock via frb has exactly the same effect as is someone dug up the same amount of silver or gold. Austrians have never denied that. In fact, it’s curious that people as brilliant as Newton wasted so much effort on alchemy when bankers had performed the same thing as alchemy for millenia. The difference between mining silver and gold and creating money from thin air as frb does is not in kind, but in degree. There are severe limits to the amount of silver or gold that can be mined at any given time. There is no limit to amount of money that can be minted from thin air, even if collateralized by land.

J. Murray June 14, 2010 at 10:50 am

Not only that, but even with mining of gold and silver the trade value of the next ounce mined always declines over the previous ounce. There will reach a point where the cost of labor required to pull the gold or silver out of the ground exceeds the value of the goods and services that the gold or silver they mine can trade for. This is a natural limit on the money supply.

FRB, however, can just add a zero at the end of the number, this allows the central bank to be able to keep ahead of the labor requirements to operate.

A gold mining firm would have to double the output per worker if the gold prices were cut in half. The output of a bank employee doesn’t have to change for the bank to double the output of money.

Mike Sproul June 14, 2010 at 11:04 am

Fundamentalist:
“An increase in the money stock via frb has exactly the same effect as is someone dug up the same amount of silver or gold.”

I was referring to silver that had already been dug out of the ground. Fractional reserve banking has the same effect on prices as if someone brought existing silver bullion into the bank and had it stamped into coins.

Dennis June 14, 2010 at 11:12 am

I think that Professor Murphy does a great job of explaining the process that takes place. I would note that while creating money “out of thin air” sounds like the result is arbitrary, he has, with varying degrees of explicitness, identified three constraints to this result: a legal constraint (the reserve requirement), a prudent business practice constraint (not lending more than a bank can cover in withdrawals) and an historical behavioral constraint (the likelihood that Billy will leave most/all of his funds in the checking account). Since beauty is in the eye of the beholder, I guess some may see this as weird, dubious and fraudulent. I think it’s awesome and cool.

Russell June 14, 2010 at 11:25 am

It’s not cool, its a con game. It allows someone, the bank, to get something for nothing. Normally such behavior is outlawed.

Julien Couvreur June 17, 2010 at 3:57 pm

Let’s institute a national “Bank Run Day” (on a random day every year), where everyone would go and cash out their deposits. This will keep this “awesome and cool” system in check ;-)

fundamentalist June 14, 2010 at 11:31 am

Sproul: “I was referring to silver that had already been dug out of the ground.

It doesn’t matter. If the silver was in bullion form, it wasn’t part of the money stock until it became minted into coin. Mining the silver just adds one step to the process, but the effect is still the same.

mikey June 14, 2010 at 11:49 am

Does the dollar represent the final unit of clearing?

Mike Sproul June 14, 2010 at 12:41 pm

Russell, Richard, Eric, and Fundamentalist:

Suppose the bank started by accepting 100 oz. of silver on deposit, for which it issued 100 paper receipts (‘silver dollars’), each redeemable for 1 oz. of silver. The bank might then issue additional paper receipts for deposits of gold (‘gold dollars’), copper (‘copper dollars’), wheat, land, etc, all redeemable in the particular commodity stated on the receipt.

I think you’d all agree that (1) There is no fraud in the issue of these receipts, and (2) The issue of these receipts does not affect the price level. Now make just one change: let the bank start issuing silver dollars to people who deposit an amount of wheat, land, etc. that is worth 1 oz. of silver. So rather than getting one ounce of silver, the bank gets an amount of wheat that could be sold, at any time, for 1 ounce of silver.

As long as customers agree to the arrangement there is no fraud, and as long as dollars are only issued to people who deposit a dollar’s worth of stuff, there is no price inflation.

J. Murray June 14, 2010 at 1:37 pm

That system would honestly bankrupt the bank rather quickly. Depositing 1 oz worth of silver of wheat in return for 1 oz of silver is a horrible idea, mainly because the value of wheat fluctuates. All this does is create a hedge game where people pay in wheat certificates when they’re undervalued and pay in silver coins when they’re overvalued. At the end of the day, the bank would be the big loser in it all. If there was a bumper crop of wheat, the bank would be flooded with requests for 1 oz silver coins. In leaner times, the bank would be selling their wheat certificates for 1 oz silver coins. Both of them would be a loss. This is exactly why the American bimetallic system failed as it did, the trade price was set between silver (the only metal permitted to hold the name Dollar and at a specific weight) and gold.

Certificates should always be listed as what the object is. A bale of wheat should only have a certificate naming it 1 bale of wheat. It should never be labled as 1 oz silver worth of wheat because that worth is never the same at any point of time. Basically, that wheat can never be sold for 1 oz of silver at any time, it can only be sold at 1 oz at a very specific point in time, and with the nature of a free market, that wheat will likely only depreciate in value as the process of growing wheat becomes more efficient, meaning the bank can never sell that wheat for 1 oz of silver.

Attempting to label one object in trade terms of another can only result in two problems:

1. The bank being used as a means to hedge profits, ultimately putting that bank out of business.

2. A return of inflation if banks have the unilateral decision to set the exchange price at any time of what 1 oz of silver worth of wheat really is. The “market” price isn’t something you can just observe and sell at, it’s only something that can be seen in arears.

I would effectively call exchanging 1 oz of silver for a certificate of 1 oz of silver worth of wheat, if used in a depository manner, fraudulent. It’s an investment, not a demand deposit.

The value or worth of any certificate should never be solidly translated as another asset. Wheat should never be valued in terms of silver and vice versa. This would only wreck the system as the relative values of both are constantly fluctuating, making it nearly impossible for the labelled price to be the real price.

A deposit of 1 bale of wheat should be labelled only as 1 bale of wheat alone, not in ounces of silver, pounds of wool, dozens of eggs, or Dollars. Specifically labelling it as such could be either a bankrupt bank (if the bank gets the raw end of the deal) or fraud (if the bank gets to set what the current trade value is worth).

Mike Sproul June 14, 2010 at 1:55 pm

The wheat can either rise or fall against silver, so the bank can either win or lose. Since today’s relative prices of wheat and silver reflect the best info about future prices, there’s no systematic tendency for the bank to lose or win. As long as it’s a voluntary deal between the bank and its customers, no libertarian should oppose it.And I’ve yet to hear any objection to my point that an increase in the supply of gold dollars, copper dollars, etc. does not cause price inflation. If you think that the supply of those kinds of dollars can increase without causing price inflation, you can’t justify claiming that the same increase in the supply of money will cause inflation when all the dollars are denominated in silver.

Abhilash Nambiar June 14, 2010 at 2:55 pm

As long as it’s a voluntary deal between the bank and its customers, no libertarian should oppose it.

When issuing silver certificates for wheat instead of wheat certificates, the bank is issuing a claim for an item it does not hold. Why is it not fraud? Because the customer is made aware of the fact and chooses to accept them anyway. So far it looks good. But it only looks good.

Now say the customer uses his silver certificates to buy things. He should in fact inform the seller that this in fact is a wheat certificate that is pretending to be a silver certificate before he exchanges it for produce, else he is committing fraud. The seller to persons he exchanges with and so on. But wait. This is getting complicated. Why not use wheat certificates instead?

Indeed, why not use wheat certificates except somewhere along the line, someone intends to commit fraud? There can be no other reason can there?

You would agree that the person who used the certificate under such false pretenses in fact committed fraud. What about the rest who willingly exchanged a fake certificate? They bear some of the responsibility too. They are facilitators of a crime; they willingly exchanged a certificate with a false claim. Facilitating a crime is also a crime. This is one of those cases where people as a group commit a crime which as individuals they do not, will not and most importantly cannot. Please read Aghata Christie’s ‘Murder on the Orient Express’. Not only does it make the point clearly, it is also a thrilling murder mystery.

Not properly dealt with in libertarian circles, perhaps because it is difficult to reconcile with the concept of methodological individualism. I do not see why. People often get together to do things that as individuals they cannot and there is no reason that they cannot get together to facilitate or commit property rights violation. Unions are a good example of that. What I am saying here is that because in a libertarian society, there can be no restrictions on private property rights, there can be restrictions on transactions that facilitate its violation.

Russell June 14, 2010 at 3:18 pm

OK Mike, I will object to your point. All other things being equal, an increase in any commodity decreases its value as against other commodities. It matters not whether the commodity is paper money or gold specie. The only advantage of gold specie in the use of money is that governments can’t print it and it is hard to fine. This is a good property for money and a big advantage.

Money is just and intermediary for trading goods more efficiently than barter. You only need a fixed amount of money that is almost infinitely dividable to fulfill that function. Suppose you had a hundred million ounces of gold or whatever that could be divided into sufficiently small pieces to serve as money. No more could be created and it would never be destroyed. That would be ideal money.

J. Murray June 15, 2010 at 5:51 am

Yes, relative prices do change, and that’s my point. If you hold a certificate that says “1 Ounce Silver of Wheat”, what does that mean? A price is relative to the individual. What you would consider 1 oz silver worth of wheat is different than my consideration. We each have different preferences. Who gets to decide what 1 oz of silver worth of wheat is? You? In that case, I get screwed. Me? In that case, you get screwed. Some third party? What makes him the expert? Some “market” price? No such beast exists, we can only look at that as the highest price the commodity sold at in the past.

And as Abhilash pointed out, my 1 oz silver worth of wheat and someone else’s 1 oz worth of wheat can mean entirely different things. You are unable to sell or transfer that certificate to anyone without commiting fraud simply because you are unable to tell him exactly how many bushels of wheat are being purchased.

You can buy that certificate if you make the decision, but any transactions of that certificate with anyone beyond the original issuer is now considered a crime. You can’t sell that certificate for 1 oz silver becuase it doesn’t tell us how much wheat can be obtained with that certificate. This is why one commodity should never be monetized in terms of another. We can monetize wheat, but that certificate should say 1 bushel, not 1 oz silver. The parties in the transaction should always know exactly what they’re getting in the trade, not a vague quantity.

Stephen Grossman June 16, 2010 at 10:23 am

>The value or worth of any certificate should never be solidly translated as another asset. Wheat should never be valued in terms of silver and vice versa. This would only wreck the system as the relative values of both are constantly fluctuating, making it nearly impossible for the labelled price to be the real price.

I believe this is why Rothbard favors money names like gold-gram and opposes ,eg, “dollar” or “franc” because it defrauds people into thinking that the national “currency” has value beyond the commodity money.

Russell June 14, 2010 at 2:25 pm

I wouldn’t agree to the substitution of wheat for silver is not fraud unless the bank disclosed this to the borrower and got his ok. then the borrower would have an opportunity to decide if he wanted to take the risk that the relative value of silver vs wheat would not go against him. Even without inflation of money, you can have an increase in production or demand for wheat or silver that changes the value as between them.

Abhilash Nambiar June 14, 2010 at 2:58 pm

I think it is a fraud, because the consent of the borrower is not sufficient. The consent of all people that the borrower would exchange the wheat certificate with and then those people will further exchange it with is also be necessary. But instead plain wheat certificates can be used. The borrower and the bank are not the only parties taking the risk.

Russell June 14, 2010 at 3:20 pm

I was not thinking about a negotiable receipt but if it is negotiable, then it has to indicate that it is redeemable in wheat so no one is mislead.

Stephen Grossman June 16, 2010 at 10:25 am

Exactly! The fraud would spread uncontrollably.

billwald June 14, 2010 at 12:52 pm

Essay answers the wrong question for several reasons. First, because “money” is no longer a store of value but a government (or bank) issued IOU that is used to exchange labor for goods and services and to compare the economic value of dissimilar items.

Second, even if money was still a store of value, the banks are making suckers out of people who can’t defer gratification and use credit to buy toys and entertainment. I should feel sorry for them?

I suspect that 80% of the working class who pay cash for consumer items and who own their house free can clear (which should include every worker over 50 years old) are doing just fine, 90% of that class who also tithe to their local Christian Church.

Current June 14, 2010 at 1:16 pm

I’d encourage everyone here to read the discussion about the Real Bills Doctorine in Mises’ “The Theory of Money and Credit”. In it he gives careful criticisms of the sort of things that Mike Sproul is saying here.

Beefcake the Mighty June 18, 2010 at 7:08 am

I second this recommendation. The irony, Current, is that I believe much of this critique applies just as well to MET/FRFB. But, we’ve discussed that on the other thread and I think we’re going to have to agree to disagree.

Current June 18, 2010 at 8:04 pm

The 100% reservist side sometimes call the FRFB side the “Neo Banking School” this is because they concentrate at policy. What really differentiates schools of thought though is theory. The theory of the old and new free banking schools is quite different from that of the British Banking School.

It’s like associating the Rothbardian 100% reservists with the old Chicago plan folks who also recommended 100% reserves. Yes, the policy recommendation is quite similar in some circumstances, but the underpinning reasons are different.

fundamentalist June 14, 2010 at 1:23 pm

Mike: “As long as customers agree to the arrangement there is no fraud,”

Some say it’s fraud and some say it isn’t. The debate has been going on for over 400 years.

“…and as long as dollars are only issued to people who deposit a dollar’s worth of stuff, there is no price inflation.”

There is no debate over that. It causes price inflation as long as the subjective theory of value holds.

Russell June 14, 2010 at 3:22 pm

It depends on how you define inflation. I define it as creation of more money without the unequivocal backing of goods or services. In other words, more money chasing or used to divide up the same amount of goods and services.

Current June 14, 2010 at 1:35 pm

It’s worth mentioning too that quite a lot of economists these days are critical of the money multiplier theory. In a long comment on the Coordination problem blog back when it was “The Austrian Economists” David Laidler pointed out that the micro-economic story behind the money multiplier doesn’t really work out and that the reality is much more complex.

Banks are limited by both finding reserves and by finding good borrowers. Neat assumptions can’t be made about when and how a borrower will use their loan. Some will keep it hanging around in their bank account for long periods, others will redeem it straight away.

If you look at Mises’ works he never relies on a specific and mechanical money-multiplier story.

DD5 June 14, 2010 at 2:34 pm

All you have to do is look at the historical data of excess reserves of banks and see that it has always been near ZERO except for some temporary brief moments in time (usually during some crisis). So as a general rule of thumb, banks are always “fully loaned up” (as Rothbard use to say). What is occurring now with excess reserves is unprecedented.

As for finding “good borrowers”, you can always trust government policy and central banks to come up with creative solutions to that, as seen by the last crisis.

Current June 14, 2010 at 2:59 pm

In general you’re right. But, that doesn’t mean that there aren’t other limitations.

If there is free banking then there is no reserve requirement. If we take the monetarist multiplier story literally then that means money supply could be expanded infinitely. But, that didn’t happen in practice. The banks were limited by finding good borrowers on the one hand and by redemptions on the other.

As I said earlier there are some countries that don’t have a required reserve fraction any more. In Australia, Canada, Mexico, New Zealand and Sweden there is no required reserve any more. The central bank control the money supply through OMOs and through capital adequacy requirements only.

> As for finding “good borrowers”, you can always trust government policy and
>central banks to come up with creative solutions to that, as seen by the last crisis.

Yes.

Steve Horwitz June 14, 2010 at 3:01 pm

Bob writes:

“Shoot I should have spelled this point out. It seems there are two different calculations going on, but they are the same: In the first scenario, the bank at Step One calculates that is has $900 in excess reserves.

So most people assume that means the bank can only lend out $900 because of reserve requirements.”

Bob’s clarification here is crucial. I would just add while this may not be a function of “reserve requirements,” what the bank can safely do here is inherent in the idea of fractional reserves. The very fact that fractional reserve banks are contractually obligated (or should be and would be under free banking) to pay reserves when depositors demand them is what means the original bank cannot make a $9000 loan to Sally. A fractional reserve bank bound by that contractual obligation would know that it has to calculate its desired reserve holdings taking into account that any new loans it creates will be immediately spent. Attending to that point is not just a matter of “good business,” but also inherent in the very nature of fractional reserve banking, when such a system includes, as it should, a contractual promise to pay on demand (or a contractual specification of the exceptions).

Trying to weasel out of this point enables you to find FRB “weird” only because you want to somehow distinguish between “good business” and something that’s inherent in FRB. I would insist that not making that $9000 loans is inherent in FRB as those of us Austrians who defend it understand it.

Without that obligation to redeem, FRB is indeed a weird and dangerous thing – as it can and has become under central banking and government intervention more generally. But not making that loan is central to how FRB would function in a truly free market.

Bob Murphy June 14, 2010 at 3:17 pm

Steve,

Fair enough, and more generally I hope you found this article to be unbiased. But just so you know that I wasn’t attacking a straw man, on my blog a few weeks ago someone in the comments specifically said (paraphrasing), “The Fed does indeed create money out of thin air, and that’s fraudulently. But a fractional reserve banker can only lend out money that he has first received on deposit. There’s nothing fraudulent about it.”

So that’s why I think it’s important to show that reserve requirements allow FRBankers to engage in “creating money out of thin air.”

For an analogy, if a business pays a worker more than his DMVP, that’s a dumb move and the business may eventually go bankrupt. But the difference between ethical and unethical business behavior, doesn’t hinge on whether it pays a profitable amount of wages to its workers.

In contrast, according to some people’s views (like the guy on my blog), the bank becomes fraudulent once it lends above the “safe” amount.

Russell June 14, 2010 at 3:32 pm

The only safe amount for a demand deposit is 100% of the deposit. Allowing lending of any of that demand deposit, other than for a demand loan and only if the depositor is agrees to the relending of his deposit, allows the bank to lend money for a period time it has not paid for. It allows the bank to create money out of thin air rather than earning it by first providing goods or services.

joebhed June 15, 2010 at 9:24 am

central government planner here

absolutely right , russell.
but from where does the money come in the first place, if not created “OOTA” by a private banker demanding uncollateralized real property for security?

The Money System Common.

Steve Horwitz June 14, 2010 at 5:10 pm

Bob,

The statement “But a fractional reserve banker can only lend out money that he has first received on deposit” is TRUE, strictly speaking. The key word is “a.” One of the first things I teach in money and banking (and is made clear in every book I’ve ever used) is that, with fractional reserves, the banking system as a whole can do what no individual bank can do by itself: namely, create a multiplied number of deposits off a given amount of reserves. Your own example, at least with my interpretation, demonstrates that. Each individual bank only creates new loans to the extent that depositors bring them new deposits, but in the process of those new loans being spent and redeposited, the original deposit of reserves is shared out among the banks in such a way that enables the system as a whole to create a multiplied number of deposits.

Under central banking, of course, the constant injection of new reserves means that this expansion process is happening all the time. Under free banking, the equivalent is deposits of the outside money (presumably gold). This would happen far less because bringing in new gold is quite costly. Of course free banks can also adjust their desired reserve ratios as their customers wish to hold more of their liabilities, but this is not “creating money from nothing” rather the new funds lend out reflect the real increase in savings coming from the greater holding of liabilities.

And just to show you that I’m not engaging as strawman, I have twice in the last few weeks (once here and once at FEE) had to disabuse people/students of the notion that every time they deposit $100 at their bank, it creates $1000 in new loans/money. Aside from the kind of example you raise here, I simply asked the FEE students “where did the $100 come from?” When they said “I deposited a check from my mom, maybe,” I said “and what exactly happens at HER bank?

There are only two ways for the banking system to actually expand via the multiplier process (assuming they always want ER = 0): an injection of outside money (Fed OMOs/cash deposit or gold under free banking) or free banks reducing their desired reserve ratios. The latter, as I’ve argued, happens in response to a greater demand to hold bank liabilities, which amounts to a greater supply of loanable funds.

I don’t think your piece is “biased” Bob, but I don’t quite understand your claim of “weirdness,” nor do I think FRB in a free banking system creates money “out of nothing.” Under central banking, absolutely. Again, folks, fractional reserves aren’t the villain in the story, the central bank is.

To rework an old chestnut from the gun rights movement: fractional reserves don’t inflate away money’s value, central banks do.

David Hillary June 14, 2010 at 8:35 pm

I don’t understand why Steve is saying that a single bank cannot ‘create a multiplied number of deposits off a given amount of reserves’.If it is a closed economy, its stock of metallic money is fixed in the short run. For example, suppose there are 1 million 10g gold coins as the stock of metallic money. Now, introduce a bank with 100,000 customers with an average balance of 20g, that holds 200,000 g of metallic reserves, and has a balance sheet as follows Assets: Coin 200,000g Marketable securities 500,000g Net Loans and Advances 2,600,000g Total Assets 3,300,000g Liabilities & Net Worth Current account balances 2,000,000g Commercial Paper 1,000,000g Total Liabilities 3,000,000g Capital 300,000g Total Liabilities & Net Worth 3,300,000gNow each of the bank’s customers has a current account balance averaging 20g, but that average is made up of a range of balance sizes, and such balances for any given customer fluctuate substantially over time.Steve Horwitz is arguing that, other things being equal, if a customer with a balance of 40g who writes a cheque to a non-customer for 40g, will, when the cheque is presented for payment over the counter, lose 40g of reserves, and that, because of this, the bank can’t use that 40g of balance to fund 36g of non-reserve assets. However, this ignores the character of such current account balances as having a cyclical nature over time as each customer is paid and makes payments. When the 100,000 customer balances are aggregated, they provide a stable source of long term funding for the solitary bank, in the same way they provide a stable source of long term funding for the bank within a multi-bank economy. In this example, hasn’t the solitary bank created 2,000,000g of demand deposits with reserves of 200,000g?Could not the example be altered so that it takes in the entire stock of metallic money? In the long run, the stock of metallic money could be consumed by deficits in the market for the monetary metal, these deficits funding additional buildings and other forms of investment, no?

Bob Murphy June 14, 2010 at 10:40 pm

Steve wrote:

The statement “But a fractional reserve banker can only lend out money that he has first received on deposit” is TRUE, strictly speaking. The key word is “a.” One of the first things I teach in money and banking (and is made clear in every book I’ve ever used) is that, with fractional reserves, the banking system as a whole can do what no individual bank can do by itself: namely, create a multiplied number of deposits off a given amount of reserves. Your own example, at least with my interpretation, demonstrates that.

OK we’ve finally gotten to the heart of our disagreement here, Steve. You are missing the whole point of my second scenario. (Doesn’t mean my overall conclusion is correct, it just means you obviously aren’t getting what my point is.)

An individual fractional reserve banker certainly CAN create a multiplied number of deposits off a given amount of reserves. He would be stupid to do so, but he has the legal right to be stupid.

To repeat, I am stressing this point because I’ve had at least one person explicitly tell me it wasn’t possible. I.e. he thought that the commercial bank could only hand out a fraction of money that was first deposited.

But if, on the contrary, what actually happens when a banker issues a new loan, is that he “magically” increases the number in the client’s account balance, then the 10% reserve requirement definitely allows the creation of a multiple amount.

This is presumably so elementary to you that you don’t understand why I’m stressing the point, but *I* didn’t fully grasp this aspect of FRB until about a year ago. Because of the standard textbook treatment, I was picturing the banks getting $1000 in new cash, then handing $900 of it (in cash) to the borrower, etc.

Whatever else you want to say about it, that process seems a lot less “weird” than the case where the bank just decides to increase its assets and liabilities with the stroke of a pen by granting a client a new loan.

David Hillary June 14, 2010 at 11:41 pm

Bob,

The typical reason for a transaction where the bank grants a loan and credits the proceeds to the customer’s current account with the bank is because the terms of the two sides of the transaction differ. Although, legally, the amounts offset leaving the positions of the parties unchanged, the purpose of the transaction is to enable the customer’s position with the bank to change.

For example, if a home owner provides a mortgage over his house in favour of the bank as security for a line of credit. In this case the bank is undertaking to lend to the customer up to the credit limit, as and when the customer calls upon this credit by drawing cheques or making withdrawals or effecting payments to third parties. Although the bank has the legal right to demand repayment in full upon demand, the commercial purpose of the transaction is for the bank to continue to lend and make available for lending the amount of the credit limit until further notice.

If the bank used the same security to provide a fixed loan, and credited the proceeds tot he customer’s current account, the effect would be similar, although the accounting would probably be different, and the economist might argue that the money supply had increased even before the customer’s net position with the bank changed.

In the old days banks effected transactions by an exchange of negotiable instruments: the bank exchanged its bank notes for notes issued by the customer. The bank’s notes were payable on demand, while the customer’s notes were payable on a specified future date, e.g. after 90 days. This process indicates that the bank’s business is exchanging credit, and that the terms of the credit differ. This practice also gave rise to the discredited ‘needs of trade’ doctrine: the idea that the bank’s notes would remain outstanding for the same period as the customer’s loan. Of course the purpose of the transaction was not to issue bank notes but to make profitable loans, and the effect of the transaction could not keep them outstanding any longer than the borrower or other holder wished to hold them, and typically the bank’s borrower would seek and obtain funding for much longer periods than the bank’s notes would remain outstanding. This left the bank able to fund only as many loans as the bank’s total funding from capital, deposits and other borrowings, and notes sustained outstanding. Although the bank probably did want to encourse issue and circulation of its notes by such a means of transacting, there is another likely reason for doing it this way: the lending officers had segregation of duties from the cashiers (tellers) who were authorised to pay notes in metallic money as a means of internal control within the bank.

Steve Horwitz June 15, 2010 at 7:49 am

One last round Bob, then back to work for me.

But if, on the contrary, what actually happens when a banker issues a new loan, is that he “magically” increases the number in the client’s account balance, then the 10% reserve requirement definitely allows the creation of a multiple amount.

“Allows” in the metaphysical sense, sure. The banker can press whatever computer keys he wants. Or the free bank can tell the printing press to run faster to physically create more banknotes. But “allows” in the economic sense, no. Isn’t it the latter that matters? Gravity allows me to flap my arms and try to fly to the moon, but gravity will also put a quick stop to the experiment. Banks can try to create the 10,000 but economic reality will drive them into the ground. What’s the point of trying to make an economic argument by what seems to me like reference to a metaphysical notion of “allow?”

This is presumably so elementary to you that you don’t understand why I’m stressing the point, but *I* didn’t fully grasp this aspect of FRB until about a year ago. Because of the standard textbook treatment, I was picturing the banks getting $1000 in new cash, then handing $900 of it (in cash) to the borrower, etc.

Maybe that’s YOUR weirdness then. ;) Every M&B text I’ve ever used has made this point quite clear: when banks make loans they do so by creating an asset and a liability: the loan that borrower must pay back is the asset and the electronic credit to their account that the bank owes the borrower is the liability. This is as old as banking: one of the key entrepreneurial insights of the early goldsmith/proto-banks was that they didn’t have to lend out the actual gold they had on hand, they could just print up receipts equal to those excess reserves and lend those.

I don’t see the magical weirdness here as long as one recognizes my point above: the bank is economically limited to lending out its excess reserves and it does so by creating that liability. What the Fed does is a lot weirder as it can bring reserves into existence ex nihilo by making a bookkeeping entry. Banks, under free or central banking, cannot do anything like that. It’s the Fed that’s responsible for the multiplier process, not the individual banks.

Whatever else you want to say about it, that process seems a lot less “weird” than the case where the bank just decides to increase its assets and liabilities with the stroke of a pen by granting a client a new loan.

To you maybe! I think this is just some kind of “yuck” factor on your part as I just don’t see the weirdness. I think the Fed’s ability to create reserves is the thing that really is “weird.”

How would a 100% reserve bank create a loan off a time deposit? Suppose I give Rothbard Bank a deposit and want a one-year CD. Presumably RB can then lend that $1000 (let’s say) to a business for one year. Do you think RB is going to hand over the exact $1000 in gold I deposit? What if RB gave the borrower money certificates instead because the paper was easier to use? Is going down to the basement and printing off 10 $100 money certificates any weirder than creating a demand deposit at the stroke of a pen? And why couldn’t Rothbard Bank actually give the borrower a checking account? The underlying reserves are still 100% in the bank, but perhaps negotiable IOUs that can be written for a precise amount are more convenient?

In either the money certificate case or the checkable account case, Rothbard bank creates both a new asset and a new liability that is no more or no less “out of thin air” than what the individual bank does under fractional reserves, no? And neither case would involve fractional reserves given that the original gold is still there and untouchable by the depositor for one year.

And note: RB could print up extra money certificates or over expand its checkable accounts in that situation in the same way that FRB “allows” banks to create multiplied loans off a new deposit. But in both cases, there’s a reality: for RB it’s the law saying they must keep 100% reserve and for FRB it’s the economic law that says that adverse clearings will lead them into a breach of contract and a liquidity crisis. What’s metaphysically possible is not economically or legally permitted. I just don’t see the difference Bob.

Abhilash Nambiar June 14, 2010 at 11:56 pm

What your argument basically boils down to is that a $100 deposit will not lead to $1000 deposit and $900 loan from the multiplier effect because multiple claims on the reserve will pressure the bank against playing the multiplier effect all the way though, absent of course the Central Bank. Agreed. A commodity money places a severe constraint on the bank’s capacity to inflate existing money supply using fractional reserve.

Nevertheless how do you reconcile this with the fact that commodity money being a scarce resource cannot be used by different people at the same time? It is in the nature of scarcity that when I use something, it is not available for you to use. So when I am using my money, I cannot loan it to you. Here it is like, I can use my money, but I can also lend it to you at the same time. And that lies at the root of the “weirdness” that Bob is referring to.

We need to come to some sort of agreement such that one person can use the scarce resource (here money) while the other refrains from using it for that time. Without that, there are conflicting claims on the resource and that does not mesh with reality.

This will send false pricing signals throughout the market place. The demand depositor presumes he has claim on all his funds (when in fact he does not) and that informs his spending habits. The borrower too acts under that same false presumption. Only one is correct, but both have been lied to. An now neither players are acting the way they would have, had they been made aware of the true state of scarcity and recognized its consequences. Thus the pricing signals are distorted and misallocation of resources will result. But I agree, there is a limit to inflation through fractional reserves that can only be surpassed by a central bank with a printing press. They are the bigger villains.

Russell June 15, 2010 at 6:57 am

Mr. nambiar is exactly right. The idea behind money is that one acquires it by first adding to the economic pie by creating goods and service for which one received money. This encourages people to add to the mutually available economic pie to obtain money. When the bank or Federal Reserve creates money or credit, it creates a claim on the economic pie prior to the creation of goods or services and dilutes the value of the pie for everyone else. This is free riding and creates demand by money that does not represent the creation of goods and servcies first. This interferes with supply and demand price signals by those who have first created goods or services to acquire money. While it is true that if that fiat money is loaned to someone who creates huge additions to the economic pie with creative inventions, we are all better off, in the long run, it is a less conservative system which lead to a lot more waste – booms and busts. One may be able to survive driving 90 miles and hour on windy mountain roads in a BMW M5 but you are a lot safer doing thirty in a Ford Fusion. Fractional reserve banking and the Fed’s actions in creating credit is simply poor human engineering.

joebhed June 15, 2010 at 9:31 am

central government planner here

right-on again, russell.
The basic capitalist-based, fractional-reserve-fed, boom-and-bust cycle was addressed in the Chicago Plan for Monetary Reform back in ’33.
Had that passed, we would have BOTH full-reserve-based banking, and an honest, open, public expansion of the money supply to maintain price stability – the antithesis of the wishes of the Austrian thinkers.
The Money System Common.

Ireland June 14, 2010 at 3:11 pm

Ok, now lets swap Bank for a Warehouse and $1000 for 1000 bushels of wheat. Case #2 is out, Warehouse cannot lend out 10000 it doesn’t have. How about lending 900? Is it ok? If yes, why? If not, why? What’s the difference in warehousing wheat and money?

scineram June 14, 2010 at 3:27 pm

Nothing. Just banks don’t warehouse money.

Ireland June 14, 2010 at 3:41 pm

What’s a demand deposit account about, then?

scineram June 14, 2010 at 4:06 pm

A callable loan to the bank.

Ireland June 14, 2010 at 4:11 pm

Strange, I never thought about it that way. I always took the balance numbers to represent my money, available to me at any time, and fullfiling my present demand to hold money. Time to get them out, perhaps. Thanks for the warning.

Ireland June 14, 2010 at 4:13 pm

Hey, perhaps I should sue them for fraud and misrepresentation? They should’ve clearly warn me about my deposits being in fact a loan, callable or otherwise?

Abhilash Nambiar June 14, 2010 at 4:20 pm

An interest free loan with no specified maturity date? It has none of the characteristics of a loan.

scineram June 14, 2010 at 4:39 pm

My account pays interest.

Also, there are plenty such loans.

Abhilash Nambiar June 15, 2010 at 12:25 am

scineram June 14, 2010 at 4:39 pm
My account pays interest.

Also, there are plenty such loans.

Well if your account pays interest. It is not a checking account. Checking account paying interest is the weirdness of fractional reserve banking.

There are interest free loans with no maturity date? Maybe the loans your rich uncle gives you. But to be fair I need to expand.

An interest free loans with no maturity date and lent without consent from the person whose money you are lending?

Abhilash Nambiar June 14, 2010 at 3:44 pm

A bank that offers only checking account is supposed to be a warehouse for money, at least according to Austrian Economics. They keep your money safe and you pay them a fee for it.

Current June 14, 2010 at 3:53 pm

A bank should be a money warehouse according to *Rothbard* not “Austrian Economics”. Some Austrian economists would agree with Rothbard, but not all.

Ireland June 14, 2010 at 4:07 pm

Ok, Rothbard’s position seems clear. What would the others say about demand deposit account? How would they descride Bank’s duty to depositor?

Current June 14, 2010 at 4:21 pm

It’s not particularly clear in Mises. Hayek thought FRB was reasonable.

Jonathan Finegold Catalán June 14, 2010 at 4:27 pm

In Monetary Theory and the Trade Cycle Hayek certainly believed that fractional reserve banking, or what he called “our current credit organization”, was a factor behind intertemporal discoordination. He just thought that it was a necessary evil. Maybe his opinion matured as he wrote more. I, unfortunately, am not well acquainted with his later theoretical works. See: Hayek, the Business Cycle and the Financial System.

David Hillary June 14, 2010 at 3:31 pm

Bob Murphy, for the sake of simplicity, has left out a) the bank’s other existing assets and liabilities and b) the bank’s existing equity.

When you consider that any free bank typically has a strong capital position, and is a going concern of good credit standing, it can make more full use of the new funding provided by Bill. Suppose, for example, that the bank expects Bill to retain the balance with the bank, repayable on demand, but sitting there for some months. The bank can use these funds from Bill to fund long term assets. Should Bill withdraw his funds early, the bank can initially pay him out from their reserves (their balance sheet consisting of reserves that are a fraction of total demand deposits, but many times larger than any individual demand deposit), and then replenish its reserves from either a) some other customer whose new demand deposit happens to occur at the same time, b) by going to the wholesale market and issuing 90 day commercial paper or c) selling some marketable assets or d) collecting or selling some less marketable assets such as long term loans.

The character of the bank’s demand deposit business is to borrow not from one or a few demand depositors, but from a large number of demand depositors whose deposits and withdrawals offset each other to a substantial extent, and that therefore provides the bank with a reliable source of long term funding. The bank suppliments this business with funding that it can control to fill any gaps, e.g. 90 day commercial paper. The bank also controls its long term assets, and marketable assets, in addition to its reserves to avoid running out of reserves. It also needs to have a profitable business model and a good capital ratio to attain the credit standing required to attract demand deposit funding and other sources of debt funding from the market.

When you put all these factors together the function of the bank is clear: it is in the business of borrowing and lending money, and demand depositors as much as investors in 90 day commercial paper have positions of providing debt funding to the bank. The fact that the demand deposit debt funding is a substitute for holding metallic money (or central bank paper money) does not imply any concern about causing changes to the purchasing power of money (unless you’re a quantity theorist).

See http://www.lostsoulblog.com/search/label/fractional%20reserve%20banking for various posts of mine on fractional reserve banking.

Russell June 14, 2010 at 3:39 pm

All your are doing is describing what banks do now, play the odds that they can cover all demand deposits one way or another. And they usually can until they can’t. Then the inherent weakness in this gambling type of system is exposed with runs on banks. It is a poor system leading to larger booms and busts.

There is no need to take this risk. Banks need only charge for demand deposits or obtain the depositors consent to loan out his money for a period of time for which the banks will have to pay no doubt. Allowing the bank to both take a demand deposit and lend out the demand deposit is dishonest, unnecessary, and screws up the demand signals in the economy leading to bigger booms and busts. See my comments above.

Ireland June 14, 2010 at 3:59 pm

Another take. Ponzi schemes are fraud, right? Only, they don’t need to be. See, if I explicitly told in advance I’m about to run a Ponzi scheme, and people would still give me money, full well aware of that some of them will win, and most of them will loose, where’s the fraud? Weird kind of hazard perhaps, but fraud no way. It only becomes fraud if I misrepresent what’s going on, if I lie to them.

Now FRB can be OK too, all we need is to publicly announce that demand deposits will NOT be backed in full, and to make things perfect also announce the exact amount of surplus deposits at any given time.

The only issue is — without the pretending that gains come from investment (Ponzi), or that all demand deposits can be paid out in full (FRB), people would not be attracted to these schemes the way they are when they’re mislead and lied to. In case of FRB such deposits would be discounted immediately. No sane person would deposit with such an institution.

What’s so great about FRB, which can’t deal in the open and needs to conceal and lie if it wants to do business, that so many people defend it? Could it be some of us like the fraudulent profits it enables so much as to deny the very nature of what’s going on?

Mike Sproul June 14, 2010 at 4:05 pm

Ireland:

Fractional reserve demand deposits are backed in full. A bank that has issued $100 in demand deposits will normally hold 10 paper dollars PLUS a $90 IOU, backed by a $90 lien on the borrower’s collateral. You talk as if you only see the $10 of reserves, without seeing the other $90 of assets.

Naturally, the IOU might lose value, or the $10 might be stolen, and in that case the demand deposit dollars will lose value. But that is an ordinary business risk.

Ireland June 14, 2010 at 4:16 pm

Dear Mike, if it’s as OK as you write, the Bank for sure wouldn’t mind to disclose, as I suggest above, the info, about how much is backed by real stuff and how much by IOUs. Or would it mind?

Russell June 14, 2010 at 4:20 pm

But that is not the way demand deposits are presented and no one pays attention because the government (and ultimately the taxpayers – us) back the whole stupid, unsound, dishonest scheme with FDIC insurance. You wouldn’t need FDIC insurance if you had 100% reserve banking.

Abhilash Nambiar June 14, 2010 at 4:57 pm

Mike,

The ‘demand’ in the demand deposit is there for a reason. The deposit must be available on demand. It was not meant to be used for any investment activity no matter what the risk. There are different types of deposits for that purpose and the depositor who is now an investor consents before assuming the risk.

That is not what the demand depositor signed up for. He put the money in the bank so that it will be safer than it is under his bed, or in his vault. The purpose was to mitigate risk, not to enhance it. So taking $100 demand deposit and leaving $10 plus $90 IOU backed by a $90 lien on the borrower’s collateral is fraud. The full price of the risk is not reflected in the service. When you remember that there is the pyramiding effect that creates more demand deposits, the fact that it is a self-perpetuating fraud must be evident. Kind of like a MLM.

Russell June 14, 2010 at 5:19 pm

Exactly right!

Steve Horwitz June 14, 2010 at 7:33 pm

Abhilash,

How do you know what the depositor wanted from putting his money in the bank? Perhaps he wanted a more convenient means of payment (e.g., a bank note or checking account rather than gold) or perhaps he wanted to earn interest on it rather than leaving it under his bed. And if he wanted safety and nothing else, why not just put it in a safe deposit box? Why open a checking or savings account?

Historically, people made deposits in banks for all kinds of reasons, in full knowledge of the nature of their choice. People were willing to take the very small risks associated with fractional reserve banking (and they are small even without a central bank) in order to reap the gains of the more convenient means of payment and interest return.

I find it strange that someone interested in Austrian economics thinks he knows the subjective valuations of actors better than the actors do themselves. Don’t different actors have different risk-return tradeoffs or different motives for making what appears to be the same choice?

Abhilash Nambiar June 14, 2010 at 9:28 pm

Steve,
Did you miss the part where I wrote

There are different types of deposits for that purpose

So to answer your question

How do you know what the depositor wanted from putting his money in the bank?

There are different deposit options for people with different needs. People who want interest put their money in a savings account where there is restricted withdrawal. Certificate of deposits give you sligthly better interest, provided you don’t take your money out for a fixed period of time. Here you take the risk that you may not have access to your the money when you need it. But you are not lead to believe that it is a demand deposit.

But you can take even more risk. You can put your money on a mutual fund. You could gain more, or loose a lot. You can directly invest in companies at the risk of loosing all. Or buy bonds that having ratings on them which indicate the risk of default.

The important thing to note here is that you know the risk that you are taking before hand.

So when you ask

Don’t different actors have different risk-return tradeoffs or different motives for making what appears to be the same choice?

Yes ofcourse. And there are different options for that in the form of different financial instruments for different actors.

But fractional reserve banking on demand deposits does not fall under any of those categories. The bank is taking a different risk than the depsoitors are lead to believe. If they have the consent of the depositor, they do not even need to keep a fractional reserve. Suppose the bank issued notes that said
‘THESE NOTES ARE REDEEMABLE FOR 1 oz SILVER, SOME OF THE TIME.’

Then I suppose fractional reserve banking is ok. I see nothing wrong in principle about a one hundred percent transparent fractional reserve bank. If a 10% reserve requirement is the norm, and if Silver is a $1 an ounce, then for every 1000 oz of silver,the bank will issue $1000 worth bank reserve notes which they can pyramid into $10,000 worth of note reserves and $9000 worth of loans. So when people want to spend the loan amount, they will need to issue $8000 more worth of bank notes.

So for the $9000 in circulation, there is only 1000 oz of silver in the bank. Which is to say, in the open market, you will need to exchange atleast $9 worth of those silver ceritifcate to get what you would get for 1 oz of silver. Which is to say, regardless of what is printed on the certificate, you will get for it, what the market gives and just that.

So the original depositor who got demand rights on $1000 silver certificate for the deposited 1000 oz silver is now screwed. When he makes his demand there will be $10,000 worth of notes in circulation (assuming none of the loans are yet repayed) so he cannot expect to get more than 100 oz of silver for his notes. To get the worth of his original 1000 oz of silver he needs to have earned 10 times of the original $1000 before any of the loans are fully repayed. In any case he is not going to get back his 1000 oz worth unless all of the borrowers have returned their loans. Something tells me that it is not what you had in mind about fractional reserve.

Unless he is really stupid, he won’t willingly buy into it. He has to be tricked into it. Otherwise the whole excercise is wasteful. Which is what history shows, people got tricked.

In principle a one hundred percent transparent fractional reserve bank is ok, but in a fair playing field full reserve bank will easily leave it in the dust. In principle, you have the right to leave your valuables in your garbage as well.

Steve Horwitz June 14, 2010 at 9:57 pm

In principle a one hundred percent transparent fractional reserve bank is ok, but in a fair playing field full reserve bank will easily leave it in the dust.

There is no historical evidence to back this argument whatsoever. Whenever fractional reserve banking has existed in the absence of a central bank or related interventions, it has always out-competed 100% reserve banks. In fact, historical examples of 100% reserve banks that survived more than a very short period are nearly impossible to find. 100% reserve banking is a market loser precisely because people prefer the trade-off offered them by fractional reserve banks.

The argument about people not understanding the process just doesn’t hold up to empirical scrutiny as some recent work by economists in the UK have shown. The clear majority of people “get it,” not to mention the fact that the agreement you sign with the bank makes it clear that you are granting them a loan not a bailment.

Historically, bank notes were very clear about what they were promising: redeemable on demand. That’s the contract and where banks were free (and fractional) they lived up to it almost universally. And they learned to tinker with the contract to deal with the potential problems.

And this:

If a 10% reserve requirement is the norm, and if Silver is a $1 an ounce, then for every 1000 oz of silver,the bank will issue $1000 worth bank reserve notes which they can pyramid into $10,000 worth of note reserves and $9000 worth of loans. So when people want to spend the loan amount, they will need to issue $8000 more worth of bank notes.

does not make sense to me. As I discuss elsewhere here, an individual bank cannot pyramid 1000 worth of new reserves into 10,000 in new notes. And I have no idea what “bank reserve notes” and “note reserves” are. Can you explain to me what you’re arguing here, as I’m lost.

Abhilash Nambiar June 15, 2010 at 1:00 am

There is no historical evidence to back this argument whatsoever. Whenever fractional reserve banking has existed in the absence of a central bank or related interventions, it has always out-competed 100% reserve banks.

Is that really the case? Or is it the case that fractional reserve banking lead to crises, that eventually resulted in the formation of a Central Bank?

I had said in a fair playing field playing field full reserve bank will easily leave one hundred percent transparent fractional reserve banking in the dust. So historically has there ever been one hundred percent transparent fractional reserve banking ? And more importantly has there ever been a fair playing field? Meaning a playing field absent full government intervention.

In fact, historical examples of 100% reserve banks that survived more than a very short period are nearly impossible to find.
Yes, but what does that show? That lenders are eager to lend money that was left to them for safe keeping only? It does not speak for the soundness of the practice.

100% reserve banking is a market loser precisely because people prefer the trade-off offered them by fractional reserve banks.
Yes, it creates something of a boom that people like to enjoy. But again, does that make it economically sound? And more importantly to what extent where the people aware that they where enjoying the outcome of fractional reserve banking. There are unsound decisions that can offer short term benefits.

The argument about people not understanding the process just doesn’t hold up to empirical scrutiny as some recent work by economists in the UK have shown. The clear majority of people “get it,” not to mention the fact that the agreement you sign with the bank makes it clear that you are granting them a loan not a bailment.

Well, yes the checking and saving functions have merged so as to speak and the line between lenders and savers have blurred. That coupled with fiat money means the bailment option is extremely unappealing. What people ‘get’ is that they have the right to demand the deposit at any time, call it a loan or otherwise. When they lose confidence, there is a bank run. Except in the US, where the FDIC takes care of that.

Historically, bank notes were very clear about what they were promising: redeemable on demand. That’s the contract and where banks were free (and fractional) they lived up to it almost universally. And they learned to tinker with the contract to deal with the potential problems.

Yes, redeemable on demand, except they are not in a state to fulfill that obligation when all depositors demanded at once. They where not promising ‘redeemable on demand, conditions apply, where they? If so, then it is not truly redeemable on demand.

does not make sense to me. As I discuss elsewhere here, an individual bank cannot pyramid 1000 worth of new reserves into 10,000 in new notes. And I have no idea what “bank reserve notes” and “note reserves” are. Can you explain to me what you’re arguing here, as I’m lost.

Yes, I think you argued well that 1000 worth reserves cannot cause 10,000 in new notes absent a central bank. But that only says that the inflation won’t be as intense as theoretically possible. Never the less it creates a distortion. The demand depositor presumes he has claim on all his funds (when in fact he does not) and that informs his spending habits. The borrower too acts under that same false presumption. They are misguided actors misallocating resources.

Matt C. June 14, 2010 at 5:33 pm

Mike Sproul:

Let me just ask you something: How do you pledge collateral that you do not yet own? It’s a basic sequence of events problem. And are you saying that the banks didn’t take a hit in the recent crisis? Are you also suggesting that there is no such thing as an unsecured loan? Are you also saying that banks don’t misappropriate non-mutuum deposits? What people fail to understand is the basic problem with not honoring legal contracts and not protecting property rights. A deeper insight is that fractional reserve banking eventually produces demand for a central bank because of the abuse. People who can’t understand that will always fail to keep the state out of planning the money supply.

http://mises.org/books/desoto.pdf

Eric June 14, 2010 at 5:50 pm

When you deposit money into a bank demand account your deposit is at risk and is backed only by the claims paying ability of the bank. Your deposit is not warehoused.

Do the banks make this clear in the demand deposit agreement? I don’t know.

If the bank is up front and has a disclaimer on any funds that one deposits then I would argue that it is NOT fraud. I wouldn’t have any problem with fractional reserve banking if they weren’t given a monopoly on currency.

In a free market, I don’t think that FRB is at odds with libertarian law. The problem is entirely one of “legal tender” status which uses force to make all of us trade using only one currency. If I could trade and save with gold (or gold substitutes) and not pay taxes on capital gains or sales taxes and contracts in gold were honored, then FRB wouldn’t be a big deal. It’s the FEDs monopoly that makes their use of FRB evil.

Matt C. June 14, 2010 at 6:25 pm

Eric,

History seems to show that FRB leads to central banks.

Read De Soto’s book at page 675 (725 of PDF).
http://mises.org/books/desoto.pdf

cargocultist June 14, 2010 at 8:27 pm

It’s fundamentally a distributed system, and consequently it would need a single point of reference, somewhere, in order to prevent some otherwise intractable problems.

george t morgan June 14, 2010 at 6:42 pm

“Your deposit is not warehoused. Do the banks make this clear in the demand deposit agreement? I don’t know.”

do you use a bank at all??

my bank uses the terms deposits and funds and availability but no the words dollars or money.

if a deposit is not warehoused what does that mean??? if they have a few paper dollars and non-paper dollars is that the same as a warehoused currency??

did early banks truly warehouse money??

george t morgan June 14, 2010 at 6:43 pm

is the paper dollar significantly different than the non-paper dollar as far as being reserved in anyway??

Mike Sproul June 14, 2010 at 6:00 pm

Ireland:
A fractional reserve bank would disclose all its assets, or else nobody would trust the bank with their deposit.

Russell:
Fractional reserve banks don’t need FDIC insurance either. Under free banking, depositors would judge for themselves whether to trust a bank, and history shows that when banks are relatively free, fractional reserve banking is the norm.

Abhilash:
I, like most people, prefer a fractional reserve bank. I know that such a bank can pay interest on deposits instead of charging fees. I know that that bank is less vulnerable to robbery than a 100% reserve bank, and I know that there will be times when the bank suspends convertibility. Strange how so-called libertarians are so eager to muscle in on a voluntary transaction between me and my bank.

Matt C.
Bank’s don’t accept collateral unless the borrower has clear title to the property he offers as collateral. If I want to borrow $100,000 from a bank, the only way they will lend it to me is if I offer a clear lien on my house, and the house would have to be worth around $130,000 or more. So-called ‘unsecured’ loans are actually secured by the lender’s knowledge that he has a high probability of being able to recover his loan from the borrower in court.

Matt C. June 14, 2010 at 6:35 pm

Mike Sproul,

You miss the point big time. First of all, many loans that come about are not established by existing collateral. First time home-buyers don’t have an existing house to pledge. How can they pledge the house they are going to buy? What is significant is that the bank doesn’t buy the house and sell it to the borrower because the bank doesn’t really have the money either.

“So-called ‘unsecured’ loans are actually secured by the lender’s knowledge that he has a high probability of being able to recover his loan from the borrower in court.”

What? Has anyone mentioned toxic assets? That logic is quite profound.

Read De Soto’s book at page 675 (725 of PDF).
http://mises.org/books/desoto.pdf

Abhilash Nambiar June 14, 2010 at 8:27 pm

Mike,

You and your bank cannot voluntary conclude any transaction that involves putting other people’s property at risk, without asking them first. Not all voluntary transactions can take place.

You know the bank will suspend convertibility once in a while, your bank does too. But what about the people who receive the paper notes that you give them? Are they all accepting the notes with the same confidence. To put it plainly, would those notes have it written on them in big bold letters ‘THESE NOTES ARE REDEEMABLE FOR 1 oz SILVER, SOME OF THE TIME.’ If so would you expect these notes to be traded at par with 1 oz silver? If hope that is not what you are expecting.

Here is an analogy. Warehouse owner displays sign in front of warehouse.

Goods stored in this warehouse may be rented out from time to time indefinitely without asking you first. Sometimes you may have no access to your goods at all, but we cannot say beforehand when.

Now you try selling your stuff in that warehouse and see if you get the same price as those at others.

Here are some other things that have no place in the libertarian society. Cartels, labor unions, monopolies and intellectual property. If you think about it, there is nothing preventing from private players from indulging in contracts that mimic some if not many of those aspects through private contract. But such financially unsound instruments will fizzle out with a government like enforcing mechanism.

But you are right, I do not anything wrong in principle with a 100% transparent fractional reserve system. However, there is nothing wrong in principle with showing all your cards to your opponents while playing poker either.

However, historically it has been just an excuse to create a crisis, that can usher in a central bank. It is the Road to Serfdom.

Matt C. June 14, 2010 at 6:25 pm
Eric,

History seems to show that FRB leads to central banks.

Read De Soto’s book at page 675 (725 of PDF).
http://mises.org/books/desoto.pdf

Peter Surda June 15, 2010 at 7:43 am

You and your bank cannot voluntary conclude any transaction that involves putting other people’s property at risk, without asking them first.

This transaction does not put the physical integrity of other people’s property at risk, only the market price thereof. But there is no such thing as a right to the market price of one’s property.

Russell June 15, 2010 at 7:49 am

Mike, you said

“Russell:
Fractional reserve banks don’t need FDIC insurance either. Under free banking, depositors would judge for themselves whether to trust a bank, and history shows that when banks are relatively free, fractional reserve banking is the norm.”

That is right, under free banking, depositors would judge. And if there were complete transparency, then depositors could make an informed judgment about the risks depositing money interest free with a bank that lent out 90% of it or some smaller fraction vs the risk of a bank that warehoused it and charge a fee for its services. Let the market decide. Clearly, warehousing is safest for the depositor. Once a depositor experience a few runs on his bank, I suspect he will opt for the safety of 100% reserve banking for at least some of his wealth.

As for history showing that fractional reserve banking was the norm when banks were free, as I understand the history of banking in the U.S., they were never that free (or transparent). They were either charted by the Federal government or state governments. When state governments charted them, they required the banks to accept state notes as legal tender which could be used for reserves. Maybe I am wrong here. Please do not hesitate to correct the record. So the state could inflate.

The real point is that a gold standard represents money that is earned before it is created while fractional reserve banking is money created “on the come” like a bet at the race track. There is no theoretical limit to how much can be created. Political forces tend to encourage creation of more and more money “on the come” as we see today. This is inflationary and, as Abhilash points out, interferes with supply and demand signals in a market economy causing distortions. It is an inefficient system.

Mike Sproul June 14, 2010 at 7:56 pm

Matt C.
The house, plus your down payment, is the collateral. Try buying a house with no down payment and you might see what I mean. And toxic assets are just IOU’s that lost value.

Matt C. June 14, 2010 at 8:05 pm

The house can’t be collateral unless the transaction is fraudulent.
(http://www.youtube.com/watch?v=pp7tiySCyb4)

“toxic assets are just IOU’s”
OK. You just proved my point.

But concerning the FRB:
“The Banking School failed entirely in dealing with these problems. It was confused by a spurious idea according to which the requirements of business rigidly limit the maximum amount of convertible banknotes that a bank can issue. They did not see that the demand of the public for credit is a magnitude dependent on the banks’ readiness to lend, and that
banks which do not bother about their own solvency are in a position to expand circulation credit by lowering the rate of interest below the market rate.” (Mises, Human Action, pp.
439–40)

cargocultist June 14, 2010 at 8:21 pm

This is an extended version of the Rothbard fallacy, and it’s very disappointing to see it still being propagated. It’s also extremely harmful, since it and similar misunderstanding prevents discussion on the actual problems of reserve banking – of which there are many, and which deserve discussion. It has also helped bring Austrian economics into disrepute – which is a real shame, since many of the ideas from Hayek in particular on local knowledge, and distributed control, are vitally important in today’s economic environment.

In general, the first problem with most critiques of the fractional reserve banking system is that they don’t specify which version of it they are critiquing. Since there are a lot of different ways, based on implementation, for this system to go wrong (and that in and of itself is a major problem), the assumptions need to be clearly presented first so that readers can understand which particular version is being criticised.

Whatever version this article is talking about, it’s not the one that’s currently being used.

In the current system, vault cash doesn’t determine the individual banks’ loan ceiling, equity capital does that. Equity capital is a completely separate amount of money or financial instruments (including debt instruments unfortunately, which is a major bug), provided by the shareholders and owners of the bank. If customer money were taken as the author suggests, and put into equity capital in order to expand the loan capacity of that bank, then that money would no longer be in Billy’s account, and he would no longer have access to it. Since the other constraint on lending is the amount of money on deposit at the bank, the bank wouldn’t be able to create loans as is then suggested.

I would strongly encourage anybody who wants to understand how the current banking system is implemented to take the time to examine the individual call report records published by the FDIC for all banks in the american banking system, http://www2.fdic.gov/call_tfr_rpts/

Matt C. June 14, 2010 at 8:32 pm

Just to be clear, there is no money in Billy’s account. The current system works as if it is really a promise to pay.

cargocultist June 15, 2010 at 4:30 am

To be clear? I think to be clear, what this article and subsequent commentary is demonstrating beautifully is that economists don’t understand reserve based banking.

To jump up a couple of levels of abstraction – there is something called money in Billy’s account, which is an electronic token of exchange. In the two centuries that this system has evolved, it’s gone from a physical token based ‘promise to pay’ to an almost completely electronic based system, where de facto, all ‘money’ is deposited in the banking system, all the time – and the banks and central banks are essentially managing flow relationships.

Which is Steve Horwitz’s point about how you have to analyse both the behaviour at the local bank (which Murphy has done incorrectly here) and the behaviour as money flows between the banks – which it turns out Keynes did incorrectly. (Probably Keynes, it seems to trace back to the 1930 MacMillan report.)

It’s extremely unfortunate that Rothbard made the mistake that he did, it seems to have almost completely derailed Austrian analysis of this system from offering anything useful.

Russell June 15, 2010 at 8:05 am

Cargocultist,

Here is the problem you do not address. Fractional reserve banking is the creation of money “on the come” on the gamble that the borrower will pay it back. Fine.

But it turns the basic concept of money on its ear and throws off the supply and demand signals in the economy resulting in missalocation of assets and investment. Money is supposed to be a store of value, something one has to work to acquire, representative of the prior creation of goods and services that are available to the marketplace, and which send a price signal to the marketplace about the relative supply and demand of a given good or service in the marketplace by someone who has previously added something to the marketplace. It is a relatively closed money system requiring creation of something to acquire money.

Fractional reserve banking, and especially with a central bank involved, that can just create credit out of thin air, opens up the system and allows the creation of unlimited money. Money is just a commodity that has a purpose, to facilitate the exchange of goods and services and to accurately transmit supply and demand signals of creators of value. If there is an unlimited supply or people don’t have to follow the rules and add something to the market to get money, then the usefulness of that money diminishes and in fact harms the balance of supply and demand in the long run.

Geoff June 14, 2010 at 8:37 pm

I think this article was fair and balanced (not like Fox News). It was clearer and easier to understand than Joe Salerno’s article even though Salerno’s article was trying to make a different point (I think). I think there is a division within the so-called “free bankers” and it is quite a difference indeed. Some want fractional reserve banking and may even think it is good for the economy. Others, such as myself, do not necessarily want FRB and it doesn’t really matter whether it is good or bad for the economy. We just believe that people should be able to freely associate.

Mike Sproul June 14, 2010 at 9:25 pm

Abhilash”
“To put it plainly, would those notes have it written on them in big bold letters ‘THESE NOTES ARE REDEEMABLE FOR 1 oz SILVER, SOME OF THE TIME.’ If so would you expect these notes to be traded at par with 1 oz silver?”

We have about 400 years of banking history in which fractional reserve notes did, in fact, trade at par with silver. People saw that the convenience of notes, checks, etc., were enough to offset the small risk of default.

Matt C.
“It was confused by a spurious idea according to which the requirements of business rigidly limit the maximum amount of convertible banknotes that a bank can issue. They did not see that the demand of the public for credit is a magnitude dependent on the banks’ readiness to lend, and that banks which do not bother about their own solvency are in a position to expand circulation credit by lowering the rate of interest below the market rate.”

Mises attacked a position that Tooke, Fullarton, et. al. never took. It was Mises who failed to see that banks ARE concerned about their own solvency, that such banks will not lend below the market rate, and that the value of bank notes is maintained, not by limiting their amount, but by assuring that the bank’s assets move in step with its issue of notes.

Matt C. June 14, 2010 at 10:14 pm

“93. Charles A.E. Goodhart states: “There were plenty of banking crises and panics prior to the formation of central banks” and cites O.B.W. Sprague’s book, History of Crises and the National Banking System, first published in 1910 and reprinted in New Jersey by Augustus M. Kelley in 1977.”

I assume it was the Gods.

Mike Sproul June 14, 2010 at 10:37 pm

Banks, like all businesses, are not immune to failure.

Matt C. June 14, 2010 at 10:48 pm

The master of truisms strikes again. Happen to mention why they failed though? I think De Soto gives a good explanation in the first part of his book (excess credit expansion). Read about the bank of Amsterdam on page 98. And let me ask you: why do you think people start demanding central banks?

cargocultist June 15, 2010 at 4:31 am

Matt’s quite correct, there are solid systemic reasons why you have to have a central bank in setups like these.

Abhilash Nambiar June 15, 2010 at 1:07 am

We have about 400 years of banking history in which fractional reserve notes did, in fact, trade at par with silver. People saw that the convenience of notes, checks, etc., were enough to offset the small risk of default.

Not true. There where in fact several instances when fractional reserve notes did not in fact trade at par. Remember the term ‘not worth a continental’. They where forced to be traded at par and then Gresham’s law took over. Have you read “What has the government done to our money?”

http://mises.org/money.asp

historian1944 June 14, 2010 at 10:43 pm

I realize this is a bit off the topic, but perhaps it fits. Earlier in the conversation, there was a short discussion on whether fractional reserve banking is fraud or not. If it’s acceptable for a bank to do this, why is it not acceptable for a grain elevator to do the same thing? I’m sure grain elevator operators would love the opportunity to sell more grain than they’ve actually got on hand. Why are there no fractional reserve grain elevators, fluid warehousers (like crude oil) or the coal storage equivalent?

Additionally, can anyone recommend a book that goes over the mainstream (or non-Austrian) theory of money and banking? I’m reading Theory of Money and Credit” and I’ve read most of “Man, Economy and State” and “The Mystery of Banking” but I’m largely ignorant of what the non-Austrian perspective on money and banking is. More specifically, the reason why it’s believed that the money supply must increase year after year.

cargocultist June 15, 2010 at 4:40 am

I think it’s fair to say that both sides are in disarray at the moment. The mainstream textbooks present a theory that says the money supply should be stable, or vary between known bounds, or at the very least be controlled by the central banks. However, all the historical monetary figures for the last 70 years or so, even for countries with supposedly well controlled systems, show a small but significant annual growth in the money supply, and a much larger one in the loan supply.

The facile explanation offered by some of the posters here is that the central banks are increasing the money supply. And it’s true that they can do this, but there’s no evidence that they actually are to the extent shown in the money supply figures. Similarly, the mechanism Murphy is proposing, if it was indeed possible, would lead to a much larger expansion of the money supply than the figures are showing, especially once people learnt to exploit it.

It’s a much larger set of questions than is being presented in this article.

Gene Berman June 14, 2010 at 10:53 pm

Current:

I’m late to this discussion and haven’t read all the comments but wanted to remark on something you’d written.

Yes, it’s true that a single free bank can circulate notes in excess of its reserve. The amount of the excess would be a matter of the banker’s discretion (or “balls”). But that’s not a “fractional reserve system.” which implies the coordination (or cartelization) between different banks. Again, it is possible for one or more banks to agree to delay the presentation of each other’s notes for payment–that would be a cartel of those particular banks and would operate in the area of the combined clientele of those particular banks; each would thus be safe against a demand from one of the others (but there would still need be agreements as to total covered under the agreement and a further agreement as to the lowest agreeable rate charged–otherwise an individual banker could take
advantage of the other by loaning more or charging a lower rate in order to increase business at the others’ expense. But that still falls short of being a “system.” A system comes into being as the result of a central bank (or an entity to which all the banks agreed to have “rule” their practices) cartelizing virtually all banks. Where the particular purpose of the individual banks in an agreement or cartel is merely to enable them each to over-lend more safely, the central bank is not so much concerned with reaping a profit through interest on non-existent funds (the individual banks making the loans are going to get most of that, I’d surmise, with, perhaps, some sort of kickback to the central in the form of fees, etc. But the principal objective of the central bank is political, rather than financial: it is to foster the growth of capital investment and business in general by a lowering of the cost of borrowing money; in this manner, they hope to stimulate industrial growth and commercial activity; they want the satisfaction experienced by the public during “good times” and the political credit which accompanies such “achievement.” And, despite the Austrians (and despite the numerous incidents in which the Austrian predictions and warnings have materialized) most of the “people who count” are either still true believers or are bound tightly in relationships with interests whose prosperity–existence, even–is dependent on continuation of the present system.
It is my sad opinion that the situation is not politically “fixable” and that only economic catastrophe is capable of precipitating change. In other words, catastrophe of the size just experienced ain’t big enough to do the job. Too big–and it’ll end civilization as we know it. So, we’re in the awkward position of having to hope for one larger than anything we’ve seen–but not too large. Something like Goldilocks and the bears.

Gene Berman June 14, 2010 at 11:01 pm

And, by the way. They’re not “creating money out of thin air” and they’re not counterfeiting. What they’re doing is merely diluting the money here and there with a little more and sometimes, a little more than that. You know–sort of like taking a nip of the Jack Daniels in the cabinet and filling it back with water. Can’t hurt (and won’t be as bad for ‘em as the straight stuff!); maybe even fill it back with tea sometimes (so the color won’t show so bad).

Abhilash Nambiar June 15, 2010 at 1:13 am

Exactly. That is a slippery slope that culminated with a central bank.

Russell June 15, 2010 at 8:13 am

Gene,

As I noted above in my response to Cargocultist:

Fractional reserve banking turns the basic concept of money on its ear and throws off the supply and demand signals in the economy resulting in missalocation of assets and investment. Money is supposed to be a store of value, something one has to work to acquire, representative of the prior creation of goods and services that are available to the marketplace, and which send a price signal to the marketplace about the relative supply and demand of a given good or service in the marketplace by someone who has previously added something to the marketplace. It is a relatively closed money system requiring creation of something to acquire money.

Fractional reserve banking, and especially with a central bank involved, that can just create credit out of thin air, opens up the system and allows the creation of unlimited money prior to the creation of goods or services.

Money is just a commodity that has a purpose, to facilitate the exchange of goods and services and to accurately transmit supply and demand signals of creators of value. If there is an unlimited supply or people don’t have to follow the rules and add something to the market to get money, then the usefulness of that money diminishes and in fact harms the balance of supply and demand in the long run.

Guard June 14, 2010 at 11:45 pm

Government force is always involved in these scams at some level, but it is often very complex to trace the scam to its source. My guess would be a combination of legal tender laws and enforcing the acceptance of corporations as persons but there are probably other ares involved as well.

Doug Stewart June 15, 2010 at 5:37 am

Pardon my language if it doesn’t meet the blog standards, but I can’t help but comment – I love this shit!
Thank you mises.org for hosting such great threads. I’ve tried to read and grok a number of these & have learned more each time. It feels very much like a virtual bar or club with drinks and cigar smoke billowing. Yet, it’s even better because everybody gets their turn and most arguments are acknowledged and addressed without much presumption.
I can’t imagine where else us amateurs could sit in on a discussion (of some of the most vital issues of our times) by some of the best pro’s in the business.
FWIW, I am most persuaded by the argument for repealing the legal tender laws and letting the market sort out the answers. My guess is (as long as the government can be kept from interfering) the 100% reserve banks will win the competition for demand deposits.
I see goldmoney.com as the precursor. I just don’t like their having patented some parts of their business model.

Mike Sproul June 15, 2010 at 9:10 am

Russell:
“as I understand the history of banking in the U.S., they were never that free (or transparent). They were either charted by the Federal government or state governments. ”

Check the history of Scottish banks, Italian banks, and many others. Around the world, fractional reserve banking has been the norm, regardless of the degree of government regulation or lack thereof.

“The real point is that a gold standard represents money that is earned before it is created while fractional reserve banking is money created “on the come” like a bet at the race track. There is no theoretical limit to how much can be created.”

I can buy my groceries by handing the grocer my personal IOU for $20. He accepts it because I have a history of paying my bills. If I were well-known, that IOU could circulate as money, even though it was created on the come. If my issue of IOU’s starts to outrun my ability to cover them, they will lose value, so there’s your upper limit.

Abhilash:
“There where in fact several instances when fractional reserve notes did not in fact trade at par. Remember the term ‘not worth a continental’.”

Of course there have been times when notes traded below par. You had made it sound like notes always have to trade below par, when in fact they normally trade at par.

Historian:
“Why are there no fractional reserve grain elevators, fluid warehousers (like crude oil) or the coal storage equivalent?”

There are. Farmers make promises to deliver grain before they have grown it, and various traders promise to deliver many things they do not currently own. Such promises put them in a short position, and the people who take the corresponding long positions usually insist that the people making the promises post some collateral to guarantee delivery.

Abhilash Nambiar June 15, 2010 at 12:11 pm

Mike,

If you have not read “What has the government done to our money?” I urge you to read it now. Notes rarely trade at par with specie. When they do they are in fact forced. Then Gresham’s law kicks and poorer quality metal begins to circulate along side the notes. That is how we ended up here, where metal is no longer currency.

http://mises.org/money.asp

Current June 15, 2010 at 2:51 pm

> If you have not read “What has the government done to our money?” I urge you to
> read it now. Notes rarely trade at par with specie.

Rothbard’s evidence is from America pre-central banking. Although in that era there were no central banks there were laws against branch banking. As a result banks were small organizations.

However, this did not happen in Scotland. Notes from those banks were traded at face. That’s because whenever a bank was thought to be insolvent the info would travel fast there would be a run. As such banks had to keep enough quality assets and enough specie to back their notes.

In America though there were many small banks that only had one branch and were very widely geographically spaced. That made bank runs difficult. So, people coped with the risk of bank failure in a different way, they accepted notes from banks that were far away and possibly unstable at less than par.

Within the local area of a bank its notes would be accepted at par. If they weren’t then people wouldn’t convert coins into notes at par, and they would redeem those notes they had.

DD5 June 15, 2010 at 3:16 pm

Current: “However, this did not happen in Scotland.”
” As such banks had to keep enough quality assets and enough specie to back their notes.”

And if they didn’t, were they always forced to liquidate? And how come the period of “free banking” in Scotland suffered from recurrent boom/bust cycles?

Or perhaps the author is lying through his teeth in this document:
http://mises.org/journals/rae/pdf/rae2_1_15.pdf

Current June 16, 2010 at 11:27 am

> And if they didn’t, were they always forced to liquidate?

Generally yes.

> And how come the period of “free banking” in Scotland suffered from
> recurrent boom/bust cycles?

Scotland is right next to England. It’s economic fortunes are strongly influenced by those of England. Even in the 19th and 18th centuries there wasn’t a “Scottish Interest rate” the market for debt spanned both countries. So, miscoordination is inevitable because the monetary influence from the Bank of England on the interest rate in England affects the interest rate in Scotland.

This is something I wish more Austrian economics folks would understand. Even if the US changed to a 100% reserve gold standard that would probably not stop boom-and-bust because the US interest rate is affected by foreign carry trade. If other countries still had central banking then there would still be boom-and-bust. Since America is such a large place it would probably be much attenuated boom-and-bust though.

> Or perhaps the author is lying through his teeth in this document:

Nobody is saying that Rothbard was lying, we’re just saying that he was wrong about this.

DD5 June 16, 2010 at 12:42 pm

If banks were sound in Scotland, there would be no recurrent systematic widespread crisis every few years, and suspension of specie payment would not have occurred. For example, 100% reserve banks (or your Scottish FRB sounder banks)would redeem all notes of in species from all those unsound banks of England. The sound banks would certainly put the non-sound banks at risk but not their own. It is completely contrary to your own conclusions that you now provide excuses to as why Scottish banks were also prone to runs. 100% reserve banks would be prone to no such runs so your excuse doesn’t hold.

Look, your entire response is just a defensive excuse to why banking in Scotland operated no better then that of England. So which is it? You go around telling everybody that history has proven fractional reserve free banking worked in Scotland, and then after I show you that it’s nothing but a bunch of nonesense, you start listing endless excuses.

Current June 16, 2010 at 2:08 pm

> If banks were sound in Scotland, there would be no recurrent systematic
> widespread crisis every few years

Not so. Think about the logic of ABCT. The miscoordination is mediated by the interest rate. The interest rate emerges from the actions of all the banks in the market for interest, not just one of them.

> For example, 100% reserve banks (or your Scottish FRB sounder
> banks)would redeem all notes of in species from all those unsound banks
> of England.

Why should they redeem notes of other banks? I don’t think I understand your point.

> The sound banks would certainly put the non-sound banks at risk but
> not their own.

Imagine you are running a 100% reserve bank now in the current US. You also run savings & loans operations. Now, does that make you immune from the rest of the market that uses central banking and FRB? Of course not. To compete on the savings & loans market you must charge similar rates to others.

Let’s say we come out of an ABCT induced boom into a bust. In the bust lots of bad debt is exposed. Now, whether or not your 100% reserve bank survives depends entirely on how good it’s loans are. It’s in exactly the same situation as the other banks. If it has made bad loans then there will be a run. The proof against systemic crises that Rothbardians claim for 100% reserve banking only comes about when all banks use it, or at least all across a wide economically-interlinked area. Similarly, the proof against systemic crises that FRB free bankers claim for free banking only comes about when all banks across a wide economically-interlinked area use it. Neither of these groups can point to historical evidence here, since neither have had relevant conditions over a long enough period of reliable history.

> Look, your entire response is just a defensive excuse to why banking in
> Scotland operated no better then that of England.

It did perform better than England, there were fewer bank failures in Scotland.

> So which is it? You go around telling everybody that history has proven
> fractional reserve free banking worked in Scotland, and then after I show
> you that it’s nothing but a bunch of nonesense, you start listing endless
> excuses.

I discuss Scotland because it is the best historical example that we currently have.

Tell me, where is your historical discussion? Your argument consists of the old saw “that wasn’t a free enough market”. But, that argument applies equally well to the Bank of Amsterdam.

DD5 June 16, 2010 at 10:27 pm

Current,

“Not so. Think about the logic of ABCT. The miscoordination is mediated by the interest rate. The interest rate emerges from the actions of all the banks in the market for interest, not just one of them.”

As the bust emerges, the inherent part of the crisis is the banking crisis. But this only occurs because
1. the real value of assets is now discovered to be only a fraction of the total liabilities due to the fact that much of the investments are now proving to be unprofitable, thus, being literally annihilated by defaults.
2. The bank is now susceptible to a bank run. bank runs are always contagious and the entire fractional reserve system is facing the danger of insolvency.

Neither 1 or 2 can occur in 100% reserve banks. Deposits function as a safe keeping warehouse. There can be no systematic wide spread banking crisis.

“It did perform better than England, there were fewer bank failures in Scotland.”

I don’t dispute the validity of this claim and neither does Rothbard in his article. But the question is this: Why are you so sure of your position that you obviously don’t even bother to consider anything that can possibly shake it. Rothbard, as other did also, adequately responds to your fallacious conclusion that you carelessly infer from this alleged evidence of “fewer failures”.

“I discuss Scotland because it is the best historical example that we currently have.”

It may well be the best example. It’s debatable. However it would be dishonest to simply come out and say that frb outperformed 100% reserves in a free market. This is simply not correct.

Abhilash Nambiar June 15, 2010 at 3:27 pm

You seriously must read ‘What has the government done to our money?’ The fact that branch banking was disallowed did not mean that information about banks over-issuing notes took more time to reach.

There where two forces at work. Local banks would issue shares which would be mostly bought by the bank’s own clients. That was one disincentive against the run. It allowed them to inflate a bit more, but there was another market force to counteract that.
When it came to banks in other towns, the notes would be accepted and exchanged for notes of the local bank which local businesses more readily accepted. The local bank thus maintained reserves of bank notes from out of town banks, they could thus break the other bank any time by demanding specie for all the reserve. This was a check on inflation.

But of course one run on the bank would not break the whole system. So notes where not traded at par with metal. Although notes of banks that regularly over-issued notes would steadily decline in value.

I suspect that in Scotland, where there was a better check on inflation through fractional reserves, banks had even fewer chances to inflate that the US and fewer chances of getting away with it. That could be why notes traded at par with metal.

None of this is an endorsement of fractional reserve banking though. The reason that the bankers had to squirm and wiggle is because they where making promises inconsistent with reality.

Current June 16, 2010 at 1:40 pm

> You seriously must read ‘What has the government done to our money?’

I’m familiar with the ideas of the Rothbardian side. I used to be one of them myself.

> When it came to banks in other towns, the notes would be accepted and
> exchanged for notes of the local bank which local businesses more readily
> accepted.

That didn’t always happen in Scotland. If a bank wanted to operate in a particular place then it could open a branch there, and that’s often what they did.

The two largest banks didn’t exchange each other’s notes for a long period of time. Those who wanted to convert a Bank of Scotland note into a Royal Bank of Scotland note needed to redeem or find an intermediary.

> The local bank thus maintained reserves of bank notes from out of town
> banks, they could thus break the other bank any time by demanding specie
> for all the reserve.

Scottish banks also participated in such “note wars”. The two largest banks I mentioned earlier tried to bankrupt each other, but they didn’t succeed.

Think about the logic of the situation you describe. If a bank could break another bank then why wouldn’t it? In what situation would removing competition not benefit another bank? The answer is: when there are laws preventing benefiting from it. In a place with laws against branch banking it doesn’t benefit bank X in town A to bankrupt bank Y in town B because even if it did then they couldn’t start up a branch in town B.

In Scotland the note wars were stopped by two forces. Firstly, the big banks got good at spotting when their notes were being hoarded to prepare for attack. Secondly, the banks invented the option clause which gave them the option of using paying later. That made attacks impractical because the attacked bank could invoke the option-clause on the attacking bank without annoying any genuine customers.

> But of course one run on the bank would not break the whole system. So
> notes where not traded at par with metal. Although notes of banks that
> regularly over-issued notes would steadily decline in value.

The FRB free banking school think this was also a consequence of branch banking laws. Consider the situation from your own point of view. You’re offered a banknote you think may be bad. Is it sensible for you to exchange it at a discount? If you lived in Scotland in the free banking period then you could visit the local branch of that bank and request redemption at full face value. So, why accept a discount of the note? Why not redeem since it’s not your problem that the bank’s specie is diminished by it?

This is why, as Selgin points out, in Scotland those who were suspicious of some sort of banknote had them redeemed. In the US though things were different because the bank itself may be very far from the note, so requesting redemption may not be simple or low cost. It’s quite reasonable in that situation for bank-notes to exchange for less than face.

> That could be why notes traded at par with metal.

Part of the reason too was that banks offered services to customers to compensate them for the slight extra risk they took above owning specie.

newson June 15, 2010 at 10:18 am

the fact the bank views the $1000 as a deposit liability is precisely the point in contention. if the anti-frb school is correct, the $1000 doesn’t appear on the balance sheet, period. the grain silo doesn’t count include its deposits in the balance sheet.

Russell June 15, 2010 at 11:53 am

Mike,

I said, “as I understand the history of banking in the U.S., they were never that free (or transparent). They were either charted by the Federal government or state governments. ”

You said “Check the history of Scottish banks, Italian banks, and many others. Around the world, fractional reserve banking has been the norm, regardless of the degree of government regulation or lack thereof.”

There is on dispute that fractional reserve banking has been the norm. That is not the question. The question is that an optimal way to do banking to promote a stable and healthy economy? I have not heard a cogent explanation of fractional reserve banking that shows how it promotes a balanced allocation of goods and services in the marketplace because it interferes with market signals by sending false signals assuming signals are supposed to be sent by the spending of money that was first earned. See my explanation above if this does not make sense.

I said “The real point is that a gold standard represents money that is earned before it is created while fractional reserve banking is money created “on the come” like a bet at the race track. There is no theoretical limit to how much can be created.”

You said “I can buy my groceries by handing the grocer my personal IOU for $20. He accepts it because I have a history of paying my bills. If I were well-known, that IOU could circulate as money, even though it was created on the come. If my issue of IOU’s starts to outrun my ability to cover them, they will lose value, so there’s your upper limit.”

All you are describing is a credit transaction where everyone knows it is a credit transaction and the IOU’s value is based on the market’s opinion of your credit. But money does not depend on credit. It has absolute value. A 1 oz gold piece is a 1 oz gold piece. A note that says it is redeemable for 1 oz of gold means it is unconditionally redeemable for 1 oz of gold, not just if the note issuer has the gold. He is supposed to have the gold in his warehouse. Ultimately, the value of money vis a vis its monetary function depends on the total amount available compared to the total amount of goods and services available to purchase (and the buying and savings preferences of the holders of all the money at any given time. And it changes over time. But in a market, supply and demand balance at any given point in time). There is no room for the concept of credit if it is money.

george t morgan June 16, 2010 at 3:24 am

“There is on dispute that fractional reserve banking has been the norm.” did you mean there is NO dispute or there is a dispute ‘on’ whether fractional reserve banking has been the norm??

if fractional reserve banking has been the norm ……….

what was the rothbard referring to when someone writes “It is also why it would be far better to suffer a one-shot deflationary contraction of the fraudulent fractional-reserve banking system, and “go back” to a sound system of 100% reserves. ”
http://mises.org/econsense/ch78.asp#ixzz0nhGCdMr1

was that not a real statement by someone named rothbard?? what 100 percent system was there to go back to??

Stan Warford June 15, 2010 at 12:37 pm

I have not seen anyone acknowledge or refute this point by cargocultist:

“In the current system, vault cash doesn’t determine the individual banks’ loan ceiling, equity capital does that. Equity capital is a completely separate amount of money or financial instruments (including debt instruments unfortunately, which is a major bug), provided by the shareholders and owners of the bank. If customer money were taken as the author suggests, and put into equity capital in order to expand the loan capacity of that bank, then that money would no longer be in Billy’s account, and he would no longer have access to it. Since the other constraint on lending is the amount of money on deposit at the bank, the bank wouldn’t be able to create loans as is then suggested.”

This is the first time I have heard of this “Rothbard fallacy” critique of the Austrian treatment of banking. If this critique is true, then it seems that the Austrians should incorporate current practice in their attacks against FRB or risk being ignored by the mainstream. Does this “fallacy” negate the arguments against FRB?

Russell June 15, 2010 at 12:52 pm

Stan,

Not sure about the Rothbard fallacy as I don’t remember Rothbard’s comment on this in the Mystery of Banking. But it is clearly true. You cannot create something from nothing. You can’t lend what you do not own or have not legally borrowed in a manner that permits relending. It does not negate the argument against fractional reserve banking. It supports it.

You can’t both maintain a demand deposit in a demand deposit account and also lend it out. You can only lend what you have the right to lend, your own capital or money people loan you for a term that allows relending. Read some of the analysis in the earlier posts about the problems FRB injects into the market supply and demand signals.

Stan Warford June 15, 2010 at 1:26 pm

Russell,

I understand the argument against lending out what you don’t own and agree with it. But, cargocultist says equity capital provided by the shareholders and bank owners determine the loan capacity of the bank as opposed to bank deposits (or is it in addition to bank deposits? It is not clear to me). If so, to that extent, isn’t the argument negated?

Russell June 15, 2010 at 1:44 pm

Stan,

I believe what he is talking about is that a bank is supposed to have a certain amount of capital to cover loan losses. So capital does constrain loans as well. So 90% of deposits can only be loaned if you have an additional cushion of capital to begin with. But that does not prevent the lending out of demand deposit money and creating inflationary credit, it only constrains it to limits set by the government. The Federal Reserve has no such limits, that is why it grew its balance sheet to $2 trillion. This was certainly not money it first earned.

Stan Warford June 15, 2010 at 2:10 pm

Russell,

I understand about the Fed, which is not the point here. Also, as I understand Murphy, it is not 90% of deposits that can be loaned out, it is nine times deposits. However, the point I am confused about is that if the amount of the loan is constrained by equity capital that would be used to cover a demand, then, to that extent anyway, the argument against FRB is negated. That is, it is the shareholders of the bank that would take the loss. I really want to know what the current banking practice is so I will know how to make an informed argument. This is the first time I have heard about equity capital limiting credit issued by a FRB in my study of Austrian economics. How does that work in today’s banking system in the US?

Current June 15, 2010 at 2:30 pm

Why is equity capital any different from debts in this respect?

Abhilash Nambiar June 15, 2010 at 4:01 pm

Stan,

Take an FRB bank that lends its demand deposits to a point where reserves have significantly dwindled. So they use equity capital to cover demand on deposits. So the equity capital has stretched the bank’s loaning capacity. I fail to see how that negates the argument against FRB.

You still have a situation that emerged because you where lending money that you where never supposed to lend. That does not change. The equity capital seems like a red herring to me. So maybe the bank and shareholders will also be forced to take a loss. But that does not impact the core argument against FRB. The real problem comes because demand deposits are being misused.

Russell June 15, 2010 at 7:05 pm

Thank you Abilash for responding to the point so cogently. Bank capital is required to be only 8% of risk weighted assets: http://wfhummel.cnchost.com/capitalrequirements.html. It is not much constraint and ignores the fundamental problem with lending money you have no right to lend. This applies whether it is 10% or 90% of the money you have no right to lend.

It is a bad system because as Abilash pointed out in earlier posts, it sends falls demand signals throught the market. They false becasue money is supposed to represent the prior creation of goods or services. This money represents neither. There is earned money and then there is printed money. If everyone could just print it, no one would work to earn it. We’d be back to barter and people would use gold. So why should some people be able to print it rather than earn it?

Current June 15, 2010 at 2:18 pm

> You can’t both maintain a demand deposit in a demand deposit account and also
> lend it out. You can only lend what you have the right to lend, your own capital or
> money people loan you for a term that allows relending.

Why not?

What your saying is that only timed savings and bailments should be legal? Why?

Why can’t myself and my friend Tim organize a call-loan. Tim loans me 5 ounces of gold and I agree to pay him back whenever he asks for it back. He and I could make it perfectly clear that I intend to invest the 5 ounces of gold elsewhere.

If I had many similar call loans with others then I could keep a fractional reserve of gold to pay people back when they ask. There is nothing wrong with me making such agreements if I can keep them in practice.

Abhilash Nambiar June 15, 2010 at 5:54 pm

Why can’t myself and my friend Tim organize a call-loan. Tim loans me 5 ounces of gold and I agree to pay him back whenever he asks for it back. He and I could make it perfectly clear that I intend to invest the 5 ounces of gold elsewhere.

How are you able to hold on to that contradiction?

If you have to pay it back anytime he asks for it, then you cannot invest it elsewhere. If you are investing it elsewhere, then he cannot ask for it anytime he wants. Two people can voluntarily agree to a transaction that defies the laws of scarcity, but they will not be able to fulfill it. Such an argument is thus invalid. Which is probably why FRB did not emerge in the free market. No free people dealing with scarce resources are going to agree to a use of the scarce resource that violates the constraints imposed by simple scarcity.

Another example of a logically impossible agreement that can be made. I can promise both my bosses who are of equal seniority that I would complete both their different tasks at the same time. But my body is a scarce resource. Only one task can be done at one time with it. So the agreement is de facto invalid even if all parties consent.

Another example. Two people put in 50% each and buy a chair. They both agree that any one of them can sit on it any time. Cannot be done. When one sits the other cannot. It will always be that way.

Stan Warford June 15, 2010 at 6:26 pm

Abhilash

This is an interesting historical question. Earlier in this thread the statement was made that FRB does emerge in the free market. You state that “… FRB did not emerge in the free market.” I wonder which is true, and why.

Russell June 15, 2010 at 7:11 pm

Stan,

The market was never free in banking. It was always government regulated in U.S. chartered either by the federal or state government who required them to take government notes and allowed them to use them for bank capital even though they were backed by nothing but the governments promise to pay like with Continentals.

Abhilash Nambiar June 15, 2010 at 7:50 pm

Earlier in the thread, I was thinking that FRB was a stupid thing that can be done, you know kind of like smoking cigarettes. That if people are not deliberately being misled into it, then it is ok. In fact I have already said it in this thread, although it never was clear to me why there always an element of deceit in the practice of FRB.

But it was when Current put his example of call-loan that this statement struck me.

Why can’t myself and my friend Tim organize a call-loan. Tim loans me 5 ounces of gold and I agree to pay him back whenever he asks for it back. He and I could make it perfectly clear that I intend to invest the 5 ounces of gold elsewhere.

Suddenly the oddity of the whole process became apparent. Free bankers seemed to have overlooked one simple rule when it comes to scarce resources. Multiple people cannot have exclusive control over the same scarce resource at the same time. And yet for FRB that is exactly what you require.

Even with voluntary agreement, such a state of affairs cannot be realized. It is an immutable law when it comes to scarce resources. Multiple people cannot have exclusive control over the same scarce resource at the same time.

Once that is realized, the need for fraud in FRB is easy to recognize. The FRB Bank is binding two parties to a contract that cannot be enforced even with their full consent. So through fraud you hope to fulfill the expectations that the two parties hope to realize through such a contract.

Current June 16, 2010 at 12:47 pm

How are you able to hold on to that contradiction?

If you have to pay it back anytime he asks for it, then you cannot invest it elsewhere. If you are investing it elsewhere, then he cannot ask for it anytime he wants. Two people can voluntarily agree to a transaction that defies the laws of scarcity, but they will not be able to fulfill it. Such an argument is thus invalid.

Let’s say I’m a banker and I have 1000 customers who have on-demand accounts. Those accounts are my debts. The total of them equates to 100000 ounces of gold, that is the amount that I owe. But, that doesn’t mean that I need to have all 100000 ounces available in gold all the time in case my customers call. All I need is a reasonable fraction of it, so I can service reasonable demands. I can arrange this sort of contract with my customers. Doing so isn’t logically contradictory, all it means is that my customers are taking a risk.

All contracts involve some degree of risk, and many contracts are similar to the on-demand account contract we’re discussing. Think about your contract with your water supplier or electricity supplier. The likelihood is that if all consumers in your area were to drastically increase their usage of water then that would mean that the water system would fail. Does that mean that it’s sensible for people to refuse contacts with water suppliers unless they can provide water under any conditions? I don’t think so.

Which is probably why FRB did not emerge in the free market.

This is wrong. In the most free markets that we know of FRB did emerge.

Another example of a logically impossible agreement that can be made. I can promise both my bosses who are of equal seniority that I would complete both their different tasks at the same time. But my body is a scarce resource. Only one task can be done at one time with it. So the agreement is de facto invalid even if all parties consent.

That’s not really the same situation. You’re confusing availability with scarcity. On-demand banking is about availability.

Let’s take an example that’s more like the actual case. Let’s say each of your two bosses want to employ you for only one day per year. You don’t know when those days are, the boss will call you the day before.

Now, would it be unreasonable to agree to this request from both bosses? Certainly there would be problems if it so happened that both bosses wanted your work on the same day. But, I don’t think any court would uphold the idea that making the agreements in the first place was illegal or fraudulent. The same principle applies to banking.

DD5 June 16, 2010 at 1:12 pm

“This is wrong. In the most free markets that we know of FRB did emerge.”

How free is “in the most free markets”? Maybe the current US system is the “most free” among the others (European, Asian, etc…), so according to your method of inference, I shall conclude that the US system is proof that FRB emerges in the “most free market”.This constant reference to your dubious proof by History propagated by you and others is starting to border intellectual fraud.

I showed you the counter-argument for this above and you provided nothing but irrelevant excuses, which shows that you are not even familiar with the counter-argument and perhaps not interested in any objection to your preferred ideological position.

Current June 16, 2010 at 2:22 pm

I often here the argument from Communists that the Soviet Union was not a *sufficiently* Marxist place. That the Soviet leadership deviated from the path of true Communism. These Communists claim that if there had been “True Communism” then everything would have been sweetness and light. I find this dubious because although it’s quite true that the Soviet Union wasn’t true communism it was the nearest historical example we have.

This is the problem with your argument. If we reject all historical examples where there wasn’t a “truly free market” then we have no historical examples remaining.

The relevant historical fact here is that in the historical situation that is the nearest we have to a free market fractional-reserve banking prevailed even though 100% reserve banking was quite legal.

If you reject historical evidence then surely we can still discuss the theory? Supporters of free-banking don’t claim that the history is the only evidence. We have a theory for why fractional-reserve free-banking works. If you don’t want to discuss history then the argument comes down to which theory is the most robust. So, what’s wrong with our theory?

Abhilash Nambiar June 16, 2010 at 3:56 pm

Let’s say I’m a banker and I have 1000 customers who have on-demand accounts. Those accounts are my debts. The total of them equates to 100000 ounces of gold, that is the amount that I owe. But, that doesn’t mean that I need to have all 100000 ounces available in gold all the time in case my customers call.

That is exactly what it means if you call it a demand deposit.

All I need is a reasonable fraction of it, so I can service reasonable demands. I can arrange this sort of contract with my customers. Doing so isn’t logically contradictory, it means is that my customers are taking a risk.

The nature of a demand deposit requires the fulfilling of any and all demands for the deposit by the depositors, not just ‘reasonable’ demands. So the agreement between you and the customer is meaningless. They are not taking risk, they are agreeing to impossibility.

You can demand your money any time you want, except when you cannot? Talk about grammatically correct, but logically self contradictory! Usually what lawyers do is fill up the space with a lot of meaningless legal garble to keep people from recognizing it. Realistically how it works out is that people expect to get their money most of the time and in fact they do, but logically it is still meaningless.

Reality of course does not reflect the logically impossible contract they have agreed upon and finds its own way. Which of course begs the question, why would sound individuals agree to such a contract? Historically the answer to it is that they where misled. The rules where changed after they signed the dotted line.

All contracts involve some degree of risk, and many contracts are similar to the on-demand account contract we’re discussing. Think about your contract with your water supplier or electricity supplier. The likelihood is that if all consumers in your area were to drastically increase their usage of water then that would mean that the water system would fail. Does that mean that it’s sensible for people to refuse contacts with water suppliers unless they can provide water under any conditions? I don’t think so.

Again, you are confusing between risk (arising from uncertainty) and impossibility. The contracts with the water supplier or electric company may incorporate a risk but they do not incorporate any logically impossible situations. There are foreseeable risks of shortage that the utility firms are obligated to overcome and logically can. In fact for peak usage, electric companies have backup generators and water suppliers depend back on backup reservoirs.

You’re confusing availability with scarcity. On-demand banking is about availability.

No I am not. They are two sides of the same coin. It is because of scarcity that there is a constraint on availability. If people entering into a contract cannot recognize that, then they are entering into a meaningless contract. You are confusing risk with impossibility. FRB results in impossible obligations.

Let’s take an example that’s more like the actual case. Let’s say each of your two bosses want to employ you for only one day per year. You don’t know when those days are, the boss will call you the day before.

Now, would it be unreasonable to agree to this request from both bosses? Certainly there would be problems if it so happened that both bosses wanted your work on the same day.

In such a case, both parties must agree before hand how the situation would be handled if both call on the same day. Maybe it would be first come first served. Or they may have some sort of a blanket clause that says “Any disputes arising from this contract will be handled by a third party that we both trust.”

If they do not agree to such a thing, then their contract incorporates a logically impossible situation that can never be fulfilled. The fact that people agreed to it does not change that. Eventually a situation will reach where I have a logically impossible obligation to fulfill, even the fact that it is of low probability also does not change that.

But, I don’t think any court would uphold the idea that making the agreements in the first place was illegal or fraudulent.

Such a contract is neither illegal nor fraudulent. To the extent that it incorporates a logically impossible situation, to that extent, it is simply irrelevant.

Current June 20, 2010 at 12:47 pm

> The nature of a demand deposit requires the fulfilling of any and all demands
> for the deposit by the depositors, not just ‘reasonable’ demands. So the
> agreement between you and the customer is meaningless. They are not
> taking risk, they are agreeing to impossibility.

The law doesn’t agree with you on that point. I’ll discuss it more later.

> You can demand your money any time you want, except when you
> cannot? Talk about grammatically correct, but logically self contradictory!
> Usually what lawyers do is fill up the space with a lot of meaningless legal
> garble to keep people from recognizing it. Realistically how it works out is
> that people expect to get their money most of the time and in fact they do,
> but logically it is still meaningless.

The problem here is that you take a promise to do something quite different from how the law looks at it. The law looks at it in a practical sense not a logical sense.

What a promise means in this context is that in practical situations the bank agrees to redeem notes.

> Which of course begs the question, why would sound individuals agree to
> such a contract? Historically the answer to it is that they where misled. The
> rules where changed after they signed the dotted line.

That has certainly happened. However, people have also agreed to use fractional reserve banking knowing exactly what it entails. They have done that for long periods of history and without state backing.

> Again, you are confusing between risk (arising from uncertainty) and
> impossibility. The contracts with the water supplier or electric company
> may incorporate a risk but they do not incorporate any logically impossible
> situations. There are foreseeable risks of shortage that the utility firms are
> obligated to overcome and logically can. In fact for peak usage, electric
> companies have backup generators and water suppliers depend back on
> backup reservoirs.

Certainly there are foreseeable risks of shortages. But, what if everyone turned on all their taps at the same time? Or what if everyone in an area bought a device that consumed a lot of electricity and then turned them on at the same time? I know that those systems are not built to operate under those conditions. If the electricity company has agreed to provide a continuous supply then it will fail.

Let’s say we have a village where each household is limited to 7KW. The village contains 100 houses, but the main supply lines are limited to 350KW. That means that the system will fail if each house demands it’s maximum. Now, the electricity company may agree to supply electricity to all of these houses without mentioning that. It may be argued that it is a “logical impossibility” to agree to supply a potential maximum of 700KW on-demand with a system capable only of supplying 350KW.

However, the law generally doesn’t take this view. As I understand it the legal view is that what matters is if the electricity company has made reasonable provision to provide the service, not 100% provision. I think that that is wise, though I think it’s better if the service providers state explicitly what they will do if failure occurs.

> No I am not. They are two sides of the same coin. It is because of scarcity
> that there is a constraint on availability. If people entering into a contract
> cannot recognize that, then they are entering into a meaningless contract.
> You are confusing risk with impossibility. FRB results in impossible obligations.

When you mean “impossible” what you mean is that under some set of circumstances the contract cannot be fulfilled. The problem here though is the *risk* that those circumstances occur. Yes, if everyone redeems at once then logically the bank can’t pay them, but what is the risk of them all redeeming at once?

Insurance suffers from the same logical flaw. Insurers don’t keep enough reserves to back all accidents that could occur. So, a spate of accidents could leave them unable to pay. In insurance there is the same sort of logical contradiction that you point out in fractional reserve banking, or that I mention in relation to utilities. If an insurance company keep X assets but promises to pay 5*X assets if all claimants have valid claims then the situation is similar.

> In such a case, both parties must agree before hand how the situation
> would be handled if both call on the same day. Maybe it would be first
> come first served. Or they may have some sort of a blanket clause that
> says “Any disputes arising from this contract will be handled by a third
> party that we both trust.”

Certainly, it’s best if they did that. And, in this simple circumstance they could easily do that.

> If they do not agree to such a thing, then their contract incorporates a
> logically impossible situation that can never be fulfilled. The fact that
> people agreed to it does not change that. Eventually a situation will reach
> where I have a logically impossible obligation to fulfill, even the fact that it is
> of low probability also does not change that.
>
> Such a contract is neither illegal nor fraudulent. To the extent that it
> incorporates a logically impossible situation, to that extent, it is simply
> irrelevant.

You’re taking a Rothbardian view of contracts that I think is too simplistic. In practice “even the wise cannot see all ends”.

In the case of fractional reserve banks it’s quite easy, especially with the benefit of hindsight, to see the problems. This is one of the reasons that the option-clause was added to Scottish banknotes. That allowed the banks to pay with debt.

If I write on a banknote

“This note is a loan for 10 ounces of gold. If it is presented for redemption at any branch of foo-bank, the foo bank will do either #1 or #2 at it’s option…
1: Pay 10 ounces of gold immediately.
2: Pay 12 ounces of gold within 6 months time.”

Then the contradiction problem is solved. Insurance companies and electricity suppliers can do similar things and often do.

However, I my point is more general. Some folks take a hardline on logical problems “if the contract isn’t logically valid or complete then it’s not a contract”. I think this is foolish and I’m glad real legal systems don’t do it. Notice that above I mention the place of redemption, that’s because without it the contract isn’t really complete. Had you ever noticed that before?

In practice it’s impossible to ensure that a complex contract is fully logically valid and complete. So, when a contract is found otherwise then a court should decide on the spirit of what the two parties agreed.

george t morgan June 16, 2010 at 3:44 am

“You can’t both maintain a demand deposit in a demand deposit account and also lend it out.”

by saying you cant are you saying that it is impossible and/or does not actually happen or by cant are you saying that it is somehow wrong or improper???

george t morgan June 16, 2010 at 3:52 am

Tim loans me 5 ounces of gold and I agree to pay him back whenever he asks for it back.

well..if i have 5 ounces of gold already and get a call loan because i think i can get some more money before giving up all my 5 ounces is that a double claim on a real resource?? were you assuming me not to have any ounces of gold??

for whomever to loan money and think to get it back on a whim demand when it is very likely to be spent doesnt make sense to loan the money in the first place.

Current June 15, 2010 at 2:05 pm

Like other businesses there are multiple forces that limit banks.

Consider a fractional reserve free bank. This sort of bank holds gold reserves, and other assets. Those other assets are shareholders capital and the debts of borrowers.

On the one side of it’s balance sheet are the liabilities, those are the banks banknotes, it’s current accounts, savings accounts and any bonds it issues. On the other side is that shareholders capital, gold reserves, and the loans and debts the bank has made.

Now, let’s suppose the banks makes more loans, this poses two problems. Firstly, the bank must make loans to borrowers who are “good risks”. They must take steps to ensure that the borrowers will pay them back. Secondly, by making those loans they will increase the number of times that they are called upon to redeem their money-substitutes into gold. These are the points Steve Horwitz was making above.

Free banks have no government-set “reserve requirement”. They can hold as much or as little as they want. They have to judge how much is the right quantity by watching how often their customers use the redemption facility and for what amounts. Despite what Rothbardians say this isn’t very difficult, as Mises says bank managers “usually manage pretty well with it”.

If a free bank misjudges it’s redemptions or makes bad loans then it faces the possibility of a run or of other banks refusing to deal with it.

In free banking banks have “clearing houses” that provide interbank transfers. They do this by reciprocal cancellation and transfer of gold or high-grade debt. If a bank was thought to be too risky then it’s notes would no longer be accepted at the clearinghouse.

When central banking began it changed this. By offering the “lender of last resort” function it prevented marginal banks from going bankrupt. Many central banks also offered an inter-bank payment/clearhouse system. After those changes the central bank would back up failing banks, and often gaurantee inter-bank transfers too so there was little chance of being kicked out of the clearhouse anymore. This meant banks that would have gone bankrupt under free banking could continue to trade. In western countries this was further exacerbated by government deposit insurance which caused moral hazard. Then redemption in gold was abolished and fiat currency introduced, which broke one of the last remaining limitations.

These protections meant that banks could run down the amount of reserves they kept and the quality of their debt. Because, if they got into trouble then the central bank would help them out. This in turn made a government mandated reserve-ratio useful to ameliorate the problems. By setting a reserve-ratio the state could control the overall quantity of lending to some degree. If a bank has to keep a certain quantity of reserves then that restricts it’s lending. That in turn leads to state control over the supply of money.

However, the whole “money multiplier” the monetarist and folks here are discussing on institutional circumstances. Under the old central banking systems there are always banks somewhere who have a set of potential borrowers “on tap”. These borrowers are marginal and its quite likely that without the central bank and deposit insurance protection no banker would lend to them. However, since those things are there the only remaining limitation is reserves. So, whenever reserves expand so does borrowing and the money supply. As another poster wrote Rothbard said that banks are always “fully loaned up” this is why.

However, even central banking need not work like this. In Australia, New Zealand and Sweden there is no reserve ratio. Banks can keep no reserves. In those countries the central banks use capital requirements, and other tools to police the system. That is, to reduce lending they require that banks hold more AAA grade debt, or less lower grade debt.

In the modern US the system also isn’t quite as it’s described in the textbooks. If a bank acquires a $10million deposit then to loan it out it needs $1million reserves. The bank no longer has to negotiate for those reserves, instead the fed supplies them *automatically* (at a cost). That would seem to indicate that infinite money would be quickly created. There are two reasons why it isn’t. Firstly, the asset quality issue still has some bearing (though not as much as it should), so banks can’t always find new borrowers. Secondly, the fed use other legal tools at their disposal. If they think a bank is doing reckless or suspicious things then they start a regulatory investigation into them.

Russell June 15, 2010 at 7:17 pm

It is sorry system that interferes with supply and demand price signals by creating excess credit that goes to dubious borrowers who would not get it with the creation of credit out of thin air. This leads to bigger bubbles and panics than would otherwise be the case. Lots of sleep lost as a result of this system.

george t morgan June 15, 2010 at 8:43 pm

by creating excess credit that goes to dubious borrowers who would not get it with the creation of credit out of thin air…..

doesnt someone accept the dubious credit out of thin air to create the price signal interference?? what ever price signal interference is??

Russell June 15, 2010 at 9:46 pm

Sure they accept it. That is not the point. The point is the bank now create demand that they would not be able to create without frb and the credit having been created out of thin air, no additional goods or services were first added to the marketplace to offset this additional demand. Thus prices rise for those who worked for their money. The bank makes money lending money that was not earned. This is not good human engineering because it rewards sloth.

Adrián Ravier June 15, 2010 at 1:35 pm

Very interesting article. But it not adds any new argument. See for example, Chapter 4 of “Money, Bank Credit and Economic Cycles”, by Jesús Huerta de Soto.

I think the most importante debate in this blog was that between Murphy vs Horwitz.

Horwitz said:
“the bank is economically limited to lending out its excess reserves and it does so by creating that liability.”

What Murphy is not seeing, is that Horwitz point of view is the same that Mises present in Human Action. See specially Chapter 17.12 (The limitation of the issuance of fiduciary media. Observations on the discussions concerning free banking).

Nicolas Cachanosky June 15, 2010 at 3:53 pm

I think Murphy’s example of the “out of thin air” argument is clear.

However, it seems that the $1.000 in gold came out of thin air as well. Economically, it shouldn’t matter if this $1.000 in gold fall from the sky, magically appear out of nothing or were unexpectedly discovered in an old attic. So, following the line of argument in the example, it seems that is not the notes, but the gold, the one that is “created out of thin air.” Would there be no new gold, the bank would not be able to issue notes. If the gold came from an accoun in another bank, then the system as a whole is not creating new money.

If banks were not to have a legal restriction on their reserves, but they were totally free to decide with what reserves to work, then they shouldn’t need a commodity deposit to issue more notes if they can do that out of thin air. Why do they need new gold deposited to issue more notes? If they have a limit on what they can issue, then it doesn’t seem to be “out of thin air.”

Adrian’s reference can be a good explanation of how this limit works.
NC

Abhilash Nambiar June 15, 2010 at 8:14 pm

Economically, it shouldn’t matter if this $1.000 in gold fall from the sky, magically appear out of nothing or were unexpectedly discovered in an old attic.

Yes it does. If gold really did come out of thin air, it would not be used as money. Gold falling out from the sky and magically appearing out of nothing are impossible. Gold can only be attained through a resource intensive process, be it mining or some other way. That is part of what goes into making it sound money and if it stops being sound, there are other options. Dough French has a blog entry in which he quotes Mises.

http://blog.mises.org/12974/wsj-letter-writers-on-gold-as-money/

It may happen one day that technology will discover a method of enlarging the supply of gold at such a low cost that gold will become useless for the monetary service. Then people will have to replace the gold standard by another standard. It is futile to bother today about the way in which this problem will be solved. We do not know anything about the conditions under which the decision will have to be made.

As for gold found in your attic, that does not pop out from thin air, although to you, it may feel that way. It is the product of the efforts put in the past, most likely by a dead relative who never came back for it. It is also the product of a resource intensive process although you where not the one who expended the resources.

What gold found in the attic really means here is money that has remained outside the banking system for a while. Only when it re-enters can excess reserve notes be created out of thin air.

Nicolas Cachanosky June 15, 2010 at 11:01 pm

I see what you say. But I still don’t follow.

a) Even if it’s the product of past work, given how the example is built, for the market is the same as it didn’t exist anymore (or was destroyed) and suddenly cames out of nothing. This $1000 gold were completely out of the market, the discovery, is as if came out of nothing. Instead of being the gold in and old attic it could come from the discovery of a new source with gold ready to use; this doesn’t change the example. Past work shouldn’t matter (that may sound close to a labor-theory of value), gold is not used as money because labor is “in” it. It’s true that society evolves with the help of capital goods accumulated from previous generations, but this previous labor does not give value to capital goods, or gold in this case, so that it can be used as money. For not being out of nothing, I would expect, for example, that this $1000 gold came from another bank account (which is costly for the other account), new gold production (which is not free), from industrial use (which is also not free). What’s the cost in the new $1000 gold? None, past costs of production are in the past. There would be a cost if the discovery came out of an expedition with the purpose of finding new gold, but that’s not the case in the example. The attic is an unexpected and uninteded discovery of forgotten gold which is completely out of the market. The example would work just as well if instead of assuming a discovery this $1000 fall from the sky, even if we now that’s impossible; however, if that’s the case, even more for the discovery to be “as if” came out of nothing.

b) Still, if the banks require new deposits to be able to expand further, then the notes are not produced out of thin air, something else is there. If notes could be produed out of thin air then (without legal imposition on reserves) banks should be able to offer notes free of cost. But to issue more IOU’s than there is demand for it is not free for the issuer banks.

c) My point was that in the example gold came out of thin air before the notes, and this may become confusing in how the new notes come to existence in the market. In the example, what is free is the new gold, not the new bank notes. But even if that’s not the case, if the new gold came from a new production process (not free), and if fractional reserve banking were the creation of notes out of nothing, banks should not need a deposit of commodity money to expand their fiduciary media in the first place. If it’s not free for the banks to do this, how it’s “out of thin air”? That is, I think, a question that may help to understand the “out of thin air argument.”

Best,
NC

Russell June 16, 2010 at 1:07 am

The Federal Reserve bank doesn’t. Where do you think it’s $2 trillion balance sheet came from?

Nicolas Cachanosky June 16, 2010 at 9:28 am

Fine, but there’s no central bank in the example. Note that the new gold discovered in the attic plays the role of the new 2$ trillon in the Fed Balance (of course, with an important difference of amount). That’s why I say the what comes “out of thin air” is the Gold, not the bank notes. So, it seems that we are actually saying a similar thing (at least on this point).

Because in reality gold cannot “fall out of the sky”, a free market in banking cannot create gold (or fiat dollars through a monetry authority) out of nothing. But this is not how I understand the example is working; gold comes out of nothing, like the Fed notes you mention. In the second case, what is created out of nothing would be the Fed notes, not the commercial bank notes.

But, again, there’s no Fed in my previous comment. Or, if you want, the Fed could be the old attic which cames with new $1000 money ni the narrow sense out of nothing.

Best,
NC

Abhilash Nambiar June 16, 2010 at 5:00 pm

Even if it’s the product of past work, given how the example is built, for the market is the same as it didn’t exist anymore (or was destroyed) and suddenly cames out of nothing. This $1000 gold were completely out of the market, the discovery, is as if came out of nothing.

As if coming out of nothing and coming out of nothing is not the same thing. What came out of nothing represents an unreal and false signal about economic activity. What looks as if it came out of nothing represents the outcome of real economic activity, all be it unknown. But that is always the case. Person accepting money in exchange for goods or service does not care about its origins or its age, he does not need to know it. The price itself incorporates all necessary information about the economic activity, provided of course we are using sound money and sound banking.

Past work shouldn’t matter (that may sound close to a labor-theory of value), gold is not used as money because labor is “in” it. It’s true that society evolves with the help of capital goods accumulated from previous generations, but this previous labor does not give value to capital goods, or gold in this case, so that it can be used as money.
.

Past work does not matter in the sense present price of the same work would be based on needs of the present. But it does matter in the sense; the present situation is an outcome of the past work. The outcome of past work on the present could be accumulated capital or accumulated savings. If it is accumulated savings, then the value of that savings will be depending on current economic conditions.

For not being out of nothing, I would expect, for example, that this $1000 gold came from another bank account (which is costly for the other account), new gold production (which is not free), from industrial use (which is also not free).

All gold including that from another bank account and used in industries comes from past gold production, be it the recent or the distant past. Distant past is not nothing. It just appears to be so.

What’s the cost in the new $1000 gold? None, past costs of production are in the past. There would be a cost if the discovery came out of an expedition with the purpose of finding new gold, but that’s not the case in the example. The attic is an unexpected and uninteded discovery of forgotten gold which is completely out of the market. The example would work just as well if instead of assuming a discovery this $1000 fall from the sky, even if we now that’s impossible; however, if that’s the case, even more for the discovery to be “as if” came out of nothing.

The example would work if gold fell from the sky just once in a lifetime or something that rare. The market would not have enough incentive to switch to a different exchange medium. Having said that the money in the attic is an outcome of economic activity and the money falling from the sky is not. Gold that is mined is also a product of economic activity. Instead of teenager Bill, suppose we had old man Bill who stored $1000 in gold in his attic which he had earned as a teenager, forgot about it and came back to rediscover it, neither he nor you will say the gold came from nothing. But instead of old man Bill passes on and his teenage grandson Bill finds it, it looks to both you and teenage Bill that it came from nothing. It has not. It just looks that way. If old man Bill has left all his inheritance to teenage Bill, then that gold is his.

Still, if the banks require new deposits to be able to expand further, then the notes are not produced out of thin air, something else is there.

You are right, not all notes are produced out of thin air. But a lot of them are. How much depends at the end on the banker’s prudence.

If notes could be produced out of thin air then (without legal imposition on reserves) banks should be able to offer notes free of cost. But to issue more IOU’s than there is demand for it is not free for the issuer banks.

There is an upper limit dictated by the behavior of the bank’s customers.

My point was that in the example gold came out of thin air before the notes, and this may become confusing in how the new notes come to existence in the market. In the example, what is free is the new gold, not the new bank notes.

The new gold is not free. Someone earned it. Just not its current owner. The example would work just as well, if old man Bill discovered gold in his attic that he had forgotten about.

If it’s not free for the banks to do this, how it’s “out of thin air”?

Real money is used to back free money. That is how.

Russell June 17, 2010 at 2:14 am

Abhilash is correct. Think of it this way. Before there was money, there was either barter, I trade a cup of sugar for a teaspoon of salt, or a loan, I lend you a cup of sugar in return for you providing me with something of value to me later assuming you can pay. Money is supposed to take the place of the cup of sugar, not the promise to pay later. In frb, the bank creates what looks like money but is really just a promise to pay. With frb, a substantial portion of the value in the transaction Is crated after rather than before the transaction but the market cannot distinguish between the segments and is therefore fooled as to their relative value. It is a bad system for balancing supply and demand.

Tony Immarco June 15, 2010 at 7:18 pm

If $1000 is deposited in a bank account and the reserve requirements are 10% should the bank’s account be augmented by $9000 and not $900?

Allen Weingarten June 15, 2010 at 8:36 pm

Many articles in the literature give an incorrect view of how fractional reserve works.
It operates as follows. Suppose the FED has $100, so that using a fractional reserve of 20% (or .2) lends $80 to a bank (or $100 (1-.2).
The bank which receives the money lends out $64 (or $80 (1-.2). This money then has at most the compound effect of successive loans of $64 (1+.8 + .82 + .83 + …) = $64 1/(1-.8) = $320 (or $64/x).
The total loaned is then $80 + $320 = $400 (or $80/ .2); while the total deposited is
$100 + $80 + $320 (or $100 + $100 (1-x) (1/x) = $100 ([x+1-x]/ x) = $100/ x.
For x= .1, .2, .5, the totals deposited are then $1,000, $500, $200, as expected.

More direct: the deposit to the FED is $100; to the first bank is $100 (1-x); to the second bank is $100 (1-x)2; $100 (1-x)3; …, for a total deposit of $100/ [1-(1-x)]= $100/x
The total loaned is then $100/x – $100 = $100 ( 1/x – x/x) = $100 (1-x)/x

In other words, fractional reserve at 10% does not result in 10 times the value at the first bank, but is rather a limit after passing through a cascade of banks.

george t morgan June 15, 2010 at 8:40 pm

Many articles in the literature give an incorrect view of how fractional reserve works.

why is that??

Stan Warford June 16, 2010 at 1:33 am

Allen,But according to Bob Murphy above in this long thread, a 20% reserve requirement means that the original single bank could legally (even though it would probably not do such an imprudent thing) loan out five times the $100, which is $500 dollars. In other words, because 20% of $500 is $100 such a loan meets the reserve requirement. Murphy is claiming this is how to establish the reserve requirement. You do not establish the legal upper limit as 80% of $100 which is the $80 in your example. This is before the deposits pass through a cascade of banks.

Allen Weingarten June 16, 2010 at 5:51 am

Stan, I agree that the original bank could loan out the whole amount. As you note, that isn’t the way it occurs, which is why I wrote the above, as an answer to Tony’s question.

As an aside, consider when the $100 (under a 20% reserve requirement) loans out $500. I view this as $100 being loaned out which is redeemable (even though this is fraud to the depositor), and $400 which is created out of thin air. Some argue that this $400 is not created out of thin air, because the borrower has provided collateral. By that reasoning, one could abandon the need for a deposit of the $100, and just loan out the $400. In other words, the argument that ‘money is not created out of thin air’ would justify having no reserves whatsoever.

Russell June 16, 2010 at 9:14 am

Allen is exactly right. But the real question is functionally, why is it bad to run the banking system this way. After all, if it resulted in a faster growing, more stable and vibrant economy that without fractional reserve banking, it would be in our best interest to continue the practice.

Allen Weingarten June 16, 2010 at 12:26 pm

Russell, I submit that when money is created out of thin air, it results in insolvency when the money cannot be redeemed, or else it is tantamount to wealth redistribution to those who receive the early benefits. There is a moral objection to wealth redistribution, and to the fraud where depositors are led to believe that their deposits are secure, when they are not.

There are short range advantages, just as one gets energy from taking a drug, but there is an inevitable payback, which becomes worse as we become more addicted.

Russell June 17, 2010 at 2:18 am

True but see my comment above about the cup of sugar.

Bala June 16, 2010 at 9:32 am

” After all, if it resulted in a faster growing, more stable and vibrant economy that without fractional reserve banking, it would be in our best interest to continue the practice. ”

A big “if” at that. As we have no point of comparison, any claim that FRB resulted in a faster growing, more stable and vibrant economy than without it would be an extremely hollow claim indeed.

Stephen Grossman June 16, 2010 at 2:48 pm

>See Austrian economics for the point of comparison, ie, savings vs. counterfeit money and counterfeit bank credit.

Current June 20, 2010 at 11:48 am

What you’re talking about is the “Rothbardian” or “100% reservist” view. It’s not “Austrian Economics”. Other Austrian economists have had quite different views.

Russell June 17, 2010 at 2:19 am

Too true!

Current June 20, 2010 at 11:47 am

It is true that episodes of 100% reserve banking are rare.

However, theory provides assistance here. There are two principle advantages of fractional-reserve banking compared to 100% reserve banking. Firstly, fractional reserve banking reduces the cost of the monetary system. Rather than having to store unproductive gold, other assets can be used to back money. Any balance held in a current account is in productive use being loaned to others. Secondly, the fractional reserve system buffers price shocks. For example, if a recession happens due to a bubble bursting abroad then a rise in the demand for money may ensue. A fractional reserve banking system can issue more money to supply that demand.

Will June 16, 2010 at 10:04 pm

If we are deontological libertarians who base the Austrian philosophy on the Non Aggression Principle then FRB can’t be banned but nor can money be imposed by any Statist coercion nor can banks be coerced into a cartelised system that exists to enable any leveraging on price increases in a certain sector made certain by the same banks fiat money creation, with the moral hazard of inter-bank bailout or Central Bank bailout which exists for the purpose of removing 100% of the risk from leveraging on prices whose likely increase is subject to the chance that the banker has deluded himself about the market’s propensity to buy products related to that sector without the market having to reduce prices in order to clear after overproduction signifies relative underproduction thanks to bankers distorting prices and production thereby enabling gluts. What I’m saying is that the free-market is a system of perfect justice that blinds as well as the whole market, also the very bankers themselves who inflate currencies as to actual demand and actual relative scarcities between sectors and where investment would not be malinvestment but taking opportunity of an undervalued asset or sector (profiting from being bearish in unwarrantedly bullish markets, another reason why Affirmative Action is unnecessary to lift allegedly undervalued people out of poverty) so money creators will harm themselves by overleveraging and in an anarcho-capitalist world would not be able to gain bailouts external from bank cartels, being then without the ability to con the populace through State education and the alleged benefits of redistributive taxation. Market money can’t be embezzled in breach of contract to be replaced with debased coinage or fiduciary media which inflation is bound to redistribute wealth and distort investment by distorting relative prices and giving people incomes and easier credit that the market would not allow, but the people who accept such money will be the fools not those who shun it so the system of justice works without a positive intervention by coercive means to impose sound money. Of course, money can be contractually lent to investors if they can make a case for not saving the money which is not banking but investment banking i.e borrowing. The difference is that in a free market banks won’t have the legalised cartel to prevent any banks from offering full-reserve services so investors will have to earn loans by merit not just by becoming a banker and duping the choice-denied public. The problem is that we accept the theft of our old free market money that increases in value and we even more meekly accept the lack of choice in banking. Full reserve banks can compete with fractional reserve banks because the latter are not banks but borrowers for investment who have taken over the banking industry to ensure that they don’t need to contractually arrange loans but need rely only on dupes placated by low interest rates. We need to be deontological and allow contract, not teleological creators of law that breaches contract supposedly in the name of preserving liberty.

Russell June 17, 2010 at 2:33 am

True,people just don’t understand how harmful frb is and governments like because it allows them to do things that voters would otherwise not approve if they understood the implications for the future. See my cup of sugar illustration above. But government is necessary to assure property rights. It is just tough to keep it from trampling on those rights once it has the power because government is run by people who don’appreciate the implications of what they are doing or or just don’t care. Education of voters is our only protection.

Allen Weingarten June 17, 2010 at 5:20 am

Russel, I agree that an IOU is not the same as a cup of sugar, so that we would avoid much of our insolvency by requiring real money (i.e., that which is immediately redeemable in goods or services). However, there is nothing wrong in principle with a contract where one individual accepts an IOU from another (even if it is not redeemed). The problem arises with the fraudulent practice of many IOUs that are given for the same cup of sugar.

Russell June 17, 2010 at 4:49 pm

Allen,

That is one way to look at it and I don’t disagree.

Russell

Stephen Grossman June 17, 2010 at 11:39 am

>We need to be deontological and allow contract, not teleological creators of law that breaches contract supposedly in the name of preserving liberty.

So we have an alleged duty to allow contract, a duty without purpose? This is absurd and destructive. Life requires purpose, life itself. And law, including contract, exists as a means to life.

Allen Weingarten June 17, 2010 at 12:24 pm

Stephen, are you saying that protecting contract and the rule of law has no purpose? You appear to say it has the purpose as “a means to life”, so I do not understand your position.

Stephen Grossman June 17, 2010 at 10:18 pm

I was rejecting deontology (action w/o purpose) for teleology. Perhaps my expression was ambiguous in its sarcasm. Contract and rule of law are means to the end of life. All values are based in life. Life is conditional upon (species-specific) values being obtained and maintained. Eg, reason. See Ayn Rand’s “Objectivist Ethics” (in her _Virtue of Selfishness) for a metaphysics of morality.

Daniel April 27, 2011 at 3:59 pm

I am no expert on banking or economics, so this is as much a request for correction as it is an argument.

I think they key sentence in Russell’s assessment (which seems to be a good representation of the rest of the anti FR banking proponents who have commented so far) is “If Billy withdraws his $1000 before Sally repays the loan, the bank cannot repay it.”

The fact that the $900 in physical assets would remain in Sally’s hands if Billy attempted to withdraw them demonstrates that the bank is not actually adding to the circulating money supply. The money that shows as being in his account, notwithstanding Sally’s use of them, is purely illusory. The circulating money supply is the same. What has changed is that the bank now has $900 in unfunded liabilities that exactly matches the $900 in physical assets Sally now possesses. These two cancel each other out.

Whether loaning deposited funds violates and implicit agreement between the bank and the depositor is another issue entirely, but it seems fairly obvious that people know how banks work by now and accept the fact that their money is being loaned out in return for interest payments. This is an arrangement they obviously favor or, as someone has already pointed out, they would not engage in it.

But banks loaning money that they DON’T have by simply changing their ledgers is a fundamentally different problem. Inasmuch as FR banking opponents oppose this aspect of modern banking, they are not really objecting to FR banking but to fraud in its truest sense. As far as I am aware (and again, I am no expert) regular banks cannot create money in this way. If that were the case there would be little sense in even having a reserve ratio. If a bank is loaning notional money, then the borrower, or whoever he uses the notional money to pay with it, will be depositing notional money in another bank account. If that money is purely notional, then this new depositor has no claim to real physical assets in return. Any money a regular bank loans out, therefore, MUST be in the form of physical assets at bottom, otherwise none of us would be able to withdraw physical assets from a bank based on an electronic deposit. At the end of a business day, actual physical assets representing fractions of deposits must change hands among banks clearing notional transactions so that they will meet the reserve ratio requirements.

The only bank that can manufacture money by simply changing ledgers is the Federal Reserve. This only “works” because the Federal Reserve will never try to redeem real physical money based on the notional loans it has made to member banks. The real enemy then is not fractional reserve banking but central banking.

FR banking, on the other hand, provides a valuable service to individuals by allowing depositors to realize the benefits of investment without giving up liquidity. It also benefits the economy as a whole because it makes funds available for investment that would not otherwise be available due to individual preference for liquidity.

Daniel April 27, 2011 at 4:43 pm

Please disregard most of that reply. I just realized my own error. It is precisely the reserve ratio that prevents banks from creating as much money on the books as they want. They only have to transfer a tenth of the value of a loan in real money.

Peter May 15, 2011 at 11:31 am

This debate shows that Mr Muprhy and commenters have not a slightest clue how banks work.

Banks DO NOT lend reserves, there is no money multiplier. Reserves can only be used in interbank market and to execute payments with the Fed, they cannot be lent out.

One Austrian gets this:
libertarianpapers.org/articles/2010/lp-2-43.pdf

Matthew Swaringen May 15, 2011 at 5:57 pm

Of course banks don’t lend reserves. Reserves are the money banks keep on hand. Are you even sure you know what Murphy believes?

What do you mean by “no money multiplier”? Are you saying that banks can’t lend more than their reserves?

Elwood P. Dowd May 15, 2011 at 11:55 am

If the pro-FRBie position, that there is no fraud, or any other misdeeds
involved in FRB is correct, why are banks the only ones who are allowed to do
it? If there is nothing wrong with making a scarce economic good available to
multiple parties at the same time, why can’t everyone do it? Why only banks?
As that, oh so clever fellow, perfesser Selgin loves to point out, the banks
make it clear that the only relationship between them and their customers is
that of creditor and debtor, nothing else. Curiously, in common parlance the one
borrowing the money is usually called the customer, not the other way around. I
guess that makes the bank my customer when I deposit money in my account. Why is
it illegal for me to treat my ‘customers’ the same way the bank treats its
‘customers’?
It is a commonly accepted point of law in free countries that if an activity
is legal, then it is legal for everyone, not just for the cronies of the powers
that be. Lets take a look at FRB from the idea that these activities should be
open to everyone, after all, they are harmless, if not outright beneficial to
society.
I notice that I can get a checking account that pays a small rate of
interest, 1% on the one I am looking at. I take this $100 bill I have here, in
front of me, to the bank and open an account. Then, because there is nothing at
all wrong with telling someone else that they also have access to that same
money, I go to a second bank. At bank 2 I open an account by writing a check for
$100 on the first account. Then I go to a third bank and write a check on bank 2
for $100 and open another account. I follow this pattern until the one hundredth
bank, at which point I write a check on that bank for $100 and send it to the
very first bank. I now have 100 accounts, each with $100, assets and liabilities
balance. I have done nothing wrong according to FRB.
Following the methods described so eloquently by the pro-FRBies, I use my
right to temporarily delay transfer of funds in what is, after all, just a loan,
to make sure that all of the checks clear in order and in rapid succession. This
is called good banking practices. The original $100 circulates through the
accounts, cascading from one to the next like the water in M. C. Escher’s
wonderful drawing of those waterfalls.
By continuing this pattern of check writing in a timely manner, accounting
for the time involved in clearing transactions, I can keep every account
continually at $100. The banks, my customers, are not hurt in any way, because
they each have the use of the original $100 in exactly the same way that THEIR
customers have the use of any other depositors money under FRB. They turn around
and loan out the money from my accounts, at higher interest than they are paying
me, to multiple customers just as I have done with them. Prosperity flows from
my actions like water from a holy spring.
At the end of one year each account has earned $1 in interest. A total
return of $100 on an original investment of $100 , not bad at all. Resisting the
temptation to take my honestly earned profits to Ms. Bunny”s Sartorial Parlor
and Club for Gentlemen, I instead gather up all the interest and add it to the
first $100 in bank number one. I continue as before, but now I am writing checks
for $200. At the end of the second year I have honestly earned $200 in interest,
which I add to the first account once again, doubling my wealth once again.
Still resisting the charms of Ms. Bunny, I follow this pattern for 15 years, at
which point every account balance reads $1,638,000. If you doubt it, do the
math, $100 doubled 15 times. Think of the prosperity I have brought to all of
those bankers.
But alas, I can no longer resist the pleasures of Ms. Bunny”s Sartorial
Parlor and Club for Gentlemen, so I allow the checks to clear one last time, in
order, and write no more. One at a time I close the accounts, in reverse order,
until I get back to the original account. The original account which holds only
my original $100 and all of the honestly earned interest over the 15 year
period. The original account which now has $1,638,000 none of which was stolen
from anybody according to the tenets of FRB. It seems Ms. Bunny and I will have
a fine time indeed.
Imagine now, if you will, everyone in the world following the tenets of FRB,
as is their right in a free society. Why, in a single generation poverty would
be erased, all mankind would be so wealthy that no one need ever work again. We
would all, each and every one, bask in luxury and ease. Does it sound a little
too good to be true?
This is the nub of the issue, the very heart of the fraud that is FRB. If
every person were allowed to engage in the practises that make up FRB, the
entire system would collapse. If every person were free to create credit money
according to the tenets of FRB our banking system and monetary system would
obviously collapse, we would be reduced to a barter economy. Those who practise
FRB are like the burglar who complains when he is robbed, they insist that only
they should have this particular license to steal. FRB is sustainable only if
its practises are restricted to a lucky few, it requires that others be
prevented by law from doing the exact same thing. Governments are only too happy
to oblige their owners in the banking industry. After all, what is a government
if not a gang claiming the exclusive right to steal and murder?
I am truly amazed at the individuals who claim that FRB would never arise in
a free market, one of them even said “there would be no incentive to engage in
FRB”. FRB is wildly profitable up to the point that it fails, much more
profitable than honest banking has ever been. Typically, when it does fail, the
executives who rewarded themselves with outrageous salaries and the stockholders
who received outrageous dividends, get to keep that money. It is the depositors
who lose out. The adage “crime doesn’t pay” holds true only so long as a society
actually makes the activity criminal. Saying that FRB would disappear solely
from the competition of honest banks is the same as saying that armed robbery
would disappear solely from the competition of honest labor, no need to make it
illegal.
If you truly believe that FRB is honest and legal, then you should support
the right of every individual in a free society to engage in these activities.
Imagine, every single one of us free to engage in FRB….

Yours Truly, the heretic and poor lost soul, Sy Akhplart

King George May 15, 2011 at 2:17 pm

If you illegalize FRB then you’ll have to get rid of all stocks and bonds too. There’s nothing wrong with lending out against a deposit, you just need to state up-front that the depositor no longer has actual cash; instead, they have a bond. Using state-force to prop-up said banks and allow them to pretend it’s actual cash when it isn’t is where the problems come from.

Elwood P. Dowd May 15, 2011 at 4:09 pm

“If you illegalize FRB then you’ll have to get rid of all stocks and bonds too.”
Ridiculous beyond belief. Way to go, you completely missed the point.

Yours Truly, the heretic and poor lost soul, Sy Akhplart

Comments on this entry are closed.

{ 1 trackback }

Previous post:

Next post: