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Here is a cake I baked earlier

Here is a brief comment I left over at Tim Worstall’s blog, regarding fractional reserve banking and supposed journalistic illiteracy about said:

“I can see why smart people are dubious about fractional reserve banking. The whole “maturity transformation” line that defenders of FRB come up with only works if you are prepared to take the risk that, in the event of a crisis, you won’t be able to get your money out of a bank when you want it. That is why, in a real free market, not the rigged charade we have now, FRBs would have to be clearly advertised as such, and without the moral hazard-machines of state deposit insurance and a central bank acting as lender of last resort, printer of funny money, etc. In such a laissez faire world, FRB might persist, but it would be a lot more restricted than now, and its capacity for causing booms and busts reduced. Like I say, it should not be illegal so long as everyone knows what it is.”

17 comments to Here is a cake I baked earlier

  • Lee Moore

    Just out of interest, how does non fractional reserve banking work ? You keep cash on hand equal to your demand deposits, you lend out your one month fixed deposits for one month, your one year deposits for one year etc ?

    If that’s what you do, it’s not obvious to me that the risk of being caught short in FRB because you misjudge the maturities of your loans in and out is any greater than the risk of being caught short in non FRB because some of your debtors default while you’re maintaining a perfect maturity match.

  • Alisa

    Lee, the only way that can work is if you make a clear distinction between deposits (i.e. the money you put in the bank’s vault to be guarded), and the money you loan to the bank, with the understanding that it will loan that money to other people. You pay a fee for the former, and you get paid interest for the latter.

  • Laird

    Alisa, that is essentially what Lee said when he differentiated between demand deposits and time deposits. It’s a valid point.

    And in answer to his question, the only difference is that with FRB you have added maturity mismatch risk to the inherent credit risk. But maturity mismatch risk can be managed, either with hedges or some form of credit pooling (bankers banks, etc.). Credit risk can only be managed (partially) with capital and reserves. FRB exacerbates that problem.

    Which doesn’t mean that I oppose FRB; I don’t. But I agree with Johnathan that better disclosure should be required. And also that the state shouldn’t be in the deposit insurance business (but that’s another discussion entirely).

  • RRS

    At the level of the “central” FRB (and to some degree at the districts) we have moved from “Reserves” to “Balance Sheet.”

    Initially “reserves” were based on assets comprised of specie or bullion which made up the “deposits.”

    Deposits today are generally comprised of credits or claims for credits and even the currency (paper money) is totally fiat being nothing more than a claim on future goods and services (including retirement of prior obligations).

    In its beginnings, the FRB “reserves” consisted of obligations of the U.S. and “discountable” obligations of business enterprises. If a member bank’s liquidity (need for paper money) was squeezed it could go to its district Fed with qualifying assets (U S bonds, business loans) and borrow enough cash (in paper) to meet the demand excess of incoming funds (deposits, interest, repayments).

    That’s not how things work now. It is not that kind of “reserve” system, it has become a “Balance Sheet” system subject to valuations of the assets held.

    So, the “fractional” part refers only to liquidity, not solvency.

  • Alisa

    Thanks, Laird – I knew I had a blind spot there somewhere. I think it’s the use of the word ‘deposit’ that may be confusing a lot of people when they first learn about FRB, but I could be wrong.

  • Last Thursday 21st June, I attended the Ayn Rand Lecture by John Allison, as organised by the ARC and Adam Smith Institute. Interestingly, I thought I saw Johnathan Pearce there too.

    John Allison is an ex-banker of repute who is reported as “a strong proponent of Ayn Rand’s Objectivist philosophy“.

    Through (possibly despite) his personal philosophy, one of his statements at that talk was:

    Banks make money by borrowing short and lending long.

    This came across as fundamental purpose rather than any sort of side issue. It is a view that I very much agree with, on the purpose of having banks. It also, in my logic at least, has (as a consequence) the existence of fractional reserve banking.

    The problem is not one of existence, but one of ratios, timing (and other policy) – prudent or imprudent – that affects the risks and hence the average frequency of problems for any specific banking policy (and the bank or banks that pursue that policy).

    Best regards

  • 'Nuke' Gray

    If we didn’t have a charade, we might have metal-based money, or metal-backed money. However, we will never be able to outlaw FRB, unless we want a heavily-regulated finance system. Here in Australia, we have some exceptional libertarians- meaning they are libertarian EXCEPT for one particular hobby-horse, in this case, they are anti-FRB. they don’t want to admit that the degree of policing would destroy the freedom that they (say that they) want.
    Maybe, instead of talking about it, libertarians could just issue gold and silver gram coins or token notes for use amongst themselves- a working parallel economy? Use them to buy your illicit drugs and weapons with.

  • Michael Brazier

    Trouble is, we know how a metal-backed monetary system without government-backed deposit insurance or a “lender of last resort” works in practice; that’s almost exactly the American financial system between the Civil War and World War I. And the US economy in those years was not free of booms and busts. Nor was FRB a rare thing in that period; I understand it was the norm, and full reserve banking the exception. If most banks in 19th Century America used FRB, when the risks of doing so fell wholly on them, surely they would do so in a perfected free market as well? The historical record doesn’t favor your theory.

  • 'Nuke' Gray

    If you were talking to me, what theory? I think we should have a freer economy because of my libertarian leanings- I don’t claim that everything would be perfect, but it would be better, because of less heavy-handed government interference.

  • Lee Moore

    I’m still struggling with why FRB presents a particularly wicked risk that we should frown at. Even if banks retain cash (or other security) against 100% of their demand deposits, if they are taking credit risks with the rest of the money that people place with them (term deposits, loans etc) then, unless the demand deposits are senior to all other creditors, demand depositors are still at risk of losing some of their money, even though the bank is keeping 100% reserves against demand deposits.

    If you make demand deposits senior to everything else, you just have a bank carrying on two completely different businesses – being a piggy bank and being a regular bank taking credit risks. There’s no obvious reason why it would make sense to run these two businesses in one organisation.

    If you don’t make demand deposits senior to everything else, then you have a single coherent business, but then you have demand depositors sharing in credit risk. Sure I see that FRB may add an additional risk, but whether this is actually a serious additional risk is surely a question of mathematics rather than one of political theology ?

    And since someone mentioned metal money – even metal money banks have credit risks. You take metal in, and the depositor has now got a paper right. You lend money out and the bank’s now got a paper right. Metal money systems may or may not be better than paper fiat ones, but risk free banking is not amongst the advantages available.

    Banking necessarily involves risk. It seems to me that the problem comes in trying to argue that somehow it could be made risk free. Young and impressionable depositors could be led into unhappy financial losses by imagining that those extra 40,000 regulators have made sure that the bank can’t go under. It can – whether you’ve got FRB or not, metal money or not.

  • Alsadius

    I’d take objections to FRB a lot more seriously if its opponents could point to an example of any other sort of banking ever existing in locations where FRB was legal.

  • 'Nuke' Gray

    In any freed-up economy, you couldn’t stop FRB. If Adam Smith starts a safety deposit box company, there would be no way he could stop a depositor from writing cheques, or ‘promises to pay’ to more people than can be satisfied by the amount in the vault, or box. So long as people trade the paper, and don’t come for the metal (or whatever is in the box!), then the system should work well. In fact, FRB would be the natural banking system in any libertarian economy. Any remnant of government could pay its’ employees from a public banking system, and thus try to set a standard, but that would be it.

  • Johnathan Pearce

    Michael Brazier:

    “And the US economy in those years was not free of booms and busts. Nor was FRB a rare thing in that period; I understand it was the norm, and full reserve banking the exception.”

    If you read Rothbard’s “The Mystery of Banking”, it is quite clear that, while there was a metal-backed currency system of sorts, that a lot of banks had the freedom, carved out of political wheeler dealing and much else, to be able to operate on a fractional basis. Federal and state governments enabled banks, whenever there was a serious glitch – such as over-lending followed by a correction – to suspend specie payments. The knowledge that they could suspend such payments added to the moral hazard of the system.

    In other words, even under a system where gold (or some other inelastic monetary base is used) if governments give banks the right to suspend the rules of the game when it suits, then if FRB is allowed, then there is a danger. And the period from the aftermath of the US Civil War through to the early 20th Century proves this.

    Let’s be clear: defenders of laissez faire are not saying there won’t be crashes or mistakes. However, the impact of said will be relatively short and concentrated if banks are allowed to fail quickly and if contractual obligations are enforced without special favours being granted to banks (such as bailouts, suspension of gold payments, etc).

  • Johnathan Pearce

    “I’d take objections to FRB a lot more seriously if its opponents could point to an example of any other sort of banking ever existing in locations where FRB was legal.”

    Not quite sure of the point here. If FRB is legal then by definition, some people will make use of it. Of course they will: FRB, by being riskier, is also able to pay depositors a rate of interest. If you no longer have a “safety deposit” sort of banking for depositors, and most money deposited is immediately lent out for periods of time, then a lot of people will take the gamble and hope to earn the interest.

    When it all goes tits up, of course, during a crash and there is no lender of last resort or depositor to step in, then people can see the downside. That is the point I was making. Simple.

  • John McVey

    FRB should be legal, for the simple reason that there is no justification for a law that bans the use of on-call credit as a medium of exchange in its own right alongside physical specie. The only thing the governments should be doing is punishing actual deceit and upholding contracts, including not letting banks get away with suspension of specie-payments on said calls.

    Beyond that it is up to market participants to sort out. When it is legal under laissez-faire, for so long as most people don’t see a problem with it then sure enough there will be fractional banks. Of course, without government backing etc average reserve ratios will be higher, so, whatever else one might say, that world would be far financially sounder than today.

    What is also true is that its being legal even under laissez-faire wont necessarily guarantee a market for it, if people do see a problem. That would be an even better world than above, though as an aside I have my doubts as to the measurable degree of betterness.

    To believe in the value of FRB is to believe that monetary expansion will of its own accord lead to a lasting increase in total economically-viable productive capacity and/or that without recourse to FRB financial markets would otherwise be so inefficient that intermediation rates (and hence the same productive capacity) would be retarded from achieving their full potential. I dismiss both of these – the theory does not stack up and the facts also militate against both claims. FRB has no economic value to offer to compensate for the extra risk generated – all it can offer is opportunities to profit at the expense of the less astute.

    FRB – and maturity mismatch in general – will continue to be practiced only so long as banks’ creditors and shareholders don’t realise that they’re systematically underpricing risk. That is, it will last only so long as they don’t start caring about how badly they’re overpricing the fiduciary media and investments issued by fractional institutions. It is lack of this realisation or care that has been the missing element throughout history, in which same period people did believe one or both of the above. I don’t automatically fault people for that, but that is a separate story.

    If this state of knowledge and concern changes for the better then the margins currently being enjoyed by fractional banks will evaporate. Perhaps every now and then some people will pop up to try it on, whereupon the naive will get taken to the cleaners by more savvy. But in such a world, sober people wont have a bar of it.


  • Midwesterner

    It is the legal tender mandate to use a paper money system that permits FRB lending of demand deposits that is the problem.

    If the Federal Reserve Note’s status as mandatory legal tender was ended, does anybody have the slightest doubt that the entire system would come crashing down at the speed of information?

    It bears repeating since so many people miss the point, it is FR lending of money placed on demand deposit that is the sapping charge in the banking system. “Borrowing” (scare quotes because it is without the informed consent of the depositors) demand deposits and lending them long, rationalized on historical patterns of withdrawals, means that when those withdrawals exceed predicted amounts, the system cannot help but fail. Has nobody watched It’s a Wonderful Life ? George Bailey’s bank lent out demand deposits to various borrowers, and the evil Mr. Potter creates a panic that causes a run on the demand deposits in Bailey’s bank. George Bailey (Jimmy Stewart) tries to explain the system to the depositors and does a remarkably good (if incomplete) job.

    Money, be it gold, silver, bitcoins, Fed notes, whatever, must have an order of claim that is clear to everybody. By definition, “demand” depositors have the top position in the order of claim, their deposits are promised payable “on demand”. When the banks lend against those deposits to borrowers who are unable to pay off their borrowings “on demand”, then the bank is violating its contract with the depositor to return the money “on demand”. Breaking that contract is theft. Returning a car before its owner notices it is missing doesn’t make it OK. And our present banking system is driving these “borrowed” cars recklessly because they know the car owners’ insurance (FDIC) will cover it if they crash them.

    When word goes around (or is put around as in It’s a Wonderful Life ) that a bank can’t return it’s demand depositors’ money on demand, a run on that bank is inevitable.

    The solution is a simple one. Fully disclose to everybody in the chain of provenance of a particular unit of money (regardless of what kind of money it is) who has what claim to it in what order. Any long/short disparities must be addressed and resolved. Place the banks’ owners/stockholders personal assets on the line in front of any FDIC claims and deposit management will change instantly. Note I said “personal” assets. None of this hiding behind an LLC of some form. If the bank owners understand they are gambling their own houses and childrens’ college funds, they will pay better attention.

    An acquaintance of mine lost everything including his paid up house to bankruptcy when he was unable to pay his medical bills. Why should bankers financial management errors be paid for by depositors and taxpayers? Are they more equal than farm workers?

    Banking under strict liability has been very stable and returning to strict liability could ease the transition from legal tender back to free banking.

  • Paul Marks

    J.P. you have opened a can of worms here…..

    But then you know that.

    Firstly the word “deposit” is misleading.

    Money “deposited” with a bank for interest is obviously NOT deposited. It is LENT OUT (otherwise paying interest would be impossible).

    When someone puts money in a bank (for interest) they are INVESTING it.

    Someone who puts money in a bank (for interest) NO LONGER HAS THE MONEY – because it is lent out.

    One only has the money when and IF, the borrowers pay it back.

    Also the basic term “fractional reserve banking” is misleading – WILDLY misleading.

    A “fractional reserve banking system” does NOT mean that the banks take in (for example) one billion Pounds in savings and lends out 900 million Pounds (thus “90%” or “nine tenths”).

    That is NOT what fractional reserve banking is about.

    Via complex interactions within and between banks, real savings of (for example) one billion Pounds may generate lending of TEN billion Pounds, or a HUNDRED billion Pounds.

    This is the difference between “narrow money” (for example the “monetary base”) and “broad money” (bank credit).

    It is not a “fraction” of real savings that are lent out, it is VASTLY MORE than real savings that are lent out.

    That is why bank credit (“broad money”) is often vastly bigger than the monetary base.

    It is called a “CREDIT BUBBLE”.

    This was first wrote about be Richard Cantillion (John Law’s partner in “legal” crime) back in the 18th century.

    Every credit-money bubble (every “boom”) MUST (eventually) lead to a “bust” and the bigger the boom (the bigger the bank credit bubble) the bigger the bust.

    And every time there is a great crash – a great credit money bust, the cry goes up…….


    To which a true answer would be….


    It was credit expansion.

    A “fraction” not of “nine tenths” of real savings – but hundred tenths, or a thousand tenths.

    Central Banking…..

    Institutions such as the Bank of England and the Federal Reserve system operate via various antics.

    The result of these antics is to prolong credit bubbles – to put off, but NOT prevent busts.

    And to make the credit bubble (the credit money expansion) VASTLY BIGGER than it would have been otherwise.

    And (remember) the bigger the “boom” – the bigger the bust.

    Lastly – as Richard C. pointed out.

    The boom-bust are NOT neutral.

    Not only would the economy be better off (much better off) without them, but they also have income and wealth “distribution” effects.

    Broadly speaking certain normally wealthy and politically connected people are better off at the end of a boom-bust than they would have been otherwise.

    And a lot of ordinary folk are worse off than they would have been otherwise.

    And the ecomomy as a whole is (as stated above) worse off than it would have been had no boom-bust taken place.