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 -
DD5: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.
I already gave you a word-for-word quote, from the Theory of Money and credit, which explicitly defines both terms, and elucidates the differences between them. If Mises' isn't an authority on this, then I don't know who is. When liabilities > assets (not money proper), you are insolvent.
DD5: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?
Because they're money substitutes and not money. People don't like carrying around bars of gold, so they deposit them at banking institutions, get paid interest, and use notes. The note circulation cannot exceed the demand for notes, for if it does, the bank will compromise its own position and the credibility of its notes (and its competitors will hoard its notes and seek redemption).
DD5:What's actual Austrian economics, I have no idea.
The works of Menger, Bohm-Bawerk, Wicksell, Hayek, Mises, Kirzner, Rothbard, Lachmann, Hazlitt, Reisman, ect.
DD5: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.
The theory of money and credit took the Wicksellian framework (laid out in Prices and Interest) and showed that (a) neutral money is illusory, (b) the organic adjustment mechanism breaks down when there is no competition amongst banks (Wicksell's "imaginary construct"), (c) explained the origins of money (solved the so-called "Austrian circle"), and (d) took Wicksell's insights and developed an exogenous theory of business cycles (this is debatable--Hayek says that Mises' position is purely exogenous, but I don't agree). He did not, in anyway, attempt to refute Wicksell or his framework. You can have bad deflation--it exists.
"If we wish to preserve a free society, it is essential that we recognize that the desirability of a particular object is not sufficient justification for the use of coercion."
Esuric: DD5: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? Because they're money substitutes and not money. People don't like carrying around bars of gold, ...........
Because they're money substitutes and not money. People don't like carrying around bars of gold, ...........
I don't need a lesson in how money substitutes evolved. I was referring to Fractional reserve banking and not warehouse banking so why are you evading the question with a lesson on money substitutes.
Esuric:so they deposit them at banking institutions, get paid interest, and use notes.
So they use notes backed by assets that are not perfectly liquid as money. There goes Manger's and Mises' theory on money out the door, right there!
Esuric:The note circulation cannot exceed the demand for notes, for if it does, the bank will compromise its own position and the credibility of its notes.
This doesn't address at all the contradiction of people using money substitutes that are not backed by perfect liquidity. I don't need an explanation of why free banking can work better then the present system.
Esuric:You can have bad deflation--it exists.
You can have a lot of bad things that exist. So? It doesn't follow from this that Fractional reserve free banking can alleviate some alleged problem with holding money. You are so inconsistent on this matter. Is holding money detrimental or not? If not, then you don't need FRB regardless of whether there is such a thing as "bad deflation".
Anyhow, here is the biggest fallacy of them all: That demand for fiduciary media always amounts to a demand to restrict consumption on the part of the individual, as contended by the modern free bankers.
DD5:There goes Manger's and Mises' theory on money out the door, right there!
Well, good riddance!
DD5:It doesn't follow from this that Fractional reserve free banking can alleviate some alleged problem with holding money.
The problem is excessive demand to hold money.
DD5: Esuric:so they deposit them at banking institutions, get paid interest, and use notes. So they use notes backed by assets that are not perfectly liquid as money. There goes Manger's and Mises' theory on money out the door, right there!
What? I mean, I don't know how to respond to this. Can you please tell me what you're trying to say. What is Mises and Menger's theory of money? How does the introduction of money substitutes invalidate their theories?
DD5:This doesn't address at all the contradiction of people using money substitutes that are not backed by perfect liquidity.
What contradiction? They wouldn't be "money substitutes" if they were money proper.
DD5:Is holding money detrimental or not? If not, then you don't need FRB regardless of whether there is such a thing as "bad deflation".
The world isn't as simple as you would like it to be. If everyone held all of their money for an extended period of time, starting tomorrow, it would be very bad; if the money supply was cut by 75%, for example, it would also be very bad (worse then it needs to be). The point of the market is to assure that prices (including the interest rate) move towards the level determined by the interplay of subjective valuations.
Esuric:What? I mean, I don't know how to respond to this. Can you please tell me what you're trying to say. What is Mises and Menger's theory of money? How does the introduction of money substitutes invalidate their theories?
I meant this to be some food for thought. that is all.
I am not talking about any money substitutes but specifically fiduciary media. They are not the same.
Money is not a high liquid asset but a perfect liquid asset. To claim that people knowingly accept notes backed by assets that are not perfectly liquid is to also claim that it must not be true that one of money's primary characteristics is its perfect liquidity. You cannot have it both ways. This is why it is quite unlikely that fiduciary media can evolve in a free market without deception.
The use of fiduciary media as money doesn't necessarily invalidate this fact about perfect liquidity if and only if the market participants are
1. tricked into thinking that they are backed up by perfect liquidity
or
2. government guarantees liquidity by its power to use force.
Esuric:The world isn't as simple as you would like it to be.
You are evading the question.
Esuric:If people are selling products and limiting purchases, just to satiate the demand for money (which is the same as saying that the supply of money is below the demand for cash holdings), then the market rate is necessarily elevated above the natural rate.
How can it possibly be above the natural rate when everything you are describing is directed by voluntary action?? Natural rate is the market rate, and market rate corresponds to voluntary action. Your assertion doesn't make any sense. Natural rate is the result of whatever the voluntary action of market participants is. Don't try to evade this by saying that "the world is not as simple as is".
Esuric:Now, prices will adjust, and restore equilibrium, but this process is painful.
This is the modern free banking position. It is their sophisticated way to enjoy both worlds; Mises and theories about elasticity.
I thought you said that you do not hold the position of the modern free bankers. (I saw that comment before you removed it before).
Esuric:Now, if you want to say that fractional reserve banking will replace bad deflation with inflationary bubbles, and that this is much worse, then fine.
I can easily put a hole in monetary equilibrium theory based on the works of other Austrians. Would that satisfy you? You can then evaluate the validity of their criticism on your own.
Esuric:bad deflation, or when the market rate is elevated above the natural rate
Again, I don't want to argue about the concept of bad deflation. The market is run by humans and they could be behaving in some stressful way for what ever reason.
I simply object to the claim that the rate is elevated above the natural rate when people hold money as oppose to some system providing elastic currency.
This is tantamount to saying that holding money is detrimental which is starting to be more in line with Keynes then with Mises.
What happens when the market rate is elevated above the natural rate?
DD5: This is the modern free banking position. It is their sophisticated way to enjoy both worlds; Mises and theories about elasticity. I thought you said that you do not hold the position of the modern free bankers. (I saw that comment before you removed it before).
This is the Austrian position. I don't want to debate this bullshit with you anymore (which is why I edited my last comment). Mises and Hayek both supported an elastic money supply (though they acknowledge its problems).
DD5:I can easily put a hole in monetary equilibrium theory based on the works of other Austrians.
No you can't.
DD5: This is tantamount to saying that holding money is detrimental which is starting to be more in line with Keynes then with Mises.
If the demand for money skyrocketed, and if the money supply was cut by 75%, there would be enormous problems. What Hayek called "secondary shocks."
Esuric:This is the Austrian position. I don't want to debate this bullshit with you anymore (which is why I edited my last comment). Mises and Hayek both supported an elastic money supply (though they acknowledge its problems).
Mises had made it clear from the beginning. That any supply of money is optimal. There is no social benefit from tempering with the supply. I don't know how you can possibly reconcile that with your statement above.
You've basically only read Mises' first work and you profess to know what the Misesian position is. You read 3 other papers by Hayek and you know the Austrian position. Give me a break! Move on.. Read at least Human Action before you declare what the Misesian position is.
Anyhow, all of the quotes that you have provided are out of context. Some of them don't support anything you say at all. You are misinterpreting many of them.
For example:
They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they help to stabilize the objective exchange value of money. To this extent, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended one of the phenomena of the market, even f it has also completely misapprehended its cause." pp. 347 Theory of Money and Credit.
In in its full context, Mises is showing the superiority of competitive banking vs central banking. That in the absent of a single uniform interest policy, banks will tend not to overextend their issuing of fiduciary media. That is all! This certainly doesn't mean that Mises is in the opinion that elastic money is necessary. There are just so many other quotes, even in "Money and Credit" that don't do justice to your assertions at all. So what, you just ignore the rest?
Esuric: DD5:I can easily put a hole in monetary equilibrium theory based on the works of other Austrians. No you can't.
Good argument. Is that your reason talking or your pride.
Esuric:If the demand for money skyrocketed, and if the money supply was cut by 75%, there would be enormous problems. What Hayek called "secondary shocks."
And all of the references to Hayek about "secondary shocks" etc.. are all analysis of statist policies. It's amazing that you are interpreting this stuff in any other way.
The obsession with the problem of the public's demand to hold money is a curious one for people who supposingly attack Keynesians for their fallacious "pardox of thrift".
But here is the main problem in your examples:
How can the money supply be cut by 75% with a 100% gold system???? You are simply all over the place misapplying and misquoting Hayek. (this tone is for your "bullshit" remark above).
I think somewhere in your analysis you tend to forget that the 100% gold standard is extremely inflexible to contractions and would render such violent and abrupt deflationary pressures practically impossible. As far as demand is concerned, it would likely decrease and not increase, as purchasing power is expected to gradually increase. I seriously think that you are misapplying Hayek, who is usually talking about contractions in the modern world of monetary expansion and contraction.