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.
scineram: They were not helped by the state. Only quite lately.
They were not helped by the state. Only quite lately.
Yes, they were.
Like how exactly?
scineram: Like how exactly?
Legal privileges, how else? Read Money, Bank Credit and Economic Cycles if you want the specifics, I'm not feeding them to you.
Dmuldoon: I think this will answer your question if it hasn't been answered already.
I deposit money into a checking account at a bank (money in the Austrian sense). This is a demand deposit, which means that the funds must be immediately available at any given time. These funds would not be loanable. The deposit would most likely require a fee to be paid as this particular transaction in itself could not generate any revenue for the bank. Real loanable funds would come from the investors and owners of the bank itself or through other financial instruments made available to customers. A CD would not be a useful financial tool in a world of 100% reserves. The reason is simple. If a bank were to loan out funds from a CD and the loan were not repaid in time, then the bank could not pay back the CD at its maturity. One might make the following argument:
"If the default rate of lent funds is 1%, then a bank may keep available 1% of total lent funds for the purpose of covering bad loans. The funds to cover bad loans could come from the savings of investors and owners. This keeps the 100% reserve requirement in case of default."
This would leave the bank open to fraud charges should more loans go bad than they have in reserves to cover bad loans. If the purchaser of a CD was not made aware that their funds would be lent out and consequently at risk then fraud is committed. If the bank only has 1% of total lent funds in reserves, and 2% of the loans go bad then the bank is on a fractional reserve and guilty of fraud because of the fact that the bank at that point could not possibly pay back its demand depositors.
Here is how a successful bank would operate:
e.g. As an investor and owner of stock in a bank, I have made my savings available to the bank for different uses. One of those uses might be as loans to consumers and business people. These funds are at risk of being lost if lent out, but typically in this case the risk has been spread across all investors and owners of the bank.
e.g. A bank may create a financial instrument so that its customers can participate in the lending market to make returns on their savings or to offset the cost of their demand deposit accounts. A bank may create fund pools which its customers can contribute to. If 10 customers contribute $100 each, then the pool now has $1,000 to be lent out according to guidelines the customer has been made aware of. The great thing about pooling of funds is that all investors in the pool share and spread risk so that any one particular investor only takes a small loss upon a single default.
The examples others used for interest rates I'm sure were only meant to be arbitrary, but private loans made by individuals today through savings would command interest rates of around 8% (friends rate) to 16% under most normal circumstances. If lenders of private savings could not get these returns, then why would they not put their money into less risky investments which can generate greater returns? The Federal Reserve has distorted the consumer's expectation for interest rates because they are not held to be accountable for profits and losses.
One last example of the distortion of returns in the market:
An income producing property with a 10% capitalization rate (a generous rate in most of today's markets) is purchased for $1 million. The purchaser puts $200k down on the property. The lender puts $800k into the deal. With a 10% cap rate, the pretax net operating income before loan payments are made is $100,000. Loan payments on a $800k loan with a 6% interest rate and 30 year amortization comes to about $57k per year. The remaining income of $43k goes to the owner. The owner is getting a cash return of 21.5% pretax while the bank is getting a 6% return on their money pretax. The bank's income is not net to the bank since they also have to account for overhead of staff and buildings. The property owner's income already takes into account the expense at market rate for a property manager (typically 5% of the effective gross income). This is a gross distortion of risk sharing and respective returns and is one explaination for why so much speculation has occured over the past several years in the real estate markets. How can you blaim entrepreneurs for being misled? The only way these returns make sense for a bank is because they are able to practice fractional reserve banking. This would not occur when real savings are lent out.
Lastly, a HUD loan for an income producing property like an apartment complex can offer a 40 year amortization which makes the loan payment even lower than in my example. Most private notes I have seen are on much shorter payment schedules.
I think this will answer your question if it hasn't been answered already. Hopefully someone will get some use out of the information at least.
Oops. Sorry about the duplicate post. This was my first one, so I guess I kind of goofed.
The process of fractional reserve banking is quite lucrative in comparison to only lending out money that is actually yours. If you can earn interest on loans from all the money you have as well as some of the money your depositors have then clearly there is more of an earning potential. If there is no central banking system it will be more difficult to inflate the money and banks would be forced to hold more of their depositors money in reserve or suffer the dreaded bank run. Either way banks will always have the temptation to use other peoples money to turn a profit and history has shown they usually give in to it. We need to see fractional reserve banking for the fraudulent scheme it is and not tolerate it.
Shawn77:If there is no central banking system it will be more difficult to inflate the money and banks would be forced to hold more of their depositors money in reserve or suffer the dreaded bank run.
Not always. There were reserve ratios 2 or 3% way before central banks came.
which just goes to show that whether fractional reserve banking is practiced from a centrally planned banking syndicate or on a bank by bank basis it is a fraudulent scheme that benefits bankers and early recipients of the "new" money at the expense of the rest of us.
How does a given reserve ratio manages to accomplish such feat?
I would have to disagree with Shawn77 on one point.
There is nothing inherently wrong about a fractional reserve banking system. The problem with today's fractional reserve banking system is this:
There is a monopoly on the production of money and a misrepresentation of what the money is. It's the misrepresentation that is fraudulent not the idea of fractional reserve banking.
If there were no legal tender laws, then I don't see any problem with fractional reserve banks coexisting with 100% reserve banks. This would especially be helpful for banks currently employing fractional reserves to transition to a 100% reserve system without having to shut down their businesses altogether which have built valuable relationships with consumers and are reputable (assuming you could consider any current fractional reserve bank reputable). To avoid any claims to fraud, the fractional reserve banks should make clear that they are a fractional reserve bank and that they don't actually have all funds for demand deposits on hand. They would probably need to change the description from "demand deposit" to something more clear such as "might be there when you want it deposit" or something that sounds more commercially appealing. No one should have the right to interfere with two individuals who want to engage in such a contract. Of course I don't see the benefit of a fractional reserve money myself, but people should have the choice is the point. The market will determine which monies suit their needs best. The bank notes themselves should clearly state what they are, demand deposit or other.
The idea of a smooth transition I think is paramount in convincing people to consider changing the legal tender law. If fractional reserve banking were made illegal overnight, all the biggest banks would have to liquidate their accounts and dump trillions of dollars onto their customers all at once. People would be lugging home suitcases full of money until new fractional reserve banks opened up months down the line. Many would lose a lot of their money. These fractional reserve banks would need time to deleverage to avoid chaos I think.
I'd like to hear some more thoughts on this.
Carter: To avoid any claims to fraud, the fractional reserve banks should make clear that they are a fractional reserve bank and that they don't actually have all funds for demand deposits on hand. They would probably need to change the description from "demand deposit" to something more clear such as "might be there when you want it deposit" or something that sounds more commercially appealing. No one should have the right to interfere with two individuals who want to engage in such a contract. Of course I don't see the benefit of a fractional reserve money myself, but people should have the choice is the point. The market will determine which monies suit their needs best. The bank notes themselves should clearly state what they are, demand deposit or other.
I've been wrestling with this issue a bit on my own, but I've yet to come to a satisfying conclusion. Sure, the contract between the bank and the customer is voluntary, no problem there, but why would people accept currency issued by a fractional reserve bank? At least, they would have to exchange at a discount relative to notes issued by full reserve banks, because of the inherent risk in fractional reserve banking. Also, as the fractional reserve bank would have to schedule its issuance of currency, its liabilities to customers and the recovery of currency in a rather complicated way, so it would be at a competitive disadvantage against the full reserve banks. After all, the bank could not leave its notes floating around in the economy in the case of withdrawal of the funds by a customer - it would mean that there are money substitutes used that are not backed by even fractional reserves. I think that this is a inherent problem, that would be very hard to solve.
All in all, it is not clear to me that the gains from fractional reserve banking would be such that it would offset the extra cost. At least the profit margins would be rather slim and thus, at least on the margin, increase the relative gains achievable via fraud. Moral hazard is a very real issue in any kind of fractional banking system - even a free one.
For questions pertaining to whether you can voluntarily enter into an agreement for a bank to hold fractional reserves and answers to most questions about FRB read this- Against Fiduciary Media.
It's co-writtem by Hoppe, Block and Hulsmann. It doesn't get better than this.
The atoms tell the atoms so, for I never was or will but atoms forevermore be.
Yours sincerely,
Physiocrat
Physiocrat: For questions pertaining to whether you can voluntarily enter into an agreement for a bank to hold fractional reserves and answers to most questions about FRB read this- Against Fiduciary Media. It's co-writtem by Hoppe, Block and Hulsmann. It doesn't get better than this.
Didn't Huerta de Soto also write it?
GilesStratton: Physiocrat: For questions pertaining to whether you can voluntarily enter into an agreement for a bank to hold fractional reserves and answers to most questions about FRB read this- Against Fiduciary Media. It's co-writtem by Hoppe, Block and Hulsmann. It doesn't get better than this. Didn't Huerta de Soto also write it?
Nope. He wrote something along the lines of The Uneasy Case for FRB but it doesn't seem still to be hosted on the Mises site. Do you recommend de Soto's Banking and Business Cycle book?