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.
smokedgoldeye: I don't see how you can argue that common "deposits" are not actually loans.
I don't see how you can argue that common "deposits" are not actually loans.
It's within the terms of the contract. I agree with everything you said above. The problem is that you left out the fact that in a demand deposit (and even modern "savings" accounts) the contract states that the depositor has the right to withdraw the money on demand. If the money is being loaned out, then obviously the bank cannot fulfill this end of the contract. In a demand deposit you are not loaning out your money; you are not offering the bank money for a specific period of time. You are depositing your money with the intention of demanding it so you can use it to spend.
I think it would speed up the demise of FRBs if the general public were keenly aware that their "deposits" were in fact loans to banks...
This seems to contradict what you wrote above it. You agree, then, that loaning out a demand deposit is wrong, and therefore the demand deposit is not a loan. The act of loaning out money deposited in a time deposit is not the same as depositing money on demand in a bank.
Jonathan M. F. Catalán:If the money is being loaned out, then obviously the bank cannot fulfill this end of the contract. In a demand deposit you are not loaning out your money; you are not offering the bank money for a specific period of time.
They can because they do. These non sequiturs just beg the question. You just assert it is not a loan without an actual argument.
Jonathan M. F. Catalán:You are depositing your money with the intention of demanding it so you can use it to spend.
No, you usually write cheques against it or use credit cards. In neither case are you demanding it.
smokedgoldeye: I sense your acrimony against Rothbard, but alas I don't understand it. Not well read enough I guess! I googled "Rothbard is wrong" and could only find shabby critique of his self-ownership axiom. Could you indulge me with 2 or 3 sentences to summarize the thesis about why Rothbard is a "money crank"? Thanks in advance.
I sense your acrimony against Rothbard, but alas I don't understand it. Not well read enough I guess! I googled "Rothbard is wrong" and could only find shabby critique of his self-ownership axiom.
Could you indulge me with 2 or 3 sentences to summarize the thesis about why Rothbard is a "money crank"? Thanks in advance.
To be honest, I very much like Rothbard and appreciate the work he has put forth.
Rothbards model of banking is actually quite similar to the free banking model put forth by White, Selgin, and Sechrest, but it is really a "solution to a nonexistent problem." Free banking (with Fractional Reserves) is simply superior. His model wastes resources by demanding that 100 percent specie reserve. If money supply is incapable of growing our contracting in response to conditions (such as consumer demand) then monetary equilibrium cannot be maintained.
Jonathan M. F. Catalán: I think it would speed up the demise of FRBs if the general public were keenly aware that their "deposits" were in fact loans to banks... This seems to contradict what you wrote above it. You agree, then, that loaning out a demand deposit is wrong, and therefore the demand deposit is not a loan.
This seems to contradict what you wrote above it. You agree, then, that loaning out a demand deposit is wrong, and therefore the demand deposit is not a loan.
Now we're getting somewhere. The fog is lifting for me! We both have the same dim view of FRBs but have different approaches for attacking the problem:
ME: Banks claim to have ready cash on hand to pay back depositors on demand. They don't actually have the cash. Therefore, let's expose this fraud by shocking the public: NEWSFLASH: your deposits are actually loans to banks (technically true - just look at any bank's balance sheet)...and they don't have anywhere near the cash on hand to pay you back on demand as they promise (again, check out that balance sheet). Tell your children that deposits are loans. Tell them the truth! Terrify your family and neighbors with the ugly truth about banks today. Deposits are really loans!! RESULT: FRBs will crumble as people withdraw their money...Mobs with pitchforks will confront Bernake and any Fed supporters and end the Fed. Hurray!
YOU: Banks claim to have ready cash on hand to pay back depositors on demand. They don't actually have the cash. Therefore, let's expose this fraud by insisting on the ideal that deposits are really deposits, ie. funds kept on your behalf by the banks to spend as you direct them to (online bill paying, tuition checks, cash withdrawals for an unexpected Vegas trip). NEWSFLASH: Deposits should be treated as Honorable Deposits. Banks must follow the terms of their contracts and truly have cash on hand to pay back your demand deposit whenever you show up. RESULT: FRBs will crumble as they are shamed into keeping higher reserve ratios and being more conservative.
Am I close? Or was it just wishful thinking that I thought my fog was lifting. We both want FRBs to wither away, don't we? I think my strategy is better!
scineram: They can because they do. These non sequiturs just beg the question. You just assert it is not a loan without an actual argument.
I did provide an actual argument, that you simply have decided not to respond to. In the short-run it proves true that a bank can fulfill a limited amount of demands for money. Banks operate under this assumption (that depositors will only demand a certain amount of their money at any given time). However, when the malinvestments produced by credit expansion (resulting from fractional-reserve banking) is finally revealed, historically banks have not been able to meet these demands (i.e. bank runs).
I'm sorry? Checks, like debit, are immediately withdrawn from your account. It is the same as using cash. It is not synonymous with credit, which is debt (even the "credit card" attached to my checking account operates as a debit, it just withdraws the money after three days, instead of doing the transaction immediately).
smokedgoldeye: Am I close? Or was it just wishful thinking that I thought my fog was lifting. We both want FRBs to wither away, don't we? I think my strategy is better!
I think what you're saying is that you prefer that fractional-reserve banking be exposed emperically versus theoretically. The former is a natural outcome of its usage, but I'm not sure what damage exposing it theoretically/intellectually does.
DD5:Do you want to add Mises to that list also? (note text in bold)
Yes, yes. We've had this discussion before Mises' views on FRB and feduciary media aren't clear and apparently change over time. This debate has been done many times.
"Therefore the dangers of credit expansion were not very great as long as the credit expansion was the business of private banks and private businesses subject to commercial laws. As long as the surplus banknote could be returned to the bank of issue for redemption, there was a check on credit expansion, and there couldn't be credit expansion of any considerable extent"
--Marxism: Unmasked (which came out after HA)
Angurse: "Therefore the dangers of credit expansion were not very great as long as the credit expansion was the business of private banks and private businesses subject to commercial laws. As long as the surplus banknote could be returned to the bank of issue for redemption, there was a check on credit expansion, and there couldn't be credit expansion of any considerable extent" --Marxism: Unmasked (which came out after HA)
Actually, this quote seems pretty consistent. I guess it depends on how you interpret it. I think that the key portion of the quote is:
As long as the surplus banknote could be returned to the bank of issue for redemption,...
Jonathan M. F. Catalán:I did provide an actual argument, that you simply have decided not to respond to. In the short-run it proves true that a bank can fulfill a limited amount of demands for money. Banks operate under this assumption (that depositors will only demand a certain amount of their money at any given time). However, when the malinvestments produced by credit expansion (resulting from fractional-reserve banking) is finally revealed, historically banks have not been able to meet these demands (i.e. bank runs).
Fair enough. I disagree heavily the it necessarily produces malinvestment.
Jonathan M. F. Catalán:I'm sorry? Checks, like debit, are immediately withdrawn from your account. It is the same as using cash. It is not synonymous with credit, which is debt (even the "credit card" attached to my checking account operates as a debit, it just withdraws the money after three days, instead of doing the transaction immediately).
If the transfer is to an account at the same the reserves play no role in it, there would not have to be any so far. On the other hand, with an interbank transfer reserves will have to be eventually moved to the other bank through the clearings system. But then still only the account differences will have to be settled, not the total amount of transactions, at the end of the day or any clearing period. This is the source of its great efficiency.
scineram: Fair enough. I disagree heavily the it necessarily produces malinvestment.
Thinking about it, that is where the majority of the disagreement should be. The way I originally posed the concept was that loaning out of a demand deposit was not fraud if the bank could meet the demand for money. I posed this in a blog post, but neither George Selgin or Lawrence White commented on it (or the idea that over the long-run calculating this demand proved impossible; Selgin embarrassed me since I completely misinterpreted something he wrote in a paper on small change (in regards to Gresham's Law) and White simply tried to disprove me through historical example, to which I replied that there were enough counterexamples to at least cast doubt on this historical evidence, and so the argument should be done from a theoretical standpoint).
One of the comments in the blog post, however, said that fractional-reserve banking was inherently inflationary. Furthermore, on this forum DD5 responded to my "not fraud if demand is met" argument by saying that the third party is defrauded, referring to this idea of inherent inflation. I don't think I will comment on that.
I'm not sure how this is relevant to what I said, or what the original argument (in that section of the post) was about. I admit that the language is confusing, so maybe I am missing something. The point is that using money from a checking account is akin to demanding money, as it is akin to physically withdrawing money (or money substitutes) and spending it. The transaction is done immediately, and it is taken from your deposit. Credit cards do not fulfill this function. Credit cards are a method by which to accumulate debt you promise to pay within a specified time period (or else you suffer interest).
Jonathan M. F. Catalán:The point is that using money from a checking account is akin to demanding money, as it is akin to physically withdrawing money (or money substitutes) and spending it.
The account itself, which is basically bank liability, is money. You pay by transferring it to another account. Your point might have been about using cash. But using cheques is different from using cash because it does not directly involve transfer of the bank's cash reserves to another bank.
Jonathan M. F. Catalán:Credit cards do not fulfill this function. Credit cards are a method by which to accumulate debt you promise to pay within a specified time period (or else you suffer interest).
I might have misused this terminology. How do you call such instruments with which I can make transfers from my checking account or withdraw cash through an ATM? Debit cards?
scineram: The account itself, which is basically bank liability, is money. You pay by transferring it to another account. Your point might have been about using cash. But using cheques is different from using cash because it does not directly involve transfer of the bank's cash reserves to another bank.
Actually they do, and it has become more obvious in the past few months (due to changes in how checks are processed), where money paid through with checks is immediately transferred from the reserves of one bank to the other (or from one account to another, which should be considered one in the same, as it is the only thing that really matters). The difference in the past few months that I speak of is that the transfer used to take a number of days to fulfill, while now it is done immediately and electronically.
Checks, cash and debit are one in the same.
That is debit.
Jonathan M. F. Catalán: Actually, this quote seems pretty consistent. I guess it depends on how you interpret it. I think that the key portion of the quote is: As long as the surplus banknote could be returned to the bank of issue for redemption,...
That portion hardly differs from the standard banking fare. Within the book Mises clearly explains "credit expansion" as bankers lending out more money than received from depositors (i.e. surplus banknotes or fiduciary media)
Angurse: That portion hardly differs from the standard banking fare. Within the book Mises clearly explains "credit expansion" as bankers lending out more money than received from depositors (i.e. surplus banknotes or fiduciary media)
He nevertheless makes it clear that fractional-reserve banking is, in general, bad (as he still believes that there should be limits imposed on credit expansion). The language he uses is not very clear, but I think that it still underscores his argument against credit expansion. He says:
As I said before, I think this is the key portion of the quote. If the money is being lent from demand deposits, then the banknote cannot be redeemed in money or commodity, because there is already an existing claim for said money and/or commodity. This would be a natural check to the expansion of fiduciary media.
Jonathan M. F. Catalán: Banks operate under this assumption (that depositors will only demand a certain amount of their money at any given time). However, when the malinvestments produced by credit expansion (resulting from fractional-reserve banking) is finally revealed, historically banks have not been able to meet these demands (i.e. bank runs).
Banks operate under this assumption (that depositors will only demand a certain amount of their money at any given time). However, when the malinvestments produced by credit expansion (resulting from fractional-reserve banking) is finally revealed, historically banks have not been able to meet these demands (i.e. bank runs).
I was always under the impression that malinvestments were due to a lack of a price mechanism in the interest rates - a failure of markets to occur, usually due to government action.
I'm uncertain why an increase in the supply for money should cause malinvestments, all things remaining equal.
existence is elsewhere