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.
I have also been puzzled by this question. If a deposit is truly a bailment and not a loan, why then is interest paid on it? Did it become a de facto loan when interest began to paid on deposits? If so, when did banks first start paying interest on their deposits? Before that, were banks simply warehousing the money?
It doesn't become a loan, because it is suposed to be there for you on demand - not on a specific, mutually agreed date on the future. But the fact is that it is not there and is being used for real loans by the bank, so it receives interest. If fractional reserve became fraud under the law, your deposit wouldn't receive interest at all, in fact, you will probably pay the bank for the warehouse service. But by no means a deposit becomes a loan just because it receives interest.
«I believe there is something out there watching us. Unfortunately is the government». Woody Allen.
It kind of does. This is what loan and bailment mean.
On the balance sheet of a bank, deposits are counted as liabilities aka amounts of money owed to others aka loans. When you deposit money at a bank you are in essence extending a demand loan to the bank. The implicit contract is: "here's some money for you to borrow and do what you want with...but if I demand the loan repaid, you must fork over the cash immediately when I show up to get it." Kind of a strange arrangement, isn't it? The whole idea of "demand" is stupid if you ask me: If you've got ready cash lying around to pay your creditor back when he shows up....why did you need to take his loan in the first place? The truth is, banks don't have the ready cash lying around and just hope you'll be fooled by the big Greek columns out front into thinking they do. Things will all be sorted out when the Federal Reserve and FDIC go away. There will follow a series of healthy bank runs followed by the happy result of fractional reserve banking going the way of the dodo bird. Explicit term loans will be the norm and eBay-type intermediaries between rated savers and rated borrowers will flourish.
«Credit transactions are in fact nothing but the exchange of present goods against future goods» (p.47) (Theory of money and credit)
If your deposits were loans you would be exchanging a present good for a future good. that is: you would loan the money to the bank today in order to receive it with interest later. but the fact is that you are suposed to be able to get it today if you want it. you are not exchanging a present good for a a future good, you are only keeping your money safe in a vault, trusting that it will be there on demand, not at some future time. therefore, deposits are not loans.
This is stupid. What you deposited you do not have. You gave it up in the present, and you can collect it and the interest in the future. What is so damn hard to understand?
you did not gave it up. it is suposed to be there. the only way it gets interest is because the bank uses it for loans to other people. either you loan your money to the bank and expect to colect it in some future date with interest or you deposit it and expect it to be there on demand, without interest.
if you keep something of value in a safe, are you giving it up in the present and expecting to colect it in the future? no, you are simply keeping it safe, knowing you can get it anytime. neither do you expect it to gain «interest», if it just stands there waiting for redemption. and it does not become property of the vault until you claim it; it is your property, safe in the vault.
with fractional reserve, even though the bank is suposed to have the money there on demand, you get interest because they do not have it. if every depositor went to get his money at the same time (bank run) there wouldn't be money for everyone - but it wouldn't be their right to do so if it were a legitimate loan.
More question begging. Prove a demand deposit is not a loan!
i just did. in fact, Mises did it in 1912, almost 100 years ago. if you don't understand it i can't do much more for you.
Rui Botelho Rodrigues: you did not gave it up. it is suposed to be there. the only way it gets interest is because the bank uses it for loans to other people. either you loan your money to the bank and expect to colect it in some future date with interest or you deposit it and expect it to be there on demand, without interest.
You're right about there being a problem here: it's not much of a loan when you might turn around and ask for it back in 10 minutes. How about this: I hereby decree that henceforth no bank may use the word "deposit" any more for money they "keep" for customers in checking and savings accounts. They must start calling them "loans". Purge the word deposit from bankers' lexicon. Are you with me Rui?
Well, even if they did that a demand «loan» would still be redeemable on demand (in theory), and the whole imorality of fractional reserve - and it's inflationary effect - would still exist.
i think rothbard was right when he called for the separation of those two different concepts: deposit banking and investment banking, and most importantly, the classification of fraud for the pratice of fractional reserve.
Rui Botelho Rodrigues:Well, even if they did that a demand «loan» would still be redeemable on demand (in theory), and the whole imorality of fractional reserve - and it's inflationary effect - would still exist.
Yes it would still exist...but its existence would be weakened. I believe that the longest journey begins with the first step. This step would be simple: purge the word "deposit" from bank advertisements etc. Banks would then have to cajole savers with lines like: "Have extra money around? Lend it to us. The Bank of Greek Columns will pay you a high interest rate...and you can come and take back your loan any time you want!" Even the average dolt will scratch his head about that . He'll say: "Wait a minute...how can you pay back all your lenders if they all ask for their loans back on the same day?" When the bank answers: "That's easy, we're part of a government sanctioned cartel called the Federal Reserve. They've got a printing press that can print more money whenever any members need it to pay back loans in a hurry -- especially when the FDIC is short on cash"...the dolt will think to himself, "That doesn't sound proper. I think I'll vote for a politician who advocates ending this Federal Reserve scam." Does this make sense Rui? I agree with you about fractional reserve banking being bad. I agree with Rothbard. You and I must do what we can to CLARIFY the fraud that is going on now. I think that insisting that people call "deposits" what they really are, "loans", is a small but important step along the path of ending the fed. We must remember that muddle-headedness on the part of the American public about banking and money is the best survival weapon the Federal Reserve has. We must disarm them. One step at a time.
well, ok, but how are we to make that first step? how do we convince the banks to change their advertisement and vocabulary? the only way that first step would be possible would be through government action. so either we call Big Brother to interfere a little more or the word changing scheme is unrealistic. and i'd rather keep the word deposit than calling the government fist to change it.
I've read Rothbard's thoughts on FRB, and to be honest I was in complete agreement. However, I always wondered: in absence of any government would the total cost minimization for banks be to hold 100% reserves? It seems that they'd equate two costs:
1) The cost of depositors withdrawing when the reserves are lent out, forcing you to dip into your equity.
2) The cost of not lending out the reserves. (basically the interest lost on idle reserves)
In standard micro total cost minimization you'd balance these two, and this would be the rate at which you'd hold reserves. However, it wasn't until I took Dr. George Selgin's monetary economics course this fall that I Was provided with historical evidence. Selgin has studied both Scotland and Canada free-banking eras. These eras show that in virtual absence of government control (and definitely absence of government insurance) fractional-reserve systems did exist and were not insolvent due to fundamental flaws. These eras fly in contradiction to the claim that FRB is doomed to failure unless backed by a government safety net.
I do believe that in a free banking society you would no doubt witness an efficient, competitively balanced, FRB system. Sure you could open up a 100% reserve bank, but you would hardly be competetive and your deposits would be drained to banks offering higher returns. FRB banking systems (free of government) are perfectly capable of offering stable and safe monetary institutions. Banks that practice bad business will go under, just like any industry, but it is not until government got involved that you found systemic failures on such grand scale that we've witnessed continually throughout the united states. Free banking systems do not possess the same power to expand credit without limit like a central bank. The second you expand too far (Ayer Bank in scotland) rivals return your notes and boom you're insolvent.
Canada did not have a central bank and operated under fractional-reserves, yet in the great depression how many bank failures did they have? Zero.
Rui Botelho Rodrigues:well, ok, but how are we to make that first step? how do we convince the banks to change their advertisement and vocabulary? the only way that first step would be possible would be through government action. so either we call Big Brother to interfere a little more or the word changing scheme is unrealistic. and i'd rather keep the word deposit than calling the government fist to change it.
Hurray! You agree with me that the word deposit should be purged! I'm so happy. That's the first step right there!
OK, now on to the excellent topic you now raise: what should be the strategy of getting others to follow us. You are absolutely with me on your revulsion of asking the government fist to help us in our quest. But I'm rather disappointed in your oh-so typical response in the first place: got a thorny problem? call in government force! (That's another idea that we should start purging...but one thing at a time).
So we agree, no government force. How about this: just stop cooperating with the bankers' vocabulary. (I do this already at Starbucks: I insist on using the words "small, medium and large"). Here's something to try next time you walk into the Bank of Greek Columns:
TELLER: Good morning sir. Will you be making a deposit today?
YOU: I beg your pardon.
TELLER: Will you be making a deposit here at the bank today?
YOU: If you must know, I already did that at home this morning. After my shower. But thanks for asking, I guess.
TELLER: Ha ha ha. I was talking about that lovely stack of money in your hand. Do you want to make a deposit with that?
YOU: Make? Huh? I already "made" this money by producing more than I consumed. Now I want to put it somewhere safe so I can spend it later on fun consuming. Come to think of it, I did see your advertisement about renting a safe deposit box in your vault. Is that the "making a deposit" that you're talking about?
TELLER: No. I didn't mean make a safe deposit.
YOU: There's another kind of deposit then that's not a safe deposit kept secure down in your vault?
TELLER: Yes!
YOU: Oh. An "unsafe deposit"?
TELLER: Yes...well, no...We prefer just the word "deposit".
YOU: Confusing. I'd rather be clear on the type of "deposit" we're talking about. Just like it's better to say "teddy bear" instead of just "bear" when you're rubbing a magic lamp...or you might end up with a grizzly bear!! Ha ha ha. Just like if I give you a vague sounding "deposit" to keep safe for me, your Bank might do something crazy like not keep it at all but lend it out to someone else as soon as I walk out the door!! Ha ha ha. .So, where were we...oh yes: so if not in your vault with the safe deposits, where do you actually keep unsafe deposits?
TELLER: We don't keep them at all. We mark it on our balance sheet as a liability that we owe you. As soon as you walk out the door, we lend it out to someone else.
YOU: So it's not a deposit at all! It's a loan. Why didn't you just say so when I walked in, "Good morning sir, would you like to lend the Bank that lovely stack of money?"
TELLER: OK, OK I give up. Yes, it's a loan. You're right. It's deceiving to call it a deposit. You're not the first to come in here and point this out. Smokedgoldeye was in here this morning. I'm going to tell my boss to change all our advertisements to purge the word "deposit" from the bankers' lexicon. Or I quit! I can't work for a fraudulent institution anymore.
So, you see? We can do this crucial step of educating others without government coercion! Let's start today!