My post below on the experience of Scottish banking before 1845 – when the rules were changed by the-then UK government of Robert Peel – elicited a lot of great comments. It turns out that the Lawrence White paper that I mentioned had been savaged fairly thoroughly by Murray Rothbard. Rothbard’s paper is immensely detailed and shows what a thorough economic historian Rothbard was. Briefly put, he says that White has misinterpreted the Scottish banking experience by not distinguishing between free banks that operated 100 per cent reserve requirements linked to gold, and those that were simply free banks without such specie requirements. (Rothbard was an advocate of such metal-backed money). This inevitably raises that old friend of ours, fractional reserve banking, which Rothbard described as essentially a fraud. Now in trying to make up my mind on FRB, it seems to me that so long as the holder of bank notes is made aware that the note has been issued by an FRB, rather than a 100-percent reserves one, then what is the problem? It is a bit like the argument about limited liability corporations that vex some libertarians such as Sean Gabb of the Libertarian Alliance. Surely, if I transact with a LL company and knowingly do so, then such consent is what counts. LL companies could, conceivably, exist even without special government legislation, although they might not last as long as LL firms do now. (Here is a rejoinder to Gabb on LL). Same with FRB: if there is commercial deposit insurance and customers know the score, I fail to see why the existence of fractional banking should necessarily lead to disaster. Or is there something I am missing in this debate?
At first blush, some might consider all this to be a bit arcane. It is anything but. Explaining how banks work now, and how they can be made to work much better as a result of competition and basic rules, will go some way, I hope, to destroying misconceptions. Such misunderstandings that exist at the moment only play into the hands of those who want to bring the free market order down. Such as those folk protesting at the G20 summit in London today. I will be in the area on business. I might take some photos and post them up later if they are any good.
Update: I was in the Docklands area. Nothing much going on while I was there.
James Tyler gave a speech to Policy exchange calling for a free banking solution to the credit crisis. He wasn’t shouted down. 10% of the audience supported him.
From De Soto’s Money, Bank Credit and Economic Cycles:
”
let us now assume that a certain group of bank customers (or for the sake of argument, all of them) enter into a deposit contract aware and fully accepting that banks will invest (or loan, etc.) a large portion of the money they deposit. Even so, this knowledge and hypothetical authorization does not in any way detract from the essential cause or purpose of the contract for these customers, whose intention is still to entrust their money to the banker for safekeeping; that is, to
carry out a monetary irregular-deposit contract. In this case, the contract the depositors believe they have finalized is impossible from a technical and legal standpoint. If they allow the banker to use the money, then it can no longer be available to them, which is precisely the essential cause or purpose of
the contract.”
http://mises.org/books/desoto.pdf (page 141)
The argument is that it’s a legal impossibility rather than fraudulent.
From De Soto’s Money, Bank Credit and Economic Cycles:
”
let us now assume that a certain group of bank customers (or for the sake of argument, all of them) enter into a deposit contract aware and fully accepting that banks will invest (or loan, etc.) a large portion of the money they deposit. Even so, this knowledge and hypothetical authorization does not in any way detract from the essential cause or purpose of the contract for these customers, whose intention is still to entrust their money to the banker for safekeeping; that is, to
carry out a monetary irregular-deposit contract. In this case, the contract the depositors believe they have finalized is impossible from a technical and legal standpoint. If they allow the banker to use the money, then it can no longer be available to them, which is precisely the essential cause or purpose of
the contract.”
http://mises.org/books/desoto.pdf (page 141)
The argument is that it’s a legal impossibility rather than fraudulent.
Furthermore there are practical arguments against FRB i.e. it causes the business cycle even without a central bank.
The problem is, that argument doesn’t work, because the author is making an assumption on behalf of the hypothetical depositors- that their intention is “safekeeping”. By agreeing to the loan brokerage, they are implicitly declaring that they accept that the money is not safekept. They have decided that the potential for earning interest is worth a risk of the loss of their loan to the bank. There is no contradiction. The author is basing his argument on his belief regarding the beliefs held by the (hypothetical) depositors.
A depositor who has deliberately rejected a warehousing bank in favour of a fractional reserve bank has made a choice rejecting the warehousing- safekeeping- model.
Then if that is the case, and accepting that under a government of liberty which allows freedom of contract and trusts the free marketplace there will be fractional reserve banking- and it will probably be the choice of a large majority of bank customers- then libertarians must accept that the business cycle will remain. Which rather dovetails into an earlier comment I made and Johnathan made into a proper post, in which I said that I think libertarians are overstating our case by claiming we can abolish booms and busts, even though our system may make them much the lesser in extremity, and perhaps we ought to stop claiming this as it verges on the Utopian, and if anything we ought to be the pragmatists of politics/economics.
I agree with Johnathan P and Ian B about the emergence of FRB (and Limited Liability) in a free market. It that happens, it happens. Of course FRB could be fraudulent, in that the bankers might conceal their true dealings, but that goes for any contract.
Another vital ingredient in overturning Gresham’s Law, which says bad money drives out good money, is to scrap legal tender laws. So if a businessman refuses to be paid in FRB cash and only wants notes from a 100% reserves bank, he can do so. There will, through competition, be a fierce battle to establish reputations for issuing good money rather than funny money.
Of course, there will be fraudsters; it would be naive to imagine that there will not be shysters running banks which claim to be full-reserve banks which are in fact FRBs. But that is no different from Ponzi frausters now. They should be dealt with by the law to prohibit fraud.
Another thing that would hopefull come from a free banking industry is that people would be encouraged to have deposits in more than just one bank, just in case of a problem. It strikes me as nuts that people would deposit everything in one place. A “portfolio” approach to banking would be encouraged. The current system creates a false sense of security.
I note that Tesco’s is setting up banking operations. That is great; this is the sort of innovation that the markets need: getting new players into the business.
Guido, thanks for the pointer. I read your own post about this. I notice that many of the comments are snarky and plain silly. Depressing.
As to the “arcane” thing, Lawrence White makes a similar point in his Preface to the book mentioned in the previous posting, when he observes that some might consider free banking in Scotland to be only of “antiquarian” interest. But, he goes on to say, suppose that Scottish banking had served as a model for English banking, rather than being swallowed up by it (rather as the Hong Kong economy in our own time has served as a model for the rest of China, instead of being swallowed by China), that would have made the subsequent history of banking worldwide a very different story, and a much better one.
And now, recent recent financial turmoil has made this into a very hot topic. Until recently, only a few crankish libertarians dissented from the consensus that (a) banks had to be state-regulated and (b) that they were being state-regulated satisfactorily. No problem, so no need for any solution. But now, (b) having utterly collapsed, there is room for plenty of doubt about the wisdom of (a) also.
That 90% of James Tyler’s audience, whom Guido (comment one above) reports as having listened respectfully, know that there is now a huge problem about banking regulation. Tyler offered an answer: free market banking and freely competing currencies. Well, something must be done, and that is definitely something, so maybe . . . For once, that principle may just work in our favour.
Even if only the 10% who already agreed agreed, you can bet that there are quite a few amongst the 90% who are now really thinking about what Tyler said, and that a few of them will later come around to agreeing with the notion. “At first I thought the idea was crazy, but I thought about it some more, and then it clicked. . . .”
Factor in that the new media now mean that the old media can no longer stop such ideas from spreading amongst anyone who wants to think about them, and it’s a new world.
One issue that niggles at me about private currencies is the issue of entry barriers and dominance by incumbents. I’ve some experience of being niggled about this because of trading in an adult product on the web. Effectively, money on the web is to all intents and purposes private currency (convertible and pegged to the nationalised currencies), and these private currencies are credit cards, debit cards and Paypal. There have been lots of schemes to try and get other payment methods up and running, such as micropayments, but not much has come of any of them.
The problem with private currencies as experienced is that one tends to be at the mercy of their issuers. Paypal refuse to deal in “adult”, some credit cards won’t (e.g. American Express) while those who do inflict arbitrary onerous burdens on this morally unpopular sector I trade in (additional costs and very strict rules as to what one might sell). In fact a few years ago, Visa and Mastercard just reorganised the market overnight (literally), shutting down most of the payment processors by threatening their merchant banks, and forcing the remaining 3(!) to accept strict control by VisaCard or be similarly rug-pulled, in turn ordering the IPSPs to treat us as their re-sellers, rather than us hiring them as subcontractors, as we had done. Nobody could do anything, because we knew if we kicked up too much of a stink Visa would just pull out of adult altogether, and that would be that for the whole sector.
This kind of market power is kind of scary to be under. The one thing about a nationalised currency, bits of paper and metal, is you can use it to buy anything, from a bunch of flowers to a quarter of dope, from a shiny motor car to a lady of the evening. Put it in private hands, and you find your banknotes have an Acceptable Use Policy attached, and you can end up with businesses effectively having to be good little boys and beg to be allowed to trade.
Just a thought to be taken into consideration.
Ian B, a good point to make. Bear in mind, of course, that governments interfere with banking transactions in various ways, with anti-money laundering laws, for example, being used to suppress the use of cash.
Cash has been pronounced dead for years and it remains as resilient as ever. There are good reasons for this: it is convenient and leaves few trails. I have no reason to doubt that in a free banking world, cash would actually be even more popular than now.
Also bear in mind that if free banking ever does take hold – a big if, obviously – it would hopefully be attended by deregulations in other parts of the financial world, which might also deal with some of the niggles that you talk about.
But of course you are right to mention this sort of thing; I don’t think, as I said the other day, that one can treat private banking as a cure-all for what is a broader set of problems.
Johnathan, good points. I brought this up partly because the experience I described was one of my waystations on the road to libertarianism, so to speak. Particularly, thinking about why Visa, Mastercard, Paypal etc were acting this way. There seemed to be no commercial benefit. Paypal for instance don’t make any more money by blocking a long list of things you can buy with their funny money.
The answer was government of course, putting pressure on these companies to moderate what people can do on the web, for moral purposes. Governments have been “asking” them to play ball with policy, with that threat of regulation and law to “encourage” them to do as the government desires.
So obviously this wouldn’t be so much of a problem in a libertarian polity, since the government wouldn’t be entangled with business and wouldn’t have the power to threaten them, while there would be no favour for the businesses to curry.
Nonetheless it is worth considering. A business blacklisted for whatever reason by the currency providers is in dire straights.
Actually Ian that point is of vital broader importance. A discussion on free-banking will always necessarily lead into a discussion on the reduction and/or abolition of the State. The one logically implies the other, and there just isn’t any way around that.
I say it is democracy that has to go first.
Any currency issued by a bank practicing FRB, on a free market where people knew this was occurring, would not trade at face value with any other 100% backed currency. The only reason fractional reserve banking is appealing to bankers, is because government intervention forces customers to accept their fractional notes at face value.
David-
Suppose Bank of IanB trades at 50% reserve and Bank Of DavidZ trades at full reserve. We each issue pound notes with a face value of a pound of gold. Are you saying that IanB notes wouldn’t trade at parity with yours?
I’m just wondering what they would trade at, because under normal circumstances (except if there’s a run on my bank) anyone can come into my bank and exchange a pound note for a pound of gold.
David Friedman, taking on his father’s call for a mixed commodity standard, suggests that fractional reserve banks would out-compete hundred percent reserve banks in a free market:
What makes people think fractional reserve banks are unstable, Friedman says, is that the banking system seems to have obligations that excede their reserves, so that when there is a widespread run, the system collapses. Friedman suggests that this concern is not grounded, because bank’s reserves are not their only assets, and so banks that hold such other assets can sell them for currency.
If the “turnover” in deposits (ratio of deposits to withdrawals) is relatively constant, with some seasonal peaks, is the problem not so much with the “fractional” nature of reserves, as it is with the nature of the assets comprising the “reserves.”
Do we not, in fact, have problems mainly with the reserves for valuations of assets rather than to meet the flow of funds requirements?
A closer study of Interbank Borrowing might give a clearer view of the issues that have arisen. The Banks, unsure of their own reserves became convinced (with faith yet to be fully restored) that others had no clue as to their own resrve values.
@ Ian re:
I don’t have any idea what it would trade at, or if it would trade at all. Fractional reserve banking is a beast of a subject… The fact of the matter is your notes have a non-zero chance of becoming irredeemable.
This is a false dichotomy. The choice is not between lending or not lending. It is about lending money deposited for an agreed amount of time and lending money that can be demanded back at any moment.
Promising the same money to two different people at the same time is fraud. One of the people must defer to the other one. To make a micro-model, if for you to write a check to pay cash for a new hot tub requires someone to make an extra mortgage payment to keep the bank solvent, there is a problem. The system we have now is exactly that and the only reason it works is because statisticians have (at least until now) successfully calculated how many people will want to pay cash for hot tubs at any given moment.
Remember, fractional reserves are calculated against demand deposits. It is entirely reasonable to expect lenders to lend 100% of non-demand (contracted) deposits within the time frame the deposit is contracted for.
All I am asking for is the very reasonable requirement that a bank may not make contradictory promises to two different persons. One of them must be informed that his rights to the money are contingent on the others’ performance.
Regarding Bank of IanB at 50% reserve and Bank of DavidZ at 100% reserve – the notes would cash in at parity, the hedging would occur in the interest rates that Bank of DavidZ had to pay his contract depositors versus the interest you had to pay your demand depositors. And Bank of DavidZ would pay no interest at all and probably charge a fee to his demand depositors. Bank of IanB would be ethically required to inform its demand depositors that they may not be able to get all of their money out on demand. You would likely both have customers with different financial goals.
The problem is entirely one of promising the same money to be available to two different parties at once on the assumption that they won’t both ask for it at once. As long as one party clearly understands that they are in line behind the other party, no problem. Because we are in a compulsory single bank procedure/currency/FDIC system, competition between banks is all toasters and teller windows. In a non-monopoly environment competition would be genuine and probably cut throat.
I think the “fraud” thing is a bit of a red herring. There’s no secret how the banking system works and it’d be clear to any customer that if they’re being offered interest the money is being loaned out. The bank is a loan broker. All they’re doing is offering a sweetening convenience that you can take the money out at any time and stop it being loaned out, effectively- and under excpetional circumstances you may not be able to get it back immediately. Effectively an FR bank are a loan brokerage who have a sufficient diversity of business that they can allow the lenders (to them) to start and terminate lending arrangements in a random access manner. I deposit £100, they loan most of it out to earn me and they interest, when I “demand” it back I’m just cancelling that arrangement on that.
Under the nationalised/corporatised system we have now a promise is made that may not be kept, but a private fractional reserve bank/”random access loan brokers” wouldn’t be making that false promise. The customers are simply earning a profit in return for accepting the risk that the brokers will fuck up and lend all the money to people who can’t pay it back. But then, a brokerage using a timed deposit system can make the same mistake.
Under free banking banks who offer interest by loan brokering will be more attractive to most than those who charge for safekeeping. So on that basis we may as well accept there’ll be lots of credit, some malinvestment, occasional herd behaviour driving many bank/brokerages over the cliff edge at once, and our dream of a non-busty economy doesn’t look so hopeful, though we can expect it’ll be less busty than the present one without central banks. So far as I can tell. As Johnathan says, wise depositors will learn to spread their risk.
Ian –
All else being equal, sure. But all else isn’t equal – a loan intermediary and a warehouse are two completely different businesses with two completely different sets of customer needs/expectations – this is like saying that “in a free market, bakeries will be more attractive investments than foundries,” it’s an apples-to-oranges comparison.
Another way of looking at it is to think of FRB as money backed not by Gold but by Debts. Debts are an asset, and just like Gold, they can change in value.
In principle, if customers start withdrawing more Gold from the bank than they have on hand, the bank can sell the Debt to other banks for Gold. The problem occurs because the customer has been promised a fixed quantity of Gold, so if the relative prices of Gold and Debt vary with respect to one another, the bank can find itself caught short. And fairly obviously, trying to sell a huge amount of Debt on the market during a run is sure to lower its price.
But Debt is nothing special in this regard. The problem of bank runs would apply if it was invested in Platinum or anything else. If everyone turns up demanding Gold, or the price of Platinum drops too low, the bank won’t have enough.
All forms of currency have to be backed by something. Fiat money is usually backed by a portion of future taxes. Debt money is backed by the promises of debtors to repay. Commodity money is backed by lumps of stuff. None of them come with any absolute guarantees.
There are enough different varieties of scrip around that I think some sort of market could exist in principle, even now. The government doesn’t maintain a complete monopoly on printing the stuff. But running a scrip or currency is harder than it looks, and a lot of people who try it end up messing it up. Not enough people accept it, or its value becomes unstable, or people start hoarding it, or whatever. I don’t know.
Ian, without FDIC, a fractional reserve bank meets all of the definitions of insolvency. Its liabilities (demand accounts) vastly exceed funds available. The only way it can be called solvent is for the loans and deposits to be contracted for the same time period (and either no or only covered defaults).
There is no fractional reserve bank even theoretically possible that can honor all of its promises in a run.
Really? How many Americans know that their bank only has one dollar for every ten they deposited? How many know that the real purpose of FDIC is not to protect against bad bank loans, it is to protect against runs against even ‘good’ banks? How many know that without either Fed system or FDIC support there is not a bank in the land that can honor all of its demand accounts. By a factor of 10!
If they called it a demand account and not a restricted withdrawal account, then that is a completely false promise.
When Bank of IanB says they are selling the same checking account features as Bank of DavidZ, that is a fraud. What they are really selling is at best a promise that you can withdraw 10% of your checking account at any time and most of your checking account most of the time.
A huge General Motors plant just closed in my county along with a constellation of other businesses serving it. If my county were the extent of the banking system (or the entire nation faces the same fate together) then when all those newly in synchronously unemployed try to spend down their accounts at the same time, just when they need it most, they find out that it is only available 10 cents on the dollar, come back when things get better. Add to this the fact that a lot of mortgages will be failing, even that 10% reserve soon falls by the wayside.
If those people (who have been listening to rumors of plant closure for quite some time now) had put their money in Bank of DavidZ, they would not be expecting their contracted deposits and their demand deposits would be there waiting for them.
Just to make clear, I am not advocating outlawing fractional reserve banking. But clearly the wrapper has to say “Only 10% of deposits withdrawal assured. The remaining 90% is only available at the bank’s option. Depositor beware.”
Mid,
It’s more than 10%, because the bank can sell its Debts. How much more depends on the circumstances.
I’m trying to keep it as simple as possible.
Speaking of banks trying to sell their debts, I would really like to believe that Senator Schumer is telling the truth when he says he had no idea that if he caused a run on IndyMac, major donors to senate Democrats (who just happened to be friends of his) would make a windfall picking through the scraps. I would like to believe he didn’t know they already had people in IndyMac evaluating it assets. I would like to think he knew nothing of the contents of the email 4 days before he triggered the collapse. I would like to believe our politicians would never do that. Do you think they would?
You are completely right. It depends on the circumstances.
Midwesterner –
There are, of course, two definitions of “insolvency.”
The inability to meet obligations as they mature.
The excess of liabilities over assets.
Under the scenario you cite, one would have to disregard the assets held (or determine them to be of inadequate value).
In the original purposes for the establishment of the Federal Reserve System (but not in its subsequent poilitical uses [the legislated Sarbanes-type full employment “policy”]) the problems of liquidity were met with the availability of discounting loans held at the “window” of the District Reserve Bank, which would be under no pressures of “maturity.”
In fact, there is a good prospect that the current problems could be better sorted out, if not solved, by lowering the “reserve requirements” (which are entirely arbitrary extrapolations of what is “needed” for a bank’s functions) rather than the lifting of “mark-to market” rules for cash flow valuations.
The “correction” of the Commercial Paper market is not often referrenced, but, it should be noted.
Whilst it might be preferable to have what Hayek described so well, it is not to be; anymore than there will be a correction to the qualifications of the electorate.
Of those two types of insolvencies, the liabilities over assets is what would happen on bad loans. That is not what I am focusing on since it is not unique to fractional reserve.
On the other hand, “The inability to meet obligations as they mature” is a real problem as by their nature demand deposits have continuous ‘maturity’, that is they are perpetually in need of availability.
There is a warm nitroglycerin sort of problem with using ‘the window’ to provide liquidity. As long as the Fed loan is payed back, the money comes back out of circulation. But if any of it is defaulted on (something almost unthinkable not too long ago) then that money moves out of M3. At this point I think it becomes unrecoverable and a permanent, irreversible inflation factor. Not a problem on a small scale but considering the loan is not part of a bank reserve, once inflation starts, its full multiplier effect hits the economy if it has not been payed back.
I much prefer to see surplus reserves moved around between banks but that doesn’t work in the case of synchronized runs like happen in a collapsing economy.
And in any case, with fine upstanding criminals like Schumer, Dodd and Frank regulating the banking system, I just want free competitive banking out of the reach of Rent-A-Senator® manipulations.
PA, you’re right when you say that nothing is guaranteed, but this is an interesting and important admission here:
A debt does have value, and in proportion to the likelihood that it will be repaid, etc. The difference is that the banks have the unique privilege of being able to monetize debts, that is, they can create pure debt instruments out of thin air! I say “pure debt obligation” because in-fact, the bank has offered none of its own skin to the game. They have risked exactly nothing, in order to create that money, which lent to you, earns interest in repayment.
Anyone else desiring to loan money, must first save and accumulate that money. What they loan to others can never exceed what they’ve previously built.
David Z,
“Anyone else desiring to loan money, must first save and accumulate that money.”
Nope. Anyone can borrow money, and lend it out at a higher rate.
In fact, another way of looking at bank deposits is to think of them as loans to the bank. (Legally, I think they often actually are. The ‘warehouse’ model would be what lawyers call a ‘bailment’, and would indeed forbid secondary loans or conversion to other forms of asset.)
I think one problem I see with the anti-FRB Rothbardian arguments (and at this stage I’m not being pro- or anti- so much as arguing that it’s gonna happen, so we have to live with it) is that they seem to tend into a dangerously paternalistic area symptomatic of the Left. They seem to end up saying that ordinary people are not capable of judging the risk, and that somebody wiser (the state?) needs to warn them off, which is pretty much the same as the whole leftie “people in free markets buy things that aren’t good for them/are misled by evil advertising etc” attitude.
It Rothbardians want the state(?) to take an active role in discouraging banking with FRBs, why stop there? It’s difficult to argue that people should be free to kill themselves with tobacco or ride dangerous motorbikes if you believe they can’t be trusted to judge a rather straightforward financial risk.
Based on supply and demand, what happens when a bank has to dump its debts on the open market for sale?
Supply goes up, demand remains constant, ultimately, it sells the debts at a lower price than originally valued. So it still doesn’t get enough money to return to the depositors.
Give depositors a choice. As it stands now, virtually every person on the street believes he can get his money back from the bank at anytime. Few realize that their money is at risk the moment they put it into a bank.
Only a small fraction of the population understand the dangers of the current system. That they are suffering from ridiculously low interest rates in return for such exorbitant risks.
Yes, one of the flaws of the Rothbard essay that I linked to is that he seems at times to be fierce in asserting what he considers to be “true” banking as opposed to the fraudulent version. But as long as FRB banks are honest about their status, and they do what they say on the tin, so to speak, it is not as if this is a fraud.
It would be interesting to see what would happen in a free market with different banking models competing alongside one another. Take away legal tender laws, remove compulsory deposit insurance and other moral-hazard interventions, and my guess is that FRB would still operate, and during boom times, it would probably suck in a lot of money. During the first signs of stress, however, one would expect to see a rush into 100% reserve banking unless the FRB folks had good insurance. A whole new arbitrage market would develop.
In this sense, a market in private currencies would be a bit like computer software. Some forms would become the dominant standard, like MSDOS; I wonder how long some banks would scream for anti-trust legislation to prevent “unfair” competition?
PA, FRB is obviously not bailment, but the problem is that it’s not strictly a loan, either. It pretends to be both.
Under free banking, if you loan out half of your deposits, and those loan checks clear my bank, I’m going to demand redemption immediately, entirely wiping out your “reserves”. At best, you could cover 50% of your depositor’s claims.
A technicality, sure. (also note that in a truly free market, arbitrage opportunities are few and far between!)
The point is that the loaned money has to come from somewhere, from prior accumulated savings. And the person lending the money must accept the risk that the loan will not be repaid. And during the time for which the money is lent, the lender can’t use it!
It would be one thing, if banks simply were lending intermediaries, but the nature of things is that they’re not. Especially with the backing of central banks, they quite literally loan money into existence.
This is how I look at it…
A fractional reserve bank should not be able to legally call one of it’s accounts a “deposit” account. Nor should it be able to say it’s notes are redeemable on demand. It may be able to meet it’s commitments even during a run by calling in debt, this is hardly “on demand” though.
Rather, it should say that it will make its best efforts to redeem its notes on demand. They must state that in some circumstances they will have to wait for loans to be unwound before they can pay out.
This idea was suggested in the 18th century but not properly implemented. I think it makes sense.
I don’t think that if free-banking were implemented customers would do foolish things. They would look at the amount of money they need for variable week-to-week expense and say “I want that on deposit”. They wouldn’t risk fractional reserve for that amount. For the rest though they would loan it out or keep it in fractional reserve (which is really the same thing).
David Z,
It’s a loan that looks and acts like a bailment most of the time. Enough to fool people, maybe.
My point is that there is no fundamental difference between backing my bank with Debts or Commodities or anything else. If you deposit $1000 of Gold in my bank, and I invest half of it buying Platinum, thinking its price is going to go up with respect to Gold, and you immediately walk in demanding your Gold back, I’m going to be stuck. Yes, I’ve got a vault full of $500 worth of Platinum, but that wasn’t what you asked for. Maybe you think it’s going to go down in price, and don’t want it. Maybe I can sell it and maybe I can’t. My point is that while doing this sort of thing is taking a risk, and it’s true that a lot of people are unaware they’re taking, it’s not quite the outrageous Ponzi fraud some people are making it out to be.
“A technicality, sure. […] The point is that the loaned money has to come from somewhere, from prior accumulated savings.”
It’s more than just a technicality. It’s the exact same mechanism by which the banks do it. Loaning money you’ve borrowed creates money, and in a small-ish closed community you can quite easily make ten times more of it than you started with.
There are things banks can legally do that you can’t, and it’s true that if you try the above on a larger scale you’re liable to come to the attention of the Authorities, but the money-creating aspect of FRB is not a special power the banks are specially-licensed to have, it’s an inherent feature of simple borrowing and lending. On a small scale, anybody can do it.
The problem is not that they do it, but that they didn’t (and can’t) calculate the risks and value the assets correctly. It’s like any investment: if the market price of all its assets drop, the bank goes insolvent. Where they went so badly wrong is in thinking that you could get round this by tying them all together, so risks were diluted into triviality by the inertia of the whole financial system. It doesn’t work – it just means that when it crashes, everything crashes.
Attempting centralised control of a monolithic system – that’s one of the roots of it.
“the problem is that it’s not strictly a loan, either.”
Yes it is. Looks at any bank’s balance sheet (here’s a link to Wells Fargo’s, but that’s just an example), and you’ll see that the very first item in the “Liabilities” section is deposits. Every bank views its deposits as loans which must be repaid.
The problem with this whole debate is that it conflates “reserves” with “equity”. “Reserves” are merely cash on hand (or in the vault), available for withdrawal when needed, and they should be based upon anticipated normal demand. (That’s not how it’s done, of course, since our FRB system specifies a fixed percentage, which is easy to manage but makes no sense. But that’s a flaw in implementation, not concept.) The rest of the bank’s value is in other forms of assets, which (has already been pointed out) can fluctuate in value. That’s why banks also have capital ratios (there are several different types, calculated in somewhat different ways), which is supposed to absorb losses should the loan assets decline too far in value. If banks need more cash to cover withdrawals than is in the vault they have many ways to generate it (including borrowing “overnight” from other banks, secured borrowings from the Fed’s Discount Window [such borrowings must be collateralized by a pledge of loans], or selling loans outright). In an absolutely worst-case scenario there’s deposit insurance, which (as has been discussed ad nauseum elsewhere on this site) has its own problems but nonetheless is a functioning system. That’s why there have been no runs on insured institutions.
Unfortunately, in the current extraordinary financial environment selling loans isn’t a viable option for most banks, because that market is in total gridlock. The fundamental problem is not with FRB per se, but rather with “mark-to-market” accounting, which fictitiously wipes out equity capital by demanding that perfectly performing loans, which the bank has no intention of selling, be written down to a hypothetical value in a non-existent market. Totally irrational. Fortunately, just today the FASB (finally!) loosened those rules, which should greatly help stabilize the market for bank stocks. That’s the first sensible move since this whole crisis began last summer.
PA: “Loaning money you’ve borrowed creates money”
No, it most certainly doesn’t “create money” any more than if I were to loan someone my own money. All it does is transfer it from one person/place to another.
Just in the interest of clarity, how do you categorize the ‘run’ on IndyMac bank. [my underscore]
I’ve said before and still hold that this system can only work up to a certain threshold of banks facing runs. But if the pattern of runs flashes across the banking system, the Fed window or FDIC monitization will be like nothing anybody has imagined, much less seen. The resulting inflation inherent in the money multiplier impact of that Fed money (created out of thin air so that Fed/FDIC can meet the demand deposits) will devalue all bank portfolios relative to CPI type measures and the only solution I see coming from the central bankers is nationalization of the financial services industry.
We will see overnight, an entire nation’s banks reopen as [insert bank name here] Federal Bank.
Do you doubt me? How certain are you? 🙂
“All it does is transfer it from one person/place to another.”
And also creates an obligation to pay it back, which constitutes new money.
I’m not sure what you think money is, (or how it arises as a general medium of exchange and store of value out of barter transactions) but the obligation to repay a loan is not “money”.
Laird, an aside:
Are you saying that the reserve requirement should have been flexible?
“I’m not sure what you think money is,…”
Then I shall try to explain. As I’m sure you know, barter is an exchange of something of value for something of value. But it is often difficult to find traders with exactly matching needs so sometimes you conduct a barter-type trade in two parts, where A gives goods to B, and then at a later time B gives goods to A. Before and after the trade, everybody knows where they are. But while it is in progress, matters are out of balance. Money is the representation of this imbalance, reflecting the unresolved obligation B has to complete the trade with A. Every time such a transaction is started, money is created, and when it completes the money is cancelled out.
Let me give you a longer example, since this is such an important point, and is admittedly quite hard to understand.
Alice loans Bob $1000, unsecured, at low interest. Now Bob has £1000 cash, and Alice holds a $1050 debt owed by Bob. (The value includes an estimate of the interest to be paid.)
Charlie wants a new lathe to run his business. He borrows $900 off Bob, and pays it to Dave the toolmaker, who sells him the lathe. Now Alice has the $1050 debt that Bob owes, Bob now also holds the $1000 debt that Charlie owes and the $100 reserve, Charlie has a lathe (making him a tidy profit on top of paying back the loan) and a $1000 debt, and Dave has $900.
Dave deposits/loans the $900 with Bob, and the cycle starts again. Ellie wants a new training course, and takes out a $800 loan to pay Fred the teacher, who deposits the money straight back with Bob. Now Bob has all the $1000 cash, is owed $900 + $1000 in debts from Ellie and Charlie, and he owes $850+$950+$1050 to Fred, Dave, and Alice. He has $2900 in assets and $2850 in liabilities and everybody is a winner.
How can Bob possibly have $2900 in assets when there was originally only $1000 in the system?
There are several ways to look at this. The money might be thought of as representing the value of the lathe and training course, which are only actually transferred at the end of the transaction when Charlie and Ellie use their profits to repay the loan. Until then Bob effectively owns them, the debts he holds representing their value, and for Charlie and Ellie the debts owed cancel out the fact of possession. The transaction itself is considered to occur at the end of the period.
The other way to look at it is that the money represents the value of the future work of Dave and Ellie, the goods they produce and sell to be able to repay the loan. The transaction is considered to take place at the start of the period, Bob takes ownership of the fruits of Dave’s and Ellie’s labours in advance, and the debt he holds represents its value.
(Incidentally, fiat money is backed by future taxes – as I said above – in the second viewpoint, but is backed by the goods produced and work done by government contractors in the first. Just thought I’d clarify that.)
A third viewpoint is that at the start of the transaction two new entities are created that themselves have intrinsic value: the debt owed, with negative value, and the IOU – the money – with positive value. By creating them both at the same time, everything still adds up, but now the money has a value separate from the goods it is backed by (by whichever convention). Now there are two transactions, one at the start of the trade and one at the end, each of them a simple barter.
(There is even a rather fun fourth viewpoint that says a debt owed is simply money travelling backwards in time, and that the debt/money pair is only a single bit of money that loops. This is, to say the least, not the current academic orthodoxy in economics! 🙂 )
Which viewpoint is the right one? Well, to some degree it’s just a matter of the way you look at it, with no real physical difference in them. The first (the one that you apparently favour) has great merit, and is historically the oldest, but it has its limits. Most people think of the value of money in terms of what you can buy with it, not what you had to sell to get it. The third (and fourth) have the advantage that they can cover the case of a loan being taken out and repaid, with no other transactions taking place, as useless as that might be. Accountants use the third in double-entry book-keeping. When people talk about ‘inflating the money supply’, it is usually something like this they have in mind.
But whatever viewpoint out of the above you take, money is quite definitely a transient quantity, created and later destroyed by any sort of transaction conducted over an interval of time. And everybody has the same ability to do it as the banks. If you think the assets ordinary people create by making loans isn’t ‘money’, then neither is what the fractional reserve banks produce, with its “I promise to pay the bearer…” language. And if they’re not inflating the money supply, because it should actually be called something else, that’s the problem solved, eh?
Alisa, yes. Some banks naturally have a higher velocity of deposits than others. And there are probably weekly, monthly and/or seasonal fluctuations, too. The reserve should be based on rationally anticipated need, not an artificial percentage which, as far as I can tell, is not based on any empirical evidence. (Of course, in a regulated system I suppose a floor reserve level wouldn’t be too objectionable.)
Mid, you’re right about IndyMac Bank; I stand corrected. But there were extenuating circumstances (thank you, Sen. Schumer), that is the only one in a very long time. Several dozen other banks have failed in the last two years, all without public panic.
Thanks Laird, that makes sense. Needless to say, by its very nature any such flexible system wouldn’t bode well with any kind of top-down regulation:
Isn’t that exactly what we have now?
Sort of. A bank could certainly keep a larger reserve, but I don’t know any which does. If one finds that it has more cash on hand than required it immediately lends it (via “overnight funds”) to other banks which are short. Calculating the “proper” amount of a reserve would be tricky, of course, and institution-specific, which is why the regulators don’t (can’t) do it; it’s of necessity a “one-size-fits-all” system. With private deposit insurance, though, the insurer would have every incentive to calculate a more appropriate reserve level (higher or lower), as well as keep a closer eye on lending policies, loan quality, and other measures of a bank’s health. That’s partly why I favor privatizing deposit insurance.
Sort of? More like “precisely”, no? Of course banks loan out anything above the required reserve – that is the nature of the beast. Banks are in the business of making profit, and loaning money out makes them profit. They don’t care about the wider consequences, and they shouldn’t. (They also don’t care about the long-term consequences to themselves – which they should – because of the existence of FDIC). So the way I see it, this is a case where a particular piece of regulation is not evil, but simply ineffective in and of itself. It is pointless. Indeed, private deposit insurance is the only way this could work.
It is important to keep ulterior motives in mind. Notice in this story that the bank was basically, “under threat of a damaging public audit”, threatened with a run if it did not except the funny money.
He/they will nationalize all financial services, every single bank, if we allow it.
I fear you’re correct, Mid. And if that’s successful, what industry will be next? Automotive? Steel? Pharmaceuticals? Health care, of course. None are safe.
I was going to have a rant of my own here – but I have decided not to.
What I will say is this:
Please read both sides – read Kevin Dowd (and the fractional reserve “Free Bankers”) and read Rothbard and De Soto.
Then make up your own minds.
About Scotland, Chile, or other examples.
Pa, no individual is able to borrow money into existence from the Fed. Also, I think there’s some confusion with regards to circulation of money vs. creation of money.