In an FEE conference lecture, Lawrence White argues that fractional reserve banks can exist legally (under libertarian law) and are viable businesses because people primarily use banks to exchange deposit balances with one another rather than for safe storage of money. I think this argument appears to have some merit on first glance but ultimately breaks down on closer inspection.
It is true that bank customers primarily use their bank account as a money-exchange device - just calculate the average volume of check/debit or other ledger payments versus cash withdrawals. The percentage of cash flow which is ledger payments (rather than cash deposits or withdrawals) is almost 100%, and there is no reason to believe that it would be significantly less in a free banking economy. However, the root problem of paying interest on demand deposits is that, as Rothbard puts it, the bank is technically insolvent, since its liabilities have zero maturity and its assets have maturities out to 30, 60, 90 days (typically) and loans which have an even longer time horizon. A fractional-reserve bank, no matter how useful and attractive it might at first seem to customers, even under libertarian law, would always be liable to bank runs. During times of uncertainty, bank runs would occur and such banks would, in fact, collapse.
It is often pointed out by defenders of fractional reserves that all businesses are liable to go bankrupt due to mistakes or failure to foresee bad economic conditions. Collapse of fractional reserve banks, on this view, is no different - no one could have foreseen that economic uncertainty would occur and, as a result, bank panics and collapses. However, this is a false claim - successful businesses and individuals do in fact predict and prepare for "rainy days" and hold liquid assets for the purpose of self-insuring against unforeseeable (therefore, uninsurable) calamities. Over time, a "market level" of such holdings will emerge, such that, successful businesses are those which typically hold X% of their assets liquid in the event of unforeseeable economic conditions.
The same would hold true of time-deposit structuring in a free banking economy - banks would need to be able to calculate their exposure to unforeseeable risks and, over time, those banks which fail to make the time structure of their assets and liabilities solvent will collapse and serve as "object lessons" to the industry. In essence, the fractional-reserve banker is making guesses about the time horizons of his customer's deposits... "I guess they won't be demanding this money for X days, so I can loan it out to ABC Corp. for X days and provide some interest-sharing to my depositors to incentivize deposits to my bank." Banks which use time deposits do not have to take on the risk of mistaken guesses about the time horizons of its customers... the customers themselves estimate their time horizons and bear the risks of miscalculation. This distributed knowledge is certainly more accurate than the centralized knowledge of the banker and, in any case, ensures that the risks of economic uncertainty are being borne by those who actually want it. If you want to take on the risk of locking your money away in a time deposit, you can do so and assume the risk of bankruptcy if you are unable to meet your own liabilities in time... but other customers of the bank do not have to bear any of the risk you are taking on to yourself.
White suggests that the fact that people primarily use their deposits for purposes of exchanging with other account-holders implies that fractional reserves banking is a viable business model - but this fails to take into account the time horizons problem and treats monies of different maturities as if they are homogeneous. Essentially, White is claiming that people would want to perform ledger transfers between accounts whose deposits have been loaned out at various maturities. Imagine I have a time deposit with 25 days remaining to maturity. I cannot exchange dollars from this time deposit at a 1:1 ratio with deposits of zero maturity for the same reason you cannot sell a bond at face value - no one will ever pay the full price of the bond in the present because time preference is never zero. If I wanted to buy a $2500 flat screen with money from my 25-day maturity time deposit, I would have to adjust for the interest rate over 25 days. Let's say the interest comes to 0.5% (roughly 6% per annum). I would have to add $12.50 to the "zero maturity" purchase price In order to pay the TV seller out of my 25-day to maturity time deposit. The $2500 television would cost $2512.50 to purchase out of my 25-days to maturity time deposit.
Only deposits with identical maturities could be exchanged at a 1:1 ratio. This is the result of time preference and arbitrage. Any other arrangement would cause someone to bear losses and provide risk-free profits to someone else. Banking institutions could separate deposits into classes on the basis of maturity and neither banking institutions nor risk-averse depositors would want to bear the risks which other depositors choose to take on without compensation that is in direct proportion to the risk being borne, the fractional reserve system would fall into disuse after a few banking panics which leave mostly non-fractional reserve banks standing. Fractional reserve banks induce each customer to share in the common risk pool of all depositors. The profit-sharing paid from the bank's interest proceeds is pro rata to the size of each interest-bearing deposit but all depositors bear equally the risks which the bank's management takes. If the bank's assets become illiquid and it is unable to meet its obligations, all depositors lose some or all of their money, even if they wanted the bank to hold their money at zero maturity, on demand. Full-reserve banks could pay as much or more interest on time deposits without pooling risks between unlike depositors.
Fractional reserves should not be prohibited in libertarian law, IMO (I reject the argument that they necessarily constitute "fraud") but they also would not be very prevalent (again IMO). I think White's argument is neither here nor there in this regard because he fails to take into account that money at different maturities would not exchange dollar for dollar in a free banking economy.
Any thoughts?
Clayton -
Esuric: Bankers observe market conditions (trained to do so) and determine the adequate level of liquidity required at any given moment. The same way that entrepreneurs look at market demand conditions and determine how much to produce, and what to produce, ect. If a bank incorrectly assesses market conditions, then it will go bust, and some people will lose money (if it's insolvent). But when firms go out of business, people also lose money, and others lose their job. But in both situations, capital and labor would be freed up for other more warranted economic employments, and their failures would send vital information signals to other market actors. This is how the market operates.
Bankers observe market conditions (trained to do so) and determine the adequate level of liquidity required at any given moment. The same way that entrepreneurs look at market demand conditions and determine how much to produce, and what to produce, ect. If a bank incorrectly assesses market conditions, then it will go bust, and some people will lose money (if it's insolvent). But when firms go out of business, people also lose money, and others lose their job. But in both situations, capital and labor would be freed up for other more warranted economic employments, and their failures would send vital information signals to other market actors. This is how the market operates.
That's a very long paragraph to end up saying nothing at all.
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Stranger:That's a very long paragraph to end up saying nothing at all.
It's not that long. Banks need a certain amount of reserves for day to day transactions (they figure this out by studying market demand conditions). Liquidity =/= insolvency. So can you just clarify a little bit? What did I miss/fail to address?
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Esuric:Banks need a certain amount of reserves for day to day transactions (they figure this out by studying market demand conditions).
Until they hit a day that is statistically improbable, and then they need 100% reserves.
Stranger:Until they hit a day that is statistically improbable, and then they need 100% reserves.
Nope, just a moratorium.
Esuric: Stranger:Until they hit a day that is statistically improbable, and then they need 100% reserves. Nope, just a moratorium.
That's stealing.
ClaytonB:Any thoughts?
AEN: What area of Austrian economics is most and least advanced?
MNR: Methodologically, we are pretty advanced, thanks to the work of Hoppe. But we can always use more since that is what sets us apart from the rest of the profession. And Salerno is doing great work on calculation.
Banking theory, however, has taken a very bad turn with free banking. We have to show that this is the currency and banking school argument rehashed. They have adopted the banking school doctrine, that the needs of business require an expansion of the money supply and credit. Moreover, the free banking people violate the basic Ricardian doctrine that every supply of money is optimal. Once a market in a money is established, there is no longer a need for more money. That is really the key point.
AEN: What about the argument that 100% reserves requires government intervention?
MNR: I regard fractional-reserve banking as an intervention in the free market, just as any crime against person and property is intervention. In the case of banking, the government is allowing the crime to be committed.
But how do we address the needs of trade argument, those who say that business has a demand for credit? Well, there are many things demanded on the market that are also crimes. There may be a demand for killing redheads. And there is certainly a demand for government loot. What's so great about market demand? if it is not within a framework of non-aggression, there will always be a demand for fraud and theft.
The free bankers accept a kind of David Friedmanite anarchism, where there is no law, only people engaging in exchange and buying people out. If you have a group that wants to kill redheads, the redheads will have to buy them off if they value their hair. I think this is monstrous, the kind of anarchism would indeed be chaos. Just because there is a demand for something doesn't mean it should be fulfilled.
AEN: One of the criticisms of this position is that it is normative and not economic.
MNR: Yes, but the response to 100% reserves is that bank entrepreneurs have the right to offer whatever fraction of deposits they want, which is also a normative position. Any discussion of policy is inherently normative. You can't have free markets unless you have property rights,
AEN: Why isn't private deposit insurance viable?
MNR: The same reason insuring any bankrupt industry isn't viable. You cannot insure entrepreneurs because they engage in uninsurable risk. You can reasonably predict how many fires there will be in New York; the unlucky few who get burned can dip into the pool of resources. But entrepreneurship is not heterogeneous; it is completely unpredictable, and each attempt is non-random. The entrepreneurs assumes the risk. If an insurance company insures it, it becomes the entrepreneur. Who then insures the insurer? In the case of banks, either they don't need insurance, since they are 100% covered, or they are uninsurable because they are taking entrepreneurial risk.
AEN: You have been critical of White's book on free banking.
MNR: The White book says the Scottish banking system was more successful than the English system. But he doesn't say one word about prices, inflation, or business cycles. His only statistic is that were fewer bank failures in Scotland than Britain. But what's so great about not having failures? An industry that doesn't have failures might be doing poorly. What if we applied this test to the Soviet Union, where no industries fail?
When you say one banking system is more successful than another, it seems the test should be less inflation and fewer business cycles. Yet this is never mentioned.
Esuric: Stranger:That's a very long paragraph to end up saying nothing at all. Liquidity =/= insolvency.
Liquidity =/= insolvency.
You are walking a fine line here with this argument and the only reason you can make it at all is because of the special nature of FRB.
Technically, when there is insufficient liquidity to cover due liabilities, any business is considered insolvent. This is why any sound business will rarely engage in a deliberate mismatch between the term structure of its liabilities and assets. Since FRB's liabilities are due on demand, and there is always insufficient liquidity to cover them, it is not wrong to say that the bank is inherently insolvent, and will be discovered as such if enough of its customers should show up and demand their due money.
The only reason why you can make your argument at all is because of the nature of FRB, that is, most of its customers are convinced that their money is secured in the bank, or at least as is today, guaranteed by federal insurance. So FRB can take advantage of this and keep this going until some inevitable crisis that is just bound to occur at some point in the future.
Mises comes close to this conclusion also:
For the activity of the banks as negotiators of credit the golden rule
holds, that an organic connection must be created between the
credit transactions and the debit transactions. The credit that the
bank grants must correspond quantitatively and qualitatively to the
credit that it takes up. More exactly expressed, ‘The date on which
the bank’s obligations fall due must not precede the date on which
its corresponding claims can be realized.’ Only thus can the danger
of insolvency be avoided.
Conza88:Moreover, the free banking people violate the basic Ricardian doctrine that every supply of money is optimal.
The classical economists saw money as a veil which covered "real economic activity." Money is not a passive agent--Austrians, more than any other school, should understand this. The demand for money and the demand for capital are intrinsically linked in a capitalistic market economy. Ricardo's position is false.
Conza88:We have to show that this is the currency and banking school argument rehashed.
False dichotomy. No Austrian believes that the banking system is a passive agent which only reacts to demand conditions. Both Mises and Hayek never denied the organic automatic adjustment mechanism--they merely elucidated the fact that this mechanism must necessarily break down when there is a banking cartel or a central bank (Mises explicitly says that this process exists when there is actual competition). The argument is that 100% reserves (never mind the fact that it's impossible to implement and regulate) must necessarily elevate the market rate above the natural rate causing persistent deflation (bad and unnatural deflation). I can't see the connection between the Banking School and Hayek. Furthermore, Mises readily acknowledged the problems of an invariable currency, and Hayek explicitly states the need for an elastic currency.
This was a direct response to Wicksell's so-called "hypothetical construct" (one bank representing the entire banking system). Mises showed that this scenario is not hypothetical at all. The Rothbardian's seem to forget that Austrian monetary theory began with Wicksell in 1896. The argument is that a free banking system is better because (a) 100% reserves are impossible to implement, and (b) will keep the market rate at or near the natural rate (while 100% reserve elevate the market rate above the natural rate). No one says that free banking is perfect.
Conza88:I regard fractional-reserve banking as an intervention in the free market, just as any crime against person and property is intervention. In the case of banking, the government is allowing the crime to be committed.
Bankers have always chosen fractional reserve banking, going back all the way to the Medici's. In fact, the only region to ever accept 100% reserves was the middle east, and this was forced upon the banking system by Sharia law (and even then they got around it).
Conza88:His only statistic is that were fewer bank failures in Scotland than Britain. But what's so great about not having failures?
At least he acknowledges that. Either way, the free bankers have some theoretical problems, but the Rothbardian's arguments against fractional reserve banking are never economic in nature. Their defense is entirely contingent upon their own personal ethical judgments (and people don't care about Rothbardian ethics).
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DD5: The only reason why you can make your argument at all is because of the nature of FRB, that is, most of its customers are convinced that their money is secured in the bank, or at least as is today, guaranteed by federal insurance. So FRB can take advantage of this and keep this going until some inevitable crisis that is just bound to occur at some point in the future. Mises comes close to this conclusion also:
No, he doesn't come close at all. In fact, he flatly denies this assertion:
I don't know where you got your definition from.
Esuric:not merely in full, but also in time, that is, without being obliged to ask for anything in the nature of a moratorium from its creditors."
You misinterpret this statement completely. It's unbelievable that you can do this, given the quote by Mises that I had just provided above from the same book! (pp. 263, online version of Money & Credit).
"also in time" means precisely what I have said above - That there must be a match between the time structure of liabilities and assets. The maturity of both should match in time.
"without being obliged to ask for anything in the nature of a moratorium" -without having to break the terms of the contract by seeking legal autority to defer payments.
This isn't a statement of support for Fractional reserves, it's a condemnation!
Reread this quote by Mises together with the quote that I had provided by him above, and perhaps it will be more clear of how you have grossly misinterpreted Mises.
Esuric:The argument is that 100% reserves (never mind the fact that it's impossible to implement and regulate) must necessarily elevate the market rate above the natural rate causing persistent deflation (bad and unnatural deflation).
This argument is a fallacy. It amounts to the same old myths about the detrimental effects of holding money.
Mises refutes this terrible fallacy and you are somehow managing to revive it by sprinkling around quotes that you insist on misinterpreting.
Esuric: I can't see the connection between the Banking School and Hayek.
I can't see the connection between the Banking School and Hayek.
Because there really isn't one! Rothbard is attacking White and his followrs. Not Hayek!
You are attributing to Hayek ideas that he did not support. I too can start to sprinkle around quotes by him that show he is a supporter of 100% reserves.
When someone examines the operation of banking in the absent of government interference and concludes that there are built in mechanisms to curb and limit expansion, it doesn't follow from this that he sees a benefit to Fractional reserves.
A free banking system with no government, FDIC or central bank intervention would be a vast improvement over what we have now here in the U.S. Modern banking did evolve from fraud in my opinion, but this is not to say that it is without benefit or that it currently remains fraudulent. As a funny, yet poignant example, professional wrestling was born of fraud as well, but it provides a valuable entertainment benefit to society nonetheless. Modern banking is not fraudulent because banks do not engage in deceit of deposit holders.
In free banking, individual banks would be compelled to police themselves because with the FDIC and it's implicit government backing gone, depositors would have a strong preference for banks with high reserves and sound balance sheets. In cases where the books were cooked, the government would have a role in criminally prosecuting those responsible.
It's neither possible nor feasible to completely eliminate risk. A free banking system that inherently promotes sound lending and high reserve ratios is preferable to a government mandated 100% reserve requirement.for banks.
One other note to Clayton's argument: you state that only 100% reserve banks would survive in a free banking system - do you really think that a 90% reserve bank would fail? I mean, what's the probability that 90% of depositors all run to the bank within a short time frame and liquidate their accounts? Given that 5.7% of people don't watch TV, 1% of people can't read, half a million people are in the hospital, many more in nursing homes, etc. Even for a small bank, it would take a monumental effort to deliberately round up 90% of depositors and convince them to liquidate all their funds. My point is that there is some natural point that reserve ratios would gravitate towards, quite a bit less than 100%, and certainly more than the small percentage seen today.
DD5:This isn't a statement of support for Fractional reserves, it's a condemnation!
I'm not talking about fractional reserve banking (I did that in my other post); I'm talking about the definition of liquidity and solvency. Fractional reserve banks are not "inherently insolvent," period (they are inherently illiquid).
DD5: This argument is a fallacy. It amounts to the same old myths about the detrimental effects of holding money. Mises refutes this terrible fallacy and you are somehow managing to revive it by sprinkling around quotes that you insist on misinterpreting.
Your never ending stream of empty assertions, and your general dismissal of Austrian theory (in the broader sense), is extremely irritating. There are no detrimental effects of holding money--I don't believe in the "paradox of thrift." There are detrimental effects of selling goods you don't want to sell and limiting purchases (when your time preference remains unchanged) in order to get the level of cash you deem necessary (past a certain level). You conflate your own interpretation of Austrian economics with actual Austrian economics (Austrian economics is not homogeneous).
Esuric: I'm not talking about fractional reserve banking (I did that in my other post); I'm talking about the definition of liquidity and solvency. Fractional reserve banks are not "inherently insolvent," period (they are inherently illiquid).
Okay. So what? They are still going in front of a bankruptcy judge.
Esuric:I'm talking about the definition of liquidity and solvency. Fractional reserve banks are not "inherently insolvent," period (they are inherently illiquid).
If you must insist, they are insolvent the moment the customers show up to exercise their contractual right to cash out their deposits. As long as they don't, you can consider them inherently illiquid.
Do you know of any other business that conducts its business in this way on a regular basis, except for government welfare schemes and madoff sytle Ponzi-schemes?
Here is another question for thought. You don't have to reply.
Money is unique in its characteristic of perfect liquidity, according to Manger and Mises. Not high liquidity, but perfect liquidity. So how can individuals in a free market possibly accept the use of liabilities in the form of bank notes or demand deposits, as money (perfect liquidity), when even according to you, they are backed by assets that are not perfectly liquid?
Esuric:and your general dismissal of Austrian theory (in the broader sense), is extremely irritating.
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Esuric:There are no detrimental effects of holding money--I don't believe in the "paradox of thrift.
Good. So there is no need for any elasticity of money to relieve some alleged demand for money, or more accurately, demand for fiduciary media.
You always imply this by insisting that there is some inherent problem with 100% reserve banks.
Esuric:You conflate your own interpretation of Austrian economics with actual Austrian economics
What's actual Austrian economics, I have no idea. I can just say that the notion that some elasticity is required, whether provided by government or free market fractional reserve banks,is a very serious deviation from Misesian economics.