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The Kevin Dowd lecture on free banking

As promised, I have some thoughts following on from the talk given by Kevin Dowd, a professor at the Nottingham University Business School and a noted advocate of what is called “free banking”. He gave his talk at the annual Chris R. Tame Memorial Lecture as hosted by the Libertarian Alliance. (The LA was founded by Mr Tame, who died three years ago at a distressingly young age after losing a battle against cancer.)

Professor Dowd covered some territory that is already pretty well-trodden ground for Samizdata’s regular readers, so I will skim over the part of the lecture that focused on the damage done by unwisely loose monetary policy of state organisations such as central banks, or the moral-hazard engines of tax bailouts for banks.
Instead, I want to focus on those aspects of Professor Dowd’s talk in which he tried to sketch out what a laissez faire, free market banking system would actually look like. This is essential; a great deal of commentary so far – while it is very good – has mainly focused on how we got into this fix and why the fixes being attempted by Western governments are proving so stupid. As PJ Rourke said recently, the attempt by the Obama administration to flood the market with cheap money as a “solution” is a bit like the case of when your Dad has burned the dinner, so you ask the dog to cook it instead. No, what Professor Dowd did this week was lay out three broad areas for reform.

Firstly, he says we should remove many of the existing regulations, government-mandated deposit protection schemes, bank capital adequacy rules and other restrictions on what banks can do and how they work. For example, government support for depositors – who are also effectively creditors to their banks – means that there is a moral hazard problem; the banks have less incentive than they would otherwise have to act prudently if there is always the government, acting like a sort of 7th Cavalry, able to ride to the rescue. That has to go. Professor Dowd also wants to hack away at the morass of rules and regulations that violate client/banker confidentiality, or those rules that force banks to lend to people, as is the case in the US, where banks are forced to lend to certain groups or else violate laws about racial discrimination, etc.

Secondly, Professor Dowd addresses the issue of letting banks fail. At the present, policymakers adopt a sort of “too big to fail” doctrine; this doctrine, while not explicitly laid down in any form of statute or operating manual – as far as I know – is a rule that says that some institutions are so large, and the attendant systemic risks posed by their failure so catastrophic, that they should not be allowed to go out of business. The problem of course is that this rule of thumb is often arbitrary and subject to political horse-trading. To wit: the US government’s decision to let Lehman Brothers go down last September, followed shortly by the $85 billion bailout for AIG, showed a total lack of clear message to the markets, and to bankers, one way or the other.

Professor Dowd believes that banks should be allowed to fail and furthermore, if modern limited liability laws were weakened or abolished completely, then such massive conglomerates would be economically and legally unsustainable in the first place.

As a result, banks would probably be smaller, and there would be a lot more of them, so the failure of any individual bank, while unpleasant for some, would not wreck the system as could happen if a mega-bank goes wrong. Also, instead of wide-ranging and hideously expensive bailouts, Professor Dowd favours putting banks into administration, writing down, in full, the value of their loan books, and getting depositors to exchange their status as creditors for that of an equity holder.

This “debt for equity swap” arrangement, while it would anger depositors who lose money, would come with the promise, and hopefully the reality, of a rise in the capital value of their equity stake in a bank if confidence returns to a more robust banking sector, as the debt/equity swap recapitalisation is designed to achieve. And of course banks are entirely free, as are their clients, to take out deposit insurance in a commercial market.

The third leg of his solution is broader, and more long-term, although there are some immediate measures that could be taken. Professor Dowd is against fiat money – money not backed by actual commodities or real assets of any kind – and in moving to a commodity-based/asset-based system. He is not, by the way, necessarily arguing for the gold standard or some gold-based system, although he points out that in the 200 years up to the First World War, the UK enjoyed a remarkable period of stable prices, with the odd blip. What he is arguing, however, is that the message on a banknote that says “I promise to pay the bearer on demand the sum of X” should be an enforceable legal contract, not what amounts to the jeering joke that it now is.

In the subsequent Q&A session afterwards, one person made the excellent point that a simple reform would be to ban legal tender laws. Such laws currently require a person to accept as legal tender a currency that the state has mandated for a particular region. Instead, if a person wants to refuse to accept sterling and only wants to accept dollars, euros or Swiss francs instead, he can do so. He can also choose to trade in whatever medium of exchange he wants, and with whoever wants to accept it.

Inevitable questions arise. First of all, in thinking about free banking, private monetary systems and the like, the first objection will be is that this will be very messy; there has been no real experience of such monetary systems in the past, etc.

But this is incorrect. Free banking, as defined by Professor Dowd, in fact operated in Scotland, for example, up until legal changes in 1845. South of the River Tweed, the English system had operated under what amounted to state-controlled banking under the Bank of England, set up in 1692. In the 18th and 19th centuries, England saw a number of booms and recessions, such as the 1840s railway boom and the downturn of 1870s. One should remember that the BoE was established by the-then post-Glorious Revolution government as a way to raise money for wars without having to keep asking a fractious public for taxes, and without having to borrow at expensive rates in the money markets. N.A.M. Roger has explained this issue of financing for naval warfare brilliantly. Indeed, it reminds us that state monopoly money systems typically arose in order to finance wars, while the welfarist aspects came later.

There are also current, not just old, examples of banks that operate with unlimited liability partnership structures – Pictet, the Swiss bank, and Lombard Odier, are just two examples. There are dozens of such banks using these structures in Switzerland and by no coincidence; they have avoided the worst of the credit crunch. These banks are typically for the rich but it seems to me that there is no logical reason why such an approach could not be used more widely. So there are different ways of doing banking right now. And do not forget the humble UK mutual building society: they have their limitations, but as a business model they had a lot to recommend them.

Another objection might be that the debt-for-equity swap way of restructuring failed banks under bankruptcy protection laws would be politically unfeasible, since depositors would be hit. I understand that, but Professor Dowd is not trying to imagine what sort of reforms would appeal to David Cameron, say, but what sort of reforms would be workable. That is a rather massive difference, as I am sure readers will agree.

Another objection is that “real money”, as opposed to the state-arranged fiction that we have now, cannot work for as long as governments take such a large slice of GDP. That is probably correct. One of the reasons why so many advocates of Big Government regard “gold bugs” or free bankers as dangerous nutters is that they realise their welfare states would be unworkable under such monetary arrangements. The Ponzi schemes of most welfare states would not be able to function. Even so, as long as governments retain the ability to tax, they have the ability to raise debt in the financial markets in the knowledge that their collateral can be collected at the point of a gun. But a real-money system still hampers such activity considerably.

In the longest run, the best hope of avoiding such financial disasters in the future is to wean the public and policymakers off the seductive delusion that one can create wealth by turning on a printing press. Sooner or later, if you try to fake reality, it bites you hard in the arse. Of course, it is a mark of the kind of man Professor Dowd is that he is too polite to put it as bluntly as that.

I await comments!

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56 comments to The Kevin Dowd lecture on free banking

  • It sounds all very interesting and I really wish now I had been there as the other event I was at did not afford me the opportunity I had hoped to grab my local Oxfordshire MPs and try and sell them my idea for a “Bank of Oxfordshire” using, believe it or not, partnerships and asset based scrip.

    I particularly like his ideas about what to do now, practically speaking, because I guess I always focus on the “hereafter” policies of competitive currencies and so on which are probably still a bit far up the Overton window for most peoples’ comfort.

    There was an interesting piece about C Hoare & Co in one of yesterday’s newspapers just so people recall that there is at least one UK based bank on an unlimited liability model.

    Was any mention made of Gesell, WIR Bank and similar alternative structures that often started up in the Depression and some of which, such as WIR, are still going from strength to strength?

  • RobertD

    Firstly thank you for organising an enjoyable evening and thought provoking talk.

    One additional area that will be critical to moving in the direction of free banking is reform of the insolvency laws and procedures. However desirable it may be to put a bank into an enforced reconstruction the law, particularly in England, makes it impossible to complete in a realistic time scale. The timescale for advertising ceditor claims, the lack of sufficient powers of an administrator to cut a deal amongst creditors and make it stick without protracted legal action, and the absence of any legal recognition (in statute or precedence) of priority for the counterparties of many of the new financial instruments mean that any administration process under current law would take months or probably years to resolve. A bank will go under if the uncertainty lasts more than a few days.

    Sorting out the legislation and enforcing the current competiton rule to break up the major banks into more managable units will be preconditions of Prof Dowd’s approach.

    A further and slightly off topic thought. The Sarbanes-Oxley laws in the US require CEO’s and CFO’s of companies, including banks and other financial institutions, to sign declarations that their organisation has fully effective internal controls, the records are complete and accurate, and that the financial statements can be relied upon. Clearly these representation for AIG, Citibank and other were patently false. Why are there no CEOs and CFOs in handcuffs awaiting trial??

  • Laird

    It certainly appears to have been an excellent talk; I look forward to seeing a video of it.

    Johnathan’s summary mentions two points which I think could be implemented fairly quickly and do much to improve on the current system: repeal of “legal tender” laws and elimination of deposit insurance. The former is fairly straightforward and explained in the article. The second bears more discussion.

    Deposit insurance (in the US, anyway) is an artifact of the Great Depression, installed to prevent catastrophic “runs” on banks, sometimes sparked by mere rumor. It was (and is) a legitimate concern, and while the problem is exacerbated by a fractional reserve system (as I’m sure Paul will interject here at some point), it would also be a problem even without fractional reserve lending. The US’s solution was to create a new federal agency (the FDIC) to run the insurance fund, and (not coincidentally) directly regulate most banks. Therein lies the flaw.

    The FDIC is staffed by government bureaucrats with no personal economic stake in the game. They are, by and large, decent and well-meaning people, but they aren’t the “best and brightest” (such people don’t work for bureaucracies) and they are hampered by hidebound rules and a lumbering, ineffecient and inflexible system. Insurance “premiums” are not established on any actuarial basis, but are essentially identical for all banks, however well or badly managed [1], and setting the rate is quite politicized. The proper response should be to use private deposit insurance.

    With private deposit insurance, banks could shop around for insurance companies with the best rates and service. The insurance companies themselves would more accurately and carefully assess “risk” than it would ever be possible for the government to do, and would price accordingly. They would set capital levels which make sense given the specific nature of the bank’s business (rather than one-size-fits-all rules), assess the true value of its assets and liabilities (including, where appropriate, off-balance-sheet contingent liabilities), and in general do a better job of assessing the because it is their (and their shareholders’) money which is at risk. If the FDIC misprices, the insurance fund gets depleted and they go to the government for more money. If a private insurance company misprices, its capital gets depleted and shareholders replace the management. Competition among insurance companies would keep any from becoming unduly risk-averse in their regulations or expensive in their pricing. It’s a true free-market solution, and would work.

    [1] There has been a move in recent years to incorporate some sort of “risk-adjusted” element to the premiums, but if this has actually been implemented (I’m not sure about that) the differential was essentially nominal.

  • Johnathan Pearce

    RobertD, you make a good point about the speed of administration process under existing English law. Prof. Dowd made the point that the debt-for-equity swap and recapitalisation of a bank would have to be done very fast, over a weekend. A long delay would be a disaster, in particular, because of the need for businesses etc to make payments and handle invoices, etc.

    Laird, thanks for the detail on the insurance angle.

  • mike

    I am delighted to see articles like this posted on Samizdata Jonathan – excellent, more in this vein as and when you can please.

  • Current

    This is the problem I see with insurance: How can an actuarial table be constructed?

    Do bank failures follow a known statistical pattern? Clearly not.

    I wouldn’t believe any private agency offering deposit insurance. Gold reserves are all that can be believed. At least until an actuarial table can be constructed.

  • Will Anjin

    Two questions:

    1. As Laird pointed out above, the bank guarantees were specifically made to avoid panics, wouldn’t the removal of these guarantees necessarily cause panics? With the advent of instantaneous communication available to even the stupidest among us, wouldn’t ‘runs on the bank’ become a regular event?

    2. Fiat money v. asset backed currency –
    With fiat money there is a good deal of leverage that is not possible with the asset backed. This seems to imply that under a asset backed regime the economy would be significantly less dynamic one, and growth could be curtailed. Yes, a blessing in the possible smoother booms and busts, but it would seem a curse in reducing growth, productivity.

    Looking at the historical rates of inflation / deflation it really appears that prior to the 1930’s, this cycle was much more dynamic than after: (UK) Consumer Price Inflation Since 1750(Link)
    I realize this study is a reconstruction and I have no way of evaluating the methodologies but it seems relevant.

  • Laird

    This isn’t life insurance; there are no “actuarial tables”. That doesn’t mean that the risks can’t be rationally assessed. How do you think an insurance company insures any one-time event? Lloyd’s has known how to do this for centuries (even if they’ve fallen off course a bit lately). [I need help here from someone with better knowledge than mine about probability; is this a Bayesian analysis?]

    Moreover, the real point isn’t whether there is going to be deposit insurance; that’s a given, after the experiences of the Great Depression. The only question is who provides it, and at what cost? I submit that government is the least qualified entity to do so, for a variety of reasons (some noted in my previous post). In a truly free market each bank would decide whether to offer it or not and the market would reward or punish that decision, but even in a regulated environment the government could simply mandate that banks carry some minimal level of deposit insurance as a condition to maintaining their charter. Banks could choose to carry more than the minimum amount, and again the market would determine whether or not that was a wise decision, but it’s still a market solution. (Probably a market would develop for banks with different insurance levels: minimal for those with relatively small balances wanting cheap banking services, higher for those with more money who are willing to pay a bit more for peace of mind. Let the market sort it out.)

  • Current

    Laird:

    This isn’t life insurance; there are no “actuarial tables”. That doesn’t mean that the risks can’t be rationally assessed. How do you think an insurance company insures any one-time event? Lloyd’s has known how to do this for centuries (even if they’ve fallen off course a bit lately). [I need help here from someone with better knowledge than mine about probability; is this a Bayesian analysis?]

    Some risks of this sort can be measured. The problem is that bank failure involves systemic risk. How can that really be insured against today? I can see no way.

    The problem isn’t like looking at the design, history and crew of a ship and deciding a premium, as Lloyds do. It’s far more complicated.

    Until it had proven its worth I would not trust any bank that said it had “insured” my deposit. What if three other banks fail and the insurer goes bust? How would I know if the insurer could be trusted and is good for the money?

    The only real insurance is the gold reserves themselves.

  • Midwesterner

    The problem is not fractional reserve per se, Joe and Susie can bank using anything they want. The problem is that I am criminalized for not using central bank fiat-fractional reserve notes. If supporters of fractional reserve will leave me alone to bank with whomever’s currency I please, I will be blissfully disinterested in their games among each other.

    I personally would not use a fractional reserve banking system unless I was speculating on the integrity and intelligence of those administering it. For my personal use I would chose something that is based on contract-deposit lending and backed by something more than paper and ink.

    But this all leads back to why a redistributive government will never allow currency competition. The redistributive system could not possibly survive. It is not just a convenient coincidence that the Income Tax waltzed in on the Federal Reserve’s arm. Without a central bank, the taxing structure will break down completely. There is simply no way to exact a tax on a hundred or more fluctuating currencies, metals, elevator chits for grains or refinery chits for fuels. The National government would have to revert to a federal government.

    Some points. There can be no fractional reserve system without deposit insurance. It has almost nothing to do with bank management. NO bank can survive well planted rumors that cause a run on the bank. By definition a fractional reserve bank will only have a fraction (in the US case 10%) of its demand deposits available for withdrawal. Any argument against deposit insurance or even for ‘market valued’ deposit insurance is ignoring the extortion that is possible when a bank, by design, cannot cover its demand deposits.

    Second, ‘too big to fail’. It is not the banks that are to big to fail. It is that 90% fraction of all money that could disappear from the economy if all demand deposits were closed in a panic. No matter what you think I suspect everybody agrees that cutting the money supply to 1/10 of its previous size is a cataclysm. What the central bankers (Fed/Treas) are doing when they bail out banks is not bailing out specific banks, they are trying to prevent a run on the fractional reserves held in all banks. They are trying to prevent a contraction in the money supply. They are trying to defend the dollar itself. The best managed bank in the nation that has written only the most sound loans is still vulnerable to a run. Yes the first institutions to fail are generally incompetently managed, but the last to fail will still fail if there is a run on its deposits. It doesn’t matter how many and how small the banks are, even if they are optimized with bullet proof loans, if the bank is at the 10% fractional reserve requirement they still must pay out 900% more than they have on hand during a run.

    As far as whether currency is backed or standardized to gold, silver, oil or blue cheese, I don’t care. What I do care about is that I get to choose which currency I use and not be locked into the central banking/taxing authority’s scheme.

  • Chris

    The logic of the Internet is the cutting out of the middleman,and credit intermediaries aka Banks will not be immune.

    I had this published in the US recently on the subject

    http://www.policyinnovations.org/ideas/innovations/data/000085

    The beauty of a Peer to Peer model for banks is that they would no longer have to put capital at risk by creating credit based upon it.

    Instead they may act as a service provider providing banking services to the users of a networked “clearing union”.

    As Jock said above, there are existing systems which point the way, in particular the Swiss WIR.

  • Johnathan Pearce

    Mike, many thanks. It took me a bit of a while to do this post, but I am glad that you guys find this worthwhile. It is good to try and do something a bit more constructive than just rant about the latest ghastly development, clampdown on liberties, etc.

    Will: I don’t see a “real money” system being less congenial to entrepreneurship or growth than a fiat money one. If financed out of real savings, such growth, precisely because it will not be hampered by boom-bust cycles and attendant mayhem, will be more substantial and lasting over the long run. The Industrial Revolution in the UK and US, for instance, occured without central bank funny money.

  • Thank you for the effort required to analyze and share this talk. Important points:

    1) “if modern limited liability laws were weakened or abolished completely, then such massive conglomerates would be economically and legally unsustainable in the first place.”

    2) Commodity based money would be feasible using futures markets for pricing – timber could be valued in winter wheat, or any other commodity – algorithms would not need to be overly complex.

    Some points missed?

    A) There is also a moral hazard to depositors in the banks, their comfort with protections absolves them of utilizing due diligence in where they place their money. Well connected banks are seen as fungible by retail depositors.

    B) A forced debt for equity swap is interventionist and subject to being “often arbitrary and subject to political horse-trading.”

  • Johnathan Pearce

    A forced debt for equity swap is interventionist and subject to being “often arbitrary and subject to political horse-trading.”

    That is quite wrong. All banks, regardless of size or political connections, would be forced to go into receivership if they are insolvent. As for this being interventionist, it is a lot less interventionist than seizing money from taxpayers and forcing them to bail out a bank that they have used. Bankruptcy/administration procedures are an important part of a healthy free market economy in helping distressed companies to be restructured so that some of the assets can be salvaged and the rest put to more efficient use.

    We have to get from an imperfect present state to where we want to be. Getting there will involve some intermediate steps; not even a free market purist like Professor Dowd believes that doing nothing is the best course.

  • Laird

    I agree that there is a moral hazard implicit in deposit insurance, as BFU Rector states. However, I don’t see it as a significant risk as long as the level of the insurance isn’t too high. [1] Frankly, I see no societal benefit to requiring someone with $2500 in his checking account to worry about the solvency of his bank. Realistically, after the experience of the Great Depression (large-scale bank runs) we are going to have deposit insurance in some form, and I don’t see that as a bad thing. What’s important is the form it takes, and who provides it. In my opinion the least qualified entity to administer it is the government.

    [1] In the US it was set at $10,000 for a long time, then raised to $100,000 (which I consider to be too high). Early in the current “crisis” Congress raised it to $250,000, and now has “temporarily” made it unlimited. Obviously that’s a problem.

  • Given that the political class will never willingly bring about an asset-backed currency, it strikes me that talk of systemic reform is moot. So: what practical steps can individuals take to produce and safeguard wealth outside the current system? Local currencies? Trade based on gold, silver, and other assets? Peer-to-peer finance methods, as Chris outlines? Inquiring minds want to know…

  • Laird

    Excellent question, Peter. Could be a good start to a new discussion thread.

  • Brian Macker

    Hi Midwesterner. Long time no argue.

    I don’t know if you remember me from this thread.(Link)

    I had argued that participants in fractional reserve do not operate at an advantage to those who do not participate (in a free market).

    I think you accepted my argument.
    At one point you said “”Are you basing your defense of fractional reserve systems … ”

    I want to make very clear that I am 100% against fractional reserve banking not because it gives users an advantage, but because it is fraud as practiced now, or in Scotland back back before the early 1800s.

    The banknotes are fraudulent because they are in fact lottery tickets, and do not state so on their face. All lottery tickets should be printed with a face value that matches their odds of payout in the first place. So for instance if the NY lottery only pays 50% on each dollar gambled then the ticket that costs two dollars should be printed with a face value of only one dollar.

    The way fractional reserve banknotes worked the notes were denominated at the highest potential cash prize. Thus something that was worth fifty cents would be denominated as a fifty dollar note with ten percent reserves. This is deceptive.

    Likewise the bank depositor contracts are highly fraudulent. The implicit belief being that depositing money in the bank acts as an insurance of liquidity against hard times. When, in fact holding your emergency cash in a fractional reserve bank increases the risk that you will not have access to it at the very point when you are most likely to need it. It’s a exact reverse of an insurance policy.

    Fractional reserve banking is a kind of pyramid scheme and as such there is no loss in freedom if we just ban them. Freedom does not include the right to join a scheme that is guaranteed to defraud the person who joins unless they can find some other sucker to defraud.

    Anyone who thinks that fractional reserve as constituted in Scotland before the 1800’s is not fraudulent is just not sophisticated enough to understand how the scam operates.

    Any honest person who came to understand what a pyramid scheme entailed would never join one. He’d either recognize he was being exploited or he would recognize that to make any money he would have to exploit someone else. Obviously the scheme collapses with someone holding the bag when you run out of suckers.

    The exact same kind of effect happens with fractional reserve banking. It’s just a hell of a lot more subtle because the pyramid scheme has been mixed together with an actual investment scheme. Thing is that the pyramid scheme portion of the system is not even required for a banking system to work.

  • Laird

    “Fractional reserve banking” is not per se fraud. I’m sure you wouldn’t call it “fraud” if a group of people pooled their money for the purpose of making loans. That’s essentially what a bank is. Those loans aren’t liquid, and their repayment terms are defined by contract. The problem arises if the members of the group believe that they can withdraw their contributed cash at any time they choose. A bank wants to accommodate its customers but cannot accommodate all of them at the same time. The “reserve” is merely an estimate of the maximum amount people are likely to want to withdraw at any particular time. If done properly[1] it should be a pretty good estimate of the bank’s day-to-day cash needs. In extraordinary times that estimate loses its validity, but then so do most other ordinary rules of thumb. In such cases banks have alternative means of raising cash (participating or selling loans to other institutions, borrowing “overnight” funds from other banks, even borrowing from the local federal reserve bank [which is owned and managed by its member banks, not the government] or other “banker’s banks”). And that’s where deposit insurance comes in: it assures that whatever happens depositors’ cash (up to the insured limit) will be available if needed. This acts as a circuit breaker preventing runs, and as a result is rarely used.

    Please note that the “reserve” amount is wholly unrelated to a bank’s capital. The former is simply the cash in a bank’s vault; the latter is analogous to shareholders’ equity, but is at heart a regulatory construct and so is subject to political pressures and regulatory whims.[2] Much of the current banking crisis is driven by artificially (and, in my opinion, irrationally) marking down the value of loans and other assets most of which, over time, would be paid in full. The result is a regulatory-driven evaporation of a bank’s “capital” (however measured) which, if driven low enough, causes the regulator to declare the bank to be “insolvent” and close it. Private insurers would (it is hoped) be more rational in their calculation of a bank’s equity and less prone to force them into receivership purely on the basis of accounting conventions.

    But fractional reserve banking isn’t the unmitigated evil many here purport it to be. It is a legitimate banking model which (as is the case with so many things) has been perverted by governmental intrusion.

    [1] Of course, I’m not arguing that it is being done properly; it shouldn’t be a fixed number mandated by a regulator but rather determined by facts and circumstances of each individual bank.

    [2] OK, “whim” is probably too strong a term, but the point is valid. “Capital” is measured in a variety of ways, for different purposes, and the FDIC and the SEC each has its own views on what it is. Moreover, things which are counted as “capital” (which is now divided into several “tiers” of apparently differring importance) vary over time to reflect changes in the opinions of regulatory agencies and international bodies (as with the ill-conceived Basel I and II conventions).

  • Laird

    Technically, Basel I and II were accords, not “conventions”.

  • Brian Macker

    Laird,

    “Deposit insurance (in the US, anyway) is an artifact of the Great Depression, installed to prevent catastrophic “runs” on banks, sometimes sparked by mere rumor. It was (and is) a legitimate concern, and while the problem is exacerbated by a fractional reserve system (as I’m sure Paul will interject here at some point), it would also be a problem even without fractional reserve lending.“/blockquote>

    This is false. It rests on an omission. Thus a lie of omission if you are aware of the falsehood.

    The only way a non-fractional reserve bank could have a run is if it were fraudulently operating as a fractional reserve bank. In that case it would BE a fractional reserve bank in reality, and the run would be because of it’s actual nature, not it’s pretend nature. Since law would be in harmony with reality the bankers who pulled this trick would immediately be thrown in jail.

    Fractional reserve banking legalizes the fraud. So they would avoid jail.

    You are also underestimating the risks involved. Fractional reserve banking guarantees that bank runs will occur. It causes bank runs. Non-fractional reserve banking does not cause runs at all if you understand the word “cause”. The true cause of a bank run under non-fractional reserve banking would be illegal embezzlement.

    Saying it is possible for there to be bank runs with non-fractional reserve banking is like saying you can catch sexually transmitted diseases through abstinence. Sure, someone could rape you.

    Will Anjin,

    Your questions have misunderstandings in them.

    “As Laird pointed out above, the bank guarantees were specifically made to avoid panics, wouldn’t the removal of these guarantees necessarily cause panics?”

    What you are currently experiencing is what bank panics look like under a regiment of government sponsored mandatory bank insurance. There are still bank panics, and the banks still close. People still have to wait for their funds. The FDIC insurance system is underfunded and has to be shored up with extra cash.

    Removing or not removing the insurance doesn’t cause or not cause the panics. The panics are a fundamental part of fractional reserve banking. All the insurance does is shift the costs to other people. In the case of government insurance often to the innocent taxpayer.

    “With fiat money there is a good deal of leverage that is not possible with the asset backed.”

    There is no leverage involved in fiat currency. There is a one to one ratio of every dollar printed is a dollar of value stolen from the market. At least at first.

    In fact it operates in the reverse from how you think. It de-leverages over time. The more cash you print the less it becomes worth. That’s why in places like Zimbabwe the government has to resort to printing more and more of it to sustain it’s operations.

    BTW, there are people out there who argue that under the kind of fractional reserve system we have that it becomes counterproductive for the government to attempt to fund itself via seniorage (the printing up of brand new fiat currency). They argue that with a reserve rate of say 10% that every dollar printed causes a ten fold increase in the ability of banks to fractionally inflate on top of this. Therefore, they argue, the government cannot risk printing for fear of this ten fold jump in the money supply.

    They claim the governments purchasing power in doing this would be diluted ten fold, and therefore the incentive reduced ten fold.

    This is just another fallacious argument. The government gets to spend the money while prices are lower since it has it’s hands first on the new money. The total effect of the new printing is reduced by the quantity of money that already exists.

    Using their reasoning, suppose the base money supply is 10 billion. With ten percent reserves then the non-base money supply (which includes fractional reserve demand deposits) would be in fact 100 billion. Prices would be ten times that of a non-fractional system.

    Suppose the government decides to print another billion. Their argument would be that the spending power of this billion is diluted by prices that are ten times higher than before, since it is base money that has yet to be multiplied via fractional reserve.

    Furthermore, they say, it would cause the non-base money supply to increase by another 9 billion. Thus the general populous gets 9/10ths of the spending power of this extra billion. At the same time the government risks a tenfold increase in the money supply [the fail to mention it’s non-base at this point in their argument.]

    There argument being that printing under the non-fractional system the government gets 100% of the purchasing power of the extra billion it prints.

    The one billion in the example is being printed up to buy something. It’s the purchasing power of the one billion that matters, not the face value. Suppose that one billion were being used to buy a new bridge. Well under the non-fractional reserve system they could get the same bridge for 1/10 the price.

    So in the example under fractional reserve the government is essentially stealing a bridge via counterfeiting, but is deterred both by not getting the full value it could have gotten, and by more political ill will as people react to a higher inflationary rate.

    Since the inflation is part of their argument, how much inflation does this theft cause exactly? Well obviously, it is 10% inflation as they increase base money by 10% to get the bridge.

    Suppose they still want to steal the bridge under the non-fractional system. How much do they have to print up and how much inflation does it cause?

    Well the bridge is ten times less in price so they need only print up 1/10 the money. Thus increasing the money supply by only 100 million. This also causes only a one percent monetary inflation. So that part of the argument is fine. They have appeared to steal the bridge via counterfeiting without causing nearly as much inflation.

    This argument is easy to counter. The government wants to steal the bridge in either case. It doesn’t really care about the consequences. In the case of fiat with fractional reserve banking you get the bad effect of the theft of the bridge plus extra inflationary damage, plus add on destruction from the fractional reserve system. Plus the fractional reserve system causes the business cycle upon which the government can argue that the theft of the bridge was needed in the first place, and argue that the free market is inadequate at meeting peoples needs.

    They think this is a good argument for fractional reserve?

  • Jamisia

    CDSs, I read, aren’t backed by any asset, only by trust. Just like other fiat money. If they are a kind of money, that would explain some of lord Turner’s proposed reforms. But do CDSs and the explosive growth of the CDS market, mean that tender laws are already broken? Or is it that, because regional complementary currencies are also allowed, governments simply do not enforce these laws?

  • Brian Macker

    “That’s essentially what a bank is. “

    If you say so. NOT.

  • Laird

    Brian, I’m sure Paul Marks is happy to see another voice here arguing against the evils of fractional reserve banking.

    Obviously, I don’t agree with your position. In my opinion a modern economy could not function without fractional reserve banking, and I would consider that a bad thing. Under the current system a bank borrows money from its depositors (those deposits are carried on its books as “liabilities”) at some rate of interest (or zero interest in the case of checking, or “demand”, accounts), lends it out at a higher rate, and makes a profit on the spread. Without the ability to do that there would be no income with which to pay interest to depositors. The bank estimates how much cash is likely to be needed for withdrawals at any given time and keeps it available (that’s the “reserve”).

    Without a fractional reserve system we would be reduced to two types of institutions: (1) those providing demand deposit services (basically, a giant safety deposit box, although it could offer checking accounts) for which you would pay fairly hefty storage and processing fees (not only would you would receive no interest on your deposits, but the fees charged would have to be high enough to cover 100% of the institution’s operating costs and provide a profit to the owners); and (2) investment pools which would make loans, but in which the “deposits” would be locked up and unavailable for withdrawal for an extended period of time. The managers of such a pool would have to carefully match deposit and loan maturities*, which could severely constrain their lending ability (i.e., they could make 30-year mortgage loans only to the extent they have 30-year time deposits on hand). And therein lies the problem: not many people want their savings tied up and unaccessible for extended periods of time. We might buy 1- or 2-year Certificates of Deposit, and maybe even a 5-year CD if we have a lot of excess cash, but how many people are willing to go longer than that? And if you permit the managers of the fund to use estimates of likely deposit rollover rates and loan prepayment speeds, presto: you now have a species of fractional reserve banking.

    I’m not saying there aren’t problems with the current system, but as I’ve said before I don’t think that a fractional reserve banking system is ipso facto a bad thing; quite the contrary, in fact. But I think I’ve made my essential points and said quite enough on this subject. If you want the final word here have at it.

    * Banks do this now, of course (“asset-liability matching”), but the process is much more flexible than it could possibly be in a non-fractional reserve system.

  • newson

    laird says:
    “And therein lies the problem: not many people want their savings tied up and unaccessible for extended periods of time. We might buy 1- or 2-year Certificates of Deposit, and maybe even a 5-year CD if we have a lot of excess cash, but how many people are willing to go longer than that?

    hi there. here’s another of the anti-frb club. now we’re a happy three.

    your depiction of the non-frb banking model is correct, but your negative scenario is not. without the boom-bust/inflation-deflation cycle frb engenders, volatility in financial markets would be calmed, and this may well result in savers happy to lock in a fixed return for what seems an incredible period (from our current, hyper-volatile mind-set). even on the very imperfect gold standard, it was possible for lay-persons to accurately forecast cost-of-living for decades in advance.

    if you’re right, and five-year terms are the maximum demanded by savers, so what? project funding would be more dependent on equity, less on debt. this would be likely in any case in a 100% reserve banking system, as frb provides a subsidy to borrowers (as well as to bankers, naturally).

    i can see no big problem in bankers happily matching maturity demands, just that the financial industry would be have content itself with a vastly smaller amount of intermediation income.

  • I think that I can see both sides of this argument. The problem with FRB is the risk involved. But, as Laird’s points seem to correctly imply, without risk there can be no real progress. So the real questions here are: should risk-taking be mandatory (as it seems to be now under the current FRB regulations), and who should manage risk even if it is voluntary. The answer to the first question should be pretty obvious, and BTW Paul has said more than once that he doesn’t have a problem with FRB if it is based on contractual agreement between the bank and its customers. It may not be his particular cup of tea, but he would not be forced into it as he in now, along with the rest of us. As to risk management, Laird covered that very effectively in previous comments, the bottom line as I understood it, being: get the government the hell out of risk management business.

  • Brian Macker

    Alisa,

    “But, as Laird’s points seem to correctly imply, without risk there can be no real progress.”

    No, he’s absolutely wrong. You can pool and lend long term savings for the long term. What you can’t do is pool short term liquidity and lend it long term. It’s a fraud, it causes the business cycle, and it coordinates peoples error.

    It’s a fraud in the same way that pooling a bunch of subprime housing loans together then cutting it up in to tranches is fraud. You can’t convert high risk loans into quality loans by bundling.

    You can’t turn short term cash balances into long term savings by bundling either.

    It should be obvious that both are failing to come to terms with reality. Both are financial rationalizations for doing the wrong thing.

    Both are also self defeating in an unexpected way. They cause bubbles in the assets they depend upon to operate. Thus they are self feeding an will continue until the consume any supposed buffer against risk. They coordinate peoples errors this way via improper prices.

    Sure some subprime mortgages are paid off, and yes housing prices had been rising. But why? Loans are paid off if the homes are worth more than the loans, and housing prices were rising due, in part, to the subprime loans themselves. Once they ran out of suckers the housing prices topped out, and because of overbuilding at the artificial prices, fell to below where they started.

    The banks thought they could just sell the houses if the risky borrowers defaulted, but they didn’t factor in that the housing price rises were due to the banks own activities. Partially due to subprime Morgage Backed Securities.

    They sliced these MBS into tranches with priority order in the right to get repaid. The top 1/3 tranche was to be paid first and was rated AAA. The belief being their was known and low risk that 2/3rds of the borrowers wouldn’t repay.

    This risk assessment might work if the process was not self feeding. That was not the case however. The system is self feeding and loans continue and prices rise until all the buffer against risk is consumed. There wasn’t much in the first place since it was no-money down for borrowers who didn’t even have jobs in some cases.

    That’s why MBS to subprime doesn’t work. It’s a self feeding process that consumes it’s own margin of risk while at the same time distorting economic activity into unproductive activities, overbuilding long term assets.

    Fractional reserve banking is identical in these regards. People keep cash on hand for current spending and emergencies. The amount of cash kept on hand by people influences the price structure throughout the entire economy. Cash balances matter to prices.

    When you behind the scenes lend out peoples cash balances for long term investment you are doing two things. 1) You are removing peoples reserves against emergencies like losing a job. 2) Inflating the money supply.

    When you inflate the money supply this way it puts downward pressure on interest rates. This causes people to save less while at the same time believing they have saved more. They think they have more cash because bank deposits grow due to the fractional reserve monetary multiplier.

    None of the new deposits caused by this multiplier are actually backed by true savings of actual goods. Once the people who borrowed this extra cash try to buy goods far from consumption (and companies that produce these goods) at the old prices they bid them up. They bid up internet stocks, houses, building materials, commodities.

    Unfortunately there are not enough of these goods to meet the demands of the extra money that the system created. The extra goods don’t exist. That’s part of the fraud.

    So the fraud inherent in the banks has caused borrowers to believe there was more savings of goods than actually existed, and it causes savers to believe they have saved more than they actually have. The savers actually reduce their savings and increase their short term consumption as the borrowers accelerate their attempts to expand their long term plans.

    At the beginning of this process there is a economic boom as people think they are getting richer. They’ve been conned however. Economic production is shifted into areas that consumers don’t truly want given actual conditions. Sure they want the big house if it was affordable and they could feed their family, pay for utilities, and save. However, their decisions are based on false prices. The fractional reserve monetary bubble sends the wrong price signals at first telling them all this is possible, when it isn’t.

    Not only do they think long term goods like houses are more affordable due to the lower interest rates but the boom itself makes them think that their job prospects are better. The inflation in assets they already own, like stocks, and homes also makes them think they are saving. But they aren’t.

    True savings is producing more than you consume. When your home goes up in price due to a monetary bubble it is not equivalent to consuming less goods than you produce.

    This is spur in growth due to fractional reserve monetary inflation is impossible to maintain. It’s impossible as is clear from the facts we started from in the first place. People who deposit short term in banks never intended to save the money for fifteen years. They expected to spend it. They need it for risk management.

    The self feeding bubble of fractional reserve monetary inflation eats up everyone’s buffer against risk. It does so via the reserve mechanism.

    When banks say they are going to let depositors take their money out at a moments notice and then lend it for fifteen to forty years to a borrower they are defrauding their customers. They are also causing system wide economic distortions.

    This is totally unnecessary. People can save long term via bonds, stocks, and gold and other precious metals. In fact, without fiat money, and fractional reserve all those assets become less volatile. With a free money system gold actually appreciates over time and is highly liquid. It’s suitable for both savings and for emergencies.

  • Brian, I’m afraid you may be missing my point. You are describing the situation as it exists now, or rather existed until the whole house of cards had collapsed, and no one seems to know what’s going on anymore, and I agree with your description. What I am talking about (I cannot speak for Laird) is a system where you as a customer have a free choice between banks that operate under FR, and banks that don’t. If you do chose the former, you sign a contract with the specific bank where all the possible risks are outlined. It is your responsibility to educate yourself as to the full nature of those risks, only then you should sign the contract. It is not fraud if you are well aware of the risks inherent in such a deal, and if you entered the deal of your own free will (unlike what we had until now). Note that I am not saying that FRB is necessarily a good practice, all I am saying that this option should be available to people who are interested in it.

  • Brian Macker

    “In my opinion a modern economy could not function without fractional reserve banking, and I would consider that a bad thing.”

    Well, you’re wrong. In fact a modern economy would function much better without fractional reserve banking.

    “Under the current system a bank borrows money from its depositors (those deposits are carried on its books as “liabilities”) at some rate of interest (or zero interest in the case of checking, or “demand”, accounts), lends it out at a higher rate, and makes a profit on the spread.”

    I understand banking to a much greater degree that your simplifications. Your descriptions are theory-rich in that they are based on your own theories. All observations are colored by theory in some way or another or we could not make sense of the world.

    “Without the ability to do that there would be no income with which to pay interest to depositors.”

    See this is where your simplifications fail. You are presuming that we should pay interest on short term cash balances. You’ve already made a judgment based on your theory.

    “The bank estimates how much cash is likely to be needed for withdrawals at any given time and keeps it available (that’s the “reserve”).”

    NO! No estimate is needed. The bank has represented to it’s depositors that they can withdraw at any time. It has represented that ALL the depositors’ accounts are liquid via this policy. The agreement already contains an estimate by the depositor of how much cash he is likely to need at any given time. The amount is 100%.
    By estimating less than 100% the bank allows one depositor to draw down his portion of this reserve at will therefore pushing other depositors into even more illiquid investment mixes. This happens without the other depositors knowledge.

    “Without a fractional reserve system we would be reduced to two types of institutions:

    False. There are very many ways to handle savings and not just two institutions. You can directly hold precious metals, real estate, or other assets. You can do so in concert with others via contract. You can buy stocks. You can expand your business. You can buy and hold bonds. You can make personal loans. You can shorter term loan against household goods, motorcycles, cars, etc. You can loan against longer term goods like houses. You can make loans in concert with other people either short or long term as you say via investment pools, but could sell your membership which you fail to understand. Just like you can sell any personal loan contract.
    One can also back short term borrowing with long term. There is nothing wrong with pooling savings and lending it short term. For example to credit card customers.
    Those in addition to safety deposit boxes, and unsellable investment pools that you mention.

    (1) those providing demand deposit services (basically, a giant safety deposit box, although it could offer checking accounts) for which you would pay fairly hefty storage and processing fees (not only would you would receive no interest on your deposits, but the fees charged would have to be high enough to cover 100% of the institution’s operating costs and provide a profit to the owners); and

    Why assume the fees are “hefty”. I pay no processing fees on my safe deposit box. Nor are the fees particularly hefty. The fees are what they are. I’m paying for someone to guard my stuff. Under the current system the government with the stroke of a pen can steal my cash without me even knowing about it.
    I have checking accounts right now and they are not suppose to lend that money out. I pay no “hefty” fees. The fees are reasonable. Also there is nothing wrong with credit card systems just so long as backed with longer term savings, or with matching maturities.
    Just because you lack the imagination to understand how things would work under a system that is not fraudulent doesn’t mean it cannot operate.

    “(2) investment pools which would make loans, but in which the “deposits” would be locked up and unavailable for withdrawal for an extended period of time. The managers of such a pool would have to carefully match deposit and loan maturities*, which could severely constrain their lending ability (i.e., they could make 30-year mortgage loans only to the extent they have 30-year time deposits on hand). And therein lies the problem: not many people want their savings tied up and unaccessible for extended periods of time. “

    What’s with your all or nothing attitude. If I want to get the kind of rate available for a 30 year loan on a house then I shouldn’t be putting ALL my short term cash in it. So instead I only put retirement savings in it. That is 30 years out, no problem.
    There is NO issue here. Don’t put your money that you want accessible into investments that are long term. Simple as that. No constraints involved. People have to save for their old age, and do so in considerable amounts. There is a pool of savers who have such time frames for at least part of their savings. Not the money they might be saving to buy a car, but the money they are saving for retirement.
    If the plan to save for a new car in 5 years then they put it into a 5 year account. Imagine that, saving to buy a car. How many people do that anymore with the government fixing prices on interest rates.

    “We might buy 1- or 2-year Certificates of Deposit, and maybe even a 5-year CD if we have a lot of excess cash, but how many people are willing to go longer than that?”

    Everyone, you got eat and rent when you are too old to work. Your question reveals a lack of imagination and an attempt to rationalize your position instead of fitting it with reality. Reality is that people need to save long term. They don’t generally because the government has put a price ceiling on interest rates.
    Heck, people used to save for their old age in gold directly. No need for banks. Just put it in an inaccessible and hidden safe. It’s not like you have to pull it out every day.

    ”And if you permit the managers of the fund to use estimates of likely deposit rollover rates and loan prepayment speeds, presto: you now have a species of fractional reserve banking.“

    No. The maturities have to be explicit in the contracts. If they are not then there can and will be a mismatch between saver and borrower. The contract is invalid about one of the most important points, period of repayment. The chain of contracts needs to retain this important part of the agreement or it is impossible for the intermediary party to meet the obligation of the contract on either side.
    The “estimate” process makes either the banks contract with the depositor or the banks contract with the borrower invalid from the start because it’s impossible to fulfill obligations on both sides. When the front end and back end maturity conflicts are exposed the bank will either need to call in the loan violating the back end contract, or call a bank holiday which violates the front end contract.
    Then if an individual saver has mistakenly bought a CD with a maturity that is too high he will have to find a new buyer and suffer any consequent losses. There is no way for him to immediately shift his mistake onto some other bank depositor by taking the money and closing his account.

    “I’m not saying there aren’t problems with the current system, but as I’ve said before I don’t think that a fractional reserve banking system is ipso facto a bad thing; quite the contrary, in fact.

    That’s because you don’t understand the system, and the consequences of the system. You don’t understand that the fraud involve in banks making conflicting contracts.
    In your mind is it just find for a trucker to be married to two women at the same time just so long they are on different sides of the country? Obviously the exclusivity of the contracts is clear. Yet, he figures that his “estimates” of the amount of time he’s going to be spending with each is less than 100%. Therefore, he timeshares his assets between families and therefore has added benefits.
    Banks do the same exact thing. They sign two conflicting contracts (actually thousands) and then try to timeshare the underlying assets in a way that violates the underlying contracts. The bank does so in the same way as the bigamist above.
    You are rationalizing fractional reserve banking the same way that Muslims rationalize polygamy. Some of them truly believe a just society can’t be run properly without men being able to live in bigamy. Think of the widows, they’ll starve.
    But I think I’ve made my essential points and said quite enough on this subject. If you want the final word here have at it.”
    My final point if you don’t respond is that you are rationalizing the need to commit the fraud of having conflicting contracts on grounds that are wholesale mental fabrications. Fabrications generated by your brain due to your acceptance of certain theory. Your theory colors not only your beliefs but your observational interpretations.
    Fractional reserve banking is not only fraudulent but it has knock-on effects that harm others. Fractional reserve banking makes impossible for people to properly assess risk, coordinate their plans via prices, save at the proper levels, and so forth. It coordinates people’s mistakes leaving them all impoverished at the same time. It causes the business cycle.
    This generates a danger for the rest of us who don’t participate in these schemes. Schemes like pyramid and Ponzi schemes. There is a danger that you will need to rob my house to feed yourselves, or go to the government to pick my pocket. Desperate people do desperate things.
    People in general have no right to take actions that a reasonable person can see, and empirical results confirm, will endanger others. That’s one of the reasons we can outlaw pyramid schemes. In addition to the fact that the underlying contracts depend on fraud just like fractional reserve banking.
    Thus I am NOT interfering with your natural rights when I say that fractional reserve banking is criminal and should be against the law.

  • Laird

    Brian, lighten up. “Well, you’re wrong.” “False.” “You don’t understand.” “Fabrications generated by your brain . . . .” Bold statements, and rude to boot. I like a spirited debate as much as anyone, but a lack of manners doesn’t advance your case. How about an occasional “I disagree” or “I think otherwise”? We can disagree and remain civil.

    By the way, I do understand the system, having been intimately involved with it (in a variety of capacities) for many years. And I think your understanding of the securitization process is weak; it’s an extremely valuable tool and just as applicable to subprime mortgage loans as to conforming ones, auto loans, credit cards, or any other species of debt. True, it can be (and has been) misused, but that’s not the fault of the tool but the person wielding it.

  • Paul Marks

    As so often with Kevin Dowd this is a curate’s egg – a mixture of good and bad.

    The good is more important the bad – so I will mention it first.

    No bailouts, and no pretended “insurance” (as if business judgement can be insured as if it was a flood risk or whatever).

    And no Central Banking – which is, and always has been, a mixture of getting money for government spending (whilst putting off the taxes needed to pay for this spending) and Corporate Welfare for banks and certain favoured business organizations.

    The bad stuff:

    The limited liability attack is a division – it is not a new idea (both charitiable foundations and business associations always had forms of limited liability – in that one sued the organization not the individual members) many undertakings might not take place if people were told “if it goes wrong you lose everything – the shirt off your back included” an invester is prepared to lose his investment (or should be so prepared) – but not everything he has.

    Still be that as it may. Perhaps business would simply find other ways to limit liability if the 19th century limited liability statutes were repealed (after all there were ways, if one worked hard enough). And some business would always carry on even if all limited liability was got rid of.

    More in next comment.

  • Paul Marks

    As so often with Kevin Dowd this is a curate’s egg – a mixture of good and bad.

    The good is more important the bad – so I will mention it first.

    No bailouts, and no pretended “insurance” (as if business judgement can be insured as if it was a flood risk or whatever).

    And no Central Banking – which is, and always has been, a mixture of getting money for government spending (whilst putting off the taxes needed to pay for this spending) and Corporate Welfare for banks and certain favoured business organizations.

    The bad stuff:

    The limited liability attack is a division – it is not a new idea (both charitiable foundations and business associations always had forms of limited liability – in that one sued the organization not the individual members) many undertakings might not take place if people were told “if it goes wrong you lose everything – the shirt off your back included” an invester is prepared to lose his investment (or should be so prepared) – but not everything he has.

    Still be that as it may. Perhaps business would simply find other ways to limit liability if the 19th century limited liability statutes were repealed (after all there were ways, if one worked hard enough). And some business would always carry on even if all limited liability was got rid of.

    More in next comment.

  • Paul Marks

    Limited liability is really a matter for a different debate – perhaps I am wrong anyway.

    More directly relevant is the other bad stuff.

    The implied claim that handing out shares would solve a lot – it would not, people want their money not shares in a bankrupt bank.

    Also the old myth about Free Banking Scotland is repeated. Even though it was expossed many years ago.

    As Rothbard (amongst many others) pointed out, if a person asked for the gold they had deposited at a Scottish bank all Hell broke lose – but the gold often did not.

    Contracts should be enforced – and if I have a contract that the bank is to hand me X amount of gold when I present their note it should do so. Or be declared bankrupt – then and there.

    This is the problem with “gold backed money” or “silver backed money” or “milk bottle tops backed money”.

    Either the stuff is the money – or it is not.

    What is the word “backed” or “standard” for?

    At root this is the same old fallacy.

    The fallacy being that by some clever banking book of tricks the amount of money lent out than be greater than the amount of real savings – so “economic development” can be promoted more than if people were just lending out real savings.

    Such games always end badly – and trying to use the law to prevent bankrupt banks going bankrupt, is just as silly (in its way) as bailing them out.

    If people want to make contracts that say “you can have my gold [or my milk bottle tops] and you do not have to give it back when I present your note” that is fine.

    But then, in that case, a limited liability contract “you can only have company assets – not my home” would be fine also.

    In both one can decided whether or not to do business with a fractional reserve Kevin Dowd bank (out to “stimulate trade” in the best tradition of the Banking School) and with a Ltd or an Inc.

    It is when contracts are violated – such as when you present the “on demand” note and no gold is paid, that the system is corrupt and can not be honestly defended.

  • Paul Marks

    Limited liability is really a matter for a different debate – perhaps I am wrong anyway.

    More directly relevant is the other bad stuff.

    The implied claim that handing out shares would solve a lot – it would not, people want their money not shares in a bankrupt bank.

    Also the old myth about Free Banking Scotland is repeated. Even though it was expossed many years ago.

    As Rothbard (amongst many others) pointed out, if a person asked for the gold they had deposited at a Scottish bank all Hell broke lose – but the gold often did not.

    Contracts should be enforced – and if I have a contract that the bank is to hand me X amount of gold when I present their note it should do so. Or be declared bankrupt – then and there.

    This is the problem with “gold backed money” or “silver backed money” or “milk bottle tops backed money”.

    Either the stuff is the money – or it is not.

    What is the word “backed” or “standard” for?

    At root this is the same old fallacy.

    The fallacy being that by some clever banking book of tricks the amount of money lent out than be greater than the amount of real savings – so “economic development” can be promoted more than if people were just lending out real savings.

    Such games always end badly – and trying to use the law to prevent bankrupt banks going bankrupt, is just as silly (in its way) as bailing them out.

    If people want to make contracts that say “you can have my gold [or my milk bottle tops] and you do not have to give it back when I present your note” that is fine.

    But then, in that case, a limited liability contract “you can only have company assets – not my home” would be fine also.

    In both one can decided whether or not to do business with a fractional reserve Kevin Dowd bank (out to “stimulate trade” in the best tradition of the Banking School) and with a Ltd or an Inc.

    It is when contracts are violated – such as when you present the “on demand” note and no gold is paid, that the system is corrupt and can not be honestly defended.

  • Paul Marks

    Of course that is the test.

    We should simply see what prospers over time – without any bending of contract law, and without any central banking.

    Whether it is fractional reserve banking or not would be a matter for people over time – people who would know what they were getting involved in and who would know there would be no help for them if things went wrong.

    For Kevin Dowd is quite correct – central banking has always been a mixture of getting money for the government (putting off the day of the taxes needed to pay for the wild spending) and Corporate Welfare.

    Things are out in the open now because of the vast scale of the bailouts, but there have been complex ways of getting sweetheart loans to bankers and other such for as long as their have been such things as the Federal Reserve system (indeed that is what the Fed was created for – to protect banks and favoured non bank corporations from the effects of their own folly “for the good of the economy as a whole” of course, in the best “Economist” magazine double talk).

    And what the Fed (and the Bank of England and all Central Banking systems) has done – is make everything worse.

    The busts are not prevented – they are just put off and made bigger.

    The future must not only be a place without openly government backed entities – no Fannie Mae or Freddie Mac (and no “affordable housing policy”). There must also be no government backed banks like Citigroup or Bank of America (or RSB or HBOS/Lloyds). And no government backed corporations like General Electric (with its tens of billions of debt support) or AIG.

    AIG alone has had 170 BILLION Dollars, – at least 100 billion of this has already vanished in payments, mostly overseas.

    No one can justify such crimes.

    This is where the hole in the corner sweat heart loans to favoured corporations (that are paid back in a few days so “what does it matter”) this is the greatest mass theft in history.

    TRILLIONS OF DOLLARS are being stolen by the American government alone (and vast sums by other governments) – and are being handed out to favoured banks and non bank corporations.

    This “bailoutism” is the great moral (as well as economic) issue of our time.

    And Kevin Dowd is on the right side of it.

    All those who do not denounce and oppose these bailouts are lower than dirt.

  • newson

    paul marks says:
    “We should simply see what prospers over time – without any bending of contract law, and without any central banking.
    Whether it is fractional reserve banking or not would be a matter for people over time – people who would know what they were getting involved in and who would know there would be no help for them if things went wrong.”

    but paul, what sort of legal contract could accurately describe the economic reality of frb? huerta de soto points out that it could only possibly be an aleatory contract, in essence a lottery, as macker has said.

    if the frb deposit-taker were to present its product honestly and call it a lucky-dip-account/ or a first-come-best-dressed-account, i couldn’t legitimately complain. somehow i can’t see that as a big winner.

    i’ve read rothbard’s critique of free-banking in scotland, as well as sechrest’s critique of white. i share rothbard’s scepticism. i’m still trying genuinely to find ONE functional model of free-banking.
    from what i see, the 100%-ers at least have one historical model (bank of amsterdam) that worked for a couple of decades before fraudulently converting itself into a frb, from whence failure was certain.

    i find criticism (alisa?) about the deposit costs under a 100% reserve regime rather amusing after the trillions we taxpayers are watching being swallowed by the frb monster. anyone keeping tabs?

  • For me FRB is fine as long as people know that their “deposits” are not on call but are investments subject to risk and illiquidity.

    One could legitimise the current system by informing all that is the case. Of course, this would risk creating a mega run on all banks as people withdraw their savings for the safety of the mattresses. Thus, for me, without further thought, it represents an irresponsible move.

    And that is the rub – how to move from an FRB system to a full reserve system without a cataclysmic contraction in the money supply?

  • Brian Macker

    “if the frb deposit-taker were to present its product honestly and call it a lucky-dip-account/ or a first-come-best-dressed-account, i couldn’t legitimately complain. somehow i can’t see that as a big winner.”

    I agree with this line of reasoning. You’d have to do the same with the banknotes. If the old banknotes said, “Lottery Ticket” on them, or “Musical Chairs Note” and then spelled out explicitly the odds of being screwed, taking into account good economic theory, with a place to sign the note, then I wouldn’t have a problem.

  • Brian Macker

    Liard,

    I posted an apology before but I don’t see it. Must have only hit preview. So here it is again.

    I apologize. I was being to hard on you. I read your comments again and obviously got angry at what to me are obviously false statements. That doesn’t excuse my behavior however. Yes it was rude.

    I think the two false claims that got me the most angry were that non-FRB is subject to runs, and that by some imagined mechanism non-FRB was unworkable. To me those are equivalent claiming 1) That bank runs have nothing to do with FRB. 2) We can’t run a modern economy without letting banks defraud us.

    Yes, I’m certain you are wrong on this. But the way I wrote about it was surely rude and certainly made trying to hold a conversation with me unpleasant for you.

    I will refrain from such behavior in the future. It is not my normal persona but I’m pretty pissed about the economy right now and believe that ultimately the whole mess rests on FRB, both currently and historically.

  • Laird

    Brian, thank you; apology accepted. We’re all pretty pissed about the economy right now; we just have somewhat different ideas on what should be done. It’s good to have a forum in which to debate those ideas.

    For the record, I don’t think I’ve ever said that runs have nothing to do with FRB; obviously they do. What I did say (or intended to say, anyway) was that deposit insurance helps prevent and/or mitigate runs, and I think history has proven that correct. Have there been any bank runs since the 1930’s? Perhaps, but certainly very few. Yes, there have been bank failures, but they weren’t triggered by runs. Indeed, it was the fear of runs that caused Congress in increase the insured deposit level a few months ago, and it seems to have worked. A bank in GA failed just last Friday, with no run. So I continue to believe that FRB can work when coupled with deposit insurance. I just don’t like the way the insurance is being handled.

    As to a non-FRB system being “non-workable”, I don’t believe that to be completely the case, but I do think it would be much more difficult to maintain a modern economy with it. You (and others) disagree, and I respect that position. I could be wrong. We’ll probably never know unless the system totally collapses and we have to start over, because nothing short of that will change it. I do agree with you that people should be much more aware that we have a fractional reserve system and there is always the possibility that their cash will not be available for withdrawal upon demand. I suspect (although I haven’t checked this) that the agreement you sign when you open an account probably contains some sort of disclaimer of this nature, but it should be more prominent. (And, of course, the existence of deposit insurance makes this a non-issue for most people.)

    So, on to the next debate!

  • Brian Macker

    “So I continue to believe that FRB can work when coupled with deposit insurance.”

    You see, I believe the opposite. I think deposit insurance is a moral hazard that increases the likelihood that fractional reserve banks will overlend.

    “(And, of course, the existence of deposit insurance makes this a non-issue for most people.)”

    Yes and that is an enormous problem. Depositors no longer care about the financial state of the bank they deposit with, nor where it loans their money.

    I thought you were advocating free banking. Government sponsored deposit insurance isn’t even close to free banking.

  • Laird

    Go back to my first post in this thread (the third one overall). I advocate privatizing deposit insurance. Later on (3/19, 7:36 PM) I said that I thought government was the “least qualified” entity to provide deposit insurance. So whatever sins I may be guilty of, advocating “government sponsored deposit insurance” is not among them.

  • newson

    to laird: keynes, from “the economic consequences of the peace”

    “Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some. – As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.”

    frb is the agent of disorder, not created but institutionalized by government involvement, that turns so many against what they perceive (wrongly) to be capitalism, for it’s terrible uncertainty.

    regarding semantics, “deposit” accounts should be labeled as “loan” accounts, as this is how banks treat them in their accounts. that is, “depositors” don’t exist, even if they think they do. they are “lenders” to the bank. this sort of contortion speaks to the sham that is frb.

  • Laird

    Nice Keynes quote. A fine illustration of the “stopped clock” analogy.

  • newson

    glad you liked it. but the credit belongs to lenin, not to keynes, raconteur.

  • Paul Marks

    Good point about contracts newson – and not one I would argue with (see my facebook page sometime).

    However, I was trying to be a nice guy and convince J.P. that I was not really a totally crazy hard money man like Bullion Benson and so on.

    Of course, in reality, that is exactly what I am – I am about as tolerant as rattlesnake and I am as mean as a bear with a headache.

    Lending out money that does not exist (no matter how clever the use of smoke and mirrors) is fraud – and just telling people you are doing it does not really cover that (as they can not understand what you are saying – which complex financial instruments do not represent the actual money, are they a different colour?, a different type set? or what?.). The inverted debt pyramid is not just an economic problem, it is a natural law problem as well.

    Still from an economic point of view it is not the fraud, it is the consequences of the fraud that matter.

    And the consequence is a phony “boom” followed by an only too real bust – with often vast suffering.

    One of the biggest lies we can tell people is “get rid of central banking and restore the gold standard and things will be fine, it will be free banking”.

    Things will not be fine – history would repeat itself. There would be vast busts (for example the one after 1907) and people would demand that the government “do something” – i.e. set up the Federal Reserve or a National Bank (or whatever). And eventually it would happen.

    And Kevin Dowd’s way of preventing such a boom/bust credit money cycle?

    Banks being “prudent” and only lending out to “serve the needs of trade” – i.e. standard “Banking School” boiler plate.

    However, (and it is a BIG “however”) the Fed and other Central banks make things much worse – and Kevin Dowd would get rid of them.

    And he would allow the bankrupt banks to go bankrupt (I am going to ignore the nonsense about giving depositors stock they do not want – I was not at the lecture so I am going to assume that the Kevin Dowd did not really mean that).

    These are no small advances – they are great and important advances.

    Sure there would be a bust every few years (taking millions of people with it), but it would be vastly better than what we have now.

  • Paul Marks

    The Bank of Amsterdam played it straight for more than a few decades – and even in time of war.

    The Bank of Hamburg was not that bad either.

    However, most money lending were small scale operations where the lender knew the borrower (and often was lending his own money directly).

    For example, the British industrial revolution was mostly financed not by “slavery” or the “slave trade” but partly by reinvestment of profits (gradually turning workshops into factories) and partly from prosperious domestic farmers.

    A bank is just a middle man (if the banker is straight) – either a local landowner (or whatever) can invest in would/be factory operators directly, or he can hand over his savings to a banker on the clear understanding that the banker will use his personal judgement to decide what businessmen to invest them with.

    Of course one can also lend out money to finance consumption – but that will only work if a minority of people are living like that (for obvious reasons).

    A banker must be concerned about long term personal relations with borrowers.

    Lending money to people who will not pay it back is crazy – as is lending money to people who will be crippled by paying it back.

    Where is the long term profit in such activities?

    It is “commision thinking” as if bankers were glorified salesmen out to “make a sale” with everyone who walks in.

    Of course the “afordable housing” insanity was driven by government regulations (so much for “deregulation” or “unregulated lenders”) but it still depended on massive dodgy activity.

    For example, if you really thought people were going to pay the interest and principle of their mortgage why spend so much energy turning the homeloans into securities and selling them on at once?

    “To get quick money” – a bit odd for a bank to be interested in doing that.

    Unless the people concerned knew that the financial instruments (the debt/equity swaps and so on) of the inverted pyramid of debt were really based on nothing.

    After all why else lend money to buy houses in Florida.

    A State where it takes about two years to foreclose on a house.

    And a State where there is a long history of property bubbles.

    People who lent lots of money in places like that knew what they were doing was dodgy – which is why they passed on the loans.

    And the people who bought securities when the did not even know the people who had borrowed the money?

    First rule of banking – know the borrower.

    Fractional reserve or not – violate “know the borrower” and you are not a banker.

    You are just playing silly games.

  • Paul Marks

    The Bank of Amsterdam played it straight for more than a few decades – and even in time of war.

    The Bank of Hamburg was not that bad either.

    However, most money lending were small scale operations where the lender knew the borrower (and often was lending his own money directly).

    For example, the British industrial revolution was mostly financed not by “slavery” or the “slave trade” but partly by reinvestment of profits (gradually turning workshops into factories) and partly from prosperious domestic farmers.

    A bank is just a middle man (if the banker is straight) – either a local landowner (or whatever) can invest in would/be factory operators directly, or he can hand over his savings to a banker on the clear understanding that the banker will use his personal judgement to decide what businessmen to invest them with.

    Of course one can also lend out money to finance consumption – but that will only work if a minority of people are living like that (for obvious reasons).

    A banker must be concerned about long term personal relations with borrowers.

    Lending money to people who will not pay it back is crazy – as is lending money to people who will be crippled by paying it back.

    Where is the long term profit in such activities?

    It is “commision thinking” as if bankers were glorified salesmen out to “make a sale” with everyone who walks in.

    Of course the “afordable housing” insanity was driven by government regulations (so much for “deregulation” or “unregulated lenders”) but it still depended on massive dodgy activity.

    For example, if you really thought people were going to pay the interest and principle of their mortgage why spend so much energy turning the homeloans into securities and selling them on at once?

    “To get quick money” – a bit odd for a bank to be interested in doing that.

    Unless the people concerned knew that the financial instruments (the debt/equity swaps and so on) of the inverted pyramid of debt were really based on nothing.

    After all why else lend money to buy houses in Florida.

    A State where it takes about two years to foreclose on a house.

    And a State where there is a long history of property bubbles.

    People who lent lots of money in places like that knew what they were doing was dodgy – which is why they passed on the loans.

    And the people who bought securities when the did not even know the people who had borrowed the money?

    First rule of banking – know the borrower.

    Fractional reserve or not – violate “know the borrower” and you are not a banker.

    You are just playing silly games.

  • Brian Macker

    Laird,

    “So, on to the next debate!”

    Not so fast. You can’t insure a pyramid scheme. You know it’s going to fail systemically. The banks would have to pay the insurers enough for them to bail out the banks. But then why wouldn’t the banks instead just keep higher reserve levels.

    You are assuming this problem hits banks like lightening or something. This isn’t about accidents, or random chance. It’s about bad behavior. You can insure bad behavior. That’s why insurance doesn’t pay out on suicide.

    Besides all that was tried privately and it did fail.

    You just don’t understand the scam in full. You are missing an understanding of money, prices, and the economics that backs the scam.

  • Laird

    Perhaps, but I don’t think so. FRB is not a “pyramid scheme” as that term is commonly understood. A pyramid scheme involves using the newest money to pay to earlier participants, and of course it will ultimately fail. Banking involves making loans, most of which will be paid back (with interest). If too many don’t pay back (bad lending decisions), the bank fails, taking with it the investors’ capital. Bad decisions can be, and regularly are, insured against (E&O insurance, automobile liability insurance, etc.). By reviewing the bank’s credit policies and a sample of the loans an insurance company can assess the credit quality and competence of the decisionmakers well enough to make decisions about insurability of the institution and the premiums to charge.

  • Paul:

    and just telling people you are doing it does not really cover that (as they can not understand what you are saying – which complex financial instruments do not represent the actual money, are they a different colour?, a different type set? or what?.)

    Strip away the current government meddling in the economy and the financial industry – but all of it – and the average Joe ends up not really needing a bank most of the time. You’d need a bank only if you had a lot of money, to either store it securely, or invest it. In both cases, you’d better make sure you know what you are doing before you give your money to the bank. And yes, you’d have to study and understand the various financial instruments, although I’d guess that a large chunk of those would not have even come into existence under truly free market conditions. My (admittedly uneducated) guess is that most of these convoluted tools owe their very existence to the current system, and are mostly designed to play that system, rather than play the market.

    As to insurance, indeed no one is willing to insure against suicide. Banks that engage in practices that are too risky or unsustainable wold have a problem finding an insurer, and that’s the way it should be.

  • Brian Macker

    Laird,

    “Perhaps, but I don’t think so. FRB is not a “pyramid scheme” as that term is commonly understood.”

    No, kidding it’s not exactly analogous to a pyramid. I’m dumbing it down. Most people can’t understand the fraud inherent in fractional reserve banking. You worked in the industry and still haven’t figured it out. The point is that you can insure against fraud.

    FRB is a more sophisticated scam than a pyramid scheme and 99% of the people out there are not intelligent enough to figure out. It’s guaranteed to fail just a pyramid scheme is and is thus not amenable to insurance. We’ve tried insurance now and it failed also. There has been no period where deposit insurance on FRB has ever worked.

    I suggest you read about(Link) the so called “free banking” period of Scotland as presented by Murray Rothbard. It’s the same old scam we are getting now days. Always has been this way.

  • newson

    laird says:
    “By reviewing the bank’s credit policies and a sample of the loans an insurance company can assess the credit quality and competence of the decisionmakers well enough to make decisions about insurability of the institution and the premiums to charge.”

    you’re missing the feedback mechanism. loans feed into valuations of assets the banks collateralize. this is evident in the current crunch; prior to the systemic collapse, certain banks looked perfectly well-capitalized, post-crunch, they are insolvent. there is no way to predict when the system is about to break down irrevocably. macker has dealt with the moral hazard aspect.

  • newson

    to paul marks:
    bank of amsterdam made uncovered loans to three parties almost straight after it was chartered as a fully-reserved bank (1609) – the city of amsterdam (1624), bank of leening (1614), and the dutch east india company.

    it took quite a while for the public to cotton on, and for the bank’s paper to sink below par, but the breach of charter was quite early in the piece.

  • Brian Macker

    “you’re missing the feedback mechanism. loans feed into valuations of assets the banks collateralize. “

    Exactly, that’s the part of the scam they never get.

    The also don’t get the fact that if a few people participate in the scam it isn’t as harmful to the participants. Therefore when they look at the scam in isolation it doesn’t look so bad. It sort of looks like regular lending as in certificates of deposit.

    Suppose one guy borrows money from you an lies saying “I plan to pay you back whenever you ask for it” in order to induce you into his scam. He then lends the money to someone else at interest for thirty years. Well he has no way to pay the money back unless he a) Can sell his loan agreement. b) Can call in the loan and sell the house.

    What has happened to you is that you were moved from a short term position to a long term position without your knowledge.

    In this case there is a good chance his behavior has not distorted the economy much. If you go back to him couple months later and ask for your money back he can liquidate. Of course, not in a timely fashion. It may take him a long while to find a buyer for the loan, or for the other borrower to sell the house and pay back the money.

    That’s because it is conceivable that somewhere out there is someone who truly wishes to move from a short term to a long term position.

    On the other hand if everyone does this kind of behavior it becomes very problematic. That’s because when practiced widely it drives everyone into long term positions. The number of people who have short term positions that desire long term positions drys up in the process of the scam being adopted by more and more people.

    Fractional reserve banking is like a pyramid scheme in that sense. It’s success depends on finding an ever increasing quantity of people who can be unknowingly (or knowingly) forced into long term positions.

    Pyramid schemes fail when the number of chumps run out. The scheme rests on the ability to find other people willing to pay you $2000 on the off chance that they will be able to find ten other people willing to pay them $2000 for the same chance. Works find for those who are first to enter but not those who enter last because the number of potential participants is finite.

    With fractional reserve banking the value of the underlying long term assets is highly dependent on the ability to liquidate. That is dependent on the total quantity of people in the entire society who desire to move from liquid to illiquid positions. The very practice of FRB dries up that pool of people.

    Now unlike a pyramid scheme where the winners and losers are fixed by the timing of entry, in the FRB scheme it’s the timing of exit that matters. This is another aspect of the scheme that adds to the beauty of the deception. Whereas in the pyramid scheme it is obvious who the winners and losers are, in FRB it is not obvious at all. One always thinks that it is possible to exit, not only with ones original cash, but with the interest you have earned. That is not the case however.

    These aspects of the scam are on top of the economy wide wealth destruction that the scam causes. Wealth destruction that is not inherent in non-fractional lending and borrowing.

    Let me invent a new kind of pyramid scheme that moves in a direction that makes it more analogous to an FRB (but still has no productive merit and is a completely zero sum game).

    Every participant in the pyramid scheme is called a depositor. You deposit cash into your account. However much you want. You can withdraw your cash plus “earnings” at any point. You can add funds at any point.

    Of any new funds deposited 89% are deemed “profits” for all existing members, while 1% are deemed the profit of the person who recruited the new member. Even for funds added by a pre-existing member later 89% gets credited proportionally to all current “investors” and 1% credited to the original recruiter.

    This is a fractional reserve pyramid scheme. Only ten percent of actual deposits are actually kept on hand at any time. This allows the pyramid bank to not only count your deposit against your own account but against other peoples account.

    So if you deposit $1000 then your account initially shows you having $1000 that you can withdraw at any time. Your recruiters account would now show an additional balance of $10 above whatever is in his account. Another $890 is credited to all other accounts proportionally to deposits.

    The result is that for every $100 in any account there is only $10 in actual liquid cash on hand, the rest being backed by no assets whatsoever. No pretensions are made here about the value of the backing assets, they are zero.

    Note that withdrawals generate “losses”. Any person can withdraw their full account at any time and the withdrawal “loss” is booked evenly across all accounts.

    So it’s a pyramid scheme where the participants can withdraw their original “investment” at any time plus earnings of nine times as much.

    It’s called Ponzi scheme. It works much better than a pyramid scheme because of the extra layer of deception.

    You can also take a pyramid scheme alone, without this mechanism, and attach the sales or investment of products, productive activities, to the scheme in order to legitimize it, and further obscure the plan.

    Multi-level marketing schemes employ this trick, and in fact are so effective in hiding the scheme that they are considered legal.

    The largest take on a pyramid scheme was in China for $246 million US dollars(Link) (equivalence) and involved investments in forestry.

    Note that the article states:

    “The judges said the culprits made illicit gains and their operation severely disrupted the market economy. “

    See involving productive activities in any pyramid, Ponzi, or fractional reserve scheme not only makes the scam harder to detect but also disrupts the economy.

    What would be especially offensive would be if the scamsters in this Chinese pyramid scheme argued that their scam was necessary to run a modern economy.
    People buy and sell forestry products all the time without relying on scams like this. Likewise people lend and borrow all the time without fractional reserve.

    Sure FRB causes a boom but so did this pyramid scheme in forestry products. The problem is you have too look at the whole picture. The downside is part of the fraud.