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.
Monopsony:These eras fly in contradiction to the claim that FRB is doomed to failure unless backed by a government safety net
Just so I'm clear:
1. you like the idea of no government insurance (eg. the FDIC).
2. you like the idea of having no central bank
3. you think that, after achieving 1 & 2, fractional reserve bankers should not be accused of fraud and subject to lawsuits.
4. you think that owners of moderately risky fractional reserve banks will actually prosper with profits from re-lending vs. their overly conservative safe deposit box renting rivals...and if they ever experience a bank run and run out of cash in their bank's tills, they'll just hand over their "shareholder's equity" pile of cash that they have right around the corner (in their idling limos etc).
How did I do? I agree with 1 & 2. Concerning 3, I think if the banker says "Thanks for the unsafe deposit! Come back and withdraw it anytime! Pretty impressive columns, eh? Remember: your unsafe deposits are always safe at this bank!" -- that is fraud. If, on the other hand, he says: "Thanks for the 60-day loan. We can pay you back the whole amount then with interest, or 10% of the total anytime."...then that's not fraud. Concerning 4, the devil is in the details. Your scenario of bank owners merely having to "dip into their equity" to deal with any bank run sounds lovely...but how much cash will these owners really be keeping in their idling limos? Hmmm. Those bank run mobs can get pretty nasty when the tellers windows "temporarily" close. But bank runs are unlikely, right? So consumers with extra cash should be free to loan their money to any kind of bank they want. Can't argue there. I love freedom and risk taking (I'm an entrepreneur!). If it were me, though. I would likely put the extra cash I was willing to risk into stocks...and the extra cash I couldn't afford to lose in a safe deposit box. But I can see some others happy to choose to put their savings into your fractional reserve banks and collect a little interest. Why not. Overall, I'm not in favor of ANY government interference in the market. (Let's try no government at all as an experiment per Rothbard's "For a New Liberty')...so I don't think fractional reserve banking should "be banned" (who would ban things in a world with no government anyway?). Let consumers and producers and entrepreneurs be free to engage in any kind of voluntary transaction they want. What do you say?
http://www.terry.uga.edu/~selgin/freebanking.html
This is essentially the question I am trying to answer. How would banking systems operate under complete freedom of government interference. Trust me, I am not a fan of government :].
Besides theory, (check that link) there are studied episodes of periods of freedom in banking. Were they subject to bank runs and fraudulent schemes? No. In fact bank runs appear to be only a symptom of government interference. Fractional-reserve systems that HAVE operated (not theoretical) were not subject to constant runs and failures.
What has been found (again, not just theorized) is that these FRB systems in absence of government regulation and "safety" were extremely effective. They were not, as you might think, constantly run on and bid up to 100% reserves.
I think that we are in agreement on choice and absence of government, but disagreement on the outcome. I think that if we were to somehow run a perfect simulation of this you'd first witness warehouse functions of storing money. Then you'd witness the evolution of fractional reserves based on equating the two opportunity costs I described earlier. Consumers would have complete choice in where to store their money, but in the interest of maximization they'd seek higher returns (while balancing the cost of risk of course).This isn't to say that a whole spectrum of risk in banking wouldn't exist, just as in any industry.
But wait, this isn't some simulation, we have actual (see link) cases of free banking episodes.
FRB is not some demon only allowed to survive with government insurance. It is simple microeconomics at work, and has operated effectively and with stability way more than what we have now.
Monopsony: 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.
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.
Well said. I was reading Free Banking in Britain the other day, and it was an overall fascinating story. I wish I could read other books on the topic, like Selgin's and Dowd's, but they are not available around here.
http://www.terry.uga.edu/~selgin/econ4100/syllspring09.pdf
This is Selgin's Monetary econ syllabus. Every reading is available online, it's not everything, but part one of the course deals strictly with history.
scineram: Well said. I was reading Free Banking in Britain the other day, and it was an overall fascinating story. I wish I could read other books on the topic, like Selgin's and Dowd's, but they are not available around here.
Have you read Larry Sechrest's Free Banking? He is part of the free banking school, but critiques the idea of free banking in Scotland.
Monopsony:I think that we are in agreement on choice and absence of government, but disagreement on the outcome.
Please elaborate about what our disagreement is. Thanks.
Monopsony:Besides theory, (check that link) there are studied episodes of periods of freedom in banking. Were they subject to bank runs and fraudulent schemes? No. In fact bank runs appear to be only a symptom of government interference. Fractional-reserve systems that HAVE operated (not theoretical) were not subject to constant runs and failures.
This is not true!
There was no free banking era! Perhaps more free then today, but it was not free. What White and Selgin call free banking was, in fact, never free banking completely free of government intervention. see The myth of Free Banking in Scotland
Monopsony:What has been found (again, not just theorized) is that these FRB systems in absence of government regulation and "safety" were extremely effective. They were not, as you might think, constantly run on and bid up to 100% reserves.
This conclusion is backwards. Lack of bank runs is highly suspicious and probably indicates government involvement instead of lack of it. Since the establishment of FDIC, there has been literally no more bank runs. According to your logic, this fact indicates there is free banking
Monopsony:Then you'd witness the evolution of fractional reserves based on equating the two opportunity costs I described earlier.
Your "opportunity costs" is the result of your assumption that FRB can be productive. In fact, since FRB causes credit expansion, it is bound to induce an artificial boom, and an inevitable bust. The bank run will come! It always has.
Monopsony:Consumers would have complete choice in where to store their money, but in the interest of maximization they'd seek higher returns (while balancing the cost of risk of course).This isn't to say that a whole spectrum of risk in banking wouldn't exist, just as in any industry.
No matter how you slice it, these FRB claim tickets are, BY DEFINITION, not money substitutes, for they cannot guarantee redemption. So who in the market will except your claim tickets (or checks) as perfect money substitutes (and at face value) when in fact they are not? The answer is unequivocally: NOBODY. They have been accepted as such in the past only due to their deceptive and fraudulent nature of circulating as perfect money substitutes.
Yes, you can remove the fraud by a contractual clause, but then the claim tickets seize to be money substitutes. Your alleged FRB is not really FRB any longer but some crazy casino game that gives out tickets based on some shell game scheme that cannot survive the market test, as no ponzi-scheme can.
I suggest you read the entirely newly added chapter 3 of Free Banking in Britain for a response to the critiques.
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!
On the theme of criticizing bankers' vocabulary, the term "Fractional Reserve Banking" is full of holes too if you ask me. It reminds me of the kid who figures out that jargonish partial truth-telling can be a handy tool: "But mom, I didn't lie. I did tell you that there might be a Scheduling Uncertainty Occurence..." Handy for bank run press releases in the FRB free-banking future maybe: "As an openly Fractional Reserve Bank, customers have always been aware of the possibility of withdrawal suspension privileges on a temporary basis until the irrational financial panic has subsided."
Fractional is related to fracture and fractured, ie. broken in pieces or parts. Reserve implies extra supplies that might be needed in an emergency as in "Don't worry that the gas tank is on empty, there's a reserve tank in the trunk." Surprise surprise, what bankers really mean by "reserve" is the original cash that savers entrusted to them. One gas tank. Nothing extra. When they say "100% reserve banking" they mean they actually have all of depositors' cash on hand at the bank. By replacing "100%" with "fractional", the banker is sort of honestly telling you that some undefined (it's rude to ask) fraction of your cash is on hand to pay you back on demand. And is it just me, but when they add "trust" to their name, as in "Greek Columns Bank & Trust", they seem even less trustworthy.
Maybe proponents of Fractional Reserve Banking would better understand the folly of the term if you offered them transatlantic tickets on a ship with a "Fractional Preserve Life Preservation System" -- with cheaper tickets because the owner gains from renting out "excess" lifeboats.
"As an openly Fractional Reserve Bank, customers have always been aware of the possibility of withdrawal suspension privileges on a temporary basis until the irrational financial panic has subsided."
February 17 - 1600 - Giordano Bruno is burnt alive by the catholic church. Aquinas : "much more reason is there for heretics, as soon as they are convicted of heresy, to be not only excommunicated but even put to death."
When they say "100% reserve banking" they mean they actually have all of depositors' cash on hand at the bank.
You guys act as if it's some big secret that deposits are loaned out.
Monopsony: You guys act as if it's some big secret that deposits are loaned out.
And you keep misrepresenting and addressing only a fragment of the argument of the other side.
Here:
This is not true! There was no free banking era! Perhaps more free then today, but it was not free. What White and Selgin call free banking was, in fact, never free banking completely free of government intervention. see The myth of Free Banking in Scotland
see http://www.terry.uga.edu/~selgin/freebanking.html
Except that under the scenarios Selgin studied they didn't.
Deposit tickets circulate as part of the money supply because they DO function as money. You accept it because you trade it later for the actual good/service you want. This is an efficient selection of the market.