Over the weekend, Tim Evans, who has been a friend of mine for about a quarter of a century, and who is now part of the Cobden Centre ruling junta (listen to a recent and relevant interview with Tim Evans about that by going here), has been ringing me and emailing me about this, which is a so-called Ten Minute Bill (I think that’s what they call it) which Douglas Carswell MP and Steve Baker MP will be presenting to the House of Commons this Wednesday, just after Prime Minister’s Question Time.
Ten Minute Bills seldom pass. But they are a chance to fly a kite, put an idea on the map, run something up the flagpole, shoot a shot across the bows (see above) of some wicked and dangerous vessel or other, etc. etc., mix in further metaphors to taste. Were this particular kite actually to be nailed legally onto the map (which it will not be for the immediately foreseeable future) it would somewhat alter the legal relationship between banks and depositors. For more about this scheme, from Steve Baker MP (whom we have had cause to notice here before), see also this.
Basically, this proposed law says that depositors should get to decide whether they still actually own what they already now think of as their own money when they hand it over to a bank, or whether their money degenerates into a mere excuse to create much more degenerate money, out of thin air. Depositors get to decide, in other words, about whether their bank deposits will be the basis of fractional reserve banking, or not. Or something. Don’t depend on me to describe this proposal accurately, or comment learnedly and in detail on its efficacy, were we to live in a parallel universe of a sort that would enable this law to pass right now.
What I do know is that Austrian Economics (or, as I prefer to think of it: good economics), which is the theoretical foundation of the Cobden Centre, ought to have massively more sway in the world than it does now. Recently I have been trying to get my head further around Austrian Economics than my head has hitherto been, and I have also been watching the Cobden Centre as it has gone methodically about its self-imposed task of transforming Britain’s and the world’s financial arrangements, thereby massively improving the economic prospects of all human beings.
I have always been impressed by Austrian Economics, ever since I first dipped into Human Action in the library of Essex University in the early 1970s. I knew rather little about Austrian Economics until lately and I still don’t know that much, beyond the fact of its superiority over bad economics. And I am now also very impressed by the Cobden Centre. What this latest parliamentary foray shows is that now Douglas Carswell MP seems to have joined the Cobden Centre network. Or maybe, what with Carswell having been an MP for some while, the Cobden Centre network has got behind Douglas Carswell MP. Whatever, and whatever his rank or title within Cobden Centre pecking order, Carswell is now a senior member of that network. Good. I hope and believe that there are many others now joining too, of comparable weight and intelligence.
I could say more about all this, much more. And I very much hope that in the weeks, months and years to come, I will. In particular I hope to explain more about just why the Cobden Centre has so far impressed me so much. But the important thing now is to get something about this up here, now, so that the Cobden Centre crowd (Tim Evans in particular) will have one more little puff of opinion to point at, to help them suggest that the intellectual wind may at least be beginning to blow in their (and my) preferred general direction.
Strange. I’m not at all certain that this view of fractional reserve is correct.
Basically, if a bank cannot loan out deposits, it cannot offer interest on them either, since holding money in a vault doesn’t generate any income. So, having a “do not lend this money” box on a form is actually a “do not pay me interest” box. Thus, the only benefit of having a bank account is somehwhere more secure to keep your money than a shoebox under the bed, and you put it in the account and pay the bank to store it, and watch it get worth a bit less every day due to inflation.
Anyone storing money in an interest bearing account is implicitly using the “bank” as a loan brokerage. The only argument against this currently is that banks don’t explicilty make it clear that they’re loaning the money, but it is not a secret either. Rothbardians think this is fraud of some kind, but it isn’t. It’s just loan brokerage.
What needs to change if anything is the irrational belief by depositors that they can earn profits (interest) from loan brokerage by their bank, without accepting the risk.
As such, this doesn’t make much sense to me. It seems to be the flawed Rothbardian interpretation of fractional reserve. Libertarians do need to internalise the fact that, even under a hard-money gold currency system, loan brokerage will occur and it’s not fraudulent to give your money to somebody, and sign a contract that they can lend it on your behalf and you’ll split the profits, which is all that is going on now, even if people don’t necessarily understand that. What nobody can reasonably expect is both profits and freedom from risk.
It actually makes perfect sense, as long as the law does not force banks to pay interest to those checking the other box (this would be totally insane, but stranger things have happened in our lifetime alone). You can bet that banks will very quickly make it known to those other customers that interest does not grow on trees, and that secure storage has a cost.
Alisa, I agree, but if there is to be a banking regulation ordering banks to offer the option of interest-free pay as you store accounts, the proposed law ought to say that. What this formulation of the law seems to be demanding is accounts like we have at the moment (free, and interest bearing) but with full reserve.
Ian B, a bank can loan out deposits with a time-restriction on redemptions, so that the length of time a borrower gets to have a loan is matched by the length of notice a depositor must give the bank before pulling the money out. This is a simple time-matching exercise. The problem is what happens when money put on deposit in a no-notice account is lent to someone for say, 3 months. That is where the problem lies.
With no-notice access to cash, the bank is acting as little more than a custodian of cash; one might as well put the dosh in a safe, but the bank saves you the hassle and the cost. The bank obviously will want to charge for this service (which is why I have no sympathy for people who bleat about bank charges for such services, at least in terms of the general principle involved.)
I am all in favour, however, of consumer choice. If banks want to operate on a fractional basis in a free market, and if banks could issue their own notes, and those notes had to compete for credibility in the marketplace, then only those FRBs which were careful would survive. Or maybe not. But let the market sort this out.
Ian, if that is the case, then see my parenthetical.
Johnathan, unless one makes a law specifically banning the lending of demand deposits- which seems to me to be somewhat anti-libertarian- then I think it will inevitably arise in a free market due to market forces. Banks which lend demand deposits are more profitable than those that don’t. It’s bound to be a service offered on the free market. Customers profit by getting a small amount of interest and bundled services- cards, internet transactions, phone transactions, cheques, whatever.
Frac reserve itself isn’t a particular problem, except it can make banking a risky business. Bank runs without a regulatory central bank etc system could actually cover their backsides by simply advising customers something like “under normal circumstances your money is available on demand, but we reserve the right not to immediately pay demands in the event that we’ve spent it all on hookers, cocaine or even offering mortgages to people with no hope of paying them back”. But then, bear in mind that in a true free market ordinary houses would only cost about ten grand or so, so we wouldn’t get problems there anyway.
Our money is “degenerate” to quote the original article, because the government keeps expanding the money supply. With some knd of commodity money, if there’s X commodity money, frac reserve will generate kX deposit receipts, where k is the fractional resevre constant, so I think it’s a bit dishonest for Rothbardians to claim that frac reserve expands the money supply and degenerates the currency. It doesn’t; the supply of commodity money is fixed and the debt supply is fixed too as a mutlipier of the commodity supply. People will tend to treat the debt as a form of money too, so the debt becomes a commodity, but you can’t ban that either in a free market. If some idiot wants to believe that a piece of paper saying that a meth dealer in Boise owes the bank $200,000 is an asset with value, well, that’s life.
Sorry to waffle on, but after a lot of consideration I think the argument that Fractional Reserve is dishonest is mistaken. Banks are currently free to offer zero interest accounts, but there’s not much of a market because people want to make a profit from their savings, and they’d still prefer that even without inflation. People just have to realise that their money is always at risk in a bank. You can’t fix that with yet another regulation, as this Bill is trying to achieve.
True in an unregulated environment, but only true to an extent in the current one. It is all about informed consent, and currently consent by most depositors is anything but informed. You could blame them for that, but I think we all know very well that it is at most not entirely their fault.
To all on Comments
http://www.cobdencentre.org.uk/ Have a look on our front page to the right and click on the Public Attitude to Bankings Survey.
74% of people think they own money in their deposit accounts, a lot do not know and a handful know that the bank own “their” money.
So people are not aware of the state of the law. I favour a correction of this i.e. make banks tell people we can keep your money safe on deposit or we can lend it , which means you will not own it when it is lent, but the right to it, that you can get back with interest at a date we can agree in the future.
This is the bedrock of honest banking. No one is banning anything, just getting true clarity on our property rights.
If people wish to enage in fractional reserve lending to get more of a return why not let the banks say “if you tick this box here for a fractional reserve deposit, know that we will pool it with others, we will then create credit out of thin air to lend to entrepreneurs 20, 30, 40 or 50 times over and you will more than likely get your money back with a good rate of return” then I would be in favour of this type of contract. As currently stated it is a violation of private property rights and would not be an enforceable contract as there is no clear “meeting of the minds” – see survey above.
What is being proposed by Carswell and Baker is very consistent with contract law and proper liberal property rights.
I would urge you all to support.
All business has to maturity match creditors and debtors. Banks to not and they will bleet and say what the butcher , the bakers and the candle stick maker do every day, they cant. They are legally protected by a Central Bank and they account not to GAPP like all of us but to their own audit standards. The correct Liberal agenda is get rid of these closed shop proactices and liberate the market and make banking honest.
For more in depth look, see here http://www.cobdencentre.org/2010/03/free-banking-the-balance-sheet-and-contract-law-approach/
Alisa, I don’t see how it’s particularly libertarian or anarchist for the State to force “informed consent”. There’s no secret about how banking operates. Any regulation requiring banks to stress that the money is being loaned out gets us into the same territory as forcing health warnings on ciggies, beer, food etc.
Toby, FR doesn’t create credit out of thin air. A proportion of the deposit (e.g. 90%) is loaned out and the remainer stays in the fractional reserve.
The fact that some people are dim enough to think that the bank is paying them for the thrill of storing their money in a vault isn’t a case for regulation. There’s enough history of bank runs to know that their money’s at risk. I remember learning about bank runs in school history, and that was at a shitty comprehensive. This is as much about the punters wanting something for nothing as about the banks.
Fractional reserve is the situation where a bank can loan out 10 times the amount you deposit!
So it´s not just a question of the bank possibly taking risks with your money, it is a question of the banks creating 10 times your deposit out of thin air!!
Might that be inflationary and guaranteed to trash the economy?
Cobden Centre – I must look it up.
So far most of my info has come from the US Mises Institute.
Nope, that’s a common misunderstanding. They can lend out (on a 10% reserve ratio) 90% of the money you deposit. You get to a 10x multiplier only as the borrowings echo through the system- you deposit £10 in Bank A, Bank A lends £9 to somebody else, he deposits that in Bank B, Bank B lends £8.10 to somebody else, she deposits that in Bank C, who lend £7.29 to somebody else…
You end up with 10x the deposit in teh system as a whole, but that’s different to saying the bank can create 10x your deposit out of thin air. If that were the case the money supply would virtually instantly rise to infinity.
“Basically, if a bank cannot loan out deposits, it cannot offer interest on them either, since holding money in a vault doesn’t generate any income. So, having a “do not lend this money” box on a form is actually a “do not pay me interest” box. Thus, the only benefit of having a bank account is somehwhere more secure to keep your money than a shoebox under the bed, and you put it in the account and pay the bank to store it, and watch it get worth a bit less every day due to inflation.
Anyone storing money in an interest bearing account is implicitly using the “bank” as a loan brokerage. The only argument against this currently is that banks don’t explicilty make it clear that they’re loaning the money, but it is not a secret either. Rothbardians think this is fraud of some kind, but it isn’t. It’s just loan brokerage.”
Only partially agreed here. People seem to have confused a zero (or almost zero) risk “safe deposit box” with a low (but definitely not zero, as the recent crisis shows) risk loan brokerage. The difference between the two should be made plain. Of course, there may simply be no takers for the safe deposit box, but then people can hardly complain if they lose all their savings in another bank failure that isnt rescued by the government.
IanB, I would not support banning of demand deposits being loaned out (the key issue is that customers should have a choice in the matter, and that banks must clearlys state what they are doing).
Rather, I think that what the Cobden Centre folk are lobbying for is for those who have such deposits to have their legitimate property rights recognised and enforced. And as we are currently in the process of trying to figure out how to prevent a future credit bubble/crash, it is good that folk are thinking these things through. I mean, how many people who deposit cash in the bank have any clue about all this in any detail? It often comes as a shock to folk – as in the Northern Rock saga – when they realise just what a controlled fiction much of the banking/savigns industry really is.
That is not good from the point of view of those who want to defend markets and classical liberalism. It is a situation that plays right into the hands of the snake-oil salesmen of the dirigiste mainstream.
Johnathan, I’m not sure that Northern Rock actually shows that people don’t know how banking works; if anything a bank run shows people who do know how it works and are trying to get their money out because they know the bank hasn’t got enough assets to pay everyone, so the best strategy is to get your money out before they run out.
The point for me personally is that the problem is central banking and the treatment of banks as “institutions” rather than as businesses. Once anything in our society gets called an institution, people start thinking it’s essential and will always be there. That’s why they’re shocked when a bank fails; it reveals that it isn’t an “institution”, it’s just a business, and a rather speculative, dodgy one at that. It’s the same psychological effect as your local hospital just closing down. People don’t think that can or should happen.
But none of that has really anything to do with fractional reserve, which is simply the perfectly normal idea of loan brokerage. You have some money, you want to lend it at interest, you use a third party (“the bank”) who specialise in doing so, because that’s easier and in fact a lot safer than an advert on Ebay saying “I have 10,000 quid, anyone want to borrow it?”.
I’m just saying that FR isn’t the main problem with banking, and I don’t think the Rothbardian narrative that it’s fraud is particularly useful.
Well Ian, if people really knew, for instance, that NR funded much of its book via the short-term money markets, and was offering exceptionally high rates for no-notice accounts, then maybe they would have been a bit more careful in the first place. One thing is for sure, the NR debacle and others like it have been a timely reminder that banks/others that offer v. high interest rates with no apparent downsides are to be treated as dangerous.
No, I think what these MPs are calling for is sensible and a good reminder about the issues at stake. It is a lot saner than central bankers trying to save the system by printing ever greater amounts of money.
Okay, Ian, stupid mistake of mine.
However, as you say:
it does reverberate through the system.
In an electronic age, how long does it take that 10x effect (to which I was clumsily referring), to take effect?
IanB seems to be the only one on this thread (so far, anyway) who really seems to understand fractional reserve banking. Yes, asset/liability mismatch can be a problem (per Toby’s comment), but banks do spend significant amounts of effort in doing monitoring and preventing it (that’s why they all have an ALCO Committee). And no bank thinks that it “owns” the deposits, Toby; look at any bank balance sheet and you’ll see the doposits carried in the “Liabilities” column. Banks understand full well that they’re borrowing the money at wholesale and re-lending it at retail. They make their money on the spread, as does any intermediary.
I have absolutely no problem with better disclosure of the nature of the deposit relationship; people should exercise better care in the selection of the bank to whom they entrust their money. But to the extent they don’t, and blithely go around thinking their money is absolutely safe, I blame government, not the FR system per se. It’s government which offers poorly-designed and politically manipulated deposit insurance; it’s government which presumes to create a detailed, all-encompassing regulatory scheme giving the illusion that it can and will protect depositors from all harm; it’s government which meddles in the lending process to direct loans to favored groups, distorting normal market mechanisms; in the end, it’s government which created this mess. More government won’t get us out of it; that will require less government.
One more observation, on the Northern Rock fiasco: Johnathan is absolutely correct when he says “banks/others that offer v. high interest rates with no apparent downsides are to be treated as dangerous”. Of course they are; why else do you think they have to offer such high rates? Anyone who receives interest substantially above market rates has to know that there is a reason, and that reason is higher risk. If you don’t understand that, then you’re simply trying to get something for nothing, and you deserve what happens to you. “You can’t cheat an honest man.”
Ian, where did I ever say that that I support the enforcement of anything by the state?
Alisa, we’re discussing state action, so as it seemed to me that you are supporting this proposed law, that implies a support for state action in this case. Apologies if I misunderstood you.
Me too, me too!
Exactly the point I was making. Your shitty comprehensive Ian wasn’t as shitty as most other schools, it turns out, because in my experience most grownups with standard western state education and with fairly substantial amounts of money in various banks have not the slightest clue about any of this.
Laird, I understand FRB and I don’t see that it is necessary to outlaw FRB, merely to make it much clearer to folk that when they put cash into a FRB and want instant access, that this might not be possible.
I agree 100 per cent about the problems caused by governments. 99 per cent of the problems of FRB would go away if we had a, genuine competing currencies, b, no government protections such as deposit insurance, c, no “too big to fail” bailouts, and d, no “lender of last resort CBs. The result of this would be that any FRB would only survive by being as open as possible.
On the Northern Rock side, yes, of course the high interest rate was a sign of danger; but it says something about how governments have infantilised the populace that this point was not more widely understood by Joe Public at the time of NR’s demise in 2007.
Laird, I understand FRB and I don’t see that it is necessary to outlaw FRB, merely to make it much clearer to folk that when they put cash into a FRB and want instant access, that this might not be possible.
I agree 100 per cent about the problems caused by governments. 99 per cent of the problems of FRB would go away if we had a, genuine competing currencies, b, no government protections such as deposit insurance, c, no “too big to fail” bailouts, and d, no “lender of last resort CBs. The result of this would be that any FRB would only survive by being as open as possible.
On the Northern Rock side, yes, of course the high interest rate was a sign of danger; but it says something about how governments have infantilised the populace that this point was not more widely understood by Joe Public at the time of NR’s demise in 2007.
Johnathan, I don’t disagree with anything in your last post.
A few months ago there was a SQOTD from “Alchemists of Loss” which is worth re-reading.
I haven’t seen anywhere a discussion about the idea of privatizing deposit insurance. That would be an interesting thread!
Jonathan Pearce:
I agree that’s where part of the problem lies, but not all of it. Switch to all time-matched lending and you resolve the liquidity risk issues created by FRB, but you still have credit risk issues. The depositor can still end up out of pocket if the borrower doesn’t pay back the loan.
I tend to go along with Ian B’s comments.
I’ve suggested precisely this kind of approach before, but unless FSCS and other state guaranteed “depositor” protections are removed, it is pointless. Given a choice between paying a bank to act as a safety deposit box at a cost to the depositor, or allowing a bank to lend on the depositor’s money and paying interest in return, nobody is going to choose the former if the state guarantees that anybody choosing the latter will get their money back anyway.
Demand deposits means demand deposits. A bank that lends out its demand deposits is breaking a trust. There is nothing unlibertarian about requiring demand deposits to be available on demand. If they are lent out, they are not.
There are two kinds of deposits currently, ‘time’ and ‘demand’. I have not read the proposal but it appears to seek a system with three types of deposits, ‘time’, ‘demand’ and ‘request’. ‘Request’ deposits would be available unless there was a run on the bank and then available funds would be payed out according to the depositor’s contract.
Under these three systems, true demand accounts would certainly need to charged fees of some sort in order to recoup the costs of providing secure storage/transaction services. Time deposits would function as they do now but probably return a slightly higher amount. Request deposits would function like pseudo-demand deposits do currently but with ‘request’ status taking the place of taxpayer bailouts.
In the case of Northern Rock, the people with ‘request’ accounts would have been told “you’ll get your money as it becomes available according to the terms of your deposit contract”.
I see no conflict with libertarian principles here. And this is the only way to get away from taxpayer funded bailouts of reckless banking businesses. This solution creates the possibility for a bank in trouble to continue business in full compliance with its obligations and not requiring a bailout.
To address Paul Lockett’s last point, any account that is subsidized either in services or interest payments from lending its money out should (and I suspect soon would in a free market) have selectable levels of risk. Those deposits could then only be lent to appropriately rated borrowers.
Fine, but all that is being done is changing the terminology, it is literally nothing more than an exercise in semantics.
As Paul Lockett says-
And this is inescapable unless the wise government is going to ban loan brokerage.
Money is fungible. No one tracks the specific currency bills “deposited” into an account. For proper duration matching all that is necessary is that the aggregate amount of deposits of different maturities match reasonably closely the maturities of the bank’s loans.* And the next step is reasonably estimating the likely withdrawal rate of demand deposits. They aren’t all going to be withdrawn at once, and it’s perfectly rational for a bank to estimate the probable average duration of those deposits** in matching them to the duration of its loan portfolio (which, of course, is precisely what is done). Stupid bankers may “borrow short and lend long”, but smart ones don’t and regulators frown deeply upon it.
It is, of course, loan quality which is the true problem here, but so much of the problem we’ve seen with loan quality in these last 2-3 years is directly attributable to governmental actions. Whole dissertations can (and probably are being) written on this topic, but the problem isn’t limited solely to governmental “encouragement” of risky lending via the Community Reinvestment Act, or even Fannie/Freddie. It’s far deeper than that. The whole real estate bubble can be laid at the feet of the Fed and its easy money policy since the Greenspan years, and the Basel Accords strongly drive banks to real estate-secured lending (the safest collateral there is, right?). Much of the problem with mortgage-backed securities can be attributed to thoughtless regulatory and accounting policies driven by Congress, bank regulators and the SEC. And the government mandates that reserves be inadequate.***
Bankers don’t intentionally make stupid loans. They do the best they can, using appraisals, invested equity, historical and projected financial statements, borrower net worth standards, and personal guarantees. But all they really have to go on is history, and when you have a once-in-three-generations financial collapse bad things happen. The fault is not fractional reserve banking; it’s government.
Again, I repeat that I have no opposition to better disclosure of the precise nature of the deposit relationship. Furthermore, as has already been noted, there’s nothing stopping banks today from essentially holding their customers’ cash in safekeeping (for which a fee would be charged) rather than in a deposit account. It’s not done because there’s no market for it; the customers don’t want that service. And who can blame them, when the government is guaranteeing the safety of deposits? The heavy hand of government is 99.999% of the problem. Eliminate that, and let the market work, and the problem would be solved. Even with fractional reserve banking.
* This shouldn’t require saying, but I keep seeing silly posts like “the problem is what happens when money put on deposit in a no-notice account is lent to someone for say, 3 months.” Sorry, but it doesn’t happen that way.
** This is why “core deposits” have value, and why banks pay a premium for them when they acquire other banks, or when the FDIC liquidates the deposits of a failed bank.
*** Did you know that it’s illegal under SEC regulations, and is penalized by the IRS, for banks to put aside high levels of loan-loss reserves during the “good” years? Reserves have to be justified by “past experience”, and since by definition losses are low to non-existent during good years there’s no ability to build up reserves for the inevitable lean times. After all, to do is considered to be “managing earnings”, and we can’t have that, now can we? So when times turn bad and the reserves are really needed they aren’t available, and the bank’s capital is quickly wiped out. Absolutely brain-dead regulation.
Fungible. Fungible. I love that word. Fungible fungible fungible.
It’s not just that either 😉 One of the most profound problems IMV is simply a matter of belief. It has become widely believed in our society that property is by some inherent nature a “good investment” and that by some inherent nature property values must always rise and if they do not something is wrong with the Universe. It is that belief which drives much, if not most or even all, of the disastrous government interventions in this regard. Until we can challenge that belief, the property market will continue to be forced into a bizarre and economically disastrous shape.
Ian B, good point about property, although for a second I thought you had become influenced by those socialists-in-drag who pray at the altar of Henry George. Careful now!
Laird, I would be very grateful if you could expand on this.
Ian: first, semantics are of great importance, especially in areas such as this, where the majority of the population are ignorant of very basic facts and principles. Second, it is clear even from the original post and without reading the actual proposal that it includes more than mere change in terminology. Speaking of which: has anyone here actually read it yet?
Johnathan, the whole problem with the Georgists is that they believe that property prices rise without end, too!
Alisa: not the bill itself (does anyone have a link?), but I have just read Douglas Carswell’s blog post that Brian linked to. And I don’t see anything there that answers any of Ian B’s points. He seems to be saying that there needs to be a tick box for “you can lend my money”, and that people will decline to tick it, and that this will prevent, “bogus, candy floss credit, which then fuels reckless economic expansion. Followed by inevitable contraction. Ending in demands that every taxpayer then bail out the guys that built the ponzi scheme.”
So I am inclined to agree with Laird and Ian B, and wonder why stress the lending of deposits instead of, say, deposit insurance. Perhaps there is some strategy I don’t understand: “The People will be afraid of abolishing deposit insurance but if we make it seem like we’re bashing bankers they’ll go for it”?
By the way, Laird’s 6.05am post deserves to be expanded into a guest post. 😉
“The People will be afraid of abolishing deposit insurance but if we make it seem like we’re bashing bankers they’ll go for it”?
Just what I was thinking.
If we insist that deposits that are in fact substantially lent out be called “demand” and do not distinguish between fully funded and fractionally funded deposits, then obviously any banker who can’t meet ‘demands’ must be a crook.
How anybody can say “just semantics” is incredible. Words mean things. One of the biggest coups of the central bank crowd was gaining use of the word ‘demand deposit’. Once that was granted then the need for the deposit insurance was politically inevitable.
The first step in getting people to accept responsibility for their financial decisions is to return words to their true and narrow meaning.
Laird, I have to disagree with your statement that “They aren’t all going to be withdrawn at once, and it’s perfectly rational for a bank to estimate the probable average duration of those deposits”. It has been known at least since the evil Mr. Potter made a move on George Bailey’s bank assets (in It’s a Wonderful Life) and through the real world present when Chucky Schumer helps bring down a bank so his buddies can pick the plumbs from the pudding, that “the probable average duration of those deposits” can be manipulated by hostile external intent. That is a situation than cannot be changed and certainly not by government regulators. Therefore, the distinction between true ‘demand’ deposits and deposits that are exposed to market irregularities must be made clear. Privitizing deposit insurance is necessary but it costs money and why prevent consumers from distinguishing between the cost of a fully reserved deposit, a fully insured deposit and an uninsured deposit by insisting that they can all be called by the same name? Demand should mean that is is available on demand. Vault cash. Fully insured is subject to the solvency and liquidity of the insurer and large economic events tend to hit a lot of banks. Think of a homeowners’ insurer that writes entirely in an area that was in the path of a hurricane. An insured account cannot accurately be called a demand account unless the US Treas printing presses are backing up the insurance.
Hell yes. It is just semantics. And what is the point of anything if we no longer care about what words really mean?
Rob: yes, I also agree with Laird’s and Ian’s general points – but still, it seems unwise to pass judgment on a document without actually reading it.
Oh, and very much seconded on Laird’s post. In fact, if I had the key to posting at SI, I would have given him a copy long time ago.
In case anybody missed the point in the first paragraph of my 3:36PM, I was agreeing with Rob’s and Brian’s observation about the vilification of bankers.
Alisa, loan-loss reserves are very much off-topic here, so I don’t want to go deeply into this. But generally, there are two types: specific and general. Specific reserves are when you know that a certain loan has a problem and you try to estimate the loss. No problem there (although most banks have their heads in the sand concerning property values and haven’t taken sufficient write-downs for known bad loans). General reserves are those you establish because you know that there will be losses somewhere in your portfolio but not on which particular loan. That’s where the problem lies. The SEC and various accounting bodies have tightened up on this in the last decade or so, and require that you be able to justify the reserves by reference to historical results. Otherwise, they fear that CFOs will “smooth” earnings to meet analysts’ predictions, squirrelling away “excess” earnings in one year to beef up a bad one later. (One CFO friend of mine used to call this putting “nuts in the cupboard”.) This all sounds good in theory, but when you have a decade of unusually strong economic growth there will be little or no realized losses, so there’s no way to “justify” (to the SEC’s satisfaction) any significant amount of general reserves. The “good” years are precisely when banks should be beefing up their reserves against the inevitable downturn, but the current rules prohibit this.
Midwesterner, it’s good to hear from you. (And, as often happens, we’re going to have some disagreement here!) Certainly bank runs aren’t a new phenomenon (although we never saw systemic runs before the creation of the Fed, as they were generally limited to individual banks, but that’s another discussion). And yes, runs are triggered by specific events, so I stand by my statement that absent some highly unusual circumstance depositors are not going to all demand their money at once. You compare this to insurance companies, which is actually a pretty good analogy. Insurance companies are very good at forecasting their cash needs, and structure the duration of their investments accordingly (just as banks match their asset and liability durations). Most of an insurance company’s assets are not in cash at any given time, but rather are in commercial loans, securities and other investments. If an extraordinary event should occur (a Hurricane Katrina, or plague like the influenza epidemic of 1918), it is possible that an insurance company might not have enough liquidity to cover all claims. The claimants would have a legal right to demand immediate payment, but the company couldn’t meet it. In such a case you wouldn’t say that the insurance company did anything wrong (assuming that their actuarial predictions were rational and their risk diversification practices [via re-insurance] were reasonable). You wouldn’t lay the blame on “fractional reserve insuring”, you would recognize the extraordinary circumstance for what it is and acknowledge that in this world nothing is perfect.
A once-in-a-lifetime cataclysmic economic event may provide a good opportunity to re-examine regulatory and legal structures, and make corrections where warranted, but it is not a reason to make wholesale changes in a futile attempt to protect against extremely rare occurrences. We have to accept some risk; the cost of (unattainable) perfection is far too high.
I have a question for all experts, a devil’s advocate type of question.
I agree that government “insurance” of deposits, and “rescue” of failed banks is the main culprit for most banking problems.
Suppose an environment where the government does not intervene, and some banks fail, and depositors lose their dough sometimes. In such an environment many (or at least some) people will refrain from entrusting their savings to banks, and will hoard the money (presumably in gold coins), in the shoe box under the matress.
In such an environment economic activity (and wealth creation) will be reduced by a lot, as money that could be put to good use (investment) lingers in that box and produces nothing.
Doesn’t the government “insured” bank contribute to the creation of wealth more that the “natural” state (no government insurance) – in the long run ?
I mean – despite the grave problems that government creates, maybe, in the aggregate, it creates more wealth ?
Jacob, I thought it obvious that unregulated economy should grow at a substantially slower rates than the ones we have seen over the last century. That is the price for greater stability (Jonathan’s post above notwithstanding), among other things. Not to mention that certain fraction of the above-mentioned historical growth has not been real. But you are right, let’s see what the experts think…
Oh, and thank you, Laird – I got the general idea. Did you mention nuts?
Jacob, if you go to the link in my post of 9/14 at 5:12 PM, you can read about how banking worked pre-federal deposit insurance. Pretty well, actually, because not everyone wants to keep his excess cash in a box under the bed (especially if there’s any substantial amount of it). There was an awful lot of wealth created in the 19th century.
Just out of interest… I saw my sister (not a libertarian or economics buff) this afternoon, and asked her the following question (without any “priming”; we were shopping in Sainsburys)
“If you borrow, say, a thousand pounds from the bank, where does the bank get that money from?”
She regarded me a touch quizzically so I promised her it wasn’t a trick question. Her answer was (pretty much verbatim)-
“Other savers. Like, if [my husband’s] got 25 grand in the bank, and I borrow a grand, I might be borrowing it off him. Is that the answer you wanted?”
I talk to her about politics and shit, but I’ve never bored her about Fractional Reserve etc.
Only a sample of one, of course. But she’s your “ordinary housewife” so it’s a useful data point.
Yes, but does she realize that the sum of total amounts borrowed far exceeds the sum of total amounts saved/deposited?
I didn’t ask that Alisa, but I don’t think she’d specifically know that. But that’s not the premise of this Bill; which is that supposedly savers don’t know their money goes out on loan to other people.
I guess I need to be reviewing some life expectancy actuarial tables. 🙂 There was also the LTCM bailout that probably came closer to a meltdown than we think. Oh, and Continental Illinois?
In other words, absent some highly unusual circumstance (are you really suggesting that regulatory blithering idiocy is “highly unusual”?), we won’t be forced to subsidize demands that can’t be met? The policy of “too big to fail” due to the risk to the general marketplace has actually been around since 1950 although it didn’t get used for the first time until 1969. Perverse incentives by regulators have been an escalating problem and the number of these crises will be (and has been) increasing in both frequency and magnitude.
I read through my comments and the curse of commenting in a hurry, it is not as clear as it could be but I am not advocating for any changes in banking practices (aside from getting the USGov to follow Constitutional constraints). I really am, as Ian so dismissively observed, arguing semantics.
You agree that the ‘demand’ feature of typical deposits will only matter on very rare occasions when demands cannot be met without taxpayer intervention, and therefore it is correct to describe it as available on demand. I say ‘no’. If it is only available by picking the pockets of tax payers or inflating the currency, then it is not available on demand. This is why I want the name changed to ‘request’ or something that acknowledges those once in a life time occurrences that come along at least twice in the last three decades.
I’ll take your word for it that there is nothing preventing banks from offering full reserve banking. If that is true then all I am asking for is accurate semantics. Full reserve (vault cash) is truly available on ‘demand’. So let’s restrict the term ‘demand’ to full reserve. Those accounts would of course charge high fees. All present accounts would be correctly described as ‘request’ accounts where the return of your deposit is contingent on the net activity of entities (borrowers and insurers) that are beyond the banks control.
Again, I am not arguing in this thread for the elimination or mandating of banking services, only that the terminology be returned to correct usage.
I asked the first person I met during this thread about what ‘demand deposits’ meant. He is probably an above average person for caution and actually reads all of the EULAs for his software. Carefully. While he of course knows that the bank lends his money to other people, he like most people thinks that ‘demand’ means all of the time, not ‘almost all of the time’. He even brought up a cable internet contract that offered a given speed but down in the very fine print says that if a bunch of people on his line want to browse at the same time it will not be fully available. He understood the concept, but like almost everybody else he just doesn’t understand banking complexities enough to know how banks can make that promise. Like almost everybody, he accepts it on faith. And speaking for myself, I reject the use of the term ‘demand’ to describe the FDIC/Central bank picking my pocket even only occasionally to meet the demand. Those depositors are not getting their deposit back, they are getting the taxpayer/$users money redistributed to them.
RE the insurance analogy, you make the very good point that house insurers can diversify into the wider economy so that no one event can hit their entire underwriting portfolio. They also have reinsurance. It is reasonable to expect an insurance company to carry reinsurance to cover a bankrupting claim cycle. But unlike natural disasters, economic crises leave nothing safe. All possible players live in the economy. It is impossible for bank deposit insurers to diversify their economic holdings outside of the economy. Currencies and collapses tend to travel in packs. My point with this observation is that the more a crisis expands, the more important ‘demand’ availability is, yet the more likely that monitization is the only way to meet it. We quickly get beyond caring about blame and begin worrying about survival. Lending from ‘demand’ is a serious systemic flaw and the most important first step to addressing it is to acknowledge it. If depositors apply for a ‘request’ account then there is no need to second guess their choice. Let them decide. Currently we eliminate risk by spreading it to everybody which means the incentive to responsible behavior is lost. Correcting the terminology will allow individuals to place a cash value on how guaranteed their available their funds are. It is the first step towards privatizing and personalizing the consequences of risky behavior.
This is another rushed and verbose comment. Hopefully I didn’t too many mistakes or incomprehensible muddles. I really don’t think we are very far apart. You are talking about the merits of mandating/prohibiting certain banking activities, I am only referring to restricting use of certain terms to describe certain narrowly defined conditions. Given accurate information about various account options I trust the depositors to make their own choices and deal with the consequences.
“There was an awful lot of wealth created in the 19th century. ”
Well, and also an awful lot of wealth created in the 20th.
Especially in the regulated last 60-65 years (since WW2 ended) we have seen an explosion of wealth creation.
There were many factors involved, sure, but it’s not obvious to me that bank regulation and “rescues” did a lot of damage. Maybe we’ll suffer the damages in the future (possibly near future).
Take even Japan, stagnant since 1990. They are rich, a good plateau to be stagnant in. (Talking about stability….)
Yet strangely the less regulated bits were the places which created the most wealth
I am too tired to get into this at depth now (especially as I have written and talked about it for several decades – for example for several years here).
However, my own view (on this – not on a lot of other things) is much the same as that of the late Murray Rothbard.
Loans must come from real savings (i.e. from income and wealth that people decide not to consume) – if total loans are greater than real savings some fraud must be going on somewhere (even if it is really complex and is perfectly “legal” according the statutes of the government and the judgements of the courts).
Sorry but one can not have an earnings of 100 Pounds, spend 95 Pounds and then have 20 Pounds to lend out (either directly or via a bank). You only have 5 Pounds to lend out – and no clever schemes by bankers can really alter that fact (not without Hell to pay in the long run).
However, let us say that my “Rothbardian” view is wrong – i.e. that fractional reserve banking is NOT fraud.
O.K. then – so let us abolish the Bank of England, no more low interest rate loans to franctional reserve banks (and no other stuff either).
Not happy? Why not?
Surely, if fractional reserve banking has nothing fundementally wrong with it, a quiet drip feed of corporate welfare (which is what the Bank of England does in quiet times – unlike now when the corporate welfare is open and obvious) would not be needed.
So bankers (and other such) you can not have it both ways.
Either what you are doing is crooked (in which case you should be in prison), or what you are doing is not crooked – in which case there is no need for the Bank of England and other such.
However, a quick note to TUC (union) conference and other such leftists.
You are all denouncing the bankers now – and saying how government spending cuts are not the right thing do because the crises is “the bankers fault”.
However, the vast increase in government spending was based upon the antics of the bankers. The taxes from the profits of the financial industry (i.e. taxes on profits made by wild credit money expansion – the very expansion that created the boom/bust) and direct finance by the buying of government debt.
Your mega government (with its endless spending on X, Y, Z) would not have been possible without the very banking schemes you now denounce.
Gordon Brown did not bailout some banks (and other such) because he loved bankers – he bailed them out because his entire scheme of increasing government spending depended on them, and always had depended upon them.
Still – back to topic.
The people Brian talks of have my best wishes – I wish you good fortune.
It is good to know there are good people about.
Oh by the way – once money is lent out it is LENT OUT.
You can not have the money “on deposit” if it has been lent out. It is NOT available for you to spend – because it has been LENT OUT. That is why the 19th century judgements on what “deposit” means were fundementally wrong. Of course if money is really “deposited” then no bank can pay interest on it – in fact you should PAY THEM for looking after it for you.
If you want interest you must accept that the money is NOT in the bank – it has been LENT OUT (it is not avilable for you again till when and IF the borrower or borrowers pays it back).
Two people can not spend the same Pound on two different things at the same time.
Whether one calls clever schemes to get round the above “fraud” is open to debate – but what is not open to (rational) debate, is that such clever schemes must end in tears.
Jacob, my only reason for noting that “there was an awful lot of wealth created in the 19th Century” was to point out that it can (and did) occur before the invention of deposit insurance. It was in response to your original question, and its (implicit, I thought) assumption that such insurance is necessary to wealth creation. It is not.
Midwesterner, I am fine with changing the name from “demand” to “request” if that makes you happy. Lazy people won’t understand the distinction, and most others will go on as before, understanding that banks will be lending their money and there is some risk in that. They still won’t care, because of deposit insurance.
Oh, and one technical correction to your post: it was FSLIC, not the FDIC, which went broke during the S&L crisis of 1989-1992. The two have since been merged, but at the time they were independent funds managed by separate agencies. (The thrift regulators of the time were even more stupid than their bank regulator counterparts, if that’s possible to imagine, but that’s another story.) Anyway, the S&L crisis was over in about 3 years, involved fewer failures than have already occurred in the current mess (and we still have an estimated 400-800 bank failures yet to go!), cost the taxpayers far less, and wasn’t really an existential threat to the banking system. It was a problem, but of a different (smaller) order of magnitude than we have today. Same for the LTCM collapse of 1998; that was over and forgotten in 6 months, and was no more significant to the overall economic system than was the collapse of Drexel Burnham Lambert a decade earlier. (I’m old enough to have been working in financial services during all these events, and remember them vividly.)
Paul, I was wondering where you were. Good to have you join the discussion. This post is long enough already, but I’ll just point out that I’m perfectly fine with abolishing the BofE (and, for good measure, the US Federal Reserve). Fractional reserve banking existed for centuries before central banks started intervening (the Fed has only been around since 1913), and the system works about as well as any human institution can. There was the occasional failure or panic, certainly, but the system was self-correcting and stable before government-subsidized deposit insurance poured a huge dose of moral hazard into the mix. FRB isn’t the problem (Rothbard’s peculiarities notwithstanding).
Ian: this may not be the premise of the bill (have you read it yet?), but this is the real problem with FR and the only point that matters.
Fractional Reserve Banking (which means always, to keep a certain ratio below 100% of reserves for the “on demand” deposits, by they way all deposits MUST be on demand otherwise they are not deposits but loans) is a fraud because it is counterfeiting. Whatever the money is, commodity or legal tender paper money, more money certificates are issued (whatever its form: bank notes or checkbook money ) than the actual money stored in their vaults. In that situation, it happens to be that at least SOME of the certificates are fake, which is a logical deduction from the previous statement. It does not matter if those fake certificates are known a priori, or are simply those of whom arrive late at the bank to redeem them. At the very point where those are issued, the counterfeiting crime has happened in the sense that the bank is signing an impossible contract, or null contract and actually stealing customers money. Furthermore economic theory and in particular the theory of economic cycle demonstrates that it is impossible for the bank to commit the crime without being discovered sooner or later. It is simply due to the very fact that two or more individuals believe themselves to be the exclusive owners of some scarce resource leading to a conflict when that resource is to be consumed. Hence, there is not possible secure or stable ratio other than 100%.
About fractional reserve banking:
Suppose mister A lends 1000 bucks to Mr B, and B lends those buck to C, and C to D (all just men, not banks). Is there anything wrong with that ? Did this transaction create 4000 bucks out of the original 1000? Is there any fraud involved, or logical error, or any irregularity whatsoever ?
Of course, B,C and D know perfectly well that beside the 1000 bucks (assets) they also have a liability (they owe), so their net worth hasn’t increased, and no new wealth was created, the original 1000 bucks is all there is to spend.
Now – why would the same perfectly correct and fine transaction turn into fraud, or why would it be wrong if done with the help of an intermediary (the bank) ?
Paul said:
“if total loans are greater than real savings some fraud must be going on somewhere “
Where is the fraud in my example ?
Maybe the term “deposit” is misleading. But everyone knows that he is lending the money to the bank, and the bank is lending it to others, and there are risks involved, and you’ll get your money back only if the bank is solvent (ignoring gov. deposit insurance).
No, there is nothing wrong with fractional reserve banking, it’s not creating wealth out of thin air, it’s not fraudulent, it’s not illogical…
Printing of money is an entirely different matter… it is all of the above, and a crime in all legal systems, and still it is done regularly by all the central banks.
But fractional reserve banking and printing of money aren’t the same thing.
“Two people can not spend the same Pound on two different things at the same time.”
Bullseye. It is frankly amazing how often so many learned and smart folk try desperately to avoid accepting this basic fact of reality.
A really is A, as Aristole and Rand put it.
Except it’s a fallacy. Nobody is spending the same pound on two different things. So the argument doesn’t apply.
Except that it’s not a fallacy. He could have said, “two people can not have a claim on the same pound at the same time”. But under FRB, they do. The fraud is in the debasement of the currency and a depositor who signs up to it is merely participating in a fraud against other depositors.
However there is no need to ban FRB. In a free market nobody would put money into an entity that practiced FRB. The vast likelihood is that legal practices would be established whereby demand deposits are legally ring-fenced from any lending activities undertaken by the provider.
The term “deposit” is the problem. It is a form of fraud – misrepresentation – but FRB per se is not a fraud. There is no more real, actual hard money because of it, and nothing comes from thin air.
I think the Carswell Bill will be useful in that, but I doubt it will have any effect in the long term, or even medium term. Charges and/or new products will be created to meet the need.
As Jonathan Pearce has rightly said, the key is to remove the monopoly over legal tender and have free banking.
However, though there will be no more “Central Bank” nationally, each provider of currency will perform the CB role if only for individual branches or those banks who take and on-lend its currency. The Bank of England could be the owner and operator of Pounds Sterling and would perform similar functions in regards Lender of Last Resort but only for Sterling operations, not the new currencies.
I am a little worried that people think a (near) overnight switch to true demand deposits is possible, for it is not. If 15% of depositors decide to demand their deposits, then the system melts down and you have a massive credit contraction until reserve ratios recover.
Jacob,
When Mr A lends to Mr B to C to D, Mr A knows that before he can spend the money he must recover it from Mr B and is restricted by the terms of the loan. The same applies to Mr’s B, C and D
But when the bank does it, it promises the money to all of them at the same time.
I’ll explain as simply as I know how why this is so rarely a noticeable event. As ‘float time’ has shrunk to almost nothing, money spends almost no time out of the banking system. Whether credit card transactions, wire transfers, event hand written checks, they are deducted from one account almost simultaneously with being added to another account. The money almost never leaves the money systems lending base. Because of this, while imbalances in the reserves of individual banks can get out of kilter, the system as a whole maintains the base. Banks that find themselves with excess base can lend it to other banks that find themselves short. The expansion to the money supply (in the US) stays at a fairly consistent ~10 fold. That is, one dollar of ‘central bank money’ – the money that is actually created by the Fed/Treas – is multiplied through lending to equal ~10 dollars in circulation. And as I explained above, the money never leaves the banking system, so the system totters along quite nicely.
But all the time it must be kept in mind that the money has been promised to Mr’s A, B, C & D simultaneously. What happens if Mr’s B & D, who both believe they have the exclusive use of $1000, decide to withdraw their money at the same time. Suddenly the bank has to cough up $2000 cash but it only has $1000. The system is based on that never happening on a system wide basis.
If the average person holding US $ decided to withdraw only 10% of their money all at the same time, there would be no money left. This never happens in good times because nobody worries about their bank not having the money when they want it. My parents were teenagers during the Great Depression and it was the foundation of all of their attitudes towards money for their entire lives. When you go to the bank and the door is locked, what do you do? When people panic, they want cash. They want to be sure they have money if the banks close. Granted this does not make perfect sense but it is the innate response of all humans. We even have a saying “a bird in the hand is worth two in the bush” which easily translates to “a dollar in the hand is worth two when(if) the bank reopens next week”. When people panic they want cash.
If everybody drew out only ten percent of their deposits as cash, all of the loans would be written on thin air. There would be no money at all in the banking system. The mere thought of such a thing sends central bankers and the politicians that rely on them into a frothing panic. When there was a major negative swing in reserves in 2008, McCain stopped his campaign to help the panicking panickers do something to stop further panic, but what they did is a whole discussion by itself.
This is why for the last 60 years there has been this concept of “too big to fail”. It isn’t even necessarily the dollar amount of default, it is how it will effect depositors’ attitudes towards their money. If ‘the big bad™‘ looks scary enough, people might want cash and if that happens it’s Nellie bar the door time. Literally, bar the door. Don’t let the depositors have cash or we all gonna die.
This is why stability requires that people know that they don’t have guaranteed access to cash during a bank run unless the money is stored in a high fee, full reserve account. It is quite reasonable that banks would offer several levels of risk for transaction accounts and economic events would be contained. Perhaps only class single A accounts would experience a loss. The bank might liquidate all of its single A holdings and distribute the loss evenly among depositors’ accounts who chose that level of risk. No runs, no panics, varying degrees of misery and most importantly, the system keeps chugging along without a redistribution of taxpayer dollars needed to prevent the whole scheme from collapsing.
Tim, I don’t really want to be pitching for the fiat money team but that really isn’t a problem at all. There are two ways they each or more likely together would handle the problem seamlessly. One is to adjust the fractional reserve requirements. Riskier, higher returning account categories might have lower ratios than more secure, lower returning accounts. But most significantly, the central banks can increase the money supply to compensate for loss of lending multiplier. The only question is how they would chose to inject the money into the system. Helicopter Ben has his ideas but there are more targeted ways.
Now just forget I said that and focus on a return to free banking. 🙂
Laird, I suspect that a great many people do believe that available on demand really means available on demand. If they are faced up front with a choice between available on demand (at a premium) or usually available in return for either reduced fees or interest payments, they will be much less confused and inclined to panic. The cost of the deposit insurance needs to be broken out (itemized) if it is an insured account and uninsured or privately insured accounts need to be permitted with full disclosure, of course.
I agree with everything you say about the failures I mentioned except on one point. What it all means. In each of those cases the central bank had to get involved not to protect assets, but to defray panic and a domino cascade of failures. In the case of LTCM, they were able to get private parties to assume the risks and benefits but is there much doubt that if they hadn’t and panic escalated the Fed would have dumped
its ownour money into it? And in the FSLIC case does it really matter which tranche of regulators picked our pockets to stop the panic? And Continental Illinois, the monetary base at the end of 1984 was ~$190 billion. The bank had $40 billion in assets at the time of failure and required $4.5 billion from the FDIC to bail it out.For comparison, In the case of the run on Washington Mutual, the monetary base at the end of 2008 was ~$1660 billion. The bank had $307 billion in assets at the time of failure and since the FDIC was still in financial turmoil from the run on IndyMac, well. . .
As a percentage of the money supply, those two banks very close. What do these three incidents, countless more and the S&L crisis all have in common? Failure mode. They were all brought about by runs on demand deposits.
What capitalist said.
Money is a claim on resources (not necessarily physical, but including labour time, etc). If I deposit £100 of money in a bank, and want to have immediate access to it, and yet the bank lends this out for a year, then there is a contradiction. The £100-worth of resources claims cannot be simultaneously held by someone for instant potential use on the one hand, and for investment in something with a 12-month payoff, on the other.
It is simply no good the defenders of the status quo parrotting the line that banking is all about “borrowing short and lending long”. Wrong: one of the reasons why banks existed is for places where people could keep their money safe without having to bother about putting it in a safe of their own, hiding it under the bed, etc. People actually paid a fee for this service. They did not expect to earn interest on such instant-access cash reserves. The idea that the bank exists to magically turn cash into a credit instrument is false.
What banks have been doing is gambling on the idea that most folk, most of the time, don’t require their deposits so the banks can lend most of this money out and earn a difference on that; but if that is the case, the risk of this going horribly wrong needs to be explicitly spelled out to the client, if we are going to continue with FRB.
No, this will not do, for those balances are no longer bank reserves. They are on deposit. This is the issue. If 15% of depositors take the route and you have a 3% reserve system, you have 5x the existing reserves of banks now needing to be locked down and required as M0 but not available as reserves, for that is not what they are anymore. The banks would have to somehow find almost 5x their current M0 held at the BoE in addition to keeping 3% of the remaining 85% as reserves.
That is an aspect of the Cobden/Baxendale concept, but M0 will have to grow massively and I am unconvinced at this time that this would not FUBAR the Pound royally.
That is like saying how would you like your .50 round, Sir?
As for pursuing Free Banking, well, it will not slow me down and the raising of this issue is a good opportunity to bang the drum.
further…and what if you did inflate M0 to adjust for those ticking the box…what of that? Who gets it? What happens then if those people tire of the charges and then tick the box – how to bring back all that high powered money back and destroy it without disruption and before it is all 40x multiplied?
Setting interest rates and reserve ratios can be a pigs breakfast, but blatting out billions in M0 and then having to run around catching them all over again? 10x worse. Or is that 40x…?
One thing I think everybody’s overlooking is that bank runs aren’t caused by a sudden discovery by the depositors that their money has been loaned out. They are caused by a sudden belief (which may or may not be valid) that the bank has become insolvent and won’t have the money to pay them back in the future, due to malinvesting it.
As Paul Lockett pointed out all the way up the thread, banning FRB may solve the liquidity problem but it doesn’t solve the credit problem. If the bank seriously malinvests, the depositors will still lose their money, regardless of whether it is in instant access or timed deposit accounts. So you don’t get a bank “run” but you still get a bank collapse. You can’t guarantee banking stability unless you ban lending.
Tim,
There is an easy and powerful way to control money supply. The central bank lends M0 funds to banks at a ‘discount window’. Varying the discount rate controls the amount of money borrowed for consumer lending and ergo, the money supply. During the transition the rate could be 0% for existing loans with scheduled increases until long term equilibrium is located. The central bank could even set different rates for different categories of loans. “The central bank announced today that the discount rate on class BBB lending funds is increased to 3-1/4 percent while the other rates remain unchanged.” The problem is not that there isn’t enough control. It is that there is still too much. But since loan writing is already under political control that part is a wash.
On fractional reserve rates, it seems strange to be pointing this out to somebody with ‘Libertarian’ in his signature, but let the market set the price. The central bank controls money supply at the M0 discount window and after the desired money supply is achieved, if banks are running short of class ‘A’ base, they have to raise the interest charged on class ‘A’ loans and payed on class ‘A’ deposits. They are running short because the market has evaluated the risk differently than the regulators or banks have.
This gives the central bank bidirectional control of money supply. The ability to start the M0 discount a 0% means that the transition can be almost seamless. As for the pound being FUBARed, all currencies have been FUBARed ever since they went off of metal backing – not standard, although that was less ungood, but backed with bullion or minted as coin.
Like you so often do, Ian, you note the fundamentals and then dismiss them as irrelevant.
Yes, they are caused by “a sudden belief (which may or may not be valid)”. And what they are afraid of is that the bank will not be able to pay them back. The nature of a run is that even in a fully solvent 10% fractional reserve bank, 90% of deposits cannot be refunded without liquidating loans. It becomes a race to get your money out not before the bank loses all of its assets, but to get a piece of that 10% that is reserved. (I’m using US rates.) This is like the two guys walking on the Serengeti after their Land Rover broke down. The see a lion stalking them and one opens his pack and starts putting on a pair of track shoes. His buddy says “Dude, you are never going to outrun a lion. What’s the point?” And the guy with the track shoes says “I don’t need to outrun the lion. I only need to outrun you.”
With the changes I am discussing, instead of 100% of the depositors chasing 10% of the deposits, we would get a statement something like the following.
“Conglomerated Mega-Bank announced today that its class ‘B’ transaction accounts will not be yielding any dividend in the third quarter. Espectations had been for an annualized rate of 15%. Analysts speculated that this was do to a down-turn in . . . “
Followed by the sounds of cursing from class ‘B’ depositors who had planned on spending their dividend.
Remember, with Continental Illinois, perhaps the second biggest US failure of all time, it only lost less than 5% of assets. When WaMu failed, all of the assets were sold. These are not cases of banks losing their assets. These are banks that in a worst case lost 5% and a fear of a run on demand deposits triggered a run on demand deposits that brought down the bank.
Sorry, 10.5% for Continental Illinois. It was worth approximately 90% of its liabilities.
Bank runs are indeed caused by depositors being suddenly spooked that they won’t be able to get their money right now. That’s what deposit insurance is designed to prevent, and for the most part it does precisely that. Generally, runs aren’t a problem (of the 114 US banks which have failed so far this year, none were triggered by runs), and when they do occur they are limited to a specific institution.
In the final analysis, runs are a liquidity problem, a timing problem, but not (necessarily) an asset quality problem. If the assets are good the money will all be there, eventually, just not at this minute. That’s why banks lend to each other, and why there are “bankers’ banks”, central banks and other sources of temporary liquidity provided that the assets (which serve as collateral) have sufficient value. So even if a bank has only 10% cash on hand it can still meet even unusually high withdrawal demands provided its loans are good. It’s only when there are an unusually large number of bad loans in the portfolio that a problem arises, and if the cause of that is widespread economic decline everyone is pretty much in the same boat. FRB isn’t the source of that problem, although it can be a magnifier.
I’m with Laird on this. FRB isn’t the problem and isn’t creating something out of nothing.
Banks loan out ONLY the money available from deposits (less the required reserve), never more. Banks don’t make loans without first taking in deposits. banks don’t create money (or credit). (Only central banks do).
Bank runs happen when people believe the bank to be insolvent – i.e. it has made bad loans that it won’t be able to recover. They don’t happen randomly. If a bank is solvent – i.e. has more assets than liabilities, it can get cash from other banks, if it needs to pay out deposit withdrawals, a bank run can’t destroy it.
A bank run destroys a bank only if it is already insolvent, i.e. has bad loans on it’s books, but refrains from writing them off to hide it’s true state.
There is no such thing as bank runs destroying a bank because of FRB (i.e. lack of cash at a certain time to pay all depositors). All the examples of bank failures mentioned are unrelated to FRB, they all resulted from bad investments or bad loans the banks made.
I’m sorry Jacob, but you are wrong on too many counts to address in a comment. I encourage you to read and study the Wikipedia article on fractional reserve banking. It is well written and comprehensive. It is also written in support of FRB so you don’t need to worry about those crazy Austrian school libertarians.
I’ve read the wikipedia article.
Seems to me two distinct things are mixed up in this thread.
One is the practice called in vulgar language “printing money”. It started long ago when banks would issue notes “redeemable in gold”, in excess of the gold reserves they had on hand. This practice, started by private banks 200 or more years ago, has been adopted by central (government) banks (like the federal reserve), when they were created at the beginning of the 20th century. They liked it so much, that they took for themselves exclusive rights to it, i.e. – private banks were forbidden by law to “print money”. (Central banks are forbidden too, but they print anyway).
Until the 1970ies central banks were supposed to hold gold to cover at least a fraction of the banknotes and credit they issued. This practice was discontinued (they went off the gold standard), and today there is no limit to the amount of paper money they can create. This is, of course, a horrible and unsustainable practice, and all will confirm this, including the central bankers that engage in it. If, when saying “Fractional reserve banking” you refer to this – then – correct – it is fraud, it is wrong.
Private banks, that used to “print money” maybe 100 years ago (i.e. issue banknotes, or create credit), are no longer allowed to do that. They must have a balanced balance sheet. Each bank is not allowed to give more loans than it has deposits (if I’m not mistaken). Actually it is required to hold some cash reserves, i.e. total loans must be less than deposits. There is no money created out of thin air. The only problem is that the deposits are “on demand” (part of them at least), while loans are made for a term, so it is possible at a certain time, to need to pay back more deposits than there is cash, as the money is tied in term loans. That is no big problem, as banks can borrow cash from other banks (as long as they aren’t insolvent because of bad loans).
So, if “Fractional reserve banking” – in the context of private banks – means that banks are allowed to loan out the money they receive in deposits (and no more, as I understood it all along) – there is nothing wrong or fraudulent in this practice.
Returning to the model of Mr A, B, C and D. If you define M0 – the monetary base as cash and on demand deposits – then – yes – the original (tangible) 1000 bucks created additional 3000 in demand deposits, so M0 jumped from 1000 to 4000. But the money available to actually purchase goods in the market is still only 1000, because A, B and C can either loan the money further or purchase things, they cannot do both. There aren’t 4000 bucks available to convert into goods, only 1000.
To sum up: the fact that private banks (i.e. not central, gov. banks) are allowed to lend out money received as “on demand” deposits – is not wrong, not creating new money out of thin air, and not fraudulent.
If I’m mistaken, and private banks (each one, individually) are allowed to make loans totaling more than the deposits they hold, that would be wrong, but it seems to me this is not the case.
Very thoughtful response, Jacob. I agree with most of your understanding but want to add a few things that might be below the radar. First, am I correct in interpreting you to be agreeing that even though Mr’s A, B, C, & D will blow up the system if they all try to withdraw their cash at the same time, the fact that they don’t means that they will never try? You appear to be separating the questions of stability and money supply. It is good to separate the questions into smaller units, I just want to make sure I am understanding you correctly on that point.
A big thing that may be below the radar is the effect of the “velocity of money“. Let’s build a closed model since they make subtle things a lot more obvious. Imagine you live in a closed community (of Mr’s A, B, C, & D) where everything is sold at auction to the highest bidder. Groceries, cars, houses, everything. Now imagine there is a fractional reserve bank in this little community. Everybody has $100 cash except you begin with $1100 of cash money. You want to buy $100 worth of groceries. You deposit $1000 dollars in the bank and take the other $100s to the auction to bid for some groceries. If nobody borrowed the money you deposited, all four of you (we’ll call you Mr A in this community) are bidding with $100 dollars. However, FRB allows the bank to lend out $900 dollars. Mr’s B, C, & D have each borrowed $300 dollars. You are now at the auction to buy groceries except that you are bidding with $100 and Mr’s B, C, & D are bidding against you with $400 dollars each ($300 borrowed, $100 of their own). Your money is active and competing against you. Your deposit has increased the velocity of money and consequently auction prices.
Just so I’m clear, with all lending against either demand or time deposits, you are bidding against your own money. This is not exclusive to FRB.
Remember I talked a bit about ‘float’ time. The closer float times come to zero (they are effectively there now) the higher the potential velocity of money. In olden days you took out cash, put it in your pocket and went to the market, gave it to the merchant who put it in his cash register. At the end of the day he put it in a cash bag and took it to the night deposit drop at the bank or took it himself the next morning. Now a days you swipe a credit card and the float is measured in seconds.
While no one party in the economy could benefit from this increased velocity, it keeps the amount of cash in banks way extremely higher, which allows banks to lend more money, which allows people to borrow more money, which allows people to spend more money. To return to our example above, the original bank money (your $1100 and their $300) never leaves the bank. You can all spend all of your deposits all the time regardless of how much you have simultaneously borrowed. The only thing limiting the size of the combined deposit accounts is the fractional reserve rate. Deposits are fully available because of the electronic, cashless society. I’m not sure I’ve explained this well, ask me questions and I’ll try to untangle it.
Now we take this closed community above and the effective money supply expands according to the multiplier (fractional reserve requirement). In a 10% system that $1,400 total original cash is circulating fast enough to simulate $14,000 cash. However, if the money being lent is from time deposit accounts, those deposits can not be drawn against so velocity is reduced so effective money in the market is reduced.
The scariest failure mode in FRB is what if enough of you demanded to withdraw enough cash to exceed the original reserves. Two things would happen. The outstanding loans would now be backed by thin air and there would not be enough cash to give the four of you as much as you thought you had.
Two separate points being discussed. First, velocity/FR rate equal effective money in the economy. Second, failure mode of large cash withdrawals from the system. In a system where all deposits are either held as full reserve deposits, time deposits or reduced return deposits (capable of losing money), the system is stable. It is only by promising the money to multiple people at one time that problems occur.
I’m pretty sure I’m not explaining this well and I’m over simplifying things but ask me and I’ll do my best.
You make two points: velocity and sudden demand by all.
Point 1 – velocity – I don’t understand what the problem is. Taking our model : A has 1100, B,C and D 100 each. Total purchasing power: 1400. A lends 300 to B,C, and D. A has 100, B,C and D 400 each (100 is kept as reserve). Total purchasing power is 1300. No problem. The only difficulty might be that A thinks he still has his 1000 bucks in deposit and available, while they have been spent, and A only has IOUs (not money).
There isn’t actually more money available for spending (or being spent), it is only a subjective feeling that there is money. That feeling (i.e. not distinguishing between an IOU and actual money) can cause people to spend too much and go broke – but objectively, FRB and lending don’t create more cash. But there are more IUOs in the market than cash.
Now – if a merchant will accept you IOUs and give you goods for them – then the purchasing power has increased: A spent 1100 (100 in cash, 1000 in IOUs), B,C, and D spent 400 each, total 2300 (instead of the original 1400). There is an illusion of more goods being sold for the same money. In fact – the merchant is now the holder of the IOUs instead of A. B,C and D will still need to bring some new cash from home to pay those IOUs. The problem arises only when people don’t pay the IOUs, i.e. bad loans are made, and the lenders and the banks lose money and can go broke. The more IOUs are in the market, the greater the risk of default. If you wish to claim that FRB increases the risk of defaults – that goes without saying. But it is not the reason for the default. It doesn’t cause defaults.
As to sudden bank runs, i.e. when all people come and demand their “demand” deposits at once.The bank doesn’t have the cash needed, but it has IOUs (loans made). It can sell those loans to another bank and get the needed cash. If the IOUs are good (i.e. not bad loans) they will be purchased, and cash will be forwarded. No problem.
Again – the problem arises only when the IOUs are bad, and deemed to be irrecoverable. The danger of bank runs exists only where banks are insolvent.
Of course, if you forbid banks to lend out money received in deposits, then there is zero risk, but also zero banks. The institution that keeps your deposits in it’s vaults would be some kind of a warehouse, not a bank. Forbidding FRB is tantamount to forbidding banking. Libertarians don’t like arbitrary prohibitions.
I can tell I missed my target. Let’s try this again.
That is true only in a cash-in-your-wallet context. Because the transactions clear each other immediately, and because the money never leaves the bank, he does in fact have the full amount available.
Perhaps the confusion was that I didn’t make clear the initial paragraph that started “A big thing . . .” was to set up the frame work. The real example was when we eliminate float and cash and made all transactions cash-less. Because both the debit and credit side of the bookkeeping entries in this electronic age occur virtually at the same time, the bank in our closed community (banking system in the wider economy) never removes the money from the system. Let’s assume that they all four deposited all of their money in the bank and are paying for purchases directly from bank funds.
Mr A can in fact spend the entire amount electronically. The merchant, Mr E, deposits it the bank electronically and the bank/system is not encumbered with a draw down of funds. The bank/banking system simply subtracts $1100 from Mr A’s deposit, and simultaneously deposits $1100 in Mr E’s account. Meanwhile, the money that Mr’s B, C & D had been borrowing from Mr A;s deposit is now being borrowed from Mr E’s deposit. Mr A has successfully spent his entire deposit in spite of the bank having lent it to Mr’s B, C & D.
The merchant (Mr E in this case) does not need to honor an IOU and in fact can not even know whether the money credited to his account is ‘real’ or not because there is no distinction until somebody asks for cash.
It is important to remember that not only did the merchant, Mr E, deposit the $1100 dollars Mr A spent, he also deposited the $100 each that Mr’s B, C & D started with plus the $300 each they borrowed. Mr E now has $2300 in his account, $1100 + $400 + $400 + $400. This keeps going and the 10% is held out of each deposit until potentially the total amount of money available to spend is equal to $14,000 dollars at a 10% reserve rate.
No IOUs, all money deposits available to spend in real time all the time provided nobody holds physical cash.
Did I do any better explaining it this time?
Regarding the value of assets in a forced sale, I’ve been to at least many dozens of forced and unforced personal and business liquidation auctions. I absolutely guarantee you that the worth of material sold that way is extremely diminished. I once had to sell some ag equipment at auction when I lost my place to store it. I sold an older but useful combine for less than I had in the tires. It was a specialty combine that, while smaller in capacity, was capable of harvesting the major small grains plus things as exotic as clover and even carrot seed. There is not a lot of demand for that kind of asset, especially sold “as is, where is, buyer beware”. And that is how almost everything is sold at auctions. Had I sold that combine during my own sweet time, I would have sold it during harvest season and allowed the buyer to try it out on his crops first.
Liquidations will drive clearly solvent banks into the red for precisely these reasons. Imagine if you will, that you just bought a brand new car on credit. After one month, I stage a run on your assets and you have to liquidate that car for the amount of payments you still owe on it. Can you do it? How’s if I just take the car from you and announce a sale this afternoon to the highest bidder. Does that mean you paid too much for the car?
Forced liquidations always forfeit huge amounts of asset value. That does not at all mean that the prices received at a forced liquidation represent the true value of what is sold. Only that it represents the perceived value to the people who had the resources available on short term and the willingness to spend them.
This is a well known and understood problem.
Well said, Jacob. Glad to have you here; I’ve gotten tired of keeping up this endless debate, and it seems that IanB has bailed out, too (for now, anyway). The baton is yours!
Midwesterner, you’re certainly correct about forced sale values. But if a bank’s loans are good and there is no economy-wide contraction, it’s not necessary for it to sell the loans; banks can (and do) borrow against them from other banks and entities to raise the necessary liquidity. It’s only really a problem if every bank in the system has the same problem (which is pretty much where we were in 2008-09, less so today). There can be extraordinary losses if an individual bank is being liquidated (as when the FDIC shuts one down because its capital has been depleted), but that’s not a systemic problem, and is not the fault of FDB.
Well, those are a couple of pretty big ‘ifs’ considering the consequences, considering the obscurity of bundled securities, considering the chairman of the Senate Banking Committee, considering the chairman of the House Committee on Financial Services, considering ‘Helicopter Ben’ considering, well, I hope your getting where I’m coming from.
The trend lines of the last forty years (end of Bretton-Woods) to present will continue curving towards vertical until system failure. Even a Republican congress (or a Tory Commons) will not reverse the trend lines, at best maybe slow them; they are systemic.
My goal is to reconnect risk and consequence in the closest way possible. As long as there are politically managed central banks controlling banking and taxpayers funding bailouts, there is no connection. It is a perverse incentive that effects every level of society. And ending taxpayer funding of bailouts without giving depositors control of their money will not fly. Returning control of money to the depositors is the first step in reconnecting risk and consequence.
@Midwesterner
I know that, and this is part of the problem I forsee. QE or various forms of it, printing more “high powered money”/ M0 might “solve” the problem in the immediate, but will FUBAR what we have now (however FUBAR’d it is already) in the long term.
It is even stranger you mention it as I never suggested otherwise. All I mention is the reality – a 3% reserve system, Carswell’s plan in the here and now and the implications of it.
Yes, a seamless slide into the theft of saved wealth.
@Jacob “A only has IOUs”.
Not so. A has a bank statement, not an IOU. An IOU implies a scrip and potentially a transferable one at that. This concept of depositors having IOUs is all part of the “debt money virus” wibble one sees that finesses goldsmiths to FRB and screams FRAUD!
Apart from the above debate, it seems to me that the option to deposit your money in the bank for safekeeping (i.e. forbidding it to be lent out) already exists. It’s called a safe box. You can lease a safe box at any bank, put in it whatever you wish (cash, gold, jewlery), and be sure that nobody will access it but you.
So, do we need a special kind of deposit marked “not to be lent out” ?
No. People who make deposits in a bank know what they are doing. They have a choice. What is the point and the justification for introducing a new legal ban or encumberance ? What is the point and justification of depriving them of this choice?
Banks sometimes fail. I know. Everything sometimes fails. It is a fact of life.
A bank run and liquidation is a nasty thing and many losses result.
If you say you have a method to eliminate risks and avoid bank runs I don’t believe it. It’s snake oil (in the best of cases). It’s more ruinous and has more catastrophic effects than the bank runs and liquidations. (See the current system of forced collectivization of losses via bank “rescues”).
But, it seems to me, what is proposed here is to ban banking alltogether.
Tim, first the caveat. There is nothing we can do about government printing money to fund its operations that doesn’t likely require lamp posts. That has nothing to do with FRB and can occur with any entity that can create money. That can only be solved by a free banking environment where people can abandon the inflation redistributed currency.
Back to FRB, there are three ways in this discussion that money can be added to the economy.
First, Helicopter Ben – throw money at the economy, predictably channeled through political powerful players.
Second, quantitative easing. Have the central bank exchange central bank money (lending base) for bad and troubled debt.
Third, lend the lending base to banks on a short term basis with interest being set as frequently as needed.
In the first system, the money is lost into the economy, cannot be recovered and can only be removed again by taxing and withdrawing the revenue from circulation. It is plain on its face redistribution.
In the second situation (QE), banks can write bad loans and sell them to the central bank in exchange for lending base. They can use ‘too big to fail’ and the FDIC as a lever against the central bank to effectively extort the funds. In this scenario, some perhaps most of the money can be removed from the economy again as the solvent loans on the central banks balance sheet are closed out or sold. Any bad loans still disappear into the economy and cannot be recovered. And more significantly, the consequences of writing bad loans are not born by those at fault (politicians, regulators and banks) but by taxpayers or currency holders if money goes unrecovered. With this system, the money supply is at the mercy of the terms of the loans the central bank purchased.
Third system, the one I am proposing, is that banks can borrow base from the central bank to cover the loans they have written but they pay interest on that base and have to return it. There are two different failure modes with this method of capitalizing banks. If a bank fail under our FDIC type systems, it is no different than QE. But if a bank fails under the secured/insured/forfeitable deposit system, they system that ends FRB and lets depositors chose their risk/return ratios in a free market, depositors losses are covered without government intervention.
Borrowing lending base from the central bank must be made contingent on private deposit insurance to cover losses of the borrowed central bank funds and those premiums will serve as a structural restraint on banks behavior.
D’uh. Exactly how do you propose to gain access to the electronic banking system with money in a box? The function of demand accounts is to being able to use the money and access the general economy. Can you ETF money from your safety box to your credit card? I think not.
So it is OK to force everybody into a FRB account if they want access to the modern market place?
The only legal ban we are talking about is a ban on promising the same thing to two different people at the same time. You say “People who make deposits in a bank know what they are doing.” I doubt that more than a tiny fraction understand the banking system well enough to be giving their informed consent.
Jacob. Are you deliberately ignoring the point I made? Runs can destroy perfectly solvent banks that have no problems on their books at all. Yes it is usually the troubled banks that fail. But all banks will be taken down by a run. There is no bank, no bank, that can survive a full run. The best they can hope for is dissolution without any depositors or insurers losing anything.
I have been conducting this discussion in good faith and suspect that you have not. I will not be continuing it.
Midwesterner, so far this has been a good discussion, but that last sentence was completely uncalled for. Name one “perfectly solvent bank” which was destroyed by a run. It doesn’t happen. Certainly not Wamu or IndyMac; both had serious asset quality issues. (Truthfully, I don’t remember Continental Illinois well enough to be certain, but I’ll bet that was the case there too). Bank runs aren’t random events; they happen because something has occurred which spooks the depositors. Almost invariably that is concerns about asset (loan portfolio) quality. A bank with good loans can borrow against them (as I’ve explained above) and meet any withdrawal demands. Even if for some reason a run is sparked at such a bank (highly unlikely), when the withdrawal requests are all being honored and people realize there is no reason to panic the run stops.
In the case of a bank run how will that “checked box” protect the “play safe” depositors ? Seems to me they go under with the rest of the ship.
If the “safe” banking is a good service, how come it isn’t offered by banks or other financial businesses ? What keeps them from doing it ? Why don’t you open a company offering this service?
Do we need a law to create this service of “safe banking” ? Is that the way normal services come into being – by legal decree ?
“Runs can destroy perfectly solvent banks that have no problems on their books at all.”
Laird answered that, above.
I said solvent banks are not in danger, you maintain they are. We differ on this issue; both claims are unsubstantiated. You need a full historical analysis of past bank runs. I confess I didn’t do that. Still I’m not convinced.
Laird, your argument is based entirely on “has never, therefore can never”. So instead of looking at the grade school simple mathematics of bank reserves, you demand examples from history.
Okay, so first you find me any time and place in history where the current conditions existed. First we have a fiat currency without even the pretense of anything more than promises to back it up. Second, we have a fractional reserve banking system that multiples that fiat money by anywhere from ten fold in the US to it sounds like around thirty fold in the UK if I understand Tim C correctly. Third, the currency is under the control of the government of the most powerful nation on the planet in history – and it has become the world’s reserve currency and cannot be rescued by any other. Fourth, that government has deficits, staggering incomprehensible deficits, projected as far as the imagination can conceive. Both on the books and off, borrowings and promises of entitlement. Fifth, the government has leveraged that reserve currency status to export debt in unprecedented amounts allowing the system to become even more absurdly overstretched. Six, that government is grinding harder and harder to tax all activity, which will soon (probably already is) drive activity into cash. For example, the soon to be effective requirement to file IRS reports for each supplier from whom your business purchases $700+ per year.
We are in completely unprecedented territory and if you can find a time in history that fits those conditions, then I will see if I can find a fully solvent commercial bank that meets your requirements.
Yes, weakened banks fall first. And the weakest runners are the first to be caught by a tsunami. That doesn’t mean the faster runners are safe.
In the meantime, why don’t you address the claim I made instead of saying “hasn’t, therefore won’t”. Describe for me how any FRB bank can survive the unscheduled complete or near complete withdrawal of demand deposits. Don’t say that reasonable people making no interest on their demand deposits and being charged high fees and having all transactions reported to the IRS so taxes can be levied and mandates enforced in a time of general uncertainty about the security of banks will never decide to switch a substantial part of their business back to cash. Show me with arithmetic how an FRB bank can survive if they do.
You insist on talking about individual banks and how the system will take care of them. I am talking about systemic events. Why do you think there was such total panic in ’08? It is because the banking system itself was shuddering. The top officials believed a run on demand deposits could exceed system reserves on a sustained basis. Go back and look at the charts in that article we wrote. It is a very plausible fear. Certainly no one can defensibly claim that it can’t happen because it hasn’t yet.
What I am talking about is apparently too unthinkable for you to think about. I am talking about a complete collapse of the banking system. If you refuse to believe the system itself can fail, then why are you arguing with me about failure modes?
And for your defense of Jacob, telling people to do their banking out of safety boxes if they want security? That is not a serious statement. But I will answer his question asking why people would not pay the penalty for having a safe reserved account when they can instead of accept a cheap account with the free guarantee funded by the taxpayers. Second thought, no, I think that should be obvious.
Mid, just so I understand the conditions you’re establishing for me here, since I (obviously) can’t provide an historical example where the conditions exactly match those obtaining today, my perfectly rational explanation of why runs against healthy banks don’t happen is ipso facto invalid, right? However, your entirely hypothetical fear, with no historical precedent, of systemic collapse is meritorious, right? Kind of stacking the deck against me, aren’t you?
Anyway, I never said that a healthy bank could survive a total run on deposits; of course it couldn’t. I said that a healthy bank would not experience a total run, so you’ve set up a straw man. The reasons for bank runs are entirely psychological, so they have to be viewed in that light. If the fear triggering a run is assuaged (by meeting the early withdrawal demands without problem) the fear will dissipate, and with it the run. I’m not merely saying “hasn’t, therefore won’t”, I’m giving the reason why it hasn’t, and thus the reason why it won’t. If you insist on postulating a change in human psychology I can’t follow you there.
I believe the planets are aligned, the ducks in a row, whatever, for a systemic collapse. Systemic collapses have happened often enough before in history with only a few of the named conditions being met. Things are swirling into a perfect storm. I suspect with not too much effort I could find a lot of economic collapses that had several of the features I listed. I suspect the reason we’ve never seen them all is that nobody has made it this far before.
I can understand that you don’t believe that it can happen. But that is not what I am arguing about. Discussing whether it will is a bit like arguing against car insurance by explaining how well brakes and steering systems work. I am talking about the range of possibilities the banking structure itself contains. I remember twice in the last ten years having passionate arguments about economic possibilities. One was when a client of an associate of mine was defending the dotcom boom at its peak. I was arguing that it was a bubble that would explode, he was explaining to me that it was not and I was some kind of a financial Luddite. I backed down because he was after all, the client of a very good friend of mine. About a year later I got a call from my friend that the guy had lost big and had to go out and get a ‘real’ job. Not that investing isn’t a real job but if you do it wrong, the severance package is the pits.
The other occasion was summer of 2004. I was convinced that real estate was about to bust and my very elderly parents had two houses and property that they could not keep up. Everybody, no exceptions, was telling them to hold it because it would only go up. I convinced them to sell it and they did in the spring of ’05. It was never worth more than they sold it for. I was treated with varying degrees of hostility from people who thought I was advising them to walk away from easy money. The projections of future values my parents were given (I still have them) are exactly inverted from reality. They went down by approximately the amount they were expected to go up by. And my point? At those times I was the crazy guy with the weird ideas.
Maybe I am crazy. Maybe nothing I fear possible will happen. I hope that is the case. I have too many friends who are totally dependent on the system working. I also hope I don’t have a car accident. But I wear my safety belt and carry insurance just in case.
The FRB system averages out the behaviors of individuals but it goes beyond that. It is based on the absolute, unshaking confidence that consumers of banking services will never behave as a group, that assurances from the political regulators (Dodd, Frank, Bernanke, Geitner!?) will belay any contagion, that their behaviors will on average always cancel each other out and that the FDIC can deal with the biggest events. I am not willing to accept that as certain. If the FDIC is ever called on to make up more than 10% of deposits, the resulting economy will bear no resemblance to anything we’ve yet seen. As you already know, I believe our current economic crisis is the unavoidable consequence of that 2008 infusion and the unavoidable repercussions. Really, what if this initial trend had not been reversed with a massive infusion of cash? How can anyone look at that chart and retain such absolute confidence that the control mechanisms are up to the task?
I believe that all of these things that have been done to make the banking system ‘safe’ have in fact hidden the signals. If we defuse the FRB bomb, at least we can have a less violent and society destroying failure mode in the event of a major market ‘correction’. It will return to us a bunch of market signals that are currently suppressed. As things are now we are driving blind.
@Mid
Going back to the scenario, it is not a case of short term lending of temporary M0 that will guarantee a cure of the situation. If 15% of depositors decide they will keep their money in an electronic safe deposit box* banks will have to find a multiple of M0 and and owe it to the BoE, using the on-lending as the asset. You could lend it out at zero percent, but it would be in the trillions order even in the UK. You would also need to ensure that every penny of that lending is returned the moment it is not needed, for if they withdraw and then that money is spent and deposited in a “normal” FRB account, it is multiplied and BOOM. Lending at zero percent will require strict controls and monitoring of every “electronic deposit” as such a rate makes it tempting to borrow and then on-lend. it is a temporary fix, not a cure. How do you propose ending the temporary fix?
@Laird, I think Midwesterner is suggesting a Black Swan. I do not think it an outrageous suggestion. Contagion from Northern Rock certainly spread to the share prices of sound banks and if the herd got a whiff in the air, I say any bank would be at risk of a stampede, especially if the currency itself was at risk and people sought “other channels” to store wealth.
* I do think an electronic safe deposit box is very useful so one can continue to take advantage of all those electronic payment mechanisms. A physical box in a bank vault is, however, useful to Nazi Dentists, but only if it is safe.
I am not proposing short term lending of M0. I am proposing short term low/zero interest rates to take the place of currency removed from circulation. Then the lending base interest rate, which could even be set daily, would be adjusted to control money supply.
The money would not need to be returned when it is ‘not needed’. It would be returned when the interest charged for it was more than the bank wanted to pay. The interest rate would be adjusted to control money supply. Yes, it will be a lot of money. It is after all partially replacing a 10(US) to 30(UK?) fold multiplier. It is quite possible that after depositors and free market deposit insurers risk/return decisions stabilize, it could still double or triple the present amount of M0. But the higher measures of circulating currency, the ones that effect everybody would be stable and easily adjustable by raising or lowering the M0 interest rate.
BTW, to be eligible for the central bank lending base funds, banks must be carry private, non-government, ‘deposit insurance’ on those funds. That is to say that they must pay an insurance premium to a private, for-profit insurance company that thinks they are running a solvent operation. Otherwise, the incentive to take risks at the taxpayers’ expense will still be present. That insurance combined with the demand/private insured/forfeitable deposits system would reconnect risk/consequence in addition to completely stabilizing the system.
I am not so much anticipating a black swan as seeing a senescent system teetering under a century’s worth of inextricable and irreversible corporate and governmental rent seeking put in place since it was first established. Runs on sound banks will just be a market signal of system failure. I am old enough to remember silver dimes, quarters and half dollars. I remember when it was still not unusual to find a silver certificate in my wallet. I remember when pennies really were made of copper. My father remembered gold coins and FDR’s gold grab. And that is just the simple debasement that was necessary to conceal the cumulative plunder that was occurring. How much easier to debase the currency when it is digital.
@Mid Before I start, if I have misunderstood your position, my apologies.
How high an interest do you expect to have to charge to end the desire of banks to lend multiples? Banks currently tend to borrow only short term from the CB and only if they cannot borrow from other banks who have spare, unlent M0 and only then to, normally, fill the gap in short term, overnight money. Borrowing to actually fund the lending one has already committed to, which is, frankly, what this begins as, is quite different. The bank will not be alone – almost all banks will be short and so the LIBOR is not a good gauge as to the level of interest charged IMHO. Maybe I am wrong, but my gut says this.
A Bank with $1m reserves and deposit liabilities of $10m and loans of $9m suddenly finds itself with $8.5m of deposit liabilities, $1.5m of borrowing liabilities from the Fed, and $9m in loan assets and $1m in cash reserves. The $1.5m of depositors cash is untouchable and not on their books. Although you have insurance, the State has become “the lender of first resort”. $1.35m in lending funded by the State’s $1.5m. How does this and every bank unravel this situation? It has to reduce lending by $1.5m to stabilise reserves or increase reserves by, well, reducing lending! Seeing as every bank is in the same boat, what is going to give? Something between the M3 supply reducing by 15% and an increase in M0 by 15%, causing M3 to rise by 150% will be the result. You are banking on the middle road, but if people borrow at LIBOR to fund 10x multiple lending…well, what will happen to interest rates?
Again, maybe I am wrong, but I do not see a happy, productive or efficient stabilisation, even if we could stabilise such a situation that requires constant central bank intervention on a scale and sensitivity exponentially higher than today.
First, everything that is removed as cash either via full reserve deposits or ‘mattress deposits’ is not multipliable. Everything that is ‘naked’, account balances floating like stock prices, is also not of concern because it self corrects. We only need to concern ourselves with privately insured demand deposits and M0 funds.
The adverse consequences of contagion are removed because each bank can cover itself out of the circulating money supply. Full reserves are of course fully reserved. ‘Naked’ accounts lose value rather than creating a cash liability. And all fractional accounts, whether from central bank funds or commercial deposits, are insured by resources already extant in the economy.
In this paper(PDF), there is some discussion of the role of money supply in inflation.
The obvious correlation of this is that shrinking the money supply (M0) reduces the upper limit of inflation.
Increasing the interest that central banks charge lenders for base funds puts downward pressure on the amount of funds borrowed. The higher the interest charged, the greater the downward pressure. So the question becomes, “what are the monetary consequences of bank failure?” This is where private deposit insurance is the key. Private deposit insurance removes money from circulation in an orderly and prearranged fashion. So it does not matter whether the bank returns the lending funds via paying more for customer provided lending base or, worst case, a failure, because in all cases the money is withdrawn from circulation.
Control of M0 is control of the upper limit of inflation. By making M0 funds lend at a floating rate, the central bank can provide bidirectional control of the higher measures of currency, M1, etc.
Remember, the central bank is not necessarily the lender of first resort. Depositors and the central bank make offers to the commercial bank of funds available for FRB lending. The insurance premiums on those deposits are factored into the prices. Banks perceived as reckless will pay higher premiums, banks perceived as cautious will pay lower premiums. Banks look at those two offers (free market depositors and the central bank) and decide how to manage their balance sheet.
The central bank’s M0 rate controls the ratio between free market and M0 funds supporting the loan assets. There for, it controls the effective money supply.
To summarize. Interest charged for M0/depositors funds controls cost of lending base. Cost of lending base controls cost of loans. Cost of loans controls volume of loans controls effective money supply.
Does this make sense? I will keep this thread up on my computer and keep checking it when I can. The next few days are pretty full but I usually can find little bits of time here or there.
Mid,
You mix everything up.
The catastrophe you describe is not a “black swan” i.e. a “rare event”, it is what is going to happen, for sure, sometime soon. It is not because of FRB but because governments run deficits, and central banks print money. This practice of “printing money” is not FRB. It’s something else. It is “printing money”. (Seems they call it nowadays “monetary easing”).
You don’t fear a “bank run” you fear a system meltdown. This is another beast altogether. A simultaneous run on all banks. Nothing less than a total government intervention can cause that, it’s not something banks can avoid by refraining from FRB.
The proposed law, which would require depositors consent to lending out their money, would not help in the least in preventing governments from running deficits and printing money. And when the banking system collapses, the “don’t lend my money” depositors wouldn’t be any more protected than the rest.
If you have a way to prevent money printing by governments (i.e. by central banks), you’re welcome. Adding a check box to some bank deposit form won’t do it.
I think that there is a total mix-up and confusion in this thread, with me (and Laird) talking about one thing and you about another.
@Midwesterner,
I am not really going to argue with your post as it stands, because I believe we are talking at cross purposes and that is in part due to a failure of mine in communicating my concerns.
If 15% of depositors decide to tick the box, M0 has to grow in the US by 150% to be 2.5x what it was before, and in very short order.
Banks will on average have to borrow 150% of the value of their existing reserves from the Fed just to exist. This borrowing will have to be secured against their existing loan book.
If those who ticked the box then untick the box/spend it and it gets deposited somewhere, then the destination bank can either
a) Reduce the borrowing from the BoE
b) On lend the deposit.
Question: How high a rate of interest would be needed to force the bank to not take option b) in your view?
Whatever, if 15% keep their money thus and banks have to keep paying the interest as the M0 shortfall will not be made up without this borrowing because M0 is finite and cannot change without CB intervention. There is no place for the banks to go to get enough M0, for they need 1.5x more than exists. Almost all M0 is on deposit somewhere, in a bank somewhere, being multiplied.
Yes, Tim. The ‘shortfall’ would be permanently replaced by funds borrowed from central bank at variable interest. The end state is a variable ratio between lending base from deposits and lending base from central bank loans. By doing it this way, it is possible for the central bank to control money supply in both directions.
The funds borrowed from the central bank will be secured the same way as the funds borrowed from depositors; by the existing loan book plus deposit insurance. This way the insurance underwriters undertake supervising the quality of the banks loans and they are far less likely to accept Chris Dodd’s and Barney Frank’s (or their UK equivalent’s) assurances.
If some people decide to return to fractional reserved deposits, as I presume they will, then the central bank raises the interest rate on central bank funds to discourage banks expanding their loan book. How high? I don’t know. I imagine money supply targets and demand for loans will combine to drive that number. Knowing that the central bank interest rate will float with the demands of controlling money supply, banks (and more importantly, their insurers) will be appropriately more cautious. If they aren’t, the insurers raise the premiums and the stockholders start getting excited.
A big problem with the incentives built into the present system is that banks make more and more money with reckless behavior (insured by the taxpayers) with only the politically controlled regulators or a bank failure to stop them. Inevitably, some guess wrong.
I think that there is some muddled thinking that comes out with regards to the ‘Banking system’. Firstly, the majority of money is NOT created by government: it is created by the banks!
It is generally agreed that the Bank of England that the Treasury creat the notes and coind which amount to about 3% of Britians money supply and the remaining 97% originates in the banks.
According the booklet ‘Modern Money Mechanics: A Workbook on Bank Reserves and Deposit Expansion by The Federal Reserve Bank of Chicargo ” The actual process of money creation takes place primarily in banks” and goes on “Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created..” Why does the US have a National Debt of Trillions of Dollars and the UK in the hundreds of Billions? Total Debt in the UK is around 4 Trillion. Surely the best course of action is to get away from debt based finance..
Dan
I think that there is some muddled thinking that comes out with regards to the ‘Banking system’. Firstly, the majority of money is NOT created by government: it is created by the banks!
It is generally agreed that the Bank of England and the Treasury creat the notes and coind which amount to about 3% of Britians money supply and the remaining 97% originates in the banks.
According the booklet ‘Modern Money Mechanics: A Workbook on Bank Reserves and Deposit Expansion by The Federal Reserve Bank of Chicargo ” The actual process of money creation takes place primarily in banks” and goes on “Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created..” Why does the US have a National Debt of Trillions of Dollars and the UK in the hundreds of Billions? Total Debt in the UK is around 4 Trillion. Surely the best course of action is to get away from debt based finance..
Dan