I am not sold on gold,
But gold is better than mold to hold
(so I’m told)
Or paper that folds
and can be rolled
To make an expensive cigarette.

Good article. Clears up much confusion.

So actually, a lot of the inflation is due to fractional reserve banking, and the Fed has only a minimal amount of control over the banks doing it?

Michael A. Clem: I wouldn’t go so far as to say that the Fed only has “minimal” control of banks in inflating. The Fed has tremendous influence on banks. The point is that it’s not absolute, direct control.

Walt D.: If you would like to adopt a definition of inflation “relative to goods and services” that’s certainly you’re prerogative, but I don’t think it is the best definition of the term. The pace of production of goods and services can fluctuate just as the quantity of gold mined can too. I think it is easiest when trying to communicate to keep those things separate from one another.

I infer that you’re focusing on how inflation causes a change in the price level (using that term loosely). Using the definition of inflation in the article, the price level could either go up or down, even if “inflation” is occurring.

Also, in case it’s not clear, inflation (an increase in the money supply) that is faster than the increase in goods and services is not that which causes economic miscalculation and business cycles. Some people seem to have that idea, but it is not the case.

Regarding mining gold and “issuing” more money, I’m not sure exactly what you mean. Gold itself is/would be money and does not need to be issued. To answer your question, using the defintion of inflation in the article, yes, mining gold would be inflationary. This type of inflation would not, however, tend to cause business cycles.

Matthew,

If you could clear up a few points for me I would appreciate it.

“Instead of printing, the Fed’s second option is to try somehow to convince banks to extend more loans, businesses to borrow and expand, and consumers to continue to consume. This is quite a challenge indeed, given the general negative sentiment in the business world.”

Does the Fed not convince banks to loan money by the interest rate in which they initially lend the banks money?
Trying to convince consumers and businesses to expand by offering them readily available credit seems like what got us where we are now. Shouldn’t we encourage deflation and a contraction of the money supply?

“If it had allowed Bear to go bankrupt, the banks that had loaned Bear money would have had to take losses, thereby reducing their reserves and their ability to extend credit elsewhere. It is even possible that Bear’s bankruptcy would have caused other large firms to become insolvent and declare bankruptcy as well.”

Would allowing this to happen have been a bad thing? It seems it would have been a necessary correction by the market?

My final question is, doesn’t the TMS have more of an impact on the value of the dollar then the AMB?

KO:

Does the Fed not convince banks to loan money by the interest rate in which they initially lend the banks money?

Generally, banks do not borrow money directly from the Fed. They only do that through the discount window. The Fed, through its open market operations where it buys or enters swaps for securities, can increase the reserves of banks. Banks can then either sit on whatever reserves they have in excess of their requirements and earn nothing on them, or they can loan them out to businesses or other banks. Frank Shostak discussed some of these dynamics recently here.

Shouldn’t we encourage deflation and a contraction of the money supply?

I personally think that that’s going to happen regardless of whatever encouragement there is (either that or hyperinflation, which would be the worse option). Murray Rothbard touched on this near the beginning of America’s Great Depression. Basically, people need to start saving more and consuming less to eliminate the malinvestment. Deflation would probably encourage people to do that (because their money would be rising in value), so it would be good in that sense. More generally though, eliminating government interference and deeming fractional reserve banking to be fraud is the right way to go.

Would allowing this to happen have been a bad thing? It seems it would have been a necessary correction by the market?

Allowing Bear to go bankrupt would not be a bad thing from the perspective of liberty and allowing markets to function, but it would be a bad thing for those parties interested in maintaining the current financial system.

KO:

If the Fed were to increase the reserve rates the banks were required to have, would that have the same effect as a contraction in the money supply? I realize it would not change the current TMS but would forcing the banks to hold larger reserves, have the same short term effects as a contraction in the money supply?

If the Fed raised reserve rates, yes, it would probably force the money supply to contract. The “multiplier,” the theoretical limit of how much money can be created is the inverse of the reserve rate (if you’re into math, you can sum the geometric series to get that formula). So with 10% reserve requirements, the money supply could grow to 1 divided by 10%, which is 10 times. If the Fed raised requirements to 20%, the theoretical limit would be 5 times. As banks sought to increase their reserves by discontinuing loans, it would have the effect of reducing the amount of circulation credit, which is a component of the money supply.

I hope that is helpful. Also, FYI, reserve requirements are not 10% across the board. There are some exceptions, which you can see here.

Chad:

Regarding the fraudulent nature of fractional reserve banking, what if all banks were required to publicly post a notice that said something like the following with X being the current reserve rate:

“This banking institution is only required by law to keep X% of customers’ deposited money available for withdrawal at any given time.”

Would such a truthful disclosure help customers be more cautious as to where they deposit their money?

Such disclosure might help customers be more cautious, but I don’t think it would be enough. As long as the bank allowed more than one person to have legal title to the same amount of money at the same time, problems would occur.

Also, could a bank choose to keep more reserves than what is required by the reserve rate (ex. reserve rate + 10%) and use that fact to market itself as being a more secure place to deposit money than at competing banks?

Yes, a bank could, but I don’t know whether the benefit of such marketing would outweigh the revenue they could be earning by loaning out their excess reserves, especially given that the Fed is there to backstop them and their competitors.

“Yes, a bank could, but I don’t know whether the benefit of such marketing would outweigh the revenue they could be earning by loaning out their excess reserves, especially given that the Fed is there to backstop them and their competitors.”

So, it is theoretically possible (even under the current system) to have a bank to voluntarily choose to make itself relatively bank run-proof by keeping (for example) 80% of all deposits in reserve regardless of what the reserve rate may be.

You know, you really have to wonder how high the natural (vs. Fed-determined) interest rate would go in our current, no-savings climate if fractional reserve banking was not allowed. Also, I am sure there would be far fewer banks out there lending tens or hundreds of thousands of dollars to everyone buying a car or house due to a lack of matching deposits.

“Just my opinion but you can’t start with something fraudulent and make it work. If it is unsound eventually it will be exposed.”

I agree. However, if fractional reserve banking is going to occur (and it is … for now), then the banking public should at least be made aware by the banks themselves of the risks they are taking when they deposit money in a bank. Too many (wrongfully) assume that the bank will always be able to return their deposits in full on any given day as they have never even heard of the reserve rate.

After all, even lotteries are required to spell out the risks involved (i.e., the odds of winning) up front to ticket purchasers.

“In such a society, it would be expected that some amount of gold would be mined from the earth and added to the money supply each year. As long as the rate of this dilutive increase in the money supply was acceptable to the populace (if it were not, a different commodity would be selected to function as money), entrepreneurs would adjust their calculations and business plans based on this dilution. ”

Wouldn’t this be the case though if the Fed adopted the old Friedmanite plan of adopting 100% reserves but increasing the money supply by a fixed amount each year? If entrepreneurs knew what the fixed amount was wouldn’t that make it easier for them to calculate?

Mike: “A checking account dollar is just a call option on a green paper dollar…”

Not a good analogy. In derivatives trading, the difference between the option and the asset are clear cut. No one confuses the two. With money, none but economists can tell the difference between the two. Checking account dollars trade for goods just as well as green paper. So an increase in the number of options has the same effect as an increase in the volume of the underlying asset, which reduces its value relative to other goods.

Mike: “It’s strange to see Austrians waving the libertarian flag while simultaneously trying to prohibit voluntary trade between a bank and its customers.”

I don’t think most Austrians would object to FRB if customers were fully informed of the potential loss of their principal. But then fewer customers would put their money in an FRB bank. Also, I think it’s short sighted to look at just the banking transaction as the only case for potential fraud. The real fraud takes place with the rise in prices that follows inflation of the money supply. The people who get the new money first can buy goods and assets before prices rise. The people who get the new money last are stuck with money that is worth less because prices have risen. So a transfer of wealth occurs, taking wealth from the late receivers without their consent and giving it to the early receivers. That is the fraud that no one understands but Austrians.

I have no problem with Fractional reserve banking as long as government stays out of bailing out troubled bankers and their customers.

Richard:

Wouldn’t this be the case though if the Fed adopted the old Friedmanite plan of adopting 100% reserves but increasing the money supply by a fixed amount each year? If entrepreneurs knew what the fixed amount was wouldn’t that make it easier for them to calculate?

You might want to confirm this with someone more knowledgeable about Austrian business cycle theory, but my understanding is that such a scenario would be superior to one that allowed fractional reserve banking because the natural interest rate would not be being systematically manipulated through the extension of loans using money that is not intended to be loans. However, misallocation of resources would still be occurring because government would be the one spending or distributing the newly-created money. With gold as money, miners who are doing something economically productive would be the ones with the right to spend the new money. In your scenario, those who are not necessarily doing anything economically productive (without the confirmation of a market test) are the ones with that right.

Fundamentalist:
“In derivatives trading, the difference between the option and the asset are clear cut. No one confuses the two.”

You could call a broker and order 1 share of GM today. He could say OK, record it in his books, take your money, and not actually buy the share for a few days. You would actually own a derivative share, even if you thought you owned a genuine share.

“With money, none but economists can tell the difference between the two.”
Next time you get confused between a checking account dollar (the liability of a private bank) and a green paper dollar (the liability of the federal reserve), just let me know. I’ll be glad to help out.

“Checking account dollars trade for goods just as well as green paper. So an increase in the number of options has the same effect as an increase in the volume of the underlying asset, which reduces its value relative to other goods.”
1. If the company issues more of the underlying shares and sells the new shares for equal-valued assets, then assets rise in step with liabilities and there is no effect on the price of the underlying asset. When the fed issues more green paper dollars for equal-valued assets, there is no effect on the value of green paper dollars.
2. You ignore the law of the reflux, which says that as new checking account dollars are issued, existing moneys will reflux to their issuers, leaving the quantity of money unchanged.
3. Just as the issue of calls does not affect the assets and liabilities of the underlying company, the issue of checking account dollars does not affect the assets and liabilities of the fed, so the is no reason to expect an impact on the value of green paper dollars.

“I don’t think most Austrians would object to FRB if customers were fully informed of the potential loss of their principal. But then fewer customers would put their money in an FRB bank. ”

Nobody is ever fully informed about anything. The most an Austrian should insist on is that the transaction is voluntary. FRB has been around long enough for people to be aware of its nature, and the banks seem to have enough customers–including you, unless I miss my guess.

“The real fraud takes place with the rise in prices that follows inflation of the money supply. ”

Which brings us back to the heart of the matter: An increase in prices does NOT follow an issue of ADEQUATELY BACKED money.

Fraud involves deception. If the public is fully informed that for every dollar on deposit there is not a dollar’s worth of currency on hand, there is no deception and hence no fraud with the fractional reserve aspect of banking.

With fractional reserve banking, it is still the monetary base that limits the quantity of money supply in the economy. Since the Fed controls the monetary base, which all stems ultimately from currency issue, it controls the maximum amount of money supply in the economy.

Mike Sproul said: “When the fed issues more green paper dollars for equal-valued assets, there is no effect on the value of green paper dollars.”

Here’s the problem with this statement. To see it more directly, let’s deal with the typically government-owned central bank rather than the Fed (though it works the same way with the Fed, it’s a little indirect since the Fed is nominally privately owned). The typical central bank is part of the federal government.

Currency is a liabiltiy of the Federal government. Federal government bonds are liabilities of the federal government. So when a central bank uses $100 bill to purchase a government bond, effectively the government has placed in the hands of the public a small piece of paper that represents a $100 perpetual zero-interest I.O.U. The $100 government bond the public previously owned was worth $100 because that equalled the present value of the interest payments and principal repayment that was contractually guaranteed. The $100 value of the bond therefore also represented the PV of taxes that would be collected to service the bond. If the bond stayed in the hands of the public, the taxes collected to service the debt would occur bit by bit over the years.

When the government prints up a new $100 bill to buy back the $100 bond, the government is collecting the taxes all at once to cancel the bond liability to the public. The taxes are effected through the price increases for goods and services that occur due to the $100 increased currency outstanding. Note that if the government owns its own debt (through the central bank), effectively the debt has been cancelled. Imagine if you issued a bond in your name for $100 and then bought it back. What meaning would it be to hold your own I.O.U. You owe yourself $100? What does that mean?

Hello Mike,

the fact that all these people support a view tells little about the scientific value of the view. It may tell something about the people themselves, depending on if the view is good or flawed. Ok, if time allows I may read it and we can then discuss it.

What we _can_ talk about right now are the two paragraphs above and the possible confusion we see. First, there’s something wrong with the statement “issue of adequately backed money does not cause inflation”.

The context is fractional-reserve banking, and this practice (by its definition) increases the amount of the things people use in exchange for goods and services (i.e. money, by definition) and thus it does cause increase in money supply (i.e. inflation – again by definition).

Yes it’s Austrian definitions used above, but being on Mises blog one could expect as much. These definitions are useful, because they allow manipulating matters efficiently and clearly. So if there’s some error in *my* reasoning, I’m sure someone will be able to point it out.

Second paragraph references the part which was meant to remind us about how complicated the world around us is, and what is the scientific test of any theory that claims some connection with the reality.

Mike, the physics behind lasers and nuclear fission and frankly most of the modern science – because that’s what I had in mind – these are indeed strange theories. Yet there’s no escape, they work and such is the world, just as strange as the theories say. “God does play dice”, no matter how much Einstein disliked it, and “FRB causes inflation”, by definition, no matter how much you dislike us saying it.

re french fort in quebec: that’s a perfect example, thank you.

So there were these ships that every now and then brought coins from abroad, thus increasing the money supply. And the people knew that and expected that, so issuing the same amount of paper had no effect, in fact it helped, as without it there would be effective decrease in money supply when the expected increase failed to materialize. Deflation can be quite nasty, so I’d say he saved the day, especially if all the cards were as soon as possible repaid in the promised silver.

One note about absolute statements: “In no case would the value of paper livres fall below a silver livre”

Just imagine what would happen if the officer refused to redeem the paper livres each for full silver livre once the ship docked. Or if the ship was late for a long time and someone had spread rumors about war/revolution/plague in France, hinting that no more coins are ever shipped to this fortress. Excellent example.

Alex:
“The increase in prices of goods and services in terms of livres that would have occurred by the increase in 30,000 livres of silver coins would not have been augmented by the temporary issuance of French government paper I.O.U.s. There is no dispute here.”

Oh yes there is. I say those paper livres had value because they were backed by the assets of the fort: 30,000 coins on a boat, plus the IOU’s I mentioned. You say they had value because the total quantity of paper livres was equal to the value of the coins they replaced. By that logic, if the boat carrying the coins sank, the paper livres would hold their value just because their quantity was limited. I say if the boat sank, the paper would have lost value.

“Whenever some authority is able to have people accept a perpetual non-interest bearing I.O.U. in exchange for goods and services, the authority gets goods and services from the public and pays nothing back -ever, to anyone.”

So if the notes bore interest, or if the cost of issue used up the interest, then the issuing authority pays for the goods like anyone else, and there is no need for the crazy monetary theory that says that pieces of paper can have value even though they have no backing.

Ireland:
“Just imagine what would happen if the officer refused to redeem the paper livres each for full silver livre once the ship docked. Or if the ship was late for a long time and someone had spread rumors about war/revolution/plague in France, hinting that no more coins are ever shipped to this fortress. Excellent example.”
In each of those cases the paper livres would lose value, exactly in accordance with the real bills doctrine and exactly contradictory to the quantity theory. When I said “in no case” I meant “in none of the three cases I just mentioned.”

This is interesting, and straight to the point too:

Mike: “those paper livres had value because they were backed by the assets of the fort”

No. The cards had value because people who accepted them valued them so.

It’s that and it’s all and yes it’s that simple. Austrian theory of value in its purest form. The people believed they’ll get their silver for the paper soon, and so they valued them about the same, and this allowed the economy to continue operating in the existing structure. No crisis/correction/adjustment.

I wonder if we could dig out some history about them cards either being discounted slightly, or pushing real silver out of circulation, or possibly both.

Ever wonder how comes all the expensive houses now sell for so much less? Well because there’s no intrinsic (“per se”, “an sich”) value of any thing.

There are situations when even gold is useless. And paper things are only special in that they have very little other use besides the bond represented by the writing on it, and so they can be devalued both rapidly and completely.

Mike Sproul said: “I say those paper livres had value because they were backed by the assets of the fort: 30,000 coins on a boat, plus the IOU’s I mentioned. You say they had value because the total quantity of paper livres was equal to the value of the coins they replaced.”

The paper livres had value because merchants were willing to accept them for goods and services. That the merchants were willing to do this was either because they believed that they could ultimately be redeemed for silver livres or because the French government dictated that the paper livres must be accepted by the merchants as legal tender. In this latter case, the merchants accept them because they believe that they can use them in turn to buy goods and services (in other words, that they will be generally accepted in commerce).

Mike, you said: “By that logic, if the boat carrying the coins sank, the paper livres would hold their value just because their quantity was limited.” I say if the boat sank, the paper would have lost value.

I didn’t say the paper livres would “hold” their value. I said if the silver coins arrived and all the paper livres were redeemed for silver coins, then the temporary circulation of paper livres would not cause the prices of goods and services to rise by any greater amount than that caused by the increase of 30,000 silver livres. I said that if some of the paper livres continued to circulate when the coins arrive, then the prices of goods and services would rise by a greater amount than that caused by the increase of 30,000 silver livres.

Mike, you said: “I say if the boat sank, the paper would have lost value.”

Great! Now we’re getting somewhere. So, Mike, do you mean that without the new silver coinage arriving the paper livres would be worthless, or just that their value would fall on news of the boat sinking?

But suppose the boat doesn’t sink and the 30,000 livres of silver coinage arrive and the French government in Quebec spends all the 30,000 of silver coinage. And, also suppose that some of the paper livres continue to circulate, so that the money supply has increased by 30,000 silver livres plus say, 5000 (paper livres). In this case, do you contend that the prices of goods and services in terms of livres would be higher, just the same, or lower than if the 5000 paper livres didn’t continue to circulate?

Alex said:

Fraud involves deception. If the public is fully informed that for every dollar on deposit there is not a dollar’s worth of currency on hand, there is no deception and hence no fraud with the fractional reserve aspect of banking.

Not to disagree, but to expand on this, to truly eliminate the fraud in fractional reserve banking, what is necessary is to change the legal structure of deposits. Simply saying “oh, yea, we’re loaning out your money” is not sufficient. As long as a FRB is structured so that a depositor has full legal title to his deposit at the same time as a borrower, the bank is committing fraud. It is telling two different people that they have title to the same sum of money. This is, ipso facto, fraud.

If the bank were to change the structure so that the funds were pooled, say as in a mutual fund, and there were clear delineation of title and/or control, the fraud would be eliminated. I maintain that fractional reserve banking by definition is fraud because we would probably refer to other, non-fraudulent structures by a different name.

Alex:

I believe the theory underlying what you’re saying is correct, but to me it implies that you think in our present day, fractional reserve bankings are giving sufficient disclosure, they are not committing fraud, the general populace recognizes and comprehends what fractional reserve banks do, and it is intentionally assuming the risk that is involved. Is that indeed the case? If so, to what do you attribute business cycles? And do you disagree what the extant empirical evidence that unnatural credit expansion appears to lead to business cycles?

Alex:

I agree that most people would shrug their shoulders if FRB were explained to them. I also use the services of FRBs because, as you say, they serve my purposes, are convenient, and low (acceptable anyway) risk. To be clear though, I also pay taxes and otherwise comply with unjust laws because, to me, not going to jail or having my property seized serves my purposes and is more convenient than going to jail. That does not make those practices okay.

Unlike you, I am convinced that ABCT is sound. While I agree that there is nothing precluding the general populace from understanding FRB and its implications, there must be some explanation for business cycles. If FRB is understandable and its negative effects are avoidable, why can’t any other supposed explanation for the cluster of errors that occurs in a business cycle be explained away in the same manner. I perhaps don’t take as hard a stance on ABCT as other Austrians, but it is still to me the best explanation available.