Hello,
I am a layperson only recently exposed to the Austrian school of economics. I'm fascinated by it and I'm buying what you're selling. I do have a question:
I've read a few books by Murray Rothbard and he's critical of the fractional reserve banking system. What I do not understand: without fractional resreve banking, how can money be loaned and how could a bank possibly pay me interest? I certainly understand the risk of fractional reserve banking, especially when rerserve requirement is very low but I don't understand what the alternative is.
Thanks.
Don
Thanks for your answer.
But - how do you loan the first dollar? i.e., if, as a bank, all my deposits must be backed, isn't 100% of my money not loanable?
This is an easy answer:
There are a bunch of ways to get money without making fractional reserve loans on deposits that users can claim immediately:
1. Most Common: Issue equity. That is you sell ownership in a bank, normally done through stock holders but can be done through a mutual system. In either case the investors are not contractually obligated to be paid the money back. Understand that if the bank makes more than the interest rates then the investors get more money paid back. There are many more insurance companies that use the mutual system and it has advantages.
2. Contract deposits now for money later. A certificate of deposit is an example. The agreement for higher interest rates means the depositor has limit access to their deposit unlike a checking account or passbook savings. This method includes selling long term bonds.
In all likelyhood there would arise, in a stateless society, two different kinds of institutions.
The first would be a true financial intermediary, who would facilitate the loaning of money. There profits would be the result of arbitrage. For example, person A comes to the bank offering them money for 5% per annum, they would then lend this money at a rate higher than that and (e.g. 6% per annum) and then pocket the difference as a profit.
The second would be more like a warehousing business with whom individuals would conduct a monetary irregular deposit contract. The bank would charge a sum of money in order to guard the gold (or whatever other commodity) and this is how they would make money.
"You don't need a weatherman to know which way the wind blows"
Bob Dylan
dmuldoon:how do you loan the first dollar?
You have to get a depositor (or an investor) to allow you to do so. That's what a CD is for example. Remember you only need to maintain 100% backing for demand deposits.
The definitive work on this subject from an Austrin perspective is De Soto's book Money, Bank Credit, and Economic Cycles. It's available online in pdf format here.
All FracRB instances must eventually either (1) collapse or (2) require insurance. Obviously, (1) is not an 'option'. Due to an apparent dearth of private morons who would insure what Nir already suggested to be an uninsurable risk (Would you offer loss insurance to participants in a Ponzi scheme?) the only option remaining had been 'coerced public sheep' insurance, i.e. a government + central bank cartel. Logically and empirically, there are simply no other options.
One could disperse (lend) one's own money over a wide range of risks and durations via an ever more developed and liquid financial markets. FracRB as a vehicle for taking risk is both arcane and idiotic. In a free market, it would go down like a lead baloon.
"(Would you offer loss insurance to participants in a Ponzi scheme?"
I realize the obvious answer is "no", but this is a place where we can feel safe to think outside the box: maybe? I mean, not every customer loses in a Ponzi scheme, right? And it depends on just the exact parameters of that scheme, right? I'm really not a micro-economist, but I'll at least allow for the possibility that someone who is could analyze a given Ponzi scheme, estimate how much the "losers" are going to lose, and then charge so that they could cover those losers while still making a profit.
*If* there were a Ponzi scheme I might invest in, it would probably A) have to have pretty low payouts to the successful customers, and B) not be siphoning off too much of the deposited funds to consumption. It seems like FRB banks meet these criteria: the successful customers are making a tiny amount of interest and getting some services; they aren't consuming the deposits Madoff-style on luxury cruises so much as trying to turn a profit on them, so while banks certainly make a profit, I'm not sure it's directly from the deposits so much as how they invest those deposits.
"One could disperse (lend) one's own money over a wide range of risks and durations via an ever more developed and liquid financial markets. FracRB as a vehicle for taking risk is both arcane and idiotic. In a free market, it would go down like a lead baloon."
Well, just thinking about myself, I'm not sure I see it. I'm 47, so I have accumulated some wealth. I keep a tiny, tiny fraction in banks. I could care less about FDIC: I'm simply not risking very much in banks. I keep only enough in my bank to get through my daily cashflow needs. Banks have provided me a number of conveniences for dealing with my daily cashflow needs.
I suppose you could argue that my example shows that banks won't have a large fraction of the wealth in a free market - as I said, I keep a very small fraction of my wealth in my bank - but I don't see that they would have no niche.
Now, mind you, perhaps other insitutions that currently have my wealth might increasingly offer the services that banks do, but that's necessarily the case. Businesses specialize, and I can see a role for a business that spcecializes in "daily cashflow needs/conveniences". They probably wouldn't be today's megalithic, crony-capitalism monsters - the fact that the largest buildings in my city seem to generally be bank buildings kind of sickens me, so I share that emotional response - but I'm not seeing the argument that all FRBs would (or "should") be driven out of a truly free market.
Alternatives Considered: Banks have provided me a number of conveniences for dealing with my daily cashflow needs.
Banks have provided me a number of conveniences for dealing with my daily cashflow needs.
Those services could be as easily offered for free by your investment allocator (asset manager, loan pool allocator) as a token of his appreciation for the consulting fees you're paying him. As if going FracRB (Ponzi) was the only way to offer free cash transactions + storage. Online pop-up ads may work, too. Finally, when did actually paying a token fee for a service become such a downer? I mean, what's wrong with paying for something that you value?
Fractional money inevitably becomes fiat money. Dillution of property boundaries inevitably erodes freedom.
z1235: Alternatives Considered: Banks have provided me a number of conveniences for dealing with my daily cashflow needs. Those services could be as easily offered for free by your investment allocator (asset manager, loan pool allocator) as a token of his appreciation for the consulting fees you're paying him.
Those services could be as easily offered for free by your investment allocator (asset manager, loan pool allocator) as a token of his appreciation for the consulting fees you're paying him.
I think you are seriously underestimating the complexity and cost of building "those services". I *did* mention this as a possibility, but specialization usually pays in a free market, and it's not clear to me that being good at these functions is sufficiently close to the core competency of an investment allocator that they would emerge as the providers of these services in a truly free market.
z1235: As if going FracRB (Ponzi) was the only way to offer free cash transactions + storage. Online pop-up ads may work, too.
As if going FracRB (Ponzi) was the only way to offer free cash transactions + storage. Online pop-up ads may work, too.
I'm not sure what you are getting at: are we talking about what will/would happen, or what you wish would happen? I'm really only interested in the former. I don't like popup ads, but they apparently are profitable since they are still here.
Again, I'm not in any way arguing that FRB is the "only" way to offer day to day banking services. I'm just trying to figure out if it's a viable business model, both in terms of "is it likely to turn a profit" and in terms of its competition.
z1235: Finally, when did actually paying a token fee for a service become such a downer? I mean, what's wrong with paying for something that you value?
Finally, when did actually paying a token fee for a service become such a downer? I mean, what's wrong with paying for something that you value?
You are welcome to act on that in a free market, but I can't imagine that you think that that binds any other market actor to make the same judgment, nor that you think your preferences are what would prevail in a free market. It's perfectly reasonable to compare different "payments" for services; here we are comparing "a token fee" to "a token risk" (again, token because I maybe have 1% of my wealth in a bank at any given time, and because even if FRB "must eventually fail" at some point, it doesn't mean it will fail *while my money is in it*.)
z1235: Fractional money inevitably becomes fiat money. Dillution of property boundaries inevitably erodes freedom.
Meh. I've read enough to know that this is very important to you, but I have no trouble imagining that my contract with my FRB is very explicit that I am making a loan but that it is their "property" (I'm not getting into the discussion about current vocabulary and contracts; I'm only interested in how this would play out in the future, and I'd only give me money to someone that gave me a clear contract about what we were doing). I just see this as a contract, and *all* contracts have some nonzero chance of breach. I gave them some money, they contractually agree to give it back to me when I ask for it. There's some small chance they won't and they'll be in breach. I am happy as a consumer to deal with this exactly the way I would any other contract, e.g. contract insurance, diversification, acceptance of the risk, etc.
Look, I've sent emails to friends entitled "fractional reserve banking is a ponzi scheme", so I get it. There's no way I'd put a *large* amount of wealth in an FRB, at least not without insurance that I trusted. But in the absence of a better market-provided option - and I don't really see how that would be provided competitively given the profits banks make off of FRB - I'd be ok with putting a small day to day amount in such a bank because I like the services and the "payment" of a small amount of risk is a small price (caveat: if banks fail much more often in a free-market setting, thus changing the risk, obviously this changes my "payment" and my optimal decision may change. Perhaps that is your point). Worded correctly, it seems obvious that the contract I'd have with such a bank would not represent property violations, and any call to "outlaw" FRB would seem far, far more of a threat to the free market than the one you are concerned about.
Alternatives Considered: Worded correctly, it seems obvious that the contract I'd have with such a bank would not represent property violations, and any call to "outlaw" FRB would seem far, far more of a threat to the free market than the one you are concerned about.
Worded correctly, it seems obvious that the contract I'd have with such a bank would not represent property violations, and any call to "outlaw" FRB would seem far, far more of a threat to the free market than the one you are concerned about.
I'd let private courts decide on the "fraud" charge. As for which is a bigger threat to free markets, observe the present (global!) outcome after centuries of FracRB (coming in and out of bed with princes), mass delusions, and utter brainwashing. We're currently participants in a 0%-reserve FracRB scheme (yes, your "dollars" are backed by Jack Crap), issued at will out of thin air by "banks", funding governments and wars through massive covert taxation (inflation), and most of the 6 billion people (sheep?) don't even peep a squeek (They're actually asking for more because meeting everyone's "demand for money" makes us all feel good!)
Which one is a bigger threat to freedom, again?
z1235: As for which is a bigger threat to free markets, observe the present (global!) outcome after centuries of FracRB (coming in and out of bed with princes), mass delusions, and utter brainwashing. We're currently participants in a 0%-reserve FracRB scheme (yes, your "dollars" are backed by Jack Crap), issued at will out of thin air by "banks", funding governments and wars through massive covert taxation (inflation), and most of the 6 billion people (sheep?) don't even peep a squeek (They're actually asking for more because meeting everyone's "demand for money" makes us all feel good!) Which one is a bigger threat to freedom, again?
As for which is a bigger threat to free markets, observe the present (global!) outcome after centuries of FracRB (coming in and out of bed with princes), mass delusions, and utter brainwashing. We're currently participants in a 0%-reserve FracRB scheme (yes, your "dollars" are backed by Jack Crap), issued at will out of thin air by "banks", funding governments and wars through massive covert taxation (inflation), and most of the 6 billion people (sheep?) don't even peep a squeek (They're actually asking for more because meeting everyone's "demand for money" makes us all feel good!)
Violence.
You can't seriously expect me to buy into the notion that FRB is the *cause* of all that, rather than the violence of government?
And you can't seriously advocate that the way to freedom is to violently eliminate freedom (in this case, the freedom of actors to conduct business between themselves freely, namely, a bank and myself)?
I totally get it if you say "FRB is allowed in a free society, but I'm going to fight like hell to educate people about what it is and how they have better alternatives". I'm already a partial subscriber: I wouldn't put any serious amount of wealth into a FRB. But I would be a partial customer, at least until I see a better deal. I am distinctly unconvinced that this is so dangerous that violence must be used to prevent FRB.
Alternatives Considered: I totally get it if you say "FRB is allowed in a free society, but I'm going to fight like hell to educate people about what it is and how they have better alternatives".
I totally get it if you say "FRB is allowed in a free society, but I'm going to fight like hell to educate people about what it is and how they have better alternatives".
We're on the same page.
This is an outlandish idea but since your name is Alternatives Considered here goes. If currency laws were struck down and I was say... Warren Buffet, I could decide I wanted to make my own currency and a bank. I could call them Buffet Bills. I would make millions or maybe billions, depends on the market, of digital dollars and give them to people with good credit and collateral. Then write up a digital contract which states that if the person spends my digital Buffet Bills he has to begin repaying me the next month at x amount with x interest and automatically put up collateral in case of default. I then get to create and spend the interest into the economy as it comes due, if I take a loss then my future interest earnings will go down or I might have to raise my rates to compensate which gives me an incentive to not make bad loans so a competitor does not steal my idea and do a better job. If someone does default then the contract would state that the collateral has to be put up for sale to get back the Buffet Bills owing, I can't just keep the collateral. Market rates based on US dollars could be used as the baseline at the beginning and market forces would take it away from there. If I convinced people I was reliable and honest, not running around spending my currency like monopoly money but keeping it all strictly collaterized and soaking up defaults with that collateral to avoid inflation, then there is no reason to believe I could not make a go of it. It could very well fail but without currency laws someone could try and eventually someone would come up with some idea that worked. Because of that possibilty I believe the biggest problem is currency laws and the government enforced monopoly. I would not even go so far as to say that Government, especially states, should not be allowed to devise their own currencies and possibly demand taxes be paid with it but a choice to not have to carry Government currency, or do so if you wish, would be a boon to the entire economy because it would place competition into the one thing practically every act of commerce and trade has in common in this day and age, currency. If you are dealing in an uncompetitive monetary system then the efficiency and competition of the economy means nothing because it will be undermined by the wasteful and inneficient monopoly that is mandatory in order to participate in it. Frb would very likely not survive under such competetive conditions and to have what would likely not survive in a free market imposed by law through a monopoly is absolutely unethical and I would even say it smells of something that a communist country would devise, at the very least it has some parallels and similarities.
z1235:Fractional money inevitably becomes fiat money. Dillution of property boundaries inevitably erodes freedom.
A demand deposit, is a debt. It is not a bailment. There is no precedent in law that suggests otherwise. This is the problem with de Sotos position. He demands that the definition of 'demand deposit' fits his personal taste, not societies collective agreement. And as White quite smoothly rebuts: 'fine, but we'd solve this simply by calling it a 'payment account'' (indeed in the UK, 'current account' is used most often).
Given that a 'demand deposit' is a debt, the bank both owns and possesses the money. The depositor retains an IOU only, not ownership nor possession.
If it were the case that it was a bailment (which it is not), the following would occur:
Austrian economics should collectively accept the position of its Free Banking faction.
Banking on proper principles:
http://www.yamaguchy.com/library/gouge/inq_27.html
William Gouge, A Short History
Can some decipher this post on fractional vs full reserve banking by Steve Keen ? He seems to be trying to say that 100 % reserve banks will also create credit out of thin air. I dont understand his justification and explanation of this. http://www.debtdeflation.com/blogs/2012/07/14/mish-steve-debate-steve-says-i/
"Can some decipher this post on fractional vs full reserve banking by Steve Keen ? He seems to be trying to say that 100 % reserve banks will also create credit out of thin air. I dont understand his justification and explanation of this."
To understand, you really have to understand the difference between "money" and "currency", which requires understanding the difference between "ownership/title" and "a contractual obligation to pay someone money", also known colloquially as an "IOU". Neither of the two writers at the blog you mentioned is properly understanding these differences, including the Austrian.
In Austrian theory, "money" is the "hub commodity" at the center of a hub-and-spoke trading pattern: people trade other resources/commodities for the hub commodity, and then trade that hub commodity for other resources/commodities. In a free market, as Menger has detailed, the precious metals have done very well as money for a variety of straightforward reasons (divisibility, durability, etc). Let's speak of gold from now on as money, since that has and is likely to be the most common commodity used as money. As a *commodity*, gold is subject to the same strong property laws of libertarian systems: specifically, at any given time, only one "title" exists to a given unit of gold, representing ownership. This title is legally equivalent to the gold itself.
When someone "deposits" money in a bank, there are two ways to structure that transaction. The first, warehousing, is the simplest. In this transaction, *no title for the gold/money is transferred*: the depositor still owns his gold and still retains title to it. Because it is the depositor's property, the warehouse cannot do anything with it, since the definition of "property" is "the ability to control the commodity". Were such a warehouse to lend this money out, it would be fraud instantaneously.
The second kind of transaction, and in most scholars' opinion the one that is far more common today, is one in which ownership of the money *is* transferred to the bank. In exchange, the bank issues what is essentially an IOU: a contractual promise to pay the "depositor" a certain amount of money under certain conditions in the future. It may *feel* like you still own your money (your gold), but you do not. Hence, you have no say over the disposition of that money. That money can be lent out by the bank however they want: it's *their* money, they own it. There is nothing fraudulent about that: when they loan the money out to a borrower, ownership of that money is transferred to that borrower, again for an IOU, this time from the borrower, again with certain contractual statements about the conditions of paying off the IOU, penalities for being late in doing so or not doing so, etc. The borrower cannot guarantee that he can pay that loan back, so the contract includes penalties and clauses for non-performance.
The same is true of all IOUs, including the one from the bank to the depositor. The bank owes the depositor, but they can't guarantee that they'll be able to pay them back, to penalties and other clauses are put in the contract in case of non-performance.
Here's where the confusion comes in: both title to commodities and IOUs - which are *not* title to commodities, and thus legally are very different things- have value in the market and can thus be traded in the market, and to add to the confusion, they are both denominated in the same units: the units of money (gold). Thus, if I have title to 10 oz of gold, as indicated by a deposit receipt with a warehouse, I can use it to buy something that costs 10 oz of gold. Legally, there is no risk to the merchant: I own the gold, and only one person can own something. Now consider, say, the IOU that a depositor got from a bank. If they deposited 10 oz og gold, the bank gives them an IOU *denominated* in gold: 10 oz gold. This is *not* title, however. There is some chance of default, of contractual non-performance. It is legally possible to construct these IOUs such that they are fully transferrable, and thus "currency" is born. Note that clearly, such currency *is intimately tied to the issuer*. It is also *defined by construction* as debt: it's an IOU! As a market actor, if presented with such an IOU by someone as a form of trade, yes, it is delineated in "gold", but it is not title, and because there is some risk of default, most market actors will not accept these IOUs at face value, they will insist on a discount representing the contractual risk in that IOU. The amount of discount will depend on things like the issuer's reputation, their reserve ratios, etc, etc.
So what are some of the implications of looking at this correctly with libertarian property law?
1) FRFB is not "fraud" as long as the depositor's contract with a bank is clear that they are transferring ownership and in return getting a contractual obligation to be paid in the future.
2) Banks cannot make "money": money is a commodity, and the only way a commodity like gold can come into existence is by mining etc. The amount of property title always, by definition, equals the amount of property.
3) Banks can issue IOUs, which generally manifest as currency issued by the bank and redeemable at the bank under the conditions of the contract that the IOU incorporates. They are in the same units as "money", but are not money themselves, even though they can float freely in the market and are likely to be used in market transactions, albeit at a discount compared to money itself.
4) There is no legal requirement for the amount of IOUs issued to have any particular relationship to the amount of assets - including money/gold - of the bank. However, you expect *market forces* to pick and choose desired combinations of risk and benefits, to reward the issuers of IOUs who do so responsibly and with a track record of honoring them, etc. "Joe's bank" is unlikely to get many people to take his IOUs.
5) As a result, a free society would have both 100% backed money - since this just direct title over the money/gold - and fractionally backed currency, issued by banks when creating credit.
[As a nice aside, this helps slot in other things that have been suggested in a free society, e.g. poor person A gets a judgment awarded to him against rich person B: they can't collect themselves, to they sell the "debt" to a collection agency at a discount vs "face value". Well, this is really just the same thing as above: the award to A is an IOU from B, that is, "currency" issued by B. Like any currency, it can be sold in the market, including for other currency. So A sells his currency drawn on B to C for some other good (quite possibly a currency drawn on some more standard, reliable issuer, e.g.a bank), which C does because they think that X of B's currency is worth more than .8 (or whatever discount rate they paid) of bank D's currency. Once you see IOUs - debt - as currency, but not title, it all snaps into place.]
Actually, I think that is perfectly reasonable, and I agree that a free market in currency and banking etc is what is needed... there's a reason states so jealously guard their monopoly on this front. It's incredibly lucrative to them to do so.
The problem as I see it is that economists of all stripes are certain that there is and that there must be a storage of value within money. Money is not a storage of value but a storage of promise. That is why the bank can create money within its lending operations. The promise of the bank, whether in check, account, or bank drafts is money. The printing of the fed notes are worthless chits of paper while within the banking system and become worth something only as they are issued at the bank and become a portable promise. The confusion transferred throughout academia to all students who will be professors leaves me intensely frustrated as does most of the drivel on this thread. Promises are portable and transferable. Stored wealth, not so much. Trying to make money what it is not, regardless what the intention can only end in stupidity. It is such a shame that all academia's comprehension of money is founded on Smith's propaganda and Keynes' confusion. You'd think there might be some wit somewhere to be found. If the etherial promise of the bank cannot have real value in society, the individual's promise would be equally worthless. Over constrain the local banks creation of credit, and there will be nothing left of banks or money.