Any future reform will fail as miserably as past reforms, writes Jesus Huerta de Soto, unless it strikes at the very root of the present problems and rests on the following principles: the reestablishment of a 100% reserve requirement on all bank demand deposits and equivalents; the elimination of central banks as lenders of last resort (which will be unnecessary if the first principle is applied, and harmful if they continue to act as financial central-planning agencies); and the privatization of the current, monopolistic, and fiduciary state-issued money and its replacement with a classic gold standard. FULL ARTICLE
Source link: http://archive.mises.org/9270/international-monetary-reform-and-the-initial-bailout-of-private-banks/
International Monetary Reform and the Initial Bailout of Private Banks
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A good article.
One point: at least in the US, we can impose 100% reserves for demand deposits immediately without having to print more federal reserve notes. Banks are holding so many excess reserves that all demand deposits are 100% backed by reserves.
The trouble is that savings accounts are just as “available on demand” as legal “demand deposits”. (True, I may only be able to make 4 withdrawals a month – but all I need is 1 withdrawal to remove all of my money without penalty.) Right now “demand deposits + savings accounts” have roughly 20% backing with reserves… the highest that’s been in ages. Just a few months ago we were near 1%.
As I say: the time for 100% reserve banking is now.
A good proposal that could be politically feasible if we had Austrian School-friendly politicians in office… Unfortunately, few of those exist.
This is at the heart of the financial meltdown. It is frustrating that, many months after the crisis began, Congress has not even discussed setting up committees to to examine the causes. Congress is the only organization that can fix the problem it created. As the title of the article implies however, the problem is international in scope & unless all major economic powers are part of the fix, the market will bypass any one-country attempt to implement this solution. A long, hard road lies in the future.
100% reserve requirements are unlibertarian and anti-free market. If I want to put $100 in a bank that will keep $10 cash on hand and lend out the other $90 (which enables the bank to pay me interest), that is between me and my bank, and nobody else. If I want to pay my bills with Mike Dollars that I print up, and if people accept those dollars (because I accept Mike dollars in payment of rent on some houses I own), then that is certainly not the legitimate concern of professed libertarians.
The value of money is equal to the value of the assets backing that money, so when a bank issues a new dollar, and acquires a dollar’s worth of new assets in exchange. The bank’s assets rise in step with the money bank’s issue of money, and the value of the dollar is unaffected.
Wow, what a planned scheme! The first ‘rule’ is where he goes wrong: demand deposits and bank notes are NOT bailments, but debtor-creditor contracts, i.e. loans (see http://davidhillary.blogspot.com/2008/11/banking-defined-and-defended-part-1.html).
The stock of money is not the cause of its price or purchasing power: the quantity theory of money is WRONG.
The way to restore freedom is to re-establish the gold standard, which is not to say everything used as a medium of exchange will be gold coin, but that, legally, the standard of value is gold coin, which means debts, including debts owed by banks to note holders and customers, including note holders of central banks, is payable in gold coin, if so demanded. That is to say the way back to the gold standard is to resume redemption of bank issued money in standard money. To do this the ratio between gold coin and existing units of money must be re-fixed. This can be at current market value, and without reference to stocks of either bank-issued money or gold coin (or bullion).
The lack of an existing stock of ready coined gold can be overcome by way of going back to the bullion exchange standard first. E.g. first national currencies are fixed in terms of, and payable in the form of, gold bullion (1 kg bars or 400 troy ounce bars, whatever), then perhaps, after 2 years, in gold coin, giving time for the gold stock to be manufactured from bullion into coin.
Obviously freedom of commercial banks to issue notes payable to bearer on demand and intended to serve as a medium of exchange needs to be restored, too. As soon as this has occurred, central banks of issue can be liquidated, and monetary freedom has been re-established. People can use silver or whatever other goods or standards of value as money if they want to, but the gold standard was arrived at largely through natural development, so if it is restored, I don’t think it is likely to be replaced anytime soon by a competing standard.
I think Ron Paul’s competing currencies and elimination of FED legal tender would be the place to try. Anything else has about zero chance of happening.
And even in times as bad as depressions, the politicians don’t suffer much. To the contrary, the worse it is for the rest of us, the better they do. Their job is simply to lie about it.
So, what chance do you think we have that they’ll give up on things like fractional reserves? But competing currencies, might just squeak through since it doesn’t sound that radical, and let’s not forget, most of the public thinks the problem is capitalism, not the FED.
Mike, in my opinion, that’s one of your most effective refutations yet. The focus should be on restoring liberty in the monetary system. As David alludes, the central planning of the opponents of central planning is truly ironic.
I believe that the Austrian Business Cycle Theory is valuable and provides good explanation for market phenomenon. But I protest the people who want to use it to justify their own plans.
@ Mike and Joe,
Money is worth is not what ‘backs.’ In the case of paper money or book entry money, it what it is legally payable in (so long as payment is indeed expected to remain available). This is the whole point of the gold standard, gold coin is the standard in which paper money and book entry money is payable in, and therefore worth if payment is confidently expected to remain available. The issuing bank could have twice the value of assets, but it only needs to pay the face value to discharge the obligation, and so the instrument is worth no more than face value.
@ Mike Sproul,
Don’t you think there is a difference between a demand deposit and time deposit? Jesus is referring to demand, not time. Would you lend me someone else’s money, left in your care, when you don’t know when that person will demand his money? Isn’t that fraud?
And if banks can create new money against an asset, why don’t we all just get issued with our own printing machines and create money to buy whatever we want?
And what assets do the banks acquire when issuing new money? Most new money created was issued against consumption backed by future savings and not assets. What’s the use of issuing new money now against a home (asset) nobody wants, or can’t afford because future savings have been consumed to the hilt?
The focal point is legal tender laws. This curbs freedom, allows for central banks to counterfeit, and causes economic turmoil that is very difficult to avoid.
Anything else is just a symptom of the problem.
Mike Sproul presents a valid point when he says 100% reserve requirements are unlibertarian and anti-free market. Of course if the Federal Reserve System still rules the roost Lucas M. Engelhardt is correct is stating that the time for 100% reserve banking is now.
The 100% Gold Standard definitely makes sense—especially if market participants use gold and silver in their transactions. Of course it could be rather difficult to convince people that money is gold and silver.
Jesus Huerta de Soto: I conclude with an important final warning: naturally (and I must never tire of repeating it) the solution I propose is only valid in the context of an irrevocable decision to establish a free-banking system subject to a 100% reserve requirement on demand deposits.
Can you imagine the political establish relinquishing the power that fractional reserve banking and a fiat currency gives them? I doubt if that day ever arrives—unless of course political heads are rolling—and I mean this literally—not that I believe revolution and violence is the answer. How about an ideological revolution based on libertarian and free market principles? I guess it is emotionally healthy for freedom fighters to wish and hope once in a while. Do you think Objectivists will accuse us of evading reality?
If deSoto’s 2nd and 3rd steps were to be taken, I think the first step would take care of itself. I agree that if people knowingly accept money that doesn’t have 100% reserve backing, there’s not a problem with that (key word: “knowingly”). However, given a free banking system, I don’t think too many people would want to take on that kind of risk, especially given that it would contribute to the inflation of that particular currency.
Yes, the quantity theory of money is wrong, but not entirely wrong. IF all other factors remain equal, then a change in the quantity of money certainly must affect the buying power of that money. If this weren’t true, who would give a hoot about the Fed’s inflation or the contributions of fractional reserve banking? Naturally, all other factors won’t remain equal, given the complexity of the economic system, and it is here that the quantity theory falls down.
@ Jake,
In early colonial Australia every cheesemonger and cobbler issued bank notes, according to demand to hold them, however, over time, with the establishment of large and strong banks, these ‘cheesemongers and cobblers’ were driven out of the business of issuing bank notes by stronger and more efficient competitors. (See Laissez faire banking, K Dowd, chapter 7).
This shows how freedom to issue bank notes does not result in demand for others to hold them. Issuers have to compete with others in terms of financial strength, ease of redemption, brand value etc. and in that process, strong banks win, providing the transactional media in this form.
Mike,
Jake is right. I think that you mistake two different contracts based on different legal ground: “contrato de depósito” and “contrato de préstamo” (in Spanish). The right words in English as well as the explanation is fully explained in Huerta de Soto’s book (from who I’m a Phd student).
David,
It’s the freedom to issue bank notes that would keep the big banks honest – if there were no legal tender laws. That is enough reason to repeal these laws. Even if all the small ones failed eventually, it’s the threat that counts.
It’s the same as the threat of bank runs which (used to) keep fractional reserve banks at least a little bit honest.
@ Jake,
It is not fraud to use loaned money to finance operations, whether money lending operations or other operations. As long as the deposit transaction is structured as a loan and not a bailment, the bank is free to invest the funds.
The bank-customer contract establishes a debtor-creditor relationship, a simple legal debt owed, under established English common law, e.g. Foley V Hill (1848):
‘Money, when paid into a bank, ceases altogether to be the money of the principal (see Parker v. Marchant, 1 Phillips 360); it is then the money of the banker, who is bound to return an equivalent by paying a similar sum to that deposited with him when he is asked for it. The money paid into the banker’s, is money known by the principal to be placed there for the purpose of being under the control of the banker; it is then the banker’s money; he is known to deal with it as his own; he makes what profit of it he can, which profit he retains to himself, paying back only the principal, according to the custom of bankers in some places, or the. principal and a small rate of interest, according to the custom of bankers in other places. The money placed in the custody of a banker is, to all [*37] intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach, of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal, but he is of course answerable on the amount, because he has contracted, having received that money, to repay to the [37] principal, when demanded, a sum equivalent to that paid into his hands.’ (see http://www.uniset.ca/other/css/9ER1002.html)
Of course if the parties agree that the transaction is a bailment, then the money deposited needs to be stored only, and not invested. But that’s not banking, that’s warehousing or some other business (may be carried on by a banker, but not in his role as a banker).
Freebankers just never go away. If you want to take money from depositors and call yourself a, uh, hard money lender, brokerage house, Larry’s House of Cash or Bernie’s House of 12% Annual Returns, go for it. You’re just not a bank. That’s all. You are not a bank.
Are there any banks in existence today which charge a monthly fee to physically store one’s money but do not actually loan that money out to others for further profit?
In other words, the bank itself could be thought of as just a vault system you pay to securely guard your money rather than store your money in a safe at home. That probably is not likely in these days of free checking accounts and such, but it seems that such a business would be fairly immune to bank runs since it would voluntarily and necessarily maintain 100% reserves at all times.
Considering that the current interest rates paid for savings accounts are nowhere near the rate of monetary inflation anyway, it might be worth taking a further loss and banking at such a place if it meant that one’s money would always be completely available on demand without having to put one’s faith in the FDIC.
happylee might not like it, but legally, the word bank means someone who:
1. conducts current accounts for customers (legally, a debtor-creditor relationship, a debt owing)
2. Pays cheques drawn on him by his customers (paid from the credit or available credit in the customer’s current account), and
3. Collects cheques for his customers (and credits the proceeds to the customer’s current account.
(United Dominions Trust Ltd v Kirkwood, English Court of Appeal, 1966 2 QB 431)
Who the hell do you think you are to tell the commercial and legal world that they have to change their terminology?
Chad Rushing, yes they are but they don’t call themselves banks, e.g. e-gold.com
I agree with most of what David has to say so far. I think it’s silly to view banks as warehouses. They’re there to facilitate credit transactions. They may have a double function of a warehouse, but even in a 100% reserve system they’d not be mere warehouses…
http://cosmos.bcst.yahoo.com/up/player/popup/?rn=3906861&cl=11648676&ch=4226716&src=news
talk about mainstream! go Ron Paul!
Remove the legal tender laws and the ability of governments to allow suspension of payments in REAL money and the whole problem solves itself. You can call yourself a bank, you can issue as many notes as you want, but without the government backstop nobody will ever give you their money if they don’t think they’ll get it back.
This takes no act of government at all, except to do nothing.
Once upon a times “banks” and other money warehousing businesses lent out fractional reserves in conservative amounts – nowhere near the 10 to 1 pyramid ratio of a modern bank. I have no problem conceptually with such an arrangement as long as both parties are in agreement. Fractional reserve banking as it is currently practiced is deceptive if not fraudulent, but the depositor is as much to blame as the banker for not practicing “caveat emptor” and understanding who and what he is giving money to.
Yeah, just try and take your money out with one withdrawal. They will tell you not today. How about a week from now when we order the cash up.
Of course the note they give you has less value then the paper and ink that made it.
DS,
Metallic reserves under free banking are likely to be only about 3% of demand deposits and bank notes issued, based on historical examples in Scotland. Metallic reserves provide liquidity but earn no explicit interest income, and the bank can get liquidity from other interest bearing assets (marketable debt securities) and its funding capacity (funding liquidity — it can replace notes and demand deposits demanded with term debt by issuing commercial paper etc.).
The key ratio is not so much the reserve ratio but the capital ratio, as this provides the buffer to absorb any losses before creditors lose.
David Hillary:
The value of paper or credit money is determined by both backing and convertibility. If a bank has assets worth 110 oz as backing for 100 guilders, but each guilder is convertible into 1 oz, then the guilder will be worth 1 oz. But if a bank holds assets worth 90 oz as backing for 100 guilders, then even if the guilders are legally convertible at the bank into 1 oz, they will be worth only .9 oz each. Convertibility requires backing, but for money to have value, it must be both backed and convertible. (But there are dozens of different types of convertibility: Instant, delayed, physical, financial, certain, uncertain, at the bank’s option, or at the customer’s option.)
Jake and Jordi:
“Don’t you think there is a difference between a demand deposit and time deposit? Jesus is referring to demand, not time. Would you lend me someone else’s money, left in your care, when you don’t know when that person will demand his money? Isn’t that fraud?”
David H. already answered this, but I’ll add that if customers agree that the bank can lend out 90% of demand deposits, knowing that this will mean that there will be a possibility of delayed payment or even failure to pay, then that is their business and nobody else’s. People take chances with their wealth all the time.
“And if banks can create new money against an asset, why don’t we all just get issued with our own printing machines and create money to buy whatever we want?”
As I said, I can issue Mike dollars on a printing press. Several local merchants will accept them, because I own some houses, and I accept Mike dollars in payment of rent. Walmart issues Walmart dollars, Disney issues Disney dollars. Needless to say, If I issue more Mike dollars than I can redeem, they will lose value.
“And what assets do the banks acquire when issuing new money? Most new money created was issued against consumption backed by future savings and not assets. What’s the use of issuing new money now against a home (asset) nobody wants, or can’t afford because future savings have been consumed to the hilt?”
Banks that issue $1 normally get $1 worth of various assets in exchange. Let’s say that the rent on my houses totals 1000 oz. of silver per month. I can certainly issue 1000 mike dollars, and they will trade for 1 oz. each. But I also have future rents. I could keep issuing Mike dollars up to some amount reasonably short of the full value of the houses, and they would still be worth 1 oz. each. If my issue of Mike dollars outran my assets, then they would lose value. The difference between mike dollars and Fed dollars is very small.
Mike,
The sequential service constraint means that those who are first in line get 1 oz per guilder, so this means their claims are valued at par, not backing.
‘convertibility’ is a word for central planners and policy makers. The free market has not convertibility but liability to pay on demand. “The Bank of Scotland Promises to Pay the Bearer On Demand the Sum of 10 pounds, [Signed]” that is the language of negotiable instruments, private contracts freely entered into, that they either honour, or breach by non-payment. Black and white. In the same way the drawer of a cheque is undertaking that the cheque will be paid when duly presented for payment, and that he will pay the cheque himself if the drawer does not. Again it is black and white. The fact that markets might be able to price and value instruments that are not payable on demand or are in default or are payable at the debtor’s option does not make it a good thing to have or be required to use such instruments as a medium of exchange when unconditional undertakings to pay on demand by creditable parties are available.
I can’t see why there should be a requirement of 100 percent reserve. So long as the bank discloses the fraction held in reserve, there is no fraud, and the risk is contemplated in the price.
The issue is not fractional reserve itself, it is having fractional reserve imposed on the population by a government monopoly permanently and grossly inflating the currency, spreading economic disorder and aggrandising its own anti-social activities.
In the absence of regulation (apart from the law against fraud) those who wanted 100 percent backing could have it, and those who wanted the higher returns going with higher risk could have it.
It would still be inflationary, but custom and prudence – and the occasional salutary bankruptcy – would set it within much narrower limits than is now the case.
@ Mike Sproul & Justin
Part of the issue in fact is fractional reserve lending.
I understand your point however here is my rebuttal.
First off with a fractional reserve system you enable inflation, even without the lender of last resort. The higher your ratio is the higher you fluctuate in monetary inflation/deflation. Now with a 100% reserve system it may eliminates the need for a lender of last resort and keeps monetary inflation/deflation (If fiat) from fluctuating in high volume. The lower you drop that bar the more possibility that a lender of last resort may be needed for bank bailouts. If you have a low reserve ratio(100%) you can always count on other banks to lend to each other to meet their reserves. With a high ratio (100 lendable per 1 deposit(10%)) banks constantly have to seek help from the central bank because their own reserves are so low that it becomes dangerous to lend large amounts to fellow banks.
Secondly, I don’t see why it would be wrong in this system for you to have a business agreement with your bank in which you give consent to loan out your money in agreement that you will receive a percentage of the interest rate. Like a savings account.
The difference is you come to the agreement on your own choice to make this type of financial investment with your bank, it is not done without your consent or without you knowing.
Banks can continue to loan and make money with your deposits, it will only be transparent instead and you will be aware of it. I don’t think thats anti-libertarian or anti-free market at all.
A change like this would not eliminate banking. It would only make their business practices more honest.
I consider it anti-libertarian for a bank to loan my private property without my consent. I hope that was a reasonable response.
crosson,
It seems you’re assuming what you’re trying to prove in two ways:
1. That banking operations cause ‘inflation/deflation’ and
2. That bank customers are unaware that their demand deposits fund the bank’s loan portfolio.
Regarding 1. you appear to define ‘inflation’ as the issue of bank notes and demand deposits by banks and the on-lending of those funds raised by such instruments to other borrowers and likewise for ‘deflation.’ If this is how you define the terms, what is wrong with ‘inflation/deflation’?
Regarding 2. you appear to believe that investors, bank customers and note holders believe that the bank is only a storage institution, not a credit institution. However the legal status of banks as debtors, in relation to deposits from customers, and in relation to bank notes issued, is a matter of established custom and law, for hundreds of years. In fact, in law suits concerning the status and character of banks, for example in Foley v Hill (1848) again:
‘I am now speaking of the common position of a banker, which consists of the common case of receiving money from his customer on condition of paying it back when asked for, or when drawn upon, or of receiving money from other parties, to the credit of the customer, upon like conditions to be drawn out by the customer, or, in common parlance, the money being repaid when asked for, because the party who receives the money has the use of it as his own, and in the using of which his trade consists, and but for which no banker could exist, especially a banker who pays interest. But even a banker who does not pay interest could not possibly carry on his trade if he were to hold the money, and to pay it back, as a mere depositary of [44] the principal. But he receives it, to the knowledge of his customer, for the express purpose of using it as his own, which, if he were a trustee he could not do without a breach of trust. It is a totally different thing if we are to take into consideration certain acts that are often performed by a banker, and which put him in a totally different capacity, for he may, in addition to his position of banker, make himself an agent or a trustee towards a cestui que trust; for example, suppose I deposit exchequer bills with a banker, and he undertakes to receive the interest upon them, or undertakes to negotiate or make sale of these exchequer bills, and to credit my account with the proceeds of the sale, I do not stay to ask whether, in that case, he might not be in the position of a trustee, and might not partly sustain a fiduciary character; but he does that incidentally to’ his trade of a banker; for his trade of a banker is totally independent of that,–his trade of a banker consists in the general trade, to which the other is an accidental addition. This trade of a banker is to receive money, and use it as if it were his own, he becoming debtor to the person who has lent or deposited with him the money to use as his own, and for which money he is accountable as a debtor.’
Thus it is well known that a banker, as a banker, is a mere debtor, and not a warehouseman.
Crosson
2.
“I consider it anti-libertarian for a bank to loan my private property without my consent. I hope that was a reasonable response.â€
Yes it is. But that is only reason to enforce the common law of fraud and contract as they apply to banking. It is not a reason for a law banning consent-based fractional reserve banking.
“The difference is you come to the agreement on your own choice to make this type of financial investment with your bank, it is not done without your consent or without you knowing.â€
If the bank represents to the depositor that the deposit is 100 % backed by gold, when in fact it is only backed by a fraction of 100%, then at common law that is fraud and breach of contract. The only reason this fraudulent practice was able to flourish is because governments protect the bank as against the depositor. Why? So the government can benefit from inflating the currency.
1.
“First off with a fractional reserve system you enable inflation, even without the lender of last resort… banks constantly have to seek help from the central bank because their own reserves are so low that it becomes dangerous to lend large amounts to fellow banks.â€
Yes, but that is an argument against central banks, not against liberty. There is no need for a lender of last resort; there is a need for the bankruptcy laws to apply to banking as they apply everywhere else.
The only reason governments act as a lender of last resort in the present arranegment, is because they impose fractional reserve on the entire population, so no-one’s deposit is safe.
But suppose there were a free market in money, no law requiring 100% reserve, and the ordinary law against fraud applied to banking.
Some banks would advertise and hold 100% gold reserves, to provide for those customers who would accept no less than 100% backing in gold – like my parents-in-law!
Other banks would advertise and offer higher returns for higher risk based on fractional reserve. Competition between them would see different rates of return and different fractions in reserve.
Banks which couldn’t perform their contracts would go broke; and that is as it should be. People who knowingly risked their money might lose it: their consent answers all issues. No need for a lender of last resort.
Some people have argued that the creation of new money in these circumstances would not be inflationary. I don’t know Mises’ view on that point.
But even if it were inflationary, that is still not a reason to impose 100% reserve against the will of the parties. The inflation would be kept within much narrower limits because of profit and loss, supply and demand. The inflating bank would face severe pressures limiting the amount of inflation possible:
1. The law against fraud requiring the disclosure of the fraction in reserve
2. Bankruptcy in cases where there is a run on the bank and it can’t meet its obligations.
The problem at present is not fractional reserve in itself, nor the small inflation that would result in a free market.
It is that
1. Government imposes fractional reserve, and the risk of losing your deposit, on the entire population in order to impose a permanent and great inflation.
2. to do this, the government gives banks the privilege of profits they could not otherwise make
3. it also gives banks the privilege of backing and bailouts they would not otherwise have
4. the government and banks thus milk the entire population to pay for this corrupt and unstable set-up
5. in order to provide backing to ‘solve’ a problem created by its own greed and abuse, the governments set up central banks, which are the source of further and worse abuses
6. the creation of new money causes inflation
7. the inflation causes malinvestment on a vast scale
8. the correction to this process inflicts economic hardship on people innocent of the wrongdoing that caused it
9. government grows as it falsely pretends to be the solution to problems of its own creation which it blames on banks
10. etc. etc. etc.
We don’t need to try to engineer the kind of society we would like.
We need to respect and defend private property, and the rest will follow.
Apparently a lot of people are disturbed when they hear of FRB because it’s told in ghost-story tone:
“Did you know when deposit $1000 in the bank, it’s not sitting on the table waiting for you to reclaim rather it get lent out and the bank might lose your $1000 or at least not be able to pay you when you want to make a withdrawal?”.
Apparently to solve the problem is not the solution to break banks up and replace them with storage houses for those who want their money sitting in a vault and investment houses for those who a return on their money? (Those this presume a gold coin monetary system for those who trust neither and want to store their coins in their own safe)
Justin said:
“The problem at present is not fractional reserve in itself, nor the small inflation that would result in a free market.
It is that
1. Government imposes fractional reserve, and the risk of losing your deposit, on the entire population in order to impose a permanent and great inflation.
2. to do this, the government gives banks the privilege of profits they could not otherwise make
3. it also gives banks the privilege of backing and bailouts they would not otherwise have
4. the government and banks thus milk the entire population to pay for this corrupt and unstable set-up
5. in order to provide backing to ‘solve’ a problem created by its own greed and abuse, the governments set up central banks, which are the source of further and worse abuses
6. the creation of new money causes inflation
7. the inflation causes malinvestment on a vast scale
8. the correction to this process inflicts economic hardship on people innocent of the wrongdoing that caused it
9. government grows as it falsely pretends to be the solution to problems of its own creation which it blames on banks
10. etc. etc. etc.”
I agree with all of that, but I have thought a lot about number 6 and 7: The primary evil of inflation is not an increase in the price level (as many seem to focus on) but the creation of mal-investments. But mal-investment is a somewhat nebulous concept that cannot be precisely defined or predicted before the fact, but relatively easy to identify looking backwards. Because of this asymmetry it is better not to inflate the money supply at all, since nobody can predict the results.
My theory is that mal-investment is created by using FRB created money to fund projects that do not turn out to be profitable ventures. In the simplistic theory a dollar created out of FRB and loaned creates money (inflation) and when it is paid back destroys the original money created (deflation). The interest paid to the bank is a decrease in the borrower’s capital, but if the borrower makes more money from the capital employed then he is still better off. Everything is all unicorns and rainbows, and we have neat little system.
The problem is that when loans are made out of FRB funds and they are not paid back, the money is never extinguished, it becomes a permanent increase in the money supply (or if the borrower can’t pay and the bank restructures the loan to increase the borrowers debt at a lower payment so the bank can keep making money on the loan – this is much more common than outright defaults, which are low. This of course is inflationary). The bank takes a writedown on this imaginary quantity on its balance sheet, which then becomes a “real” loss to the bank’s owners. If a bank, without the back stops of suspension of payments, a lender of last resort and the moral hazard of banking regulation (making depositors and investors feel more confident in this institution than its actual financial position would justify) makes too many of these loans that don’t work out, then it shareholders will lose everything and no depositor (assuming they have done the prudent thing and constantly monitored the health of the institution that they gave their money to) would ever give it money again. Of course this is not how the system works today, but this idealized world is the one usually presented in favor of FRB. What I call the fairy tale version of FRB.
This defaulted loan is a malinvestment at its most basic and is the kernal of malinvestment spreading to the whole economy. The money created to fund this bad loan (and many others) is still circulating and is used to bid up the prices of whatever is bought with it, sending false signals to businessmen and consumers that they are richer than they would otherwise be. They then make investment and spending decisions that are based on this extra money being available. This is loosely how mal-investment perpetuates.
But the question arises: Are performing loans made out of FRB and eventually paid back in full inflationary and more importantly do they cause malinvestment? I think it’s clear that a loan made out of FRB that creates capital that leads a business to increase its productivity that leads to the loan being paid back in full with profits exceeding the interest payments, is not a malinvestment.
Of course this scenario can go lots of different ways – what if the business invests to increase its capacity, increasing its total profits, but actually becomes less productive (this happens a lot in real life). Is that a malinvestment? The bank has no way of making that economic judgement because it gets paid back its principal and interest either way.
Does a prudent FRB bank who only lends to people it knows can pay it back create inflation and mal-investment?
My argument is that FRB in theory is not a problem, it is the government interference, moral hazard and central bank inflation that are the flaws. A prudently run FRB bank (at free market determined reserve ratios way above what banks operate at today, say 50% instead of 10%), can operate without causing harm, and maybe even creating some good. And if it doesn’t do those things it will go out of business.
The real problem for bankers is that this sort of business would not be wildly profitable, the banker wouldn’t be the richest, most powerful guy in town but a simple merchant aggregating people’s savings and making pennies off loaning the differential between what he pays to depositors and the interest on his loans.
Of course if this banker wants to get rich he can start loaning money to the government and in return they will protect him from his competitors and maybe even grant him a monopoly and protect him when he overextends…..wait, I think that’s how we got here in the first place….it’s all starting to make sense now.
1. In a free banking system, all notes and deposits issued by fractional reserve banks would have to clearly say it in the Notes and in the Deposit Contract (let´s say: “This Note could have a reserve of 20%”), so this would lead to them being exchanged at discount to Notes and Deposits of 100% Reserve Banks.
So, my thesis is that with clear contracts 100% reserve banks would emerge naturally: Good money would drive bad money away.
2. The solution by Prof. HS has a problem (giving reserves to 100% of demand deposits), is that when a Time Deposit expire it goes to “Demand Deposit” and so a Bank must demand creditors to pay in hard-money in proportional amount to keep the 100%.
In fact a 100% reserve system to demand deposits automatically enforces that a bank must have more than 100% in reserves in order to be able to handle the average time deposit that expire without a particular bank creditor being able to pay the bank at exactly the same time.
I would say that is good anyway, a 100% reserve bank, must have +100% hard money, in fact part of the initial capital of a bank must be a sufficient hard money reserve in excess of the 100% reserves for demand deposits.
OK, trying to simplify this discussion in my mind…
1. If I agree a bank can loan out some of my money and that I might lose that money, that isn’t really fractional reserve banking. I’ve simply picked an investment over a savings account.
2. On the other hand, if there is a system of government deposit insurance on the money I might lose, that is fractional reserve banking. (Someone got paid to build a house… natural disaster wipes it out… not covered by insurance… all the money spent sits in the builder’s account so not wiped out… government secures my bank deposits that were wiped out by the bank failing… money is created out of thin air.)
3. If the guy who had the house built for him printed money based on the asset value of the house which now has dropped to zero, anyone holding that money would be out of luck. If the government isn’t there to bail them out either, that isn’t a problem since the money is destroyed with the asset and everything zeros out.
If understanding this correctly, I think option 3 would go by the wayside for most average folk, except when doing commerce in a closed system.
I’m not sure the arguments “against” the authors article are really dissenting from his statements. I think he means “demand deposits” to mean deposits the customer expects to be payable in full at any time (not all types of “deposits”). Also, isn’t the author writing he would insist on a process that transitions in a controlled fashion to 100% gold back currency.
@ Justin
Well said
“”I consider it anti-libertarian for a bank to loan my private property without my consent. I hope that was a reasonable response.â€
Yes it is. But that is only reason to enforce the common law of fraud and contract as they apply to banking. It is not a reason for a law banning consent-based fractional reserve banking.”
I agree with you 100%. I feel sadly however that enforcing common law is much easier said then done, especially when you calculate coercion of the state. What I want to try and do is eliminate any excuse that may arise to bring about another central bank. So long as there is an excuse politician’s will use it as a crutch to bring the current situation back.
So while I agree with what your saying, I also know that people in general are arrogant and will freak out and demand a central authority if banks are at the risk of failing.
If all banks remain solvent the point of bringing about a central bank becomes less likely.
In truth however I also feel that if banks practice was much more transparent people would be more picky about whom they banked with natural competition would then drive out risky lenders. Just a thought.
“The focal point is legal tender laws. This curbs freedom, allows for central banks to counterfeit, and causes economic turmoil that is very difficult to avoid.” Eric
I agree. Just allow competing monies and banking models and FRB will be out-competed by honest ( 100% reserve) alternatives. Equity-backed money is one alternative that should do the trick. Without the boom-busts inherent in FRB, the stock market as a whole should only rise. It could therefore be used to back appreciating monies.
Now imagine loans of equity-backed money to companies whose equity was in the backing of the money. A positive feedback loop that should out compete FRB in all but perhaps the very short run.
Disagree: the problem with money supply is purely political and is NOT economic in nature…
Allow me to elaborate:
Let us say we switch to Gold Standard. That means that all products and services will be re-priced in terms of weight of Gold, and all the prices will come to equilibrium determined by the current supply and demand ratio. Let us also assume that the banks are completely de-leveraged and absolutely meet the 100% reserve requirements…
It is important to note, that not all of the Gold (or its mapped equivalent) will be in circulation at a given time, i.e. significant amount of Gold will be deposited in banks or by other means isolated from circulation by the saving participants in the Free Market relationship…
Now, let us say the Government needs more money, let us say to build a rabbit farm on the Moon (or start a new meaningless war). What do you think it can do? It has basically two options – one is bad (politically speaking, and thus unacceptable) – option “a.” below, and one is good – option “b.” below:
a. Raise taxes (limited to certain level, and NOT politically feasible);
b. Borrow from commercial entities or private individuals holding the reserve portion of the Gold (or exchange tokens) not in circulation (i.e. not immediately due for redemption) by promising to reimburse the investors with even more Gold (which it does not have, of course)…
What do you think will happen? Exactly the same old plague – the dreaded INFLATION!
Since now the workers that were hired to build the new rabbit farm on the Moon or to support the brave troops on a patriotic mission of democratizing yet another wretched nation, will get that lent new Gold, and will put back into the circulation, which in turn, again will partially wind up in some saving instruments or under somebody’s mattress….
It’s like running a giant Ponzi scheme on the infinite loop, where you constantly borrow and spend, borrow and spend the imaginary exchange tokens (Gold in this instance), much the same way as with fiat currency, since not all of them are immediately due for redemption… And to encourage newer and newer generations of the private individual and commercial lenders or investors Government will promise more and more dividends…
This kind of situation is made possible by the fact that exchange tokens serve not only as that – tokens of exchange, but also serve as vehicles for preserving the wealth itself, thus not fully being circulated in the financial system at all times.
Like with fiat currency, there always will be private bankers or individuals willing to lend their savings, i.e. Gold to the Government, considering it as a safe investment. And like with paper currency, the Government can re-cycle the borrowed Gold over and over again with the promise of returning the borrowed amount with the dividends…
Now, unlike the “ordinary” Ponzi scheme, this scheme will NEVER collapse, since when the State runs a Ponzi scheme this is called INFLATION. Goods and services prices are automatically re-adjusted by the markets to their new, inflated values (in Gold, in this instance) in proportion to the increase in supply of money in the system.
Let me elaborate further as to WHY this Ponzi scheme will NEVER collapse when run by the Government itself, and how it is different from the “ordinary” Ponzi scheme:
Three words – credibility, scale and longevity!
Indulge me a little more, please:
With the classical (or ordinary) Ponzi scheme, there comes a critical point in time when the borrower running the scheme cannot borrow fast enough to meet its current debt obligations, and hence looses its credibility and subsequently collapses under the unsustainable debt burden. Under the term “ordinary” I mean that the private entity running the Ponzi scheme has significantly limited credibility in terms of number of its participants versus overall population, and it deals with significantly less quantity of money in comparison to the overall money supply in the market.
The difference with the Government running a Ponzi scheme is the following:
1. It has almost infinite credibility, partially due to the fact that it is an almost practical impossibility to declare it as bankrupt. Thus allowing it to borrow and restructure its debt for significant periods of time.
2. Its scale and scope is sufficiently large enough to influence the money supply in the financial system;
3. Due to its significantly greater longevity it can always pay by future obligations in terms of future taxes, or using future incomes from public infrastructure or other public assets, essentially creating the wealth out of thin air by “selling tomorrow today”;
Note that the Government can always get away with this practice, since it has much longer span of life than the individual investors, and due to the simple fact that the successful private generators of wealth will always need a safe refuge for their surplus of capital that can also generate some nominal income whenever there are no suitable higher-yield investment opportunities in the private sector (ironically as a hedge against inflation, Gold-one this time)…
As I have shown above, the inflation or the problem of money supply is purely political in nature and cannot be effectively contained by the Gold Standard or ANY other Sound Money policies…
As a follow-up to my previous posting on money supply being a purely political issue:
Forgot to mention the periods of deflation and inflation cycles due to the aforesaid borrowing and spending activity of the Government, which will cause the prices of the services and goods fluctuate: to deflate in terms of weight of Gold in deflatory cycles, and accordingly, inflate back in the inflatory cycles.
So, even though the total maximal physical mass of Gold available as medium of exchange does NOT change, what is changing is its mapping resolution. In other words in the deflatory cycles the prices of goods and services will be mapped to a unit of weight of Gold much smaller in quantity; in inflatory cycles – this will be mapped to larger units of measurement of Gold.
This follows from the way the prices in terms of tokens of exchange are being determined in the Free Market economy . The more quantity is taken out from the active circulation in markets in a form of savings and Government borrowing or taxation, the less is the supply of money, thus there are deflatory pressures in place. Conversely, the increased government spending and increased investment activity by the commercial and investment banks will spur an inflatory cycle, causing the prices of goods and services to go up in terms of weight of Gold…
This is a direct consequence of the fact that the Gold here is used as a medium of exchange, and even though it is physically limited in quantity as a precious metal, and is constant, its mapping to the real GDP is NOT constant, and can be easily manipulated by the political power…
If this were a class, I’d definitely see an “F” in my future. I dont like the “guns and gold” standard, i.e. “the guy with the guns gets the gold.” So I am in favor of vehicles and institutions which separate guns and gold. Markets and banks form that function, you dont have to have a gun to sign a contract, make a purchase, get a loan or make a withdrawal. Central banks are problematic in that respect. Government has the guns and also certifies the activities of the bank. Therefore activities of a central bank are coerced on anyone who wishes to live outside prison. However, if the government is compelled to use the guns to enforce the legitimacy of its central bank, then it interferes with its future tax income stream. Thus, the guys with the guns, government, are compelled to allow some doubt in the value of the activities of its central bank, these options seem to be boom and bust cycles. International finance moves similarly, when guys with guns invest in assets in another country, the doubts about the present and future value of those foreign assets, interferes with “kill/dont kill” decisions, and a tense peace is established. However, if all assets had constant value to “the bearer,” irrespective of the means of acquisition, then ‘kill/dont kill” decisions are simplified. The recent events illustrate my point. Up until the “freeze,” the international market operated on the “statue of liberty” principle: Any person who could put an “X” and a date on a piece of paper was considered to have made a financial transaction at face value. A long as everyone stayed blindfolded, the scales balanced. Once the blindfold fell off, the options holding those contracts at face value were terrible, prison or execution for defaulters, and war. So most, if not all, governments facilitated a markdown of the values.The OPEC crowd thought they won a big jackpot and started pulling assets off the table, but players started leaving the game, so they relented. I havent been told how many guns they faced. Now that these face values are coming unleveraged, a peace is maintained to allow for negotiation of the value of the assets. Actions by the Fed have been pretty feeble in restoring value. Even the $700 Billion printing order by Congress, and the coming $825 Billion have unknown present and future value. Most countries have taken the same path. By bolting these past contracts to their national debt, a variety of governments are guaranteeing some future tax income value to these contracts, and promising to imprison the next generation of defaulters and frauds as “tax evaders.” I dont know that mass imprisonments will happen, but the threat allows negotiation of the value of contracts I sign today.
I like it when the guys with guns have something to worry about other than “kill/dont kill,” if that is a central bank, so be it. I’ll take my “F” now, thank you.
It is too late to save the world’s financial systems. The international bankers have inundated the world with their various forms of fiat, unfunded, worthless, paper, alleged, money, and the masses-r-asses have been so dumbed-down they don’t even know that they don’t know.
Once the weapons are voluntarily donated – and they will be – it will all be over! Only the Creator can save the Republic because mankind has lost it!
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