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Source link: http://archive.mises.org/15105/the-faults-of-fractional-reserve-banking/

The Faults of Fractional-Reserve Banking

December 23, 2010 by

Fiat money — or, to be more precise, its production — is already a violation of the free-market principle; and fractional-reserve banking amounts to leveraging the economic consequences of fiat money. Austrians favor a money that is freely chosen and operates by market principles. FULL ARTICLE by Thorsten Polleit

{ 190 comments }

Onus Probandy December 23, 2010 at 9:44 am

The question that always occurs to me when talking of basing money on a commodity that is fixed in size is how that economy deals with growth?

If there is X tonnes of commodity representing the entirety of the value in an economy, and then someone creates value in that economy (of whatever form), doesn’t the commodity become more valuable?

I’m quite sure I’ve missed something fundamental.

(On this subject though: do any of the local experts have an opinion on BitCoins?)

J. Murray December 23, 2010 at 10:09 am

You didn’t read the article. The proposal is not to force a commodity as the standard of money, but to allow the market to chose what will be money. It may be gold, silver, copper, platinum, rubies, or candy bars and cigarettes. These types of money can exist concurrent with one another. The supply of money will be presented as the market demands it, meaning the price of production is less than the value of the money itself. People will unlikely accept slips of unbacked paper because they’re functionally limitless in production, thus the true value of the slip of paper on the market will always be below the price to produce it.

Additionally, it’s fallacious thinking that more goods and services requires more money to facilitate a trade. Prices can fall as the money is not the end desire of commerce, but other goods and services. No one earns money then decides the pile of cash is the final desired end. We use that money for other things. If an hour of labor can, say, buy a toaster, then if that hour of labor is $200 this year and $180 next year is irrelevant if the toaster goes from $200 to $180 as well. Prices are NOT supposed to be “stable”. A price represents that particular good or service’s preference on the market. Yes, a computer monitor does compete with a box of ramen because your labor goes into buying all of that. More goods = more competition for what you produce, thus lower prices.

The period from 1873-1913 is more than proof enough that a fairly static money supply is not detrimental to commerce. That period experienced the most rapid legitimate growth in the history of the USA, possibly the world, including increasing wages and declining poverty, despite the fact that prices were falling and the money supply was mostly static.

Onus Probandy December 23, 2010 at 11:34 am

I did read the article. I was simply asking about non-fiat money systems, there was no need to assume I am an aggressor. I accept I am ignorant of the answer to my question, that’s why I asked it. I was even careful to say that I was sure I’d not understood. So, all that extraneous stuff about not reading the article, and fallacious thinking, and money not being an end desire is utterly unnecessary.

Your reply seems to be to a comment I did not make, you will note the utter absence of the phrase “HA the gold standard is nonsense” from my comment.

I was just interested in how such a system would work, and your comment hasn’t helped me in the slightest.

RS December 23, 2010 at 11:50 am

@ Onus

Yes, the commodity becomes more valuable relative to the goods/services that exist in the market as it can command more of them but so too will all other commodities relative to each other so if 1 oz gold coin would eventually be worth 1 Ferrari then 1 oz silver coin would be worth 1 BMW and 1 oz nickel coin would be worth 1 Lexus and 1 oz copper coin worth 1 Ford and 1 oz Iron coin worth 1 GM ;-) etc. etc.

Onus Probandy December 23, 2010 at 11:53 am

Ah… I think the scales are lifting.The fact that gold gradually becomes more valuable doesn’t matter because it allows previously less valuable commodities to become more valuable too, which are then perfectly acceptable as currency?

Interesting.

A system like this pretty much requires that there is no central involvement or “official” currency, yes?

Michael A. Clem December 23, 2010 at 12:10 pm

Yes, no “official” currency. Thus, the call for free banking, so that there is freedom to adopt different commodities or currencies. What justification is there for the government to monopolize the production of money in the first place, anyway? It certainly has nothing to do with rights-protection.

RS December 23, 2010 at 12:44 pm

yes, people are generally free to exchange whatever they want for whatever they want. the only “official” involvement would be to enforce contracts and prevent force or fraud.

Regman December 23, 2010 at 5:10 pm

Onus,

I think your last question is the “central” one to this debate. As I read the article, I cannot understand how the logic of this understanding of “the law of private proprty rights” would allow for any lending scenrio; i.e., I own the house but the bank owns the loan and thus owns the house, does not this also violate the private property rights as presented?

You are correct that any commodity could be used as ‘money’. Money need only be an object with 1) an intrinsic value that can be readily and accurately determined and 2) can be divided into small enough units (of both portability and value) to be used as a generally accepted medium of exchange. Gold, silver, chickens or eggs could be used as the medium of exchange. Metals work well because there is no feeding or spoiling involved in there storage.

Any monetary solution must allow for ease of commerce, savings, lending and growing wealth. The problem is not fractional reserve banking when the bank is performing its natural function as a store of wealth. What business person has the time or knowledge to seek out everyone who may have stored wealth that business person can make arrangements with enough of these individuals to consolidate the required wealth to make what ever investment is required? What indiviual has the knowledge to determine the best place to invest every small amount of wealth that is surplus to their current needs? That the banker functions as a consolidater and interested intermediary between the owner of that wealth and borrower of same and that the banker uses his knowledge of the flow of demand and supply of that stored wealth to improve his return (and that of his investors and depositors) serves all involved, adds value to society and is a core reason to have banks in the first place.

The issue is central banking and government controlled fiat money. Again, money must have intrinsic value. By definition, fiat money has a valued defined not by commerce but by the issuer. This may work in a scenario where the issuer can guarantee the value such as with a gold backed currency or even local bank notes. However, it breaks down when those engaged in commerce cannot validate the guarantee.

Thus the government starts by introducing a “central” bank so it can control the issueance and thus guarantee the value to enable ease of commerce where distance, etc., would otherwise prevent those engaged from readily determining the echange value. However, when the government removes the intrinsic backing and becomes both the sole issuer and sole gaurantor, the monetary system is destined to fail.

Local banking works in free society because every investor, depositor and borrower has a choice as to whom they bank with and thus the market place enforces a discipline on the supply/demand flow calculation. Also, the failure of a local bank is only of local concern.

In any non-market scenario (read government controlled, central bank), the only “regulator” is the morality and competence of those in charge. When that morality or competence is overcome by expediency or “good intentions”, the outcome is a violation of the guarantor responsiblity and a devaluation of the money. There’s an old saying about putting the fox in charge of the hen house. Thus it should be no suprise when those in charge of the central bank act as if ther are neither moral nor competent.

“Devaluation” is just another way of saying “confiscation of wealth”. Governments should not be allowed to confiscate wealth except through taxation or legal penalties. Thus governements should not be allowed to contol central banks or monetary systems.

RTB December 23, 2010 at 9:45 pm

I’m thinking a commodity like gold is almost infinitely divisible. Theoretically, 1 ounce of gold could serve as the money for the whole world, provided the technology to break it down to the molecules or even atoms. Falling prices is not a bad thing. Wouldn’t it be cool if you could buy that new car with 3 atoms of gold?

On another note, I wish the article touched upon loaning in a non fractional reserve world. For example, how it might be a separate function altogether. There would be banks for holding money (deposits and checking at 100% reserves) and other institutions for lending. Intermediate bank-like institutions in which people could deposit money for the expressed and agreed upon purpose of it being lent out at interest.

Patrick Barron December 24, 2010 at 3:43 pm

Here is your key insight: “…money is not the end desire of commerce, but other goods and services.” Well said.

Andy December 28, 2010 at 3:45 am

“I own the house but the bank owns the loan and thus owns the house, does not this also violate the private property rights as presented?”Does this not also represent your time preference for quicker home ownership? Maybe the owner of the Colts should have tucked away pennies in order to build Lucas Field? I’m having trouble seeing anything but a barter system after reading some of these posts.Isn’t fiat money, in a sense, backed by the commodities it builds?

Steven October 7, 2011 at 1:16 pm

“Isn’t fiat money, in a sense, backed by the commodities it builds?”

Yes.

These comments say that gold, or other commodities, are valued by the market. The same is true of fiat money, which is why inflation and deflation occur. The “fiat” doesn’t decree the value, it just decrees the currency.

What is the value of $20? A shirt. A warm meal.
What is the value of a gold coin? A shirt. A warm meal.

If one commodity can be traded for another, it has value, even if it is just a piece of paper.

BioTube December 23, 2010 at 10:26 am

Historically, gold standards were supplemented with silver for smaller purchases; if gold becomes so valuable that it ceases to be useful as money, it will simply cease to be used. As for bitcoins, they’re divisible to eight decimal places, so even if they took off like a rocket, it’d be some time before it became a problem(fiat money theoretically has the advantage that it’s infinitely divisible, since new subunits can be created when necessary, but in practice it’s pointless).

Onus Probandy December 23, 2010 at 11:41 am

So would the idea be that growth in an economy would mean that a new commodity would be found to represent wealth?

Presumably the idea wouldn’t be that we all actually carry around the gold/silver/whatever, and kept a promissory note? Although I guess issued by some private corporation rather than by a government? Or even multiple private corporations… GoldNotes, SilverNotes and CopperBottoms :-) allowing everyone to pick as they wish.

But then aren’t we back at the beginning? Why would the private corporation need to keep the commodity in a vault. If the vault was sealed, would the economy care whether it was there or not? Very few people would ever come to claim it.

I still don’t think I’ve got it.

Michael A. Clem December 23, 2010 at 12:22 pm

Even if you use notes to represent the commodity instead using the actual commodity, the quantity of the commodity acts as a limit on monetary inflation. Monetary inflation is generally to be avoided as it devalues the money. Visibility and accountability are necessary to ensure that they aren’t “inflating beyond their means”. If the vault is sealed, there is no way to know how much money (in notes) that they should be able to issue. Since any bank can issue notes, competition helps ensure that banks toe the line and don’t overinflate or engage in fractional reserves.

Eric December 23, 2010 at 9:10 pm

I think the market would place a limit on a bank with a sealed vault. As long as there are no legal tender laws, the market would likely frown on a bank that issued paper/credit/debits backed by a sealed vault.

In this age with computers, if a market form of money came into existence, it’s likely that everyone would be using debit or credit cards of some sort or physical coins made of gold or silver. Entrepreneurs would probably quickly make networked cash registers that would decide whether a particular debit card was from a sealed vault bank and either reject it or apply a discount. Customers would have to be wary of banks once again, however, choosing one that they trust and that others would trust.

In the end, I suspect some one or a few banks would become the standard. Competition would keep them honest – at least as honest as is possible in a non-perfect world. But I suspect it would be far better than what we have today.

Steven October 7, 2011 at 1:26 pm

The point was that if nobody ever reclaimed the backing commodity, what purpose does it serve? and your answer is that it limits monetary inflation, which isn’t true because there are no market pressures to prevent fractional reserve lending.

In fact, very little lending would be possible by a bank at all without it becoming fractional. As an example, think of the scene in It’s a Wonderful Life where Jimmy Stewart explains where everyone’s money is. A banker takes your deposit and invests it in someone else. A banker would only be able to lend their own profits.

Looking at history, banking competition never ensured bankers not lend fractionally. In fact, if history shows anything, bankers will collaborate in order to continue their practices of enriching themselves.

bionic mosquito December 23, 2010 at 11:49 am

The supply of a commodity is not necessarily fixed. In any case, there is no reason that the supply of money necessarily expands with the size of the economy. However if the economy grows much faster than the supply of money (gold, if you will), this will encourage the production of gold and/or the release of gold from reserves – to take advantage of the higher value of the gold relative to the goods that can be purchased with that gold. This would then, of course, lower the value of gold. The converse would occur if, for example, a significant large discovery of gold was made.

If it is still a concern to the market regarding the extraordinarily low amount of gold relative to the value of goods produced (to utilize your example), the market would likely identify other commodities to use as a base, certainly silver comes to mind. If people can’t get their hands on gold, they will start to use something else.

panika2008 December 23, 2010 at 4:09 pm

“this will encourage the production of gold and/or the release of gold from reserves” – it’s only possible up to a point, precisely because the supply of gold is very tight. After that point, if the growth continues at 8-10% p.a. with the supply of gold pretty stagnant at 1% p.a. max (we are now probably past peak gold), severe deflation kicks in. Lending comes to a standstill, and well… nobody knows what then, but either the market relaxes its expectations on the tightness of money, or the real growth slows or everything goes on without lending. The last possibility is a great unknown. It might be possible, it might not.

Mike S December 26, 2010 at 12:35 am

Loans are often indexed to account for price inflation, and I can’t think of any reason why they couldn’t simply be indexed to account for price deflation.

panika2008 December 26, 2010 at 6:53 pm

Uhm, like actually giving back LESS than loaned? I really don’t think so.

frank December 26, 2010 at 7:19 pm

You think the world stops if the money supply stops increasing or if prices decrease slowly over time? Total nonsense.

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

panika2008 December 26, 2010 at 7:24 pm

Frank, which part of “severe deflation” and “It might be possible, it might not” you did not understand?

joebhed December 23, 2010 at 7:14 pm

the reason that the supply of money ‘necessarily’ expands with the economy is because that is a necessary monetary policy action required to maintain the stable buying power of the nation’s circulating currency.
If you have a national monetary policy that is embedded in maintaining the stability of the currency, then you ‘must’ increase the supply of circulating medium in order for the economy to grow without deflation.

bionic mosquito December 23, 2010 at 9:26 pm

1) Who will quantify “expands with the economy”?
2) Who determines the “necessary monetary policy action”?
3) Who will measure “the stable buying power”?
4) Why must there be “a national monetary policy”?
5) Why is it necessary “for the economy to grow without deflation”?

Finally, the question you have ignored all day: Why would you trust so blindly those who have demonstrated so completely their untrustworthiness?

RTB December 23, 2010 at 9:55 pm

So what’s wrong with deflation? I think it’d be kinda cool to buy that new big screen tv for $1.95.

Gil December 23, 2010 at 11:30 pm

What difference does it make what the nominal price of anything is? The real price is the only one that matters.

panika2008 December 24, 2010 at 3:17 am

Ask the TV set producer for his opinion. Or his banker. Or the people that finance him with bonds.

Dave Albin December 24, 2010 at 3:22 pm

With a relatively-fixed money supply, prices would be restrained – inflation would be conquered. So, you would actually see prices like this for things. Supply and demand alone would determine all prices.

Michael A. Clem December 24, 2010 at 3:38 pm

C’mon, the only people really hurt by deflation are the borrowers, not anybody else.
Producers and manufacturers would gain by the increased value of currency as much as anyone else.

james b. longacre December 26, 2010 at 8:09 pm

“So what’s wrong with deflation? I think it’d be kinda cool to buy that new big screen tv for $1.95.”

price deflation or money deflation?? would your wages be cool if they were 15 dollars a month??

james b. longacre December 26, 2010 at 8:13 pm

“With a relatively-fixed money supply, prices would be restrained – ”
how do you know this?? if a given demand for a comodity increased with a fixed money supply wouldnt prices increase rapidly in some cases until enough “fixed capital” could make its way into such an industry to begin to drive prives down via productivity???

would a faster growing money supply alleviate this???

Gil December 26, 2010 at 9:11 pm

Indeed. What good is price reduction if you’re getting income reduction in kind?

waramess December 23, 2010 at 10:36 am

It would seem to me that the problem with FRB is that whilst the money in my posession might be very short term, when I become a creditor of the bank it is in respect of a very small part of a large sum of money with an amorphous maturity.

The banks themselves decide on the maturity of different slices depending on the historic trends and then lend it out accordingly.

Herein lies the fallacy behind FRB, If the trend changes because the deposits are declining as they would, for example, if the velocity of money were to change, then a liquidity trap is revealed.

Then, no matter what the niceties of the argument, the banks are stuffed as am I.

As for gold, the politicians cannot be trusted with fiat money. When will we teach them a lesson? Maybe when they start to sequest our private pension funds as other European nations have started to do.

When they sequest our private savings, possibly. Who knows, but there will be a tipping point and it will be nasty but it will result in a gold standard

panika2008 December 23, 2010 at 4:13 pm

“If the trend changes because the deposits are declining as they would, for example, if the velocity of money were to change, then a liquidity trap is revealed.” – it’s not a fallacy. It’s a very real and quite normal phenomenon that shows that bank balance sheets are INHERENTLY RUNNABLE, full or fractional reserve, precisely because there is no way to assure perfect liquidity management in the face of changing interest rates and maturity preferences. Getting rid of fractional reserve demand deposits takes care of just the very shortest horizon of liquidity management, and does nothing to assure no future liquidity squeeze ensues. That’s because it is inherently impossible. There is no banking without risk.

waramess December 26, 2010 at 6:58 am

This is not so and the risk is a modern phenomena.

Not so long ago when banks were not allowed to lend against mortgages most bank lending was done by overdraft and it was not until the early sixties that the American banks introduced term lending and a little later when the banks were allowed to lend against mortgages.

There is no reason for the banking system to have been made inherently unsafe by banks getting into term lending when there are others in the market that can more easily match their funding.

There is more to this issue I fear than FRB per se

Steven October 7, 2011 at 1:36 pm

Bankers were not forced to lend against mortgages by a government. What free market mechanism would prevent a banker from lending capital it possessed, regardless of its risk?

It was the government regulations that prevented banks from lending against mortgages. When that was removed, the free market was eager to leverage whatever capital it had to make short term profits. And they didn’t learn from past bank failures, where regulations were made to prevent such lending practices.

bionic mosquito December 23, 2010 at 10:50 am

Imagine a jurisdiction with fully competing currencies, where every type of idea is afforded the opportunity to be tested and ultimately accepted or rejected by market participants. There are no laws making one scheme preferable to another. Multiple currencies can trade side by side in a given jurisdiction, with disclosure as to the nature of the currency clearly available and identified.

The author of the article certainly makes a statement that would lead one to this possibility:

“Austrian economists (in particular those in the Misesian-Rothbardian tradition) uncompromisingly call for replacing fiat money with free-market money — money that is produced by the free interplay of the supply of and demand for money.

“Such a recommendation has a firm economical-ethical footing: free-market money is the only monetary order that is compatible with private-property rights, the governing principle of the free-market society.”

From these statements, it seems safe to conclude that “Austrian economists” would allow the market to decide on “money.” For a market to do so, market participants must be free both to experiment, and to compete – without the necessity of finally settling on any one form being utilized in a market.

With this in mind, I wonder about some of the statements and assertions in the article:

“What, however, if the bank and the depositor both agree voluntarily that money deposits should be used for credit transactions via the issuance of fiduciary media?”

Such a voluntary transaction might only legitimately be discouraged if there were significant externalities caused by such an arrangement. The author attempts to present such a problem with the following comments:

“While bank and depositor benefit from such a trade (or expect to), what about those who receive fiduciary media? They would be falsely lured into exchanging goods and service against an item (fiduciary media) that is already claimed as property by others — something the seller presumably wouldn’t agree to if he had only known the very nature of the trade.”

Why is it assumed the third party is unaware of, or “falsely lured” by, the nature of what he is receiving? Certainly, if he was falsely lured, a charge of fraud would be justified. However, what if he is aware? Would you propose stopping this transaction? How, and on what grounds?

“What if all market agents voluntarily agreed to engage in fractional-reserve banking? The conclusion above wouldn’t change: voluntarily accepted fractional-reserve banking would represent a monetary system that is, by its very nature, in violation of the nature of the law of private-property rights. It would produce economic chaos on the grandest scale.”

Why is it in violation of property rights? Every actor has knowingly and willingly agreed to accept the fiduciary media. With what basis would you propose to stop them? If it, in fact, results in economic chaos, participants will suffer the consequences. But these are consequences willingly brought on by voluntary actions. Perhaps some laws prohibiting voluntary behavior would be considered? Really?

Back to my vision of multiple currencies competing on equal terms in a free market: With the opportunity to use a more stable currency (100% gold-backed, if you will), what do I care if someone else’s wealth and purchasing power is eroded and/or destroyed because they made a less-than optimal choice of a fractionally-backed currency? My wealth is secure, my purchasing power is maintained. In this scenario of freely competing currencies, why would I stop them? More so, how would I stop them?

Michael A. Clem December 23, 2010 at 12:28 pm

With free banking, different banks would be able to “mark” their currency so that anybody receiving it should know what bank issued it. If a bank is engaging in FRB, the receiver can choose not to receive it or discount it accordingly.
But this brings up a question. If a bank has, for example, 50% reserves, why wouldn’t a receiver simply discount that bank’s currency by 50%, thus making the alleged advantages of FRB null and void? Is there some reason for thinking receivers wouldn’t do that? If not, then the market would pretty much eliminate FRB on its own, and would not encourage it.

bionic mosquito December 23, 2010 at 1:23 pm

“Is there some reason for thinking receivers wouldn’t do that?”

It would be my expectation that an FRB currency would trade at some discount to a gold-backed currency. However, in truth who can say beforehand if or what the discount would be. Perhaps the FRB currency pays interest that isn’t available in the gold backed currency (which would likely come with costs for storage of the gold). Perhaps it offers other benefits to offset some of the drawbacks.

“If not, then the market would pretty much eliminate FRB on its own, and would not encourage it.”

This gets to my point. In a truly open and free system, the market would sort this out and the currencies would trade in relative value as the market saw fit.

Jim December 23, 2010 at 2:48 pm

Just out of curiosity to to this line of reasoning, would this not create a massive new accounting burden on businesses? For example, if several types of currency were in common usage in an area, like an urban center where there are enough people to support multiple banks (maybe some using FRB and some not), then stores would have to constantly monitor many levels of prices, and have cashiers with teller drawers that contain enough of many differnt types of notes, to make change in all of these currencies.

If they don’t accept these multiple currencies, then they risk losing business to those who do, so in the end, all that’s been accomplished is requiring retail businesses to keep more cash in their tellers, and for them to put a large amount of extra effort into their businesses monitoring multiple prices for each item. The increased effort and (presumably) manpower involved thus increases prices.

Michael A. Clem December 23, 2010 at 3:01 pm

It would create new business opportunities for tracking exchange rates and possibly for currency exchange businesses. While this might result in some price increase, I would expect it to be pretty minimal or miniscule as competition and technology reduce the expense of providing exchange rate info. Even today, it’s relatively easy and inexpensive to look up exchange rates in the newspaper or internet. Another button or function on the cash register wouldn’t be difficult to do.

bionic mosquito December 23, 2010 at 3:09 pm

In Switzerland, many businesses accept payment in Swiss Francs, Euros, or USDollars. I know they do this in electronic form, I do not know if they do this with cash.

Monitoring multiple prices with computers and today’s telecommunication should not be difficult.

On the electronic side, I see almost no issue. If the inventory of “cash” is too complex on the cash side, store owners will consolidate toward whatever most of their customers prefer. Certainly, it is reasonable to expect standards and norms would develop. If transactions become too costly, business has an incentive to reduce the cost and complexity. For example, I could see a business offering an X% discount if payment is made in a desired form in order to reduce overall complexity.

Overall this doesn’t seem more complex than a hardware store keeping a wide variety of bolts on the shelf in all the various sizes and standards. It is certainly much less complex than most of what the market provides in goods and services every day.

Ultimately, I do not present this with a claim to have every contingency fully covered. My purpose is to offer a consideration of competitive currencies to include FRB currency if the market desires, and to do so in a free-market, non-coerced manner. The market will solve any resulting inefficiencies.

Steven October 7, 2011 at 1:48 pm

Who forces the banks to claim FRB? What free market mechanism causes a bank to disclose this?

Why would a receiver ever discount the currency if they redeem it in full every time? There would be no problem unless a critical mass of receivers redeemed the currency simultaneously.

You’re arguing against the historical record.

Steven October 7, 2011 at 1:42 pm

This multiple competing currency idea is interesting, but it’s also a reality. Money markets. The global banking system is a currency competition, and fiat monies have won out over gold as reserve currencies.

Is is bad or good? Time will tell. But there is no free market mechanism that would cause gold to be the default reserve currency, and no profit motive to not lend on fractional reserves.

The only government involvement in international currency trading is the fact that government created currencies to be traded. Traders can chose which currencies are valuable.

Mark Lane December 23, 2010 at 10:59 am

It would seem that now with the simplicity of Global Currency trading, that the natural market already moves to the currencies with the most value. Since carrying heavy gold (or copper etc) coins around is not physically feasible, then fiat money might very well be necessary for global free markets, and consequently a source is needed to print and maintain such money.
To address fractional banking, where two persons possess the same money, is the bank not just a clearinghouse to make lending efficient? In other words, would not the original owner of the money wish to lend it to a creditworthy producer?
I’m new to the Austrian School and have enjoyed their articles. However I may not entirely agree with there position on fractional-banking, but wish to adamantly support their “free market” principals.

Artisan December 23, 2010 at 11:37 am

Perhaps you could put it like this?

What’s a potentially credit-worthy producer? Under FRB, it is one that produces more than the fraction by which the reserve is being potentially missed: as this would be anything under 900% yield in case of a bank run -not counting yearly inflation-. That’s potentially truly a hard match to find for the clearing house!
Problem: bank runs precisely happen when people sense that the producing side is not credit-worthy. So it sure looks like a vicious circle to me. The less credit-worthy producers there is, the more efficiently those few should produce to compensate.

Under free market laws thus, it really seems this monetary system would not be very appealing.

PS: I like this thought provoking article for its simplicity. When I sometimes see Mr Polleit talking on German national television, I accordingly feel (a little bit) better. Couldn’t they take him at the ECB oversight?

Steven October 7, 2011 at 1:55 pm

Under free market laws, this system was appealing, and practiced. What free market mechanism prevents a profitable endeavor from occurring?

“The goldsmith bankers quickly succumbed to the temptation to issue ‘extra’ notes, (unbacked by gold). Why? Because the ‘extra’ notes enriched the bankers by allowing them to buy property with notes for gold that they did not own, gold that did not even exist.” – Sir Josiah Stamp, president of the Bank of England, 1927

Charlie Virgo December 23, 2010 at 11:46 am

I would argue that fractional reserve banking, like bailouts and stimulus packages, actually makes lending less efficient because they are given more of other people’s money to play with. If the reserve is set at 10%, banks will be able to make riskier loans than they would if the reserve was set at 60%, simply because they have a more limited resource with the higher reserve and would want to employ their loanable funds in the most profitable way possible.

Michael A. Clem December 23, 2010 at 12:31 pm

Even with commodity-based money such as gold, gold-backed notes or certificates could still be issued so that you are not physically carrying gold around in your pockets. This violates no free market principles as long as no fraud exists. Any bank could issue notes or certificates as long as they have the commodity to back up the notes or certificates.

panika2008 December 24, 2010 at 3:20 am

And why can no bank issue a note if they don’t have the commodity to back it up? What’s wrong with a pure IOU? If all parties are well informed…

Michael A. Clem December 24, 2010 at 11:05 am

Nothing, if all parties involved agree to it. But I would think that IOU’s are inherently riskier, making them less common (in a free market society) and less likely to be used as “money”, per se. One could easily argue that our recent financial crisis was due to the overvaluation of debt, made possible by the FRB, banking regulations, and other government agencies.

Steven October 7, 2011 at 1:57 pm

What free market mechanism prevents fractional reserve?

“The goldsmith bankers quickly succumbed to the temptation to issue ‘extra’ notes, (unbacked by gold). Why? Because the ‘extra’ notes enriched the bankers by allowing them to buy property with notes for gold that they did not own, gold that did not even exist.” – Sir Josiah Stamp, president of the Bank of England, 1927

agdrummer December 23, 2010 at 11:15 am

One could expand on this excellant articule with insights to the already and excellerating authoritarianism that will come with this…..see http://www.socionomics.net….sign up for the freebies,their time dated(compared to the subscription) but still revalent. It all ties together. Merry x-mas!

joebhed December 23, 2010 at 11:30 am

Another great job of appropriately trashing the private fractional-reserve banking system.
It is a system that is broke, broken and insolvent for its many failings pointed out in the article, which sort of broaches the subject : If not the the money system of private debt-based fractional-reserve banking credits, then what?
Free banking?
Or a public money system, where banks only lend real money – what y’all like to call savings?
Here it is for the open-minded among us:
http://kucinich.house.gov/UploadedFiles/NEED_ACT.pdf

It ends the legalized crime of FR banking.
But it doesn’t enable any private money-creation.

bionic mosquito December 23, 2010 at 12:05 pm

“Here it is for the open-minded among us”

A bit too open-minded: your brain will fall out if it is this open. This is Ellen Brown come to life. About the only system that I can think of that is worse than the current Fed system is one where Congress and the Treasury has direct control of the printing press. If you fear hyper-inflation today, you ain’t seen nothin’ yet.

Denninger is peddling this scam, and is calling out Ron Paul if he doesn’t support it. It only shows Denninger’s ignorance of money and of Paul’s position. But this is nothing new. For someone so apparently ignorant of economics and politics (and politicians), he has developed quite a following. He actually believes the politicians will follow the rules presented in this bill. Nice Kool-aid.

http://bionicmosquito.blogspot.com/2010/12/denninger-dennis-kucinich-delete-fed.html

joebhed December 23, 2010 at 12:43 pm

Kudos to Denninger.
Almost hard to believe.

This is from one barred from commenting on his site because my comments are too high-faluting for his readership. The only site I’ve ever been barred from.

Have you read the Kucinich proposal?

Thanks for “joining” the issue again.
This is really where we belong. But we’ll get further if we can drop the insinuations and the hyperbole of what the players are capable of thinking.

We start out with money.
We disagree at the get-go.
Aristotle or Adam Smith?
Eventually, perhaps, we get through the history of money and resort to the science of money and money systems.
These days deSoto best frameworks the discussion for free-banking and commodity monies.
But in the end, you and I are left with what you and I think, and what you and I think we know.
Not what Ludvig or Hans or Murray have written.
Let’s talk about why we think a free-market in capital is superior to a stable, value-protecting issuance by the only people we can hold responsible if the whole thing fails.
And that ain’t the marketeers.
Thanks.

bionic mosquito December 23, 2010 at 1:18 pm

“Let’s talk about why we think a free-market in capital is superior to a stable, value-protecting issuance by the only people we can hold responsible if the whole thing fails.”

Yes, please talk about it. Explain to me how I can hold a politician accountable more so than I can hold a private actor accountable. Please demonstrate with examples, especially beginning with the bailouts in 2008.

I am all ears (or, I guess eyes, given the medium).

joebhed December 23, 2010 at 2:38 pm

No one can demonstrate either free-banking or government accountability “examples” from any modern historical perspective. Colonial currencies and Greenbacks being the most recent.

Regarding the fallacious 2008 bailouts, I think if you read the bill, you can see that private speculation in $USD-denominated funny-money would become history.
There would be NO shadow-banking industry as all new money would be created through the government’s annual budgeting process. It was really the shadow(investment) bankers that caused the financial crisis. Instead, the annual creation of new monies needed for maintaining the purchasing power of the currency would immediately become M1 and M2 active medium.
No high-powered-money pump priming through QE.
As such, it is immediately available for either savings/investment or to remain in the high velocity ‘transaction’ accounts as the Bill describes.
So, we immediately revert to “savings-based’ money, immediately revert to full-reserve banking and immediately establish the monetary policy of the stable buying power of the currency.
Surely you can see that many Americans are not likely to trust any private money creation scheme after this imbroglio has run us into insolvency.
What choice do they have with the free-banking alternative?
The accountability is written into the bill.
It requires the monetary authority maintain that non-inflated buying power of the dollar.
While external economic/financial activity can effect the dollar vis other currencies, it is the internal valuation that most people expect and deserve.
We are not all FXers.
Thanks.

bionic mosquito December 23, 2010 at 2:54 pm

“The accountability is written into the bill.
It requires the monetary authority maintain that non-inflated buying power of the dollar.”

Your naivety and faith must afford you great comfort in these difficult times. Remind me again which of Washington’s own rules they have followed?

I cannot offer any counter arguments to one who is still in dreamland even after witnessing the latest schemes from Washington. Well I could; let me know when you awake.

joebhed December 23, 2010 at 7:35 pm

tsk. tsk.
early resort to ‘naivety’.

let’s start here.
I have MORE faith in our ability to command a responsive Congress by using the democratic means that our laws do, can and should provide than I do that, in an imaginative jurisdiction, there will come to exist a gloriously free private market in all makes and models of undefined currencies, in order to ensure the long-term well being of my grandchildren.

Having said that. Congress is shit, I thought we agreed.
That’s just another part of what needs fixing.
It has nothing to do with what is an appropriate monetary system to support the national economy.
Which is what an appropriate monetary policy should do.
Or is that naive also?

Here’s how naive I am. I throw down the challenge that Ron Paul side with the Kucinich Bill in order to move THIS discussion out into the public arena, where it must be held if EITHER OF US is to succeed.

The Congressmen appear to agree on the need to end the federal reserve system, the fractional reserve system of banking and the restoration of a real-money base for all lending.

Imagine that were accomplished.
Fork in the road.
How do we make the money?
Out in public.
Where this belongs.

panika2008 December 23, 2010 at 7:42 pm

joebhed et al, how the f*k could you trust a government that ran a 14+ trillion debt and routinely has a 10% budget deficit to now somehow miraculously manage fiat currency entirely on its own, without even this thin veil of market oversight that is the explicit ban on financing deficit directly with fresh money? How can ANYONE ever be so naive???

bionic mosquito December 23, 2010 at 8:06 pm

“tsk. tsk.
early resort to ‘naivety’.”

No. Once someone claims the faith that Congress will stick to its own rules, it is not too early to resort to “naivety.” Either naivety or willful desire for destruction. You and Denninger.

If there is a plan behind this financial meltdown we are experiencing, if it was done on purpose in order to destroy the dollar and bring on a one world currency, this bill fits perfectly and it will pass. Then, with 100% certainty, count on the dollar being destroyed within a few short years based on the mismanagement of Congress. And then watch the open arms of the Administration and Congress, welcoming in a new one world currency.

Michael A. Clem December 23, 2010 at 12:50 pm

The Federal Reserve has been granted monopoly privileges by the federal government. If the central bank was an actual government agency instead of private agency with privileges, what would stop them from inflating as they saw fit? Only the competition offered by free banking offers any real restrictions on overzealous bankers and out-of-control inflation. Get the politics out of the money-production industry.

joebhed December 23, 2010 at 2:59 pm

Michael,
You and I only have the hundred-year experience of that private privilege whereby having all money created as debts has brought the end of our socio-economic order near to real time.
What would stop ‘them’ from inflating the money-supply?
If you read the Bill you see the rigorous and accountable structure that is established to determine the amount of money necessary to effect real potential GDP-growth in the national economy, coupled with the “measure” that is established by which we would judge the effectiveness of those money supply increases?
In a way, the question is yours to answer.
How do you propose to have the privateers running the commodity-based monies to be accountable for growing thee national economy to its full potential?
Who would be responsible and accountable for that?
Is it a faith-based system?
I’m not talking about individual savings/investment (take your money and run); I’m talking about the national economy.
Is nobody responsible for our national well-being?
Are we not a nation?

Michael A. Clem December 23, 2010 at 3:13 pm

There’s been lots of legislation with “accountability” that was either ignored or changed with later legislation. And don’t forget it was the presidential administrations that ended the “gold standard”, not the FRB.
The production of money is a service for the convenience of its customers, and like any other business, can only stay in business if it has customers. You propose to maintain the monopoly on the production of money and a captive consumer base. I propose letting consumers be free to choose.
When you speak of the “national economy”, do you simply mean the economy of a nation full of people? The market can handle that–it’s simply millions of individuals deciding how to handle their economic transactions. You seem to think that the “national economy” must be controlled and guided by some benevolent authority or master, when history shows that governments tend to restrict and strangle the economy, not improve it. Tarriffs, trade agreements, wage laws, etc. National identity is more of a social issue than an economic issue. It seems to me that more faith is required in this “benevolent authority” than in the marketplace.

joebhed December 23, 2010 at 8:09 pm

Legislation is required in order to achieve free banking.
It too could change at a later date.
Point being what? That we’re not perfect?

We are peoples of nations.
I don’t understand the concept of achieving freedom for free capital-currency markets without a legislative remedy.
That doesn’t mean we’re socialists just because we demand a legislative remedy.
It just means that we agree that we democratically choose our remedies, regardless of what ails you.
We equally abhor the obvious corruption, but I openly say that it needs to be fixed by the means available.
The ballot box.

Of course the government made the decisions about regulating the value of the national currency against gold. Whether it be to DO it or to NOT do it.. That’s what the Constitution requires.

“”You propose to maintain the monopoly on the production of money and a captive consumer base.”"

Actually, I propose to abolish any consumer relationship with the creation of money. The consumer relationship is in the free use of money, provided in an adequate quantity to meet the needs of the economy. The leveler of the playing field.

I think of money as not a commodity but as a circulating means of exchange. This is what i read and believe about the history of monetary systems. That national monetary systems have a special public function in the national economies of free and sovereign nations. What happens to money AFTER it is created is up to the freedom of the holder of the money.

My description of what a ‘national economy’ is all about isn’t about control except OF the freedoms of the people.
One of those freedoms is to decide how the money is created.
That’s what this is all about.

“trade agreements”. “wage laws”. Laws of any kind? Laws?
Sorry, but that is the only way that we the people can exercise our rights to whatever protections we hold dear.
I’m not throwing out that baby with this broken and corrupt bathwater.

The rhetoric is fine, if unnecessary and counter=productive.

I say we can neither be successful without legislative change.
Let’s have a public discussion of what legislative changes should drive our future.
Can’t end the Fed without legislation.

John December 23, 2010 at 11:31 am

The issue of fractional reserve banking in a market that does not have a lender of last resort (central bank) is that because they can not cover all their obligations runs on the banks will ensue and wipe out the banks. The money the depositors put in the bank would not be covered. A more secure bank would use something like C.O.D.s where the depositor knows they can not touch their money for a certain period of time without penalty.

The present fractional reserve system keeps the money deposited “safe” yet causes the money supply to be increased. This does not benefit the savers who are attempting to accumulate capital.

You may find “Theory on Money and Credit” to be particularly useful in discerning the difference between fiduciary media and real capital.

Both forms of “money” purchase goods and services in the economy. The key difference is that the fiduciary media erodes capital itself by destroying the store of value function that money serves.

The fiat system is too easily corruptible Mark. In a real free market the individual actors would seek to utilize the mediums of exchange that they have found to be most advantageous for increasing their standard of living.

It takes more than a little while to put it together. We have been conditioned to accept the idea that each individual unit of money is supposed to lose buying power…….

panika2008 December 24, 2010 at 3:24 am

“because they can not cover all their obligations runs on the banks will ensue and wipe out the banks” – your argument is fallacious. The elimination of fractional reserve lending of demand deposits does in no way eliminate the possibility of bank runs due of severe maturity mismatches.

“the depositor knows they can not touch their money for a certain period of time without penalty” – but of course he can. He can always sell his CoD on the open market. This is exactly what FRB banks do in a non-ad-hoc, formalized process.

Banks are inherently risky. Dreaming they will ever be riskless is naive.

Michael A. Clem December 24, 2010 at 4:01 pm

Banks are inherently risky. Dreaming they will ever be riskless is naive.
Sure there’s risk involved, but there’s a difference between reasonable risk and unnecessary risks. FRB seems to involve more risk than a 100% reserves banking. Thus, if there’s no FDIC or other government bailouts available, fewer people are likely to take the bigger risk.

Mike Sproul December 23, 2010 at 11:51 am

Once again the Mises institute gives libertarianism a bad name by claiming that voluntary trade between a bank and its customers should be banned.

A discussion from Cafe Hayek a few weeks ago:

Don Boudreaux: George and Larry have responded to such arguments countless times over the past nearly 30 years. George and Larry have done serious empirical work and serious thinking. Mises=Institute=and-Rothbardian ‘macro’ is just plain mistaken.

Do you mean Rothbardian macro generally or specifically regarding 100% reserve banking?

Don Boudreaux: Generally, although the 100% reserve stuff is especially silly.

panika2008 December 23, 2010 at 4:15 pm

“Mises institute gives libertarianism a bad name by claiming that voluntary trade between a bank and its customers should be banned” – well said, mister!

Richard M December 23, 2010 at 5:17 pm

In a ‘libertarian society’ of ’100%’ reserve banking people could lend as much of their money to banks as they wanted and for whatever time period they and their banks agreed upon.

How exactly does this restrict ‘voluntary’ trade?

Mike Sproul December 23, 2010 at 8:29 pm

Richard M:

In your libertarian society, would I be able to put my money in a fractional reserve bank? If not, would you still call it libertarian?

Richard M December 23, 2010 at 11:04 pm

Mike,

For the sake of argument, let’s say in ‘my’ libertarian society fractional reserve banks are forbidden (and that I would call this ‘libertarian’). What ‘voluntary trade’ pertaining to whom you lend money to, and on what terms (interest rate and payment period) would be forbidden?

Now let’s say my libertarian society allows frb’s. What additional ‘freedoms’ do you gain by contracting with these frb’s besides being able to contract with them? What benefits do they offer that banks in the former society of non-frb’s do not?

panika2008 December 24, 2010 at 3:27 am

“What benefits do they offer that banks in the former society of non-frb’s do not” – strange, I thought that the need to demonstrate that an enterprise is benevolent to “the society” is more characteristic of commnist and fascist regimes.

scineram December 24, 2010 at 3:28 am

They cannot offer demand deposits obviously.

Richard M December 24, 2010 at 8:36 am

I don’t understand your response. Are you saying that fr banks cannot offer demand deposits?

Mike Sproul December 24, 2010 at 11:33 am

FRB’s pay interest instead of charging storage fees, lend resources out instead of locking them away, are less attractive to bank robbers, and they allow resources like land to be ‘coined’ into money.

Richard M December 24, 2010 at 1:18 pm

Mike,

All money, even in FRB system, is in someone’s balance. It is all stored somewhere. There are most definitely costs to store money under a frb system. Today we have frb’s. The banks I have been to have security guards, safes and alarm systems. They cost money.

And land cannot be coined into money, unless it is money, that is, the most marketable commodity.

Mike Sproul December 24, 2010 at 1:52 pm

Richard:

Think of an old-fashioned mint. People bring 1 oz. of bullion in and have it coined into a $1 coin. Then the mint owner gets the bright idea of saving the wear on the coins by accepting 1 oz. of bullion and keeping it in his vault while issuing $1 tokens, either in the form of paper or bookkeeping entries. Then he gets an even better idea: Accept deposits of 1 oz. worth of land (in the form of liens on land titles) and issue $1 tokens in exchange, in effect coining land into money. This saves wear on coins, saves the expense of hiring guards to protect the silver on deposit, doesn’t require anyone to store money of any kind, and all the while keeps the land in production.

Beefcake the Mighty December 24, 2010 at 2:38 pm

“Accept deposits of 1 oz. worth of land ”

What do you mean for something to be worth 1 oz. of something else?

Richard M December 24, 2010 at 10:30 pm

Mike,

I have seen this from you before. A claim to land or some other durable asset is not money. You are advocating barter; shares of ‘land’ or some other good that people trade for other goods. These shares are not money – they are not the most marketable commodity.

A commodity monetary system does not require some ‘banking’ theory to resolve money ‘shortages’.

And I don’t see what this has to do with frb at all; the real bills doctrine is a totally different can of worms than frb.

Beefcake the Mighty December 23, 2010 at 5:48 pm

“Don Boudreaux:”

Who?

Eric December 23, 2010 at 9:28 pm

When Rothbard argued against FRB he was speaking in the context of fraud. He spoke about warehouses that CLAIMED to be 100% reserves but were secretly not. If a bank advertises and explains to all that it is NOT 100% reserves, AND cannot compel one to use it’s currency, then I doubt Rothbard would have objected.

After all, he wrote 3 books that were quite similar, with the most comprehensive version being “The Mystery of Banking”, but the other two were “What has government done to our money” and “The case against the Fed”.

Since it is government, and the FED, which use force, via legal tender laws, this was Rothbard’s objection. He argued for a gold standard, assuming that government was still going to use force and legal tender laws.

I believe that Hayek was always for free-banking, where there would be no legal tender laws. I’m not sure what Mises called for on this.

scineram December 24, 2010 at 3:30 am

Ok, so who was claiming to keep 100% reserves, but was not keeping in reality?

panika2008 December 24, 2010 at 3:32 am

“He spoke about warehouses that CLAIMED to be 100% reserves but were secretly not.” huh? It was public knowledge codified by law in the US at least since 19th century.

“If a bank advertises and explains to all that it is NOT 100% reserves, AND cannot compel one to use it’s currency, then I doubt Rothbard would have objected.” – Rothbard opposed it even if it was 100% voluntary and nondeceptive, at least Mike Sproul attests he heard that from the man. Please see http://blog.mises.org/11395/free-banking-and-contract-law/#comment-648188

RS December 23, 2010 at 12:07 pm

“Fractional-reserve banking thus leads to a situation in which two individuals are made owners of the same thing”

I have a problem with the premise to this whole debate. Putting money into a bank is fundamentally an act of lending. The depositor is in fact a creditor lending the bank the use of his unconsumed goods, the bank in tern re-lends those goods to others so the FRB system is nothing more than a chain of mutual exchanges of claims to those goods, the goods themselves are put to some use by the final debtor and the returns generated must be enough to cover all of the parties along the chain. To me this is how unconsumed goods are transformed into capital that allows an economy to grow. The length of the chain is entirely determined by all of the parties involved who are willing to take the risk so none of this involves force or fraud nor does it involve a violation of property rights.

Michael A. Clem December 23, 2010 at 12:38 pm

One thing the article implies but doesn’t really make clear: the difference between demand deposits and time deposits. Demand deposits are not loans to the bank, but a convenience to the depositor so that they don’t have to carry money on their person, but can use checks (or now debit cards) or the like. Time deposits, like certificates of deposit, are actual loans to the bank, which is why the bank pays interest on them. It’s up to the depositor to decide if he is merely using the convenience offered by banks or if he is in fact loaning the bank his money.
With these two types of bank accounts, there shouldn’t even be a question about FRB–it simply has no reason to exist.

RS December 23, 2010 at 1:15 pm

Actually, demand deposits are loans, they are just very short term loans. A check or a debit card is a claim against an asset, an asset that is held by the bank which it received in trust from depositors. Look at it this way, anytime one person gives another person a thing of value with the expectation of getting it back at some point in the future then that is a loan, it is fundamentally an IOU. If it were not then why would do people pool their money together in the first place, everyone would simply print their own check books or debit cards payable to their own private bank. The reason we pool our money is to gain efficiencies, banks provide this efficiency by using the money to generate returns that are unavailable to each person acting alone.

That being said, there is nothing in a free market to prevent a bank from adopting various different types of lending/reserve policies, all of which would be determined by consumers.

Richard M December 23, 2010 at 3:11 pm

Demand deposits are very short term loans? How so? Here is the definition of a “demand deposit” given in my dictionary:

demand deposit (noun): a deposit of money that can be withdrawn without prior notice.If demand deposits are for very short term loans, why is the definition not deposits made for very short term loans?

Also according to your definition if I ‘lose’ my demand deposit because the bank has lent it out I would have no recourse against the bank. I knew the bank would loan the money out and therefore incurred a risk of not being paid back.

And, yes, people do pool money for ‘more efficient’ lending purposes. But, people also use centralized storage facilities as a ‘more efficient’ (less costly) means to store goods. That is what a warehouse is. I don’t see how depositing money at a bank for ‘withdrawal without notice’ implies I am ‘pooling’ my deposit to be lent out for more ‘efficient’ lending. It implies the something very different – I am storing my money for withdrawal at any time.

scineram December 24, 2010 at 3:33 am

Wtf? Can creditors never seek payment from bankrupt institutions?

Richard M December 24, 2010 at 8:33 am

Yes, they can, but that does not mean they automatically get 100% on the dollar.

If I put my money in a ‘demand deposit’ I expect to get 100% on the dollar when I redeem it.

panika2008 December 24, 2010 at 3:40 am

“It implies the something very different” – no it does not and you should actually read the paper you sign at the bank. Your neglect of due diligence is not the bank’s or “the system’s” fault.

Richard M December 24, 2010 at 8:29 am

Which bank? The banks we have today? The banks whose ‘demand deposits’ are backed by a “printing press”?

I am not talking about banks backed by a printing press. The dispute between non-frb and frb ‘free bankers’ is not over whether banks should be backed by a printing press. Both sides agree there should be no government appointed central bank with a monopoly over note creation.

I did my due diligence. I looked up the word ‘demand deposit’. It is a deposit that can be withdrawn without prior notice. It doesn’t say ‘a deposit that is lent out for a very short time.’ It doesn’t say ‘a loan that is callable’.

Steven October 7, 2011 at 2:55 pm

Banks do have a limit on how much you can withdrawal from demand deposit accounts.

And you’re letting the dictionary define banking terms?

Michael A. Clem December 23, 2010 at 3:25 pm

When I store personal items at a storage facility, I am not loaning it to the storage facility. They can’t take my stored pool table and let someone else use it until I want it back. Likewise, demand deposits are not loaned to the bank–they are only providing the convenience of storing it for me. Sure, currency tends to be interchangable in a way that pool tables aren’t, but that doesn’t change the fundamental service that the consumer is requesting. If you want to pool your money so that it is loaned out, you specifically and deliberately put your money in a time deposit account, not a demand deposit account. Of course it’s less convenient, but it’s supposed to be less convenient–interest is paid to you for the inconvenience of letting them loan it out. It is the difference between your current consumer preferences versus your future consumer preferences that creates the interest rate (sorry if that’s not worded as well as it could be).

Mark Lane December 23, 2010 at 12:12 pm

Artisan: I just don’t get what you are saying about the 900% an so. Please explain for us weekender economists.
Concerning the risk of bank runs, that should be no more than the risk of robbing my money-bag off of my camel. So to compare actual risk, lets give the banks equal risk-of-loss to anything else (although I would prefer a bank than my camel to store my assets) which makes your position, I believe, not valid to the FB discussion.
As far as choosing a credit-worthy investor, this process has gone on since the beginning of individual wealth accumulation. So to ask “what is a credit-worthy investor” also does not appear relevant as this decision is made everyday with idle money via a Bank or the Individual.

All that said, I suspect I am am not yet versed enough to grasp your comments. I welcome elaboration.

Alex December 23, 2010 at 12:29 pm

I agree with RS regarding the premise of the article.

Also, much of the argument about FRB seems to be that it causes multiple changes in the money supply for any given change in the central bank generated monetary base. But a 100% fractional reserve system, as opposed to say 10%, means that the central bank can simply increase the monetary base 10 times as much for any given increase in the money supply. This would allow the central government to achieve greater monetary tax generation power.

I agree, however, that base money should not be in the hands of mischievous central bank creations of government.

David Hillary December 23, 2010 at 12:52 pm

The Mises Institute continues its tirade against free banking, with the same tired arguments that have been well answered countless times.

Bank notes and current account balances are merely claims on the bank, and not claims on its assets — this has been recognised under English common law for hundreds of years, in fact no English common law court has ever found otherwise.

I’ve answered the property rights claims at length here:
http://www.lostsoulblog.com/2009/12/answering-blocks-bank-impossibility.html
http://www.lostsoulblog.com/2008/12/property-rights-analysis-of-banking.html
http://www.lostsoulblog.com/2008/11/banking-defined-and-defended-part-1.html
http://www.lostsoulblog.com/search/label/fractional%20reserve%20banking

I note that Thorsten Polleit completely ignores all the arguments and evidence I’ve presented, as well as that from L White, S Horwitz, G Selgin and others. This gives libertarianism and the Mises institute a bad name: taking unsound positions and repeating them endlessly without even considering any arguments to the contrary.

Beefcake the Mighty December 23, 2010 at 5:53 pm

“I note that Thorsten Polleit completely ignores all the arguments and evidence I’ve presented, as well as that from L White, S Horwitz, G Selgin and others. ”

Sour grapes. The work of Selgin, White, and Horwitz has been extensively discussed by Mises Institute scholars. Polleit’s article does not, but so what? The relevant debates are easy enough to access. Perhaps you’re sore they haven’t acknowledged you?

Apologies if you’ve answered this before, but why should anyone care what the “common law” has to say on this? You don’t hold the common law to be infallible, do you?

“Bank notes and current account balances are merely claims on the bank, and not claims on its assets”

Isn’t this splitting hairs? What difference are you trying to highlight here?

Peter Surda December 23, 2010 at 7:02 pm

If it’s a claim on the bank rather than claim on its assets, then there is no double ownership and no fraud, even within Rothbard’s framework. The money deposited into a bank becomes property of the bank and in a subsequent arrangement, the bank enters into a conditional transfer of title with its customers, promising to pay out if certain criteria are met (e.g. the customer initiates a withdrawal). Unless all conditional transfers of title which involve risk of non-fulfillment (i.e. all, because all actions have uncertain results), I don’t see a problem. That is, I don’t see a violation of property rights, I only see inflation, and in the absence of a rights violation it can logically only be a negative externality.

Beefcake the Mighty December 23, 2010 at 10:10 pm

“The money deposited into a bank becomes property of the bank and in a subsequent arrangement, the bank enters into a conditional transfer of title with its customers, promising to pay out if certain criteria are met (e.g. the customer initiates a withdrawal).”

Well, the validity of this viewpoint depends critically on why/how, exactly, a deposit “becomes” the bank’s property. Your post suggests that this could be a contractual arrangement, in which case, sure. However, David Hillary plainly views this as deriving from the rulings of the state’s courts (he dresses it up in faux-libertarian languange of the “common” law, but this does not change the fundamentals). What is your position here?

panika2008 December 24, 2010 at 3:38 am

It is not necessary for an object to become someone’s property for him to gain a general right to handle it. It is perfectly legit to lend something to someone and, while keeping ownership, cede to him fairly general rights to the object. For example, a 99 year land lease as practiced in many countries with common law tradition is such an agreement – the owner practically cedes almost all rights to his property for a very long time (most probably extending past his life), while in fact remaining the owner and having, under very specific conditions, a right to redeem the property.

Beefcake the Mighty December 24, 2010 at 10:35 am

This begs the question of whether a depositor is really “renting” his money to the bank, which is what your example here is describing.

Peter Surda December 24, 2010 at 5:49 am

Beefcake,

Well, the validity of this viewpoint depends critically on why/how, exactly, a deposit “becomes” the bank’s property. Your post suggests that this could be a contractual arrangement, in which case, sure.

Yes.

However, David Hillary plainly views this as deriving from the rulings of the state’s courts (he dresses it up in faux-libertarian languange of the “common” law, but this does not change the fundamentals). What is your position here?

I don’t necessarily have a “position”. I am just wondering. I don’t agree fully with David Hillary that the the common law interpretation is a proof of validity, but it is still a proof that alternative explanations have not been refuted. Which is my whole point. I see an assumption that is praxeologically unsound. Only because something happened in the past, it does not follow that a superficially similar transaction has the same underlying assumptions.

David Hillary December 23, 2010 at 8:40 pm

Interesting comment on the common law, btm. I’ve recently been reading some of the work of John Hasnas and I’ve been very impressed at his approach to the common law and customary law. He says promissory notes and bills of exchange law and banking law was developed as customary law under the law merchant, before being incorporated into the common law. I’d be interested to learn about banking law under that earlier customary law.

btw, the difference between a claim on a person and a claim on an object is significant enough to answer the property rights problem invented by the anti FRBers.

Mark Lane December 23, 2010 at 1:10 pm

Regretfully, on the surface, I must favor this one with Mr. Hillary. Thank you for the extra reseach.

I say “regretfully” in that this is the first Mises Institute position that I have not totally agreed. I also pray my libertarian views have not been diminished.

I do applaud the open dialog and pray that our altruistic Leaders are reading this material.

RS December 23, 2010 at 3:06 pm

Mark,

Don’t feel too bad. I too have found fault with the libertarian/misean.org positions on several things, the FRB issue is one and their tolerance of anarchists is another. For all of their professed allegiance to individual freedom and liberty, advocating lawlessness and the forcible suppression of an individual’s risk tolerance in human actions (banking!) seems to contradict everything they profess to believe. For that reason I have to be very selective and critical about some of the reasoning behind their ideas. It does not always make sense, more sense than most, yes, but not always.

Richard M December 23, 2010 at 11:30 pm

RS,

Do you honestly believe scholars like Salerno, Hulsmann, Hoppe, Block and De Soto are against FRB because they are against freedom and for lawlessness? Where do you find ‘official’ position of the Mises Institute on FRB? The MI offers published works by ‘pro-frb’ ‘free bankers’, (do a literature and book search for Hayek, Selgin, Sechrest, etc.) and have invited them to speak at their conferences (Selgin) and feature videos and recordings of their lectures (Selgin, White).

On the subject of freedom and lawlessness I’d like to ask you the same question I asked Mike Sproul above. What ‘freedoms’ do you gain by being able to contract with frb’s other than being able to contract with them? Under a 100% reserve system you could lend as much money to a bank as you wanted, and for whatever time period and terms you and the bank agreed to. How would freedom diminish and ‘lawlessness’ abound in such a system? What freedoms does one gain in an frb system that one does not have in a non-frb system other than being able to contract with frb banks?

Michael A. Clem December 24, 2010 at 11:22 am

Well, the anarchists (including me) would argue that anarchy is not lawlessness, but you probably already know that, even if you don’t agree with it.
An argument for another thread.

The Kid Salami December 23, 2010 at 3:24 pm

Mark Lane – I would suggest this article as a counter.

http://www.independent.org/pdf/tir/tir_07_3_hulsmann.pdf

Those like David Hillary make arguments that make perfect sense except that they miss one detail that to me means their entire case stands on sand. No economy without a commonly recognised medium of exchange, ie. money, has ever to my knowledge evolved a money in a step by step fashion that was “claims on some entity XYZ” – it has always evolved one that is a commodity, something with some use in and of itself. If there is an example of this, someone please tell me.

So, as Hulsmann says

“I analyze an important case in which the market participants do not distinguish between two inherently different banking products—namely, money titles and fractional-reserve IOUs.”

The commodity money is one product which evolves from nothingon the free market – therefore, its very existence contains some information that we should in some sense respect. If someone wants to introduce another product – fractional reserve IOUs – then they are free to do so. But to introduce them alongside the existing money titles and so to assume they are the same as the money titles and can be used in the same way makes no sense to me at all.

David Hillary December 23, 2010 at 3:34 pm

the point you raise is not a problem at all. The metallic standard is just that, a standard. Metallic money is also a medium of exchange, and bank issued money is a substitute for it, but redeemable in and anchored to the metallic standard. The bank issued money can start as a minor substitute and end up as the major medium of exchange (while still being on the metallic standard) — and this is also the historical case until government intervention destroyed the metallic standard.

bionic mosquito December 23, 2010 at 4:13 pm

“No economy without a commonly recognised medium of exchange, ie. money, has ever to my knowledge evolved a money in a step by step fashion that was “claims on some entity XYZ” – it has always evolved one that is a commodity, something with some use in and of itself. If there is an example of this, someone please tell me.”

If I understand your comment correctly, and even accepting this on its face, then what is your concern? Those who advocate free-banking pose no risk or harm to this position. As you state (paraphrased, if incorrectly, my apologies), when left free to develop, money has been backed by a commodity. You therefore lose nothing by agreeing to the free-banking position. In the end, we will all evolve to a 100% backed medium.

“So, as Hulsmann says

“I analyze an important case in which the market participants do not distinguish between two inherently different banking products—namely, money titles and fractional-reserve IOUs.””

But, why don’t they differentiate? Is it fraud by the banks, or ignorance by the customer? Both have remedies readily available (in the one case, prosecution; in the other a properly deserved market loss), but neither is a reason to preclude free-banking.

I quickly read through the linked Hulsmann article. I gather the following (if I misstate a position, apologies in advance):

1) He states what he believes the market might ultimately conclude (100% gold backed), but he doesn’t state the market must conclude this.
2) As you note above, he discusses the possibility that an actor cannot differentiate between the different types of notes.
3) He states that banks have committed fraud before.

I find nothing here that identifies in a free-banking system externalities that are any more intrusive than those found in many other free-market transactions. Perhaps you could point me to something specific.

“But to introduce them alongside the existing money titles and so to assume they are the same as the money titles and can be used in the same way makes no sense to me at all.”

I don’t believe I advocated this, I have not read Mr. Hillary’s attached documents so I cannot speak for him. The different instruments offer a medium of exchange and a store of value. How the market perceives the relative value and utility of either (or any other scheme) in either role I cannot determine beforehand, and I do not assume would be identical.

The Kid Salami December 23, 2010 at 5:32 pm

“If I understand your comment correctly, and even accepting this on its face, then what is your concern? Those who advocate free-banking pose no risk or harm to this position. As you state (paraphrased, if incorrectly, my apologies), when left free to develop, money has been backed by a commodity. You therefore lose nothing by agreeing to the free-banking position. In the end, we will all evolve to a 100% backed medium.”

Not really, because once people use the bits of paper for a while it clearly gets confusing as to what money really is and they start suggesting it is something other than the thing that evolved from scratch. When people are exchanging gold coins (or silver or tobacco or whatever), there is no demand for IOUs or some other non-scarce item in exchange, or certainly not one that can compete with a commodity – people seem to have requested gold instead. Later, when money titles are in use, suggesting we can add bits of paper that look exactly like the money titles assumes that there was no function served by the type of money chosen by the market. This gold money can, for example, only be created by interacting with the price system, by bidding for labour and mining equipment at the current market prices, prices which themselves are dependent on the amount of gold. The issuance of fake titles is costless and, as do Soto points out, is something that creates its own demand.

“But, why don’t they differentiate? Is it fraud by the banks, or ignorance by the customer? Both have remedies readily available (in the one case, prosecution; in the other a properly deserved market loss), but neither is a reason to preclude free-banking.”

I think it is fraud on the part of the banks, but like i say people get confused by the paper. If a bank gives you a bit of paper that says “this is a bit of paper (not a gold title). I know we have 1 Oz gold written on it but it does not in fact mean what you might think. We have 1000 of these and the holders can at any point try to redeem them but should be aware that only the first 100 will get an Oz of gold, the rest will be out of luck” then yes, no problem. If this is free banking then fine, go for it. But this is not, as i see it, what people mean free banking. They mean creating notes identical to those that were gold titles so that there are more gold titles than gold.

“I find nothing here that identifies in a free-banking system externalities that are any more intrusive than those found in many other free-market transactions. Perhaps you could point me to something specific.”

Not sure exactly what you are looking for here, might you point me in the right direction? What do you mean by “intrusive”?

“I don’t believe I advocated this, I have not read Mr. Hillary’s attached documents so I cannot speak for him. The different instruments offer a medium of exchange and a store of value. How the market perceives the relative value and utility of either (or any other scheme) in either role I cannot determine beforehand, and I do not assume would be identical.”

Yes let the market decide – like I said above, if the new note is clear that it is not a money title then no problem and if people want to get into what is essentially a game of monetary musical chairs, so be it. And then there is indeed no product differentiation problem – it is clearly two different products and the market can value them accordingly.

Peter Surda December 23, 2010 at 6:53 pm

Kid Salami,

If a bank gives you a bit of paper that says “this is a bit of paper (not a gold title). …

This might have been what happened at some time in the past, but I don’t see any resemblance to what is happening now. FRB banks do not issue fractional reserve notes, or any notes for that matter. They take your money and for that they promise to take care of your financial obligations upon request.

There are essentially three actions that can occur:
- banks take money from lenders
- banks give money to borrowers
- banks change the account balances

The first two do not involve any instruments created by the bank (at least, not normally). They involve money created by others (e.g. central banks). The last one does not involve any money, it’s just a change of the sum of obligations following from underlying contracts. So where’s the fractional ownership? Where’s the fraud? Account balance is not equivalent to cash. Merely because they can both be used as a method of payment does not mean that they are somehow metaphysically identical.

Although it does not necessarily mean my interpretation is correct, at least it means that FRB opponents make unfounded assumptions, because a different interpretation is possible. Where is the evidence that the money you put into the bank is owned by the either the lenders or the borrowers, rather than by the bank? Where is the evidence that the account balance represents property rather than a contract? I don’t see any, and without that the illegitimacy of FRB does not follow.

The Kid Salami December 23, 2010 at 8:04 pm

I’m obviously aware there are no notes like this now, nor even necessarily very often in the past, but this talk is just a shorthand for the agreement between the lender and the bank.

Right now i would say you could argue that FRB is not fraud, precisely because money generally isn’t property (you might argue physical notes and coins are, but these are 3% of the money supply here in the UK) but a debt which is a contractual and when you tie this in with the central bank and legal tender laws, you can, as I say, argue it isn’t fraud. But the whole system now is a complete clusterfck so I don’t really think saying something happens now is any justification for anything and in fact think that much analysis of it is barely worth the time, as it will come crashing down on everyone’s head soon enough.

But free market fractional reserve banking is more interesting.

“Where is the evidence that the account balance represents property rather than a contract?”

Indeed, where is this evidence? All monies that have evolved in a free market situation have been exchanges of property. So, in the case of the first person printing up an extra gold title and lending it out, the evidence for the account balance being property and not a contract is contained in the history of that particular money. The first bogus assumption is not mine.

Peter Surda December 24, 2010 at 5:40 am

Kid Salami,

All monies that have evolved in a free market situation have been exchanges of property.

I am not sure about this. First of all, monies evolved in a free market situation usually have been commodities rather than exchanges. Second of all, there are free-market currencies that are not based on commodities (e.g. bitcoin).

So, in the case of the first person printing up an extra gold title and lending it out, the evidence for the account balance being property and not a contract is contained in the history of that particular money.

This does not follow. There is a hidden assumption that instruments provided by FRB banks represent property titles, which is exactly what I am questioning. It may be possible that this happened in the past in some cases, but there is no praxeological necessity for this.

The Kid Salami December 24, 2010 at 5:42 pm

“I am not sure about this. First of all, monies evolved in a free market situation usually have been commodities rather than exchanges.”

A commodity money involves the passing of the title of property and not debt – that was what I meant by “All monies that have evolved in a free market situation have been exchanges of property.” so I’m nor sure if you really disagree with this statement if you accept waht I say below.

“Second of all, there are free-market currencies that are not based on commodities (e.g. bitcoin).”

Well, let’s be that by “money” I mean the commonly recognised medium of exchange and the unit in which prices are in general quoted. Sure, there are many other ways to make exchanges – barter for one, and new digital currencies maybe – but there is no instance, to my knowledge, of a non-commodity becoming the most marketable commodity and taking the step from “a” medium of exchange to the primary (or one of the primary eg. gold and silver together) medium of exchange and therefore what i am calling “money”.

“This does not follow. There is a hidden assumption that instruments provided by FRB banks represent property titles, which is exactly what I am questioning. It may be possible that this happened in the past in some cases, but there is no praxeological necessity for this.”

I disagree and in fact don’t understand this objection at all. There is no “hidden assumption” – we are starting with a commodity money like, say, gold. Custom and context after the establishment of a “money” means that the exchange of a 1 Oz gold coin for an item means that it is assumed, without a written explicit contract between the buyer and seller, that what is received in return for the item priced at 1 Oz gold coin, and that looks like the other 1 Oz gold coins in use on the market, is in fact a 1 Oz gold coin. And so someone gol plating some tungsten would be defrauding the seller. This doesn’t need a specific contract but is implicit.

The same applies with titles. Either the money titles are titles or they are not and therefore are debt contracts. The market clearly would not decide, en masse, to leave their gold in banks and not carry it around, all on the same day – this was a gradual process where some isolated instances of using gold titles would start and then trust and customs would develop etc. But clearly at the beginning of this process, the titles are in fact clear property titles to gold and they would continue to be unless it is explicitly stated otherwise.So, if someone wants to break this custom and use bits of paper that are debt contracts and not simple exchanges of property, then they need to do this explicitly. If they do so – and word the note like I said above – I have no problem with it. If though they create what any reasonable person can expect is a property title but which in fact is not, then they are committing fraud.

The Kid Salami December 24, 2010 at 6:07 pm

“of a non-commodity becoming the most marketable commodity”

Ok, in this context i should have said “the most marketable good” obviously – but I typed the phrase “the most marketable commodity” without thinking because this is the phrase people use. No’one ever thinks that the most marketable good will not be a commodity or, at the least, something concrete like cattle. I say again, any evidence to the contrary will be welcomed.

Peter Surda December 24, 2010 at 7:30 pm

Well, let’s be that by “money” I mean the commonly recognised medium of exchange and the unit in which prices are in general quoted.

That still does not mean that a bank account denominated in currency A and cash denominated in currency A are somehow identical. And without that, you cannot make the argument of fraud. It’s like saying that you want a specific orange, because other oranges are a fraudulent misrepresentation of an apple. It makes no sense.

The same applies with titles. Either the money titles are titles or they are not and therefore are debt contracts.

I think here lies one of the problems. I have long had problems with the term “money”. For now, I don’t consider it a praxeological term. It leads to metaphors and therefore to problems with correct arguments.

The market clearly would not decide, en masse, to leave their gold in banks and not carry it around, all on the same day – this was a gradual process where some isolated instances of using gold titles would start and then trust and customs would develop etc.

This sounds plausible, however this merely describes historical phenomena. It is not a praxelogical argument.

So, if someone wants to break this custom and use bits of paper that are debt contracts and not simple exchanges of property, then they need to do this explicitly. If they do so – and word the note like I said above – I have no problem with it.

Bank accounts are not “bits of paper”, so I don’t understand the argument.

If though they create what any reasonable person can expect is a property title but which in fact is not, then they are committing fraud.

Again, I don’t see any relevance to what we have now. Merely because in the past banks issued deposit certificates it does not mean that the same assumption is reasonable to make now.

The Kid Salami December 24, 2010 at 8:41 pm

“That still does not mean that a bank account denominated in currency A and cash denominated in currency A are somehow identical. And without that, you cannot make the argument of fraud. It’s like saying that you want a specific orange, because other oranges are a fraudulent misrepresentation of an apple. It makes no sense.”
Well, what you say makes no sense to me either. They’re not “identical” no? Neither are two apples – that isn’t helpful. But they are interchangeable in a very relevant sense sense – ie. the essence of a “bank account” is that I can swap out cash for the same number of units in my account and vice versa and can now after this swap still acquire titles to all the property that I wanted before, the only differnence is in things pertaining to physical uses of the money (like as a bookmark), which we can agree are irrelevant.

And what’s more, how do we even define what the first “bank account” is without saying what it is an “account” of? I’m saying the first “bank accounts” were simply “counts” of gold (or whatever) and that, eventually, they stopped being this and started being a debt contract and a count of…. something other that gold. I want to examine the transition and whether it was done while respecting property rights or violating them.

“I have long had problems with the term “money”. For now, I don’t consider it a praxeological term. It leads to metaphors and therefore to problems with correct arguments.”

Whilst I have some sympathy with what you say (and I recall Mises in HA does not attempt to define “money” because of this problem but simply says that his reasoning is applicable to media of exchange in general), making this demand essentially means we can’t discuss this topic without writing a book length text for each comment. For example, Rothbard says in WHTGDTOM

“Consider the case of A, the farmer, who wants to buy the shoes made by B. Since B doesn’t want his eggs, he finds what B does want–let’s say butter. A then exchanges his eggs for C’s butter, and sells the butter to B for shoes. He first buys the butter no: because he wants it directly, but because it will permit him to get his shoes. Similarly, Smith, a plow-owner, will sell his plow for one commodity which he can more readily divide and sell–say, butter–and will then exchange parts of the butter for eggs, bread, clothes, etc. In both cases, the superiority of butter–the reason there is extra demand for it beyond simple consumption–is its greater marketability. If one good is more marketable than anothe–if everyone is confident that it will be more readily sold–then it will come into greater demand because it will be used as a medium of exchange. It will be the medium through which one specialist can exchange his product for the goods of other specialists.

Now just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media–in almost all exchanges–and these are called money.”

So Rothbard has no problem using and reasoning about the term “money” in at least some contexts – neither do I.

“Bank accounts are not “bits of paper”, so I don’t understand the argument.”
I already said, twice now on this thread, talking about bits of papers with terms written on them is a logical device to make it easier to talk about this, specifically because it saves having to go into detail every time they are brought up about whether we are talking about time or demand deposits and the exact terms, and this problem can be made simpler (without losing the essentials) by just imaging each bit of gold has a “real” title which it stands to reason only one person hold at once and then other “titles” to the same gold can be called fake titles. But ok, I can accept this might not be to people’s liking, so will withdraw from circulation future such statements.

“Again, I don’t see any relevance to what we have now. Merely because in the past banks issued deposit certificates it does not mean that the same assumption is reasonable to make now.”
I already said as clearly as I can that I don’t care about now – the system now is a total joke with many more confounding factors, and that I can accept that FRB is NOT fraud now. I am concerned about what I consider to be the transition point between where “money” (or if you prefer then, media of exchange in general) was property (ie. was a commodity and didn’t even have the name money, it was just gold – that is, “I’ll give you 2 Oz of gold for that goat” is what someone might say) to the point where the medium of exchange is not considered property and how this happened.

You appear to deny there is anything in this regard to discuss? Do you? That is, do you accept that money once didn’t even have a separate word, that the name of whatever the medium of exchange was was used? (I recall in English there was no word for money until the 14th century, though silver had been the main medium of exchange for hundreds of years at this point and in passing I’d note that the word in French is the same for silver and money). And do you accept that fractional reserve banking has existed at some point after the situation I describe in the previous question? And so from this can we conclude that the medium of exchange in which this “bank account” was denominated in these fractional reserve banks was debt/contract based and not a commodity? If not, please explain where you disagree?

And if you answer yes, then there was necessarily some transition involved. Do you say there was definitely not any fraud in this transition? Or that there was not necessarily any fraud during this transition?

Peter Surda December 24, 2010 at 10:44 pm

It appears that our differences are not really important from practical point of view, but only from theoretical. I don’t care what “money” was in the past, or what banks were doing in the past. These are empirical questions and I don’t see what they have to do with the study of economics.

Nevertheless, I still have to enquire about the following:

But they are interchangeable in a very relevant sense sense – ie. the essence of a “bank account” is that I can swap out cash for the same number of units in my account and vice versa and can now after this swap still acquire titles to all the property that I wanted before, the only differnence is in things pertaining to physical uses of the money (like as a bookmark), which we can agree are irrelevant.

I disagree. Merely because sometimes you can use a bank transfer for the same purpose as giving someone cash does not mean that there is some metaphysical connection between them. Just like you can sometimes use apple and orange for the same purpose without them sharing an identity. What you can say is that to a certain extent, bank account and cash are substitutes. But all kinds of goods are substitutes and we don’t apply the anti-FRB logic on them.

how do we even define what the first “bank account” is without saying what it is an “account” of?

Again: historical fact. It does not address my objection.

The Kid Salami December 26, 2010 at 6:36 am

Let’s accept your request and abandon the word “money” – we are in an economy in which there is direct exchange and indirect exchange and there exist commodities which are used directly in coin form to facilitate indirect exchange and they are just referred to as “gold” and “silver” or whatever, there is no word “money”. And everyone holds their gold and other media of exchange in their purse or in their home.

Like I say, I’m making the assumption that there has never been a free market economy that has evolved a debt-based medium of exchange before having a commodity one and if anyone has examples of this to prove me wrong I’ll be as keen to read about them as they. The example above from Mike Sproul is the issue of debt based money from an authority with the power to tax and so is not from the free exchange between market participants – I don’t consider this a valid counter example. And if you say this isn’t praxeological and so isn’t a valid assumption or doesn’t interest you, then you may as well stop reading now as we’ll just have to agree to differ on that.

Otherwise, based on this, can you expand on this statement

“What you can say is that to a certain extent, bank account and cash are substitutes.”

They are “substitutes” for what? Can you please outline the logical steps from the situation I describe above to the existence of a “bank account and cash” – both terms that in this restricted scenario do not, currently, exist.

Peter Surda December 26, 2010 at 7:35 am

Kid Salami,

I’m making the assumption that there has never been an economy that has evolved a debt-based medium of exchange before having a commodity

Well, without a unit of account, there cannot be debt. So at least logically, your point makes sense, but I suspect you are drawing some other conclusions out of that which I consider problematic.

They are “substitutes” for what?

They are substitutes for each other. In some situations, both of them are usable to achieve the same goal. In economics, such goods are called substitutes.

Can you please outline the logical steps from the situation I describe above to the existence of a “bank account and cash” – both terms that in this restricted scenario do not, currently, exist.

I don’t understand. Let’s say A gives some good, G, to B, and B promises to settle debt on behalf of A, and give G or a proportion thereof to A on demand. Thus, we have created something which we’ll call “Peter’s system” (the exact term is irrelevant of course). What does it have to do with any historical developments, banking or even money for that matter? Nothing.

The Kid Salami December 26, 2010 at 8:52 am

“They are substitutes for each other. In some situations, both of them are usable to achieve the same goal. In economics, such goods are called substitutes.”

I thought we were agreeing to banish the word “money”, and hence “cash”, from the debate – in which case, I was asking for a definition for “bank account” that didn’t depend on the words “money” or “cash”.

“Let’s say A gives some good, G, to B, and B promises to settle debt on behalf of A, and give G or a proportion thereof to A on demand.”

Firstly, now you’ve just assumed the whole problem away – you’ve completely ignored who has title to what present good at what time – by using the phrase “on demand”.
And secondly, this sounds great except that a medium of exchange has never, to my knowledge, developed in this fashion. That is, market participants A and B might decide to make agreements using the phrase “one demand” amongst themselves like this, and they are free to do so. But this type of indirect exchange has never become widespread because the market participants don’t deem this to be suitable for indirect exchange. They have always started off using a commodity, a present good and not a debt.

But you place no value on this information (assuming it is true) because it is “emprical”? Then you are insisting problems can all be solved from the armchair, or that nothing of use in a discussion can come from anything that you can’t deduce a priori in an armchair, or something like this. As De Soto says on this:

“The traditional, universal legal principles we dealt with in the last section in relation to the irregular deposit contract have not emerged in a vacuum, nor are they the result of a priori knowledge. The concept of law as a series of rules and institutions to which people constantly, perpetually and customarily adapt their behavior has been developed and refined”

The outcome of these processes is the customs and implicit contractual terms that exist in every exchange and – so long as they have respected and not violated property rights – these contain information (information from which we can’t make sweeping generalisations but information nonetheless). But you want to ignore it. This appears to be the root of our disagreement.

Peter Surda December 27, 2010 at 5:39 am

Kid Salami,

I thought we were agreeing to banish the word “money”, and hence “cash”, from the debate – in which case, I was asking for a definition for “bank account” that didn’t depend on the words “money” or “cash”.

Silly me. I though we were also banishing the word “back account”.

Firstly, now you’ve just assumed the whole problem away

Oh yes. Now we’re getting somewhere. What I did was I provided an abstraction which is free of interpretation. That is, in my humble opinion, a proper scientific approach.

you’ve completely ignored who has title to what present good at what time – by using the phrase “on demand”.

I did not ignore that. I merely explained that it is possible to interpret the same empirical phenomenon in multiple ways. According the alternative interpretation that I provided, the owner of the stuff that is in the bank is the bank, and the owner of the stuff that is with the bank’s customer is the bank’s customer. All else are contracts (=conditional title transfers). It does not mean my interpretation is correct, it merely means that it needs to be refuted in order for your claims to be true.

Then you are insisting problems can all be solved from the armchair…

I am not trying to “solve a problem”. I am trying to find flaws in arguments. Whether FRB is fraud or not depends on the exact nature of contracts and exchanges that are made by the banks and their customers. It is you who are claiming that these contracts must follow a certain path and offer no other explanation than historical data from hundreds of years ago.

bionic mosquito December 23, 2010 at 7:44 pm

“What do you mean by “intrusive”?”

I am thinking about externalities that are meaningful, a real third-party violation of property rights. (Yes, what “meaningful” might mean in practice is somewhat open to debate, hence my use of the term “intrusive”.)

For example, no one can stop me from selling my home at a price 50% below market if I choose. Certainly, this places a burden on my neighbor in terms of potentially impacting his home’s market value, but it’s my home to dispose of at a price I choose. An externality that is inherent in a market economy.

So, while there may be such an externality attributable to FRB currency in a market fully free to develop and implement any and all currencies imaginable, I am looking for an externality that would be a significant enough violation of the property rights of an unwilling third party such that there is some basis by which to stop the implementation of FRB (again, in the context of a freely competitive currency market).

“Yes let the market decide…”

Ultimately, this is my point; I just take a lot of words to say it :-))

james b. longacre December 23, 2010 at 8:37 pm

I am looking for an externality that would be a significant enough violation of the property rights of an unwilling third party such that there is some basis by which to stop the implementation of FRB…..

does FRB currently go on now???

how do you have an unwilling third party in your free market scenario???

bionic mosquito December 23, 2010 at 9:11 pm

“how do you have an unwilling third party in your free market scenario???”

This is my point. I do not see one. I am asking for someone, anyone to demonstrate one. If anyone can, I will gladly rethink my position. Otherwise, I see FRB, in a free market scenario, as an acceptable option. Let it then live and die on its own merits.

David Hillary December 23, 2010 at 9:14 pm

Man, you’re really lost, and have no idea about the history of banking and bank notes.

There has never been a successful form of instrument that is a bearer paper money title, issued by an institution that holds the gold on behalf of the bearer, that functions as money. The problem of allocating storage costs has not been solved, or is not worth solving, as far as the market is concerned.

Bank notes are and have always been promissory notes, which are engagements to pay to the bearer on demand the sum of money stated on the note. The normal and historical wording is ‘Bank X priomises to pay to the bearer on demand the sum of X, signed, Bank X’. (This wording is still used in England, Northern Ireland, Scotland, Hong Kong and some other countries.) This engagement does not imply any metal storage obligations, and the bank of issue is free to invest its assets to earn a return to pay for the costs of issuing and maintining the issue of the notes. This business has been viable under a metallic standard.

There is no fraud in the above business, the bank is merely promising to pay the note according to its tenor, as is the maker of any other promissory note or the drawer of any other bill of exchange or cheque. The holder of the instrument, like the holder of any other note or bill, is holding a right as a creditor of the issuer, and like any holder, is subject to credit risk and entitled to enforce the obligation according to its tenor.

There is nothing stopping anyone offering to secure such bank notes with a reserve of metal, or to maintain a 100% reserve ratio, as an additional term of the note, although this arrangement does not appear to have been viable.

I strongly recommend that you study up on banking law and bank notes, starting with this: http://www.lostsoulblog.com/2008/11/banking-defined-and-defended-part-1.html

Mike Sproul December 23, 2010 at 10:15 pm

David:
“There has never been a successful form of instrument that is a bearer paper money title, issued by an institution that holds the gold on behalf of the bearer, that functions as money.”
I might be off-base in finding fault with such a fine post, but the Bank of Amsterdam, among others, issued bank money that was backed by 100% metallic reserves. Their money was not made of paper, so strictly speaking, your statement is correct.

David Hillary December 24, 2010 at 12:17 am

Yes, just talking paper money here Mike. Book entry accounts can charge storage fees, obviously.

panika2008 December 24, 2010 at 3:44 am

“There has never been a successful form of instrument that is a bearer paper money title” – most probably because bankers gravitated towards using linen.

And really, you should do some reading on banking and trade clearing in late medieval.

The Kid Salami December 24, 2010 at 5:58 pm

I’m using the idea of notes with big long statements written on them as a logical device – I’m not discussing history. Whether these are demand deposits or whether these imaginary scenarios ever actually happened isn’t (at first at least) important to discuss the transition from people exchanging gold coins to people exchanging titles to people using banks.

I in fact wrote exactly this above before you wrote your post, when I said

“I’m obviously aware there are no notes like this now, nor even necessarily very often in the past, but this talk is just a shorthand for the agreement between the lender and the bank.”

So maybe before you tell people that they are lost you should read what they actually wrote. What is your problem with me taking this approach? What is it I’m missing that makes my approach invalid?

The Kid Salami December 24, 2010 at 6:00 pm

I’m using the idea of notes with big long statements written on them as a logical device – I’m not discussing history. Whether these are demand deposits or there are other confounding factors or whether these imaginary scenarios ever actually happened isn’t (at first at least) important to discuss the logic of the transition from people exchanging gold coins to people exchanging titles to people using banks.

I in fact clarified exactly this above before you wrote your post, when I said

“I’m obviously aware there are no notes like this now, nor even necessarily very often in the past, but this talk is just a shorthand for the agreement between the lender and the bank.”

So maybe before you tell people that they are lost you should read what they actually wrote. What is your problem with me taking this approach? What is it I’m missing that makes my approach invalid?

The Kid Salami December 24, 2010 at 6:25 pm

And what’s more, it is clear that the jump from timed deposits (where money is treated as property and property rights aren’t violated) to the creation of deposits from nowhere (meaning property rights are violated) is considered by at least one person to be at least close to the idealised model i’m discussing here. See quote from de Soto in Chapter 2 of his book.

“Abbott Payson Usher, in his monumental work, The Early History of Deposit Banking in Mediterranean Europe,40 studies the gradual emergence of fractional-reserve banking during the late Middle ages, a process founded on the violation of this
general legal principle: full availability of the tantundem must be preserved in favor of the depositor. According to Usher, it is not until the thirteenth century that some private bankers begin to use the money of their depositors to their own advantage,
giving rise to fractional-reserve banking and the opportunities for credit expansion it entails. Moreover, and contrary to a widely-held opinion, Usher believes this to be the most significant event in the history of banking, rather than the appearance of banks of issue (which in any case did not occur until much later, in the late seventeenth century). As we will see in chapter 4, although exactly the same economic effects result from the issuance of bank notes without financial backing
and the loaning of funds from demand deposits, banking was historically shaped more by the latter of these practices.

Usher points out that the first banks in twelfth-century Genoa made a clear distinction in their books between demand deposits and “time” deposits, and recorded the latter as loans or mutuum contracts. However, bankers later began gradually to make self-interested use of demand deposits, giving rise to expansionary capabilities present in the banking system; more specifically, the power to create deposits and grant credits out of nowhere.”

Peter Surda December 24, 2010 at 7:35 pm

However, bankers later began gradually to make self-interested use of demand deposits, giving rise to expansionary capabilities present in the banking system; more specifically, the power to create deposits and grant credits out of nowhere.

So, because some guys hundreds of years ago committed fraud, people who perform superficially similar tasks nowadays are also committing fraud? I still fail to see the point.

Mike Sproul December 23, 2010 at 4:59 pm

Kid Salami:

Here’s a link to Andrew McFarland Davis classic discussion of colonial American paper currency. The paper shillings issued by the colonies in this episode give a good example of how paper money actually came into existence.

http://people.virginia.edu/~rwm3n/webdoc7.html

The Kid Salami December 23, 2010 at 5:47 pm

But this is the colonial government issuing this money though isn’t it? Rothbard discusses this in The History of Money and Banking in the United States, no? This was a fiat money and issued by a body with the power to tax, so it did not evolve on the free market.

Mike Sproul December 23, 2010 at 8:48 pm

Colonial paper money was quickly adopted by all the American colonies between 1690 and 1710. Contemporary accounts make it clear that it was a boon to economic activity, although, as you say, it was issued by governments. In just about every colony, the paper notes were issued as an emergency measure to pay some urgent expense, and they were backed by the promise that future tax collections would be used to retire them. Whether you’d say the notes “evolved on a free market” is debatable, since the colonies themselves were often private enterprises established with the hope of profit. There had actually been some attempts to establish private banks, but these did not thrive.

Elwood P. Dowd December 23, 2010 at 1:29 pm

It seems appropriate to post this one more time. One comment I would like to
add, Mike Sproul criticised this little tale by raising the issue of what he
calls “assets of adequate value”. Curiously he supports FRB by claiming that
$100 cash deposited in a fractional reserve bank is not an “asset of adequate
value”. I happen to agree that money deposited in a fractional reserve bank is
very risky, but how does that mesh with his own views?
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 elquently 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

RS December 23, 2010 at 1:57 pm

very interesting but I think it overlooks one important thing and that is that credit entails risk and risk tolerance is an attribute of the individual. Henry Hazlitt once wrote that credit is not something that a bank gives to a man but is something that a man already has, he brings it with him into the bank (Economics in One Lesson). Well, I think that this principle applies to this discussion. If every person were free to be their own bank and write their own check then it would become apparent very quickly who has and who does not have “credit”, which is all a bank really does when it comes right down to it. It is a clearing house for creditors and debtors and the efficiency it brings is its reputation for finding those who have the best credit and weeding out those who do not. If it is good at its job then consumers will prefer dealing with those banks over others, it’s all about one’s personal and individual preference for risk, which is fundamentally inherent it any transaction, most especially in IOUs over time.

Elwood P. Dowd December 23, 2010 at 5:27 pm

As you surely know, speaking so wisely about FRB as you do, creditworthiness is
an issue relative to the borrower of money, not the lender of money. In my
little tale I am not borrowing money, I am lending money to the banks, my
impeccable credit rating is irrelevant. Obviously you are referring to the
creditworthiness (risk of lending to) of the fractional reserve banks. You join
Mike Sproul in supporting FRB by suggesting that fractional reserve banks are
not good risks, a curious argument indeed.

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

Steven October 7, 2011 at 3:21 pm

Bank do due diligence and would require your check to clear from the last bank, in your scenario.

A loan paid back in payments doesn’t require all of the monies in at one time, so that “check” doesn’t have to clear 100% in full.

scineram December 24, 2010 at 3:52 am

This nonsensical scenario has been debunked in other discussions already on earlier posts. Its stupidity is obvious to anyone with a brain.

Elwood P. Dowd December 24, 2010 at 1:50 pm

Funny, I went back to all of the posts of this little tale, sadly it was mostly
ignored, a few positive comments were made, a few negative comments, some
serious misunderstanding of the process described, but no attempt to refute it
was ever made. Maybe you don’t know what the word “debunked” means?

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

Sione December 23, 2010 at 1:31 pm

Mike

You write, “Once again the Mises institute gives libertarianism a bad name by claiming that voluntary trade between a bank and its customers should be banned.”

Please elaborate. Does the VMI really make the claim as outlined?

As far as some gossiping by some fellers about some other fellers on some site somewhere- one has to ask why that is relevant to anything here. So what if they are chatting away? Or is it that you think it’s important because one of them chatterers is you?

Sione

Deefburger December 23, 2010 at 1:59 pm

Fiat money and Fractional Reserve Bank notes both create the illusion of exchange when in fact any apparent exchange of value is a one way transfer of value in the direction of the issuer of the notes.

It is this fact that presents both forms of money as fraudulent in the economic system. The notes issued have no value except by force or by belief. This is not the same thing as the belief in the value of a weight of gold or a house. The gold or the house are tangible items whose existence is not dependent upon a force of law or a belief in value. They stand on their own and can be subjectively evaluated by anyone without a supporting institution.

The notes on the other hand require a supporting institution or law and a belief by the receiver of the notes in the laws or institutions and a trust in those laws and institutions in order to support any value beyond the material and form it has. Free markets will always choose exchange mediums that are capable of standing on their own over institutionally supported mediums because the institutions must be more durable than tangible substance to be of any real value. They are never more durable than tangible substance! An institution is intangible. It is real, but it is not a tangible thing. It is a pattern, an organization of tangible people, but it is no more than that. It can disappear without a trace from the tangible world at any time without even a hint of it’s being gone. To do that to something tangible, it must be annihilated in a nuclear blast!

And if the evaluation of tangibles is subjective and that is supposed to be a problem for a gold standard, then unbacked notes are the same problem squared. It is an unknown times an other unknown. What any standard based on tangible substance does is reduce the unknown to only one term because the weight or other substantive measurement is objective and reproducible.

RS December 23, 2010 at 2:17 pm

“The gold or the house are tangible items whose existence is not dependent upon a force of law or a belief in value. They stand on their own and can be subjectively evaluated by anyone without a supporting institution.”so does a paper note. it too has “value” because someone believes it can be exchanged for something else, you would not try to exchange gold or houses either if this were not true. try to sell a house in a war zone or buy gold with dirt.

your line of reasoning does not add anything to the discussion. sorry.

Sione December 23, 2010 at 4:43 pm

RS

A war zone? That’s a state of emergency isn’t it?

Using an emergency situation to develop and validate a idea or several (such as a moral code, ethics, individual rights, the nature of fiduciary media, the means of exchange, an entire economic system etc) is a hazardous undertaking at best. Lot’s of traps await. The conclusions are not necessarily as you may desire- hardly likely to be true and correct either. The philosopher Singer does something along similar lines.

Singer develops the idea that no person in the world should be allowed to have any more wealth than exactly enough to survive in regular comfort. He does this by setting up an imaginary emergency situation and asking the listener but one question. Once this is answered in the conventional manner (which it almost certainly will be) his trap has set and there is no turning back from the inevitable conclusion- his conclusion. Of course, what he fails to mention is that his approach requires the listener to already have a code of morality and an evaluation of human life as compared to inanimate objects. He exploits the listener’s shared premise. It’s a perverse and contextless form of circular reasoning.

Anyway, your line of reasoning in this instance falls into the same class. You might want to consider your starting assumptions.

Sione

panika2008 December 23, 2010 at 3:20 pm

Oh no, not again!

“fractional-reserve banking … means that a bank lends out money that clients have deposited with it” – not quite. It means that the bank lends out money deposited on demand accounts.

“Fractional-reserve banking thus leads to a situation in which two individuals are made owners of the same thing” – not at all. This is silly. What the depositor has is a claim on his deposit that clearly specifies terms under which the redemption might be suspended.

“through bank lending, the borrower and the depositor become owners of the same money” – bollocks. At leas Mr Polleit notes that this is a “legal impossibility”, which is true, because no such phenomenon takes place. Instead, both the borrower and depositor receive limited (conditional) claims on an amount of money specified only up to amount, not a concrete object. If you, Mr Polleit, have a problem with two limited claims on the same property, please care to elaborate how is lending possible at all. After all, lending IS EXACTLY a creation of a limited claim on property while the original property is relaxed for an amount of time.

“Fractional-reserve banking leads to contractual obligations that cannot be fulfilled from the outset” they cannot and still they are, day after day…

“violating the nature of the law of property rights” – what a nonsensical statement. Unless you can point WHO is violated, there can be no violation. Violation of “nature of law” is either some kind of a high flying magic esotery or fascism.

Michael A. Clem December 23, 2010 at 3:50 pm

It means that the bank lends out money deposited on demand accounts. True. And this is the problem. Demand deposits are not made with the depositor’s intention that access to the money be limited to them and lent out to others. This is precisely what time deposits are for. Demand deposits are made so that the money is available for receipt or transfer upon demand (and thus the name). It’s a convenience to the depositor so they can make financial transactions without having to carry that money around or store it in their mattresses or whatever. Sure, thanks to the interchangability of currency and credit transactions, the bank can play shell games and cover requests that usually don’t add up to the total of demand deposits the bank is “holding”, but it IS a shell game.

panika2008 December 23, 2010 at 3:56 pm

“Demand deposits are not made with the depositor’s intention that access to the money be limited to them and lent out to others” – false. I suggest your reading a demand deposit account contract. Did you ever read some such? I did. Guess what. You sign an agreement for the money to be lent and conditions under which redemption might be suspended. And it’s not some surreal hypothesising of Polleit, Rothbard or Hoppe. It’s reality, here and now.

Oh, and get this. You are in no way forced to use this system. There is a perfectly viable alternative – a full reserve system right here, right now. It’s called safety deposit box.

Michael A. Clem December 23, 2010 at 4:10 pm

I had actually considered safety deposit boxes while writing my response, but they don’t offer the convenience of checking or debit cards. It’s an entirely different sort of ‘account’. And ask anyone who has a demand deposit account if they intended for their access to be limited, instead of “on demand.” The contracts may be real, but that’s just so much fine print and legalese. What are the consumer’s real intentions??

panika2008 December 23, 2010 at 4:29 pm

It’s true that deposit boxes don’t offer transactions. But that might as well be a symptom of the fact that the market actually does not post enough demand for transactional full reserve services. You can never tell.

Real intentions… well, I think that anyone ready to use the bank’s services for larger sums of money, perhaps even all his transactions and a large part of his assets/savings, should really know what he’s doing. Neglect of due diligence is no proof of fraud on the bank’s part. Now, I am sure that the lightheartedness of depositors is in a large part an effect of the existence of FDIC and its equivalents – effectively the government inciting a sense of false security in its citizens. However, this in no way invalidates the principle of fractional reserve banking. What it means, at most, is that on a truly free banking market, the extent of FRB would probably be smaller than it is today, the reserves held would be larger etc. But it is futile to expect FRB’s disappearance. The demand is too strong.

Michael A. Clem December 23, 2010 at 4:34 pm

Who is demanding FRB? Depositors? Or borrowers? Anyway, perhaps you would care to answer a question I raised earlier in the thread: If a bank has, for example, 50% reserves, why wouldn’t a receiver simply discount that bank’s currency by 50%, thus making the alleged advantages of FRB null and void? Is there some reason for thinking receivers wouldn’t do that? If not, then the market would pretty much eliminate FRB on its own, and would not encourage it.

panika2008 December 23, 2010 at 4:43 pm

Of course depositors are demanding it. And borrowers generally don’t mind, because the weaker the bank, the better for the borrower :)

“If a bank has, for example, 50% reserves, why wouldn’t a receiver simply discount that bank’s currency by 50%” – because it does not work this way. It would be a fine method of discounting if the bank emitted 100 demand notes while having 50 pieces of base money. But it’s not the case. The bank has the 100 pieces (in fact it most probably has quite a bit more), but happens to have some of it leased. And as long as the bank clears and stays liquid (and the interbank market stays operational and/or a lender of higher resort/a reinsurence company covers unexpected surges of liquidity demands), there is practically no room for a discount, because that would generate an easily exploitable arbitrage – buy FR notes for 50% face value and redeem for 100% face value.

I could of course be wrong wrt the discount and arbitrage (although I’m pretty sure I’m not), but even then it does nothing to invalidate FRB; if anything, it would show it’s silly. But there is a lot of silly things people demand in this world, starting with gambling…

Michael A. Clem December 24, 2010 at 4:12 pm

The depositors are just wanting a safe place to keep their money until they need it. If they want their money loaned out, i.e., they want to earn interest on it, then they put it into a time deposit account, not a demand deposit account. And as long as the bank clears and stays liquid, there is practically no room for a discount, because that would generate an easily exploitable arbitrage – buy FR notes for 50% face value and redeem for 100% face value. But that’s the whole point. If a bank takes too big a risk, they can’t stay liquid. If there is no government depositor’s insurance and government bailouts, any private insurance would charge more for riskier bank behavior, which would tend to discourage low reserves. Furthermore, if we actually had free banking, it wouldn’t be up to the bank to decide how much their notes are worth, but the receiver of the notes, who could choose to refuse or accept the notes only at a discount. This also would minimize fractional reserves by banks. So even if FRB is not considered fraudulent, I think a free market would still tend to minimize its practice.

Deefburger December 23, 2010 at 3:28 pm

@RS
Then you are not thinking about the meaning of value and the value of belief. A paper money bill in the same war zone is not worth anything. The house and the gold, both tangible things, still have value relative to the situation or circumstance.

If the item “x” has tangible property “a”, and you evaluate it, you are observing the thing and assessing it’s utility to you and your situation. That assessment is subjective, but it is the only unknown in the evaluation. To evaluate a note, one must introduce a secondary unknown to the situation. That is the stability, trustworthiness, or consequences of the institution backing the note. That adds a second variable to the list of unknowns and increases the subjectivity by that factor. It is a double blind evaluation.

It is not equivalent. Both forms of value are subjectively evaluated, but only the tangible substance yields a useful result. The note never yields an evaluation that does not have a wide margin of error inherent in the mental calculus.

The note loses it’s value the moment the belief is repealed. The gold and the house are independent of belief in their substance, and only dependent upon the utility of their substance or form or both for an assessment of value to have significance. No belief is necessary in order for the value of them to be realized.

If belief is all it takes to make something have value, then go draw yourself a picture of a house and believe you have something of value. See how far you get with that and report back here, OK?

RS December 23, 2010 at 3:44 pm

then go draw yourself a picture of a house and believe you have something of value. See how far you get with that and report back here, OK?

really? so a picture of a house drawn by Picasso or Rembrandt is of no value? I think Southerby’s would disagree as would everyone else.

as for the rest of your post, a medium of exchange has utility by virtue of the fact that other people believe other people will accept it so in that respect a “note” can have the same utility as a coin, both values are derived from your belief that other people believe and will continue to do so. In fact, the entire benefits of a division of labor society is fundamentally based on the fact that people “believe” that the specialization they have chosen will be of “use” to someone somewhere, the fact that they choose to represent the products of that choice with either paper or metal makes no difference, the only thing that matters is that whatever is chosen does, in fact, represent those goods.

Alex December 23, 2010 at 4:13 pm

A medium of exchange has a use value because it reduces transactions costs.

Amanojack December 23, 2010 at 4:31 pm

Just let the market decide. That is all there is to know.

Robert Bostick December 23, 2010 at 4:41 pm

In a perfect world their would be an acceptable, species backed currency. However, in the Rothschilian world of the past three centuries, the likelihood of that is only possible through global revolution to replace central banking systems & their FRB practices.

Until then we are mired in FRB and must therefore, make the best of it. Rationale discourse on the unethical characteristics of current banking practices will not change those practices. Bankers have far too much invested to succumb to anyone nation’s bully pulpit, finger pointing, accusations of fraud. Only when bubbles continue to be created and continue to burst will the public become sufficiently aroused to take action. But, by then it may be too late.

Even now, in America, the Justice Department is shying from serious pursuit of fraud allegations on the part of the heads of major banks and former investment houses. Oh, there will be “show” indictments, and trials, but nothing on the scale of the S & L debacle of the late ’80s. Too many elected an unelected officials remain fearful of the source of their campaign funding and deign to bite the hand that feeds them.

Nor will “mainstream economists” speak out against FRB. They won’t even support using FRB principles to bail out Main St, after having supported the bail out of Wall St. using the Federal Reserve’s version of FRB.

Bottom Line!FRB is here to stay until revolution sweeps it away. No matter how you argue the need for a better way, In our hearts we know, FRB is here to stay.

Sione December 23, 2010 at 5:21 pm

I remember Villiami acted as a fractional reserve cheque writer. Some years ago he went over to the main island. He stayed there a time and somehow got interested in setting up a bank account. The bank gave him a cheque book. When he returned to his village he mentioned how he had a bank account and that it was valuable (from selling various things and doing some work one surmises). Not so long after that he started writing cheques for the gas station, the wharf, the general store and so on. Soon enough the recipients started endorsing the cheques to each other as no-one was going to the main island any time soon to change them. So there was a bit of Villiami fiat money floating about. It all came to a crashing halt when some of those cheques did find their way over to the main island and were cashed. Once his account was empty and the cheques kept coming, well those were dishonoured. Word got around pretty quick and there was a rush to get out of those cheques. Too bad for most people, for they lost out. People were very angry that they had been cheated. Yet all Villiami had done was act as a fractional reserve cheque distributor. His activities, according to him, were OK and beneficial even. It was the fault of the greedy people who went to the palangi bank to cash the cheques. By doing that to excess they’d wiped out the value of Villiami’s cheques and that is what caused those who remained holding the cheques injury. Pure greed! Also that awful palangi bank was completely out of order by not recharging Villiami’s account. After all there’d have been no problem with any of the cheques if they’d up and done that.

No matter how cleverly Villiami argued his case, what he done was considered immoral by his fellow villagers. But perhaps he was right after all and the villains were the palangi bank and those greedy’s who sought to cash the cheques.

One day I should write & tell you about how he’s used Siotu’s cars, vans, bikes and trucks to start another fractional reserve business. That one went down the toilet. Perhaps Villiami’s problem isn’t that he’s been dishonest, merely that people don’t understand fractional reserve.

Sione

ABR December 23, 2010 at 7:03 pm

If fractional reserve banking and central banks were abolished, who would lend? Why, anyone — including banks — could lend. Their own money, that is. In the case of banks or corporations: the shareholders’ money.

So, if you were desperate to do something ‘useful’ with your pot of gold, you could buy shares in a bank, or lend portions of the gold to friends or ventures that interest you, or you could buy shares in other industries, just as we do now.

The urge to do something ‘useful’ with your gold would dampen, however, since the purchasing power of the gold would, in all likelihood, increase over time. [But you'd have to pay a bank a fee to keep your gold.] But a dampening enthusiasm to put one’s money to work might not be such a bad thing. Most enterprises fail. Many fail miserably.

panika2008 December 23, 2010 at 7:20 pm

And what is wrong with lending borrowed money? Why should a fascist regulator (proposed by, no less, austrian school libertarians of ILvMI!) say I cannot borrow some cash from Mark and John just to lend it to Grace on better terms, keeping the difference to me?

ABR December 24, 2010 at 11:03 am

Nothing wrong at all.

Michael A. Clem December 24, 2010 at 3:51 pm

Nothing at all, as long as the “lenders” don’t think they can use the money while it’s loaned out.

panika2008 December 26, 2010 at 7:05 pm

Strange. I always thought that it’s up to the contract to specify the relation between adult, conscious people, not what they frivolously assume.

LRT December 23, 2010 at 7:42 pm

Because those who favor fractional reserve banking claim it is necessary for the economy to function and without it the result would be to fall into depression. We must take every opportunity to explain there is a simple alternative. Just use certificates of deposit with a fixed length of time for repayment. This way the bank can loan the money as long as its repaid by the CD’s due date. This solves all the issues! The depositor could sell his Certificate of Deposit to a third part if he needs the money sooner than the due date and the bank is safe from a run on the bank and only one person has the money at a time.

panika2008 December 23, 2010 at 7:49 pm

What is the difference between a bank lending long, say 15 years and borrowing short, say overnight (your “certificates of deposit with a fixed length of time for repayment”) and a bank lending long, say 15 years, and borrowing short, directly from demand deposits? Like, uhm, is the first case somehow more resistant to a panic? (“the bank is safe from a run” – huh?)

“The depositor could sell his Certificate of Deposit” – it’s very good that it begins to dawn on some of you. The second logical step in accepting FRB is the acknowledgement that this practice – selling a CoD – in fact is equivalent to what every bank is doing today via fractional reserves.

david janello December 23, 2010 at 10:00 pm

the authors contention is false and provably false.

there is a fixed arbitrage between fractionally reserved margin contracts and fully reserved margin contracts.

in a free banking system — with or without a gold standard — fractional reserved lenders would be liquidated sooner than fully reserved lenders, and fractionally reserved depositors would demand a higher interest rate to compensate them for the added risk.

as recently as 2007 this arbitrage condition was enforced in the US and senior executives from Enron, Lehman, Merrill and Bear are now unemployed or in prison because they did not comply with their obligations under the fractional reserve regime.

the author also naively assumes that criminal theft only occurs under fractional reserve fiat money systems , as in the 2008 bailouts , and ignores outright criminal activity taking place under a gold standard, such as the 1933 FDR gold confiscation.

Buckley December 24, 2010 at 4:12 am

I feel that fractional-reserve banking would still surely exist on a free market. Fractional-reserve banks would simply offer higher rates of interest than 100%-reserve banks in order to offset the risk. If people want to voluntarily deposit their money with a fractional-reserve bank, even more so when 100%-reserve banks are also available to them, please explain to me why this is such a bad thing.

ABR December 24, 2010 at 11:07 am

A 100% reserve bank won’t offer interest to depositors. Such a bank will charge a fee to keep the depositor’s money safe.

There’s nothing wrong with people investing in a bank, so long as they understand that their deposits are in fact an investment, akin to buying stock, with all the risks entailed.

What is evil is for the State to bail out FRBs that go bankrupt, and to insure deposits that are in fact risky investments.

Linda December 26, 2010 at 7:41 am

Banks don’t lend money.

panika2008 December 26, 2010 at 7:07 pm

Nah, they do. And what’s even worse, they demand interest for their loans. Life would be so much easier with the first in place without the second ;)

IAin December 26, 2010 at 9:31 pm

It seems impossible to justify charging interest on a loan made by a fractional reserve banker. Receiving the principle back is profit already and there is little to no risk to the creditor.

panika2008 December 27, 2010 at 4:56 am

LOL. Why don’t you fund a interest-less bank then? I wonder, how would it ever be profitable… please demonstrate this to us.

kgw December 28, 2010 at 3:48 pm

Looks like socialist rethoric to me.
See Bastiat: “Capital et Rente” and “Gratuité du Crédit” (letters exchanged between Proudhon and him) for a thorough discussion.

kgw December 28, 2010 at 7:52 am

I haven’t read the whole thread but the first half is really interesting so far.
I tend to agree with panica2008 and bionic mosquito (amongst others).
For those who understand French, I recommend listening to this
http://lumiere101.com/2010/10/09/la-creation-de-monnaie-par-les-banques-est-elle-frauduleuse/
Is creation of money by banks fraudulent ? About an unbelievable mistake by Rothbard.

A. Viirlaid December 30, 2010 at 8:46 pm

Interesting Discussion…

I found the exchange between “The Kid Salami” and “RS” and others to be fruitful.

But ultimately, it seems to me, several issues were left unresolved.

Maybe some opinions were changed, maybe not. At least new perspectives were shared —— of that I am sure.

But critically, I think what may have happened is what is wont to happen in intellectual discussions like this —— we often get sidetracked into answering questions posed by a responder, while the more pertinent questions get left behind, unresolved, sometimes forgotten or at least unidentified as being unresolved.

Speaking of “fruitful” —— I suppose it’s a little like picking fruit. One could be picking from one part of a strawberry bush or apple tree and notices an especially compelling-looking fruit on a different bush or side branch of the tree.

In pursuing that momentarily newly-compelling fruit, one abandons the previous location, and neglects to return to it, where perhaps the majority of the good fruit actually resides.

Thus it is with discussions —— sometimes we neglect to return to what might have been the most rewarding (and ultimately most compelling) branch of the discussion.

We forget what it was that we were really pursuing. In other words we can stray from our own intended path and targeted objectives and often do so against our own best interests.

In the above discussion, one of the most important points was the discussion surrounding the existence or nonexistence of Fraud within the practice of Fractional Reserve Banking.

This issue of “Fraud” can be looked at many different ways, some of which were used above in the Blog.

However one question that arises is whether looking for the existence or nonexistence of Fraud is productive… that is, is this question the most pertinent one?

If I do look for Fraud, I am likely to agree with some of the respondents, who argued that Fraud, if it initially existed (i.e., DURING the formative steps toward FRB) is embedded now within the History of Banking (and thus, as it exists largely inside the Dustbin of History, that “illegal” and immoral aspect of it has been largely forgotten, other than perhaps by Austrians).

So that we can see that Banking as a practice has moved to FRB (and perhaps arguably has even been legislated toward FRB, so that FRB is now a “legal” practice).

That this might be harmful, I will defer for later.

For the discussion in the blog, about Fraud, largely between RS and The Salami Kid, I think a different perspective might help.

Or not.

In any case I offer it with good intentions.

Suppose we imagine The Money System and The Banking System as one really big system, but a unitary system nonetheless. And let’s say we keep track of transactions on a really big computer, with a really big database.

So let’s say I make a deposit into this system from money I earn from goods and services I create, which are purchased by another person.

Let’s look at this imagined system as consisting of One Big Bank (OBB).

I take my money to this “OBB”. I deposit it. Let’s assume that my money is so-called Base Money (gold in the old days, but whatever its form, cattle or paper today, let’s say that it was not created via the debt-creation method, but starts its life in a pristine, “untarnished” and unencumbered state).

The OBB puts this in their vault (or into their barn if the money consists of cattle).

The OBB staff records this deposit as belonging to me.

If I make a term deposit, the OBB can lend out my money, since I have essentially made an investment from which I expect some return and from which return I realize the OBB will take their cut so as to cover the expense of keeping my deposit. (If I make this deposit as a demand deposit, I may have to agree to subsidize the OBB with a small fee for their trouble, for safekeeping my wealth.)

For a moment let’s assume I have made a ‘term deposit’.

Now such a ‘system’ —— consisting of one really gigantic single bank, with many, many branches worldwide, as many as the world needs for intermediating its economic transactions —— knows to whom the original money belongs.

If this system (the OBB) now finds a borrower to whom my money can be lent, and deposits that money into the borrower’s account, the system still knows to whom the original (“base” or unencumbered) money belongs, and who now has temporary custody of the lent (that is, MY) money.

This is to say that there is NO LOSS of Information in this type of imaginary Money System. Since a Money System is essentially an Information System, potential loss of information is a serious matter.

(A side comment: Austrians decry the resulting loss of valid pricing information when Central Banks inflate their currencies and drop interest rates and thereby debase their money, most significantly exactly because of the loss of good information on which to base business investment decisions, thus leading to malinvestments and a harmful series of boom-bust business cycles.)

In fact, even if the first or primary borrower spends the money, since this imagined system is all-knowing (with only one assumed database of information that tracks all deposits and loans and expenditures via checks) the OBB will still be able to differentiate between base money and loan-created money.

The base money (thus far in our scenario) is what I deposited, and the other, that which was generated by the spending of the primary borrower which was THEN deposited by the receiver of that money in their account is no longer ‘unencumbered’ —— that is, there was no real saving involved because the borrower simply consumed the proceeds of my money, and gave the money to the person who provided the consumable. That which was consumed, in a real sense, belongs to me, even though I do not want or need it at this time —— I have ‘deferred’ MY consumption for now.

In fact ANY money that is in this system that is base, unencumbered money, may be lent out as I have described, with no harm to the rest of the system and its participants. And this follows from the fact that what I personally created whereby I earned my own ‘base money’ was offered into the marketplace as a good or service to be consumed by someone else who was hopefully using money that was earned by them in a similar fashion. That is, working and spending the proceeds of such earning is fair and harmless because the participants both equally contributed to the economic system in accordance with what they consumed. We are all just using ‘Money’ in place of a system of barter, except that the intermediation provided by money allows us to slice and dice our purchases (or defer them) the way we all want, in a personally utility-maximizing manner.

The reason for this statement is that this money was earned in creating something of value, for which I had received value, and that money, for the moment assumed to be surplus to my personal needs, was deposited by me in the OBB as a Term Deposit.

When such a utopian system (which is, today, of course non-existent, given our fiat paper money and our FRB) “informationally” follows the money that the first borrower spent and which the receiver of that money then deposited in turn into the OBB, such a system recognizes that this money is now ‘encumbered’. In other words, our utopian example has the INFORMATION to know that money is not all fungible and equally ‘good’ —— it knows which money is ‘primary’ and which is not. (Even if we do not have such a system in OUR world, this IMHO does not mean that we should not give it some consideration, should we realistically be able to construct in a manner that is more utilitarian than what we are stuck with today.) The way you know that money is not truly fungible (in an thought experiment anyways) is to replace the money we have been talking about with cattle-money. Cattle cannot be created from thin air —— only so many cattle exist at a given time.

The encumbered non-primary money that I have described above cannot legitimately be lent out to another potential borrower because there is no saving that supports it —— that is to say, if it is lent out, to be used for consumption, there is nothing in the Economic System that was created, ready to be consumed by this second-class (or second-cycle) money now being proposed to be lent out to, and spent by, a secondary borrower.

So if this ‘encumbered’ money is lent out, and used for spending, then someone in this sequence of events is taking from the system something more than is logically supported by the original saving I did, and which money I put into a Term Deposit. I deferred my spending for my own reasons and this deferral legitimized a lucky borrower who needed to spend right away to spend this money once, but just ONCE, within our Economic System.

The “fraud” then within our current FRB Money System is that money can potentially be saved once, but then spend several times, with no relation to what goods and services are actually being created in our worldwide Economic System.

The “fraud” is not like the frauds of someone like Madoff.

But it is harmful.

An FRB system allows this secondary, and tertiary, and so on, borrowing and spending and consumption.

In fact Central Banks exist to ensure that this system can operate with little “loss of confidence”. (Eventually, however, even “confidence” cannot keep such a faulty system running.)

So there are insidious effects over time. And we are living through some of those effects today.

That we have a Money System today that is Broken is clear to most observers —— how or why it is broken is less clear.

How we fix it, will be the measure in this century, of what we as humans can achieve when we put our minds to it. We should have learned this lesson after the Great Depression. Maybe we will learn it this time around?

There are many ideas on this site and amongst the participants who read and contribute here. All of them should be aired and considered.

We may not go back to commodity based money, but the status quo is also clearly unacceptable, simply because it leads to so many social problems. Our welfare as individuals and as social groupings (families, companies, nations) cannot be well served by the present system for much longer.

A Money System can only really well serve one master and the master it has always best served (and in our own best interests) is the invisible hand of Adam Smith. When we ask the Money System to convey too much information, by debasing it and distorting the pricing information it normally functions so well with which to pass demand and supply information through our Main Street Economic System, we are asking for trouble.

That most of our political class does not recognize this is a tragedy in the twenty-first century. That most of our economists do not recognize this (other than on sites like this one) is beyond tragedy, beyond words.

We have been lied to, and we live in an age of betrayal of trust, in an age of economic ignorance, and in a time of consequentialism and an age of expediency.

How much longer we can go on this is anybody’s guess, but I would guess “for not much longer”.
——————————————————————————————————-

How The Federal Reserve Works! (4 separate chronological 10-minute parts)
Reasonable overview in my opinion.

http://www.youtube.com/watch?v=jXBy95JKMMY&feature=related
http://www.youtube.com/watch?v=4UeoZ4foP6I&feature=related
http://www.youtube.com/watch?v=bzgxZWgNh-g&feature=related
http://www.youtube.com/watch?v=Zoi4UdaDrss&feature=related

Also —— http://en.wikipedia.org/wiki/Fractional_reserve_banking

A. Viirlaid December 30, 2010 at 8:47 pm

Interesting Discussion…

I found the exchange between “The Kid Salami” and “RS” and others to be fruitful.

But ultimately, it seems to me, several issues were left unresolved.

Maybe some opinions were changed, maybe not. At least new perspectives were shared —— of that I am sure.

But critically, I think what may have happened is what is wont to happen in intellectual discussions like this —— we often get sidetracked into answering questions posed by a responder, while the more pertinent questions get left behind, unresolved, sometimes forgotten or at least unidentified as being unresolved.

Speaking of “fruitful” —— I suppose it’s a little like picking fruit. One could be picking from one part of a strawberry bush or apple tree and notices an especially compelling-looking fruit on a different bush or side branch of the tree.

In pursuing that momentarily newly-compelling fruit, one abandons the previous location, and neglects to return to it, where perhaps the majority of the good fruit actually resides.

Thus it is with discussions —— sometimes we neglect to return to what might have been the most rewarding (and ultimately most compelling) branch of the discussion.

We forget what it was that we were really pursuing. In other words we can stray from our own intended path and targeted objectives and often do so against our own best interests.

In the above discussion, one of the most important points was the discussion surrounding the existence or nonexistence of Fraud within the practice of Fractional Reserve Banking.

This issue of “Fraud” can be looked at many different ways, some of which were used above in the Blog.

However one question that arises is whether looking for the existence or nonexistence of Fraud is productive… that is, is this question the most pertinent one?

If I do look for Fraud, I am likely to agree with some of the respondents, who argued that Fraud, if it initially existed (i.e., DURING the formative steps toward FRB) is embedded now within the History of Banking (and thus, as it exists largely inside the Dustbin of History, that “illegal” and immoral aspect of it has been largely forgotten, other than perhaps by Austrians).

So that we can see that Banking as a practice has moved to FRB (and perhaps arguably has even been legislated toward FRB, so that FRB is now a “legal” practice).

That this might be harmful, I will defer for later.

For the discussion in the blog, about Fraud, largely between RS and The Salami Kid, I think a different perspective might help.

Or not.

In any case I offer it with good intentions.

Suppose we imagine The Money System and The Banking System as one really big system, but a unitary system nonetheless. And let’s say we keep track of transactions on a really big computer, with a really big database.

So let’s say I make a deposit into this system from money I earn from goods and services I create, which are purchased by another person.

Let’s look at this imagined system as consisting of One Big Bank (OBB).

I take my money to this “OBB”. I deposit it. Let’s assume that my money is so-called Base Money (gold in the old days, but whatever its form, cattle or paper today, let’s say that it was not created via the debt-creation method, but starts its life in a pristine, “untarnished” and unencumbered state).

The OBB puts this in their vault (or into their barn if the money consists of cattle).

The OBB staff records this deposit as belonging to me.

If I make a term deposit, the OBB can lend out my money, since I have essentially made an investment from which I expect some return and from which return I realize the OBB will take their cut so as to cover the expense of keeping my deposit. (If I make this deposit as a demand deposit, I may have to agree to subsidize the OBB with a small fee for their trouble, for safekeeping my wealth.)

For a moment let’s assume I have made a ‘term deposit’.

Now such a ‘system’ —— consisting of one really gigantic single bank, with many, many branches worldwide, as many as the world needs for intermediating its economic transactions —— knows to whom the original money belongs.

If this system (the OBB) now finds a borrower to whom my money can be lent, and deposits that money into the borrower’s account, the system still knows to whom the original (“base” or unencumbered) money belongs, and who now has temporary custody of the lent (that is, MY) money.

This is to say that there is NO LOSS of Information in this type of imaginary Money System. Since a Money System is essentially an Information System, potential loss of information is a serious matter.

(A side comment: Austrians decry the resulting loss of valid pricing information when Central Banks inflate their currencies and drop interest rates and thereby debase their money, most significantly exactly because of the loss of good information on which to base business investment decisions, thus leading to malinvestments and a harmful series of boom-bust business cycles.)

In fact, even if the first or primary borrower spends the money, since this imagined system is all-knowing (with only one assumed database of information that tracks all deposits and loans and expenditures via checks) the OBB will still be able to differentiate between base money and loan-created money.

The base money (thus far in our scenario) is what I deposited, and the other, that which was generated by the spending of the primary borrower which was THEN deposited by the receiver of that money in their account is no longer ‘unencumbered’ —— that is, there was no real saving involved because the borrower simply consumed the proceeds of my money, and gave the money to the person who provided the consumable. That which was consumed, in a real sense, belongs to me, even though I do not want or need it at this time —— I have ‘deferred’ MY consumption for now.

In fact ANY money that is in this system that is base, unencumbered money, may be lent out as I have described, with no harm to the rest of the system and its participants. And this follows from the fact that what I personally created whereby I earned my own ‘base money’ was offered into the marketplace as a good or service to be consumed by someone else who was hopefully using money that was earned by them in a similar fashion. That is, working and spending the proceeds of such earning is fair and harmless because the participants both equally contributed to the economic system in accordance with what they consumed. We are all just using ‘Money’ in place of a system of barter, except that the intermediation provided by money allows us to slice and dice our purchases (or defer them) the way we all want, in a personally utility-maximizing manner.

The reason for this statement is that this money was earned in creating something of value, for which I had received value, and that money, for the moment assumed to be surplus to my personal needs, was deposited by me in the OBB as a Term Deposit.

When such a utopian system (which is, today, of course non-existent, given our fiat paper money and our FRB) “informationally” follows the money that the first borrower spent and which the receiver of that money then deposited in turn into the OBB, such a system recognizes that this money is now ‘encumbered’. In other words, our utopian example has the INFORMATION to know that money is not all fungible and equally ‘good’ —— it knows which money is ‘primary’ and which is not. (Even if we do not have such a system in OUR world, this IMHO does not mean that we should not give it some consideration, should we realistically be able to construct in a manner that is more utilitarian than what we are stuck with today.) The way you know that money is not truly fungible (in an thought experiment anyways) is to replace the money we have been talking about with cattle-money. Cattle cannot be created from thin air —— only so many cattle exist at a given time.

The encumbered non-primary money that I have described above cannot legitimately be lent out to another potential borrower because there is no saving that supports it —— that is to say, if it is lent out, to be used for consumption, there is nothing in the Economic System that was created, ready to be consumed by this second-class (or second-cycle) money now being proposed to be lent out to, and spent by, a secondary borrower.

So if this ‘encumbered’ money is lent out, and used for spending, then someone in this sequence of events is taking from the system something more than is logically supported by the original saving I did, and which money I put into a Term Deposit. I deferred my spending for my own reasons and this deferral legitimized a lucky borrower who needed to spend right away to spend this money once, but just ONCE, within our Economic System.

The “fraud” then within our current FRB Money System is that money can potentially be saved once, but then spend several times, with no relation to what goods and services are actually being created in our worldwide Economic System.

The “fraud” is not like the frauds of someone like Madoff.

But it is harmful.

An FRB system allows this secondary, and tertiary, and so on, borrowing and spending and consumption.

In fact Central Banks exist to ensure that this system can operate with little “loss of confidence”. (Eventually, however, even “confidence” cannot keep such a faulty system running.)

So there are insidious effects over time. And we are living through some of those effects today.

That we have a Money System today that is Broken is clear to most observers —— how or why it is broken is less clear.

How we fix it, will be the measure in this century, of what we as humans can achieve when we put our minds to it. We should have learned this lesson after the Great Depression. Maybe we will learn it this time around?

There are many ideas on this site and amongst the participants who read and contribute here. All of them should be aired and considered.

We may not go back to commodity based money, but the status quo is also clearly unacceptable, simply because it leads to so many social problems. Our welfare as individuals and as social groupings (families, companies, nations) cannot be well served by the present system for much longer.

A Money System can only really well serve one master and the master it has always best served (and in our own best interests) is the invisible hand of Adam Smith. When we ask the Money System to convey too much information, by debasing it and distorting the pricing information it normally functions so well with which to pass demand and supply information through our Main Street Economic System, we are asking for trouble.

That most of our political class does not recognize this is a tragedy in the twenty-first century. That most of our economists do not recognize this (other than on sites like this one) is beyond tragedy, beyond words.

We have been lied to, and we live in an age of betrayal of trust, in an age of economic ignorance, and in a time of consequentialism and an age of expediency.

How much longer we can go on this is anybody’s guess, but I would guess “for not much longer”.

A. Viirlaid February 4, 2011 at 8:38 pm

A friend of mine read my preceding entry and remarked “SO WHAT!”

I asked him to elaborate what he meant with his retort.

He explained that in any economic system there would be lending and borrowing, and repayment of loans, and some repudiation of repayment of loans.

He claimed that even without Fractional Reserve Banks, people would lend to each other and some lenders would be repaid by their borrowers, and some would not.

And my friend maintained that this was NO DIFFERENT from what I had described in my post above.

He asked me to consider the situation on some imaginary island, where no banking had ever started, and money consisted of seashells. Some people in such a place would lend their own money, because it was surplus to their immediate needs.

I disagreed with him —— I said such a setup was quite different.

I pointed out to him that in the situation with the OBB in my post (that is, INSIDE a FRBS or “Fractional Reserve Banking System”) wherein I had deposited my money, that bank would act as an intermediary and ‘invest’ my money.

But, I continued, in such a situation, I was always guaranteed to get my deposited money back. I explained that this setup had evolved with the ‘support’ of the FDIC and The FED over the last century. In fact in most cases, I could get my money back “On Demand” and the original loan that was created with my lent money would NOT be called back in —— the bank would have in effect “created money” out of thin air (subject to any small percentage kept in the bank’s reserve due to regulated fractional reserve requirements).

In fact, I would never lose my money, whereas a person just like me, on that island paradise my friend was describing, could indeed lose all of their lent money, because there was no guarantor to back up their lending in that place.

Then he said again “SO WHAT” and actually added:

“Isn’t it good that we live in a society that does not tolerate you losing the money you lend to someone else?”

Now I really had to laugh.

I said to him, “I think you missed the entire point of my original post!”

I now patiently explained to him what I had originally meant.

I first admitted that I had not gotten to the point fast enough in my first post.

I pointed out that in the island paradise he was describing, every person who lent out their surplus money, was lending out “saved money”. In other words, every dollar (or in this case, seashell) that was lent to someone, reflected someone else’s Deferred Spending.

If one person deferred spending their own money —— that is, saved it —— and lent it to someone who did spend that money, there was no overall increase in consumption. That money could be spent only once, until it was earned again with production of goods and services that corresponded to its ‘value’. And in such a system, people would be very careful to whom they lent their money. They would not cavalierly pawn off that responsibility to some unknown bank officer.

Indeed, in the island situation, ALL consumption is accounted for by some equivalent amount of True Saving and Earning. In such a society if someone puts their seashells under their pillow, and does not lend it out, there is perhaps even a small chance that Saving might exceed Consumption, at least in the short run. But there is no chance of Consumption exceeding Saving and Earning.

He again replied “SO WHAT?”

I pointed out that in a Fractional Reserve Banking system a Society could always consume more than it had saved by creating financial claims against The Future. But in the island paradise this was simply not possible. If a loan in that island society was not repaid, it was simply extinguished (more or less automatically, depending on the societal conventions of that place and time). Perhaps the person who was owed money learned a lesson, perhaps not. Perhaps the other islanders learned that the borrower could not be trusted with more of their saved money. But the system did not careen out of control. Saving and Consumption stayed in balance over time. In fact, such a small society probably handles its financial affairs far more intelligently than we do —— the “FICO Scores” are something everyone would know just by knowing the people around oneself.

He asked me why this was in any way desirable. I pointed out that while in the short run the island-residing lender did suffer a loss, the borrower who had consumed with the borrowed funds had gained the equivalent of what that lender had lost.

We in effect did no more or less in pre-Fractional Reserve Banking systems. In such banking systems, the job of our bank is only to find us a ‘good risk’ borrower to lend to. Such a bank does not guarantee payback of our invested funds, unless the borrower makes good with his or her repayment.

But in our system today, we do not tolerate “losing” our money, even though prior to Fractional Reserve Banking, we could easily lose our money, the same way people do on my friend’s imaginary island.

I suggested to my friend that there is good reason why Austrian Economists do not recommend creating Credit where such Credit systematically and often exponentially outruns corresponding Saving. I said that this was because if such a course of action was followed for a long enough period of time, the Credit thereby created (as claims against Future Saving) would almost inevitably be repudiated. This is simply a law of human nature. In the absence of Debtor Prisons (or even with them) at some point, it becomes a ridiculous and pointless hardship to pretend that we CAN pay back such a Mountain of Loans. Society simply concludes it is better to start over again, at the cost of huge losses incurred by the Saving Class (as if that class, is today, making any Real Return on their ‘investments’ anyway!!!).

In fact such a system is prone to Booms and Busts by its very design.

So (in the immortal words of Ted Turner) “The Piper MUST be Paid” (at some point in time). The people “holding the bag” are going to inevitably lose a LOT of what they had come to expect as the FUTURE purchasing power equivalent in their various Savings Vehicles including but not limited to, public and private pensions, their cash life savings (in the Fiat Currency of their choice), their life insurance policies, and any other of their ‘investment’ vehicles.

I pointed out to my friend that any System that was set up in such a manner (as our own “FRBS”, backed up by The FED, is) would inevitably succumb to such a historical development —— in fact it did during the 1920-s and again in the period from 1990 to 2008. There will be big booms and big busts. The Business Cycle as explained by Austrians is Built into Our Economic and Financial System.

In my opinion, that The FED today is again trying to recreate this Credit Bubble is suicidal, unless The FED’s officers think that recreating the disaster of 1929 and of 2008 is something that they think is “good” and “will get the Economy moving again”.

We have been on this Broken Money System Roller-Coaster for a long time. I asked my friend if he really thought it was a good idea to stay on it for a lot longer still.

He said what if try to get off now —— would this not be dangerous?

I said sure, there will be huge problems. But I pointed out that the longer we kept this Broken Money System going, the harder the fall would be for all of us from this crazy Roller-Coaster.

I also suggested that there is no point worrying, because no one will “pull the plug” —— there will be no collapse until one day the entire coaster collapses of its own accord. The casualties will be much worse then than they would be now —— but, hey, that’s politics, and in politics, if I can pass the problem to the next guy, what do you think I will do?

It’s colloquially known as “Kicking The Can Down the Road”.

Bala February 4, 2011 at 8:49 pm

For what it is worth, let me offer my opinion. I think the entire discussion on Fractional Reserve Banking and its legitimacy is a waste of time. The real problem is the FDIC and the intervention of the government and the Central Banks to “protect” depositors. IMHO, abolishing the FDIC is almost a complete solution because if people lose money when banks fail, the money form soon fails due to loss of faith. Cheque and electronic money will soon get replaced by cash. Government will be forced to print cash as the failed banking system will not be able to help the government by hiding the cause of the fall in the purchasing power of the money form. The purchasing power of the money form will also fall rapidly because the effect of the increase in money supply is felt immediately. This will initiate the search for a form of money that will not lose purchasing power the way paper money does and hey presto! You have a solution.

A. Viirlaid February 15, 2011 at 12:40 pm

Thank you Bala.

Please read my re-worded entry in response to William Cleveland-Stevens, KCL History undergrad at

http://blog.mises.org/11247/dont-blame-the-federal-reserve/comment-page-1/

What I was trying to illustrate there was the insane expansion of Overall Systemic Credit that our current Broken Money System leads to.

And most ALL of this massive Credit Bubble is unfunded — that is, the Debt is not matched by, nor backed up by, prior Saving. It may be thought of as depending entirely on “Deferred Saving” which will of course will never occur so as to prevent that Credit Bubble from blowing up —— Saving, once deferred, tends to remain ‘deferred’ forever.

This unmatched Borrowing is abhorred by Austrian Economists because it is simply unsustainable and will ALWAYS cause things to end badly.

The Credit Bubble will therefore grow interminably until the disorder it inevitably creates prevents it from growing any further.

Understand that, seemingly for a long time, this Credit Bubble does indeed appear to create ‘good-quality’ economic growth —— but this growth-quality is anything but good. Appearances are completely deceiving. The system has within it the seeds of its own demise.

Why?

Well, once entrepreneurs are receiving wrong information about the likely profitability of initiatives, they make too many such investments —— and so do we all, like in Housing, just in the recent past. (A Fractional Reserve Banking System backed up by The FED tends to keep the price of Credit below otherwise-Free Market Rates, leading to malinformation in the Money Pricing System, which leads inevitably to malinvestments.)

The Debt that comes from our Broken Money System (the Fractional Reserve Banking System backstopped by The FED and the FDIC) is not from “Savings”. It is created mostly “from thin air”.

Thus this Debt not only finances the likely-to-be-unprofitable initiatives of entrepreneurs and investors but it also finances the purchasing habits of the consumers of the output of those initiatives and investments.

But it can only do this for a period of time. At some point, this game comes to an end.

Even suggestions (from knowledgeable people like Paul Krugman) to have The FED print, and/or the Federal Government to deficit-finance, an additional 2 or 5 Trillion Dollars (or whatever the last suggestion was) of Economic Activity can only save this Broken System for so long.

The only likely outcome of following such advice is to leave a legacy of even more Debt, with even more suffering to come from that Debt.

We have not recognized just how BROKEN our Money System is, and WHY it is broken.

Thus we have not begun to examine how to properly fix it, by redesigning it instead of just patching it up.

Mind you, it is not easy to see the actual aspects of the system that are broken —— this is because past cycles of ‘stimulation’ have seemingly always worked —— that they have only made things worse is not easy to detect IMHO.

A. Viirlaid February 15, 2011 at 12:00 pm

I agree with you Bala about the damage caused by “protecting the depositors”.

Whether this protection is offered by institutions like the FDIC or The FED (in its role of backstopping the retail-commercial Fractional Reserve Banks), it creates Moral Hazard. This is not a hypothetical or theoretical concept — Moral Hazard has very real “on the ground” consequences as you illustrate. And The FED was created to make a Bad Broken Money System last just a bit longer — the establishment of The FED did not fix anything in this Broken System; it simply patched a faulty system in order to give people more “confidence” in that system.

However I could point out that discussing “abolishing the FDIC” (or The FED) is just as much a “waste of time” as is the discussion about the legitimacy of the Fractional Reserve Banking System.

Both discussions will not in, and of, themselves lead to any change in the Broken Money System, nor are these discussions likely to lead to the termination of the existence of The FED, the FDIC, or the Fractional Reserve Banking System.

What we are trying to do is highlight the faults in the current system. What we are trying to do is to point out the very real harm that artificial booms and busts cause to all of us.

But it goes beyond this. If people do not understand why their Economic and Financial System no longer serves them well, and misidentify the reasons that this system is misfiring, then we will take incorrect remedial actions.

That would be the greatest tragedy of all. All you have to do is read intelligent people like Paul Krugman, to see how woefully inadequate our various analyses on this issue have been to date.

Steven October 7, 2011 at 12:43 pm

I’m curious. What free market mechanism would prevent fractional reserves? The article doesn’t explain this.

We know from history that lenders have been using fractional reserves for millennia, and contrary to the article’s presumption, not as a result of government intervention. You could only argue that it was government inaction that let it happen.

The only way to prevent fractional reserve lending is by auditing the reserves and outstanding certificates of deposit (bank notes). The latter is impossible.

Arguing that a free market would chose gold as a standard is just looking to the past, where the markets did chose these metals, yet, through no intervention by centralized banks or governments, these banks lent with fractional reserves, and they often collapsed as a result. Central banks – whether it was right or not – were an answer to the fact that this “free market money” system was abused by the banks, and caused the destruction of private wealth.

When something is profitable, like fraud, fractional reserve lending, or Ponzi-type schemes, there is no profit motive for actors to suspend their activities, unless there are criminal penalties.

Michael A. Clem October 7, 2011 at 4:09 pm

You’ve asked this several times, even if it was several months after the fact. Like most market enterprises, it’s called competition. In the past, as you keep referring to, banks were worried that their depositers would lose faith in their bank and there would be a bank run. A bank run is only a problem in FRB banks. If you have 100% reserves, you can’t run out of money, and are in a much better position to reassure banking customers, assuming they are worried about the soundness of the bank. Our government took the approach of providing “insurance” (at least they called it insurance), instead of transparence. One way banks could reassure customers is to make their auditing records available to the public, or at least to their customers.
Certainly, if there is truly fraudulent activity going on by a bank, you’ll want the legal system to handle it. But for basic banking risk and security, there’s little reason for the legal system to get involved.

Steven October 7, 2011 at 4:45 pm

That doesn’t answer the question. It also ignores the history of banking.

The FDIC was created in 1933 by the Glass-Steagall Act. Bank runs happened before 1933. The 19th Century is filled with bank runs, and the 1929 collapse of financial institutions is what caused the government to intervene with deposit insurance in the first place.

This is a problem I see with a lot of libertarian arguments, they assume that the problems arose when government intervened, instead of the reality where there was a problem so government acted to fix it – whether it was effective or not is unimportant to the reality that the government intervention wasn’t the cause.

A fully 100% reserved bank would be insusceptible to bank runs, you are correct. But this isn’t a market force that would prevent a bank from lending out deposits on interest.

Who would audit the banks? Would you recommend legislation requiring banks self-audit and provide that for review by customers? But if they’re committing fraud, why would a bank care? They wouldn’t be found out until the bank collapses in the even of a bank run, which only happens if there is an emergency, or if the institution isn’t thought able to repay deposits. And if they’re self-auditing, why wouldn’t they hide their fraud from the public to prevent a bank run?

Or perhaps a private auditing firm, like S&P, which the banks pay? I’m sure there wouldn’t be any corruption there either. Who audits S&P to make sure they’re fair?

Why couldn’t banks limit a daily withdrawal (which they do now), to prevent bank runs? That would meet free market principles, without applying any legislative pressure regulate their business.

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