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.
Wilmot of Rochester:I'm uncertain why an increase in the supply for money should cause malinvestments, all things remaining equal.
Mises explains that when banks issue fiduciary media and loan them out to entrepreneurs they cause the market rate of interest to deviate from the rate of originary interest.
Mises: 6. The Gross Market Rate of Interest as Affected by Inflation and Credit Expansion Whatever the ultimate effects of an inflationary or deflationary movement upon the height of the rate of originary interest may be, there is no correspondence between them and the temporary alterations which a cash-induced change in the money relation can bring about in the gross market rate of interest. If the inflow of money and money-substitutes into the market system or the outflow from it affects the loan market first, it temporarily disarranges the congruity between the gross market rates of interest and the rate of originary interest. The market rate rises or drops on account of the decrease or increase in the amount of money offered for lending, with no correlation to changes in the originary rate of interest which in the later course of events can possibly occur from the changes in the money relation. The market rate deviates from the height determined by that of the originary rate of interest, and forces come into operation which tend to adjust it anew to the ratio which corresponds to that of originary interest. It may happen that in the period of time which this adjustment requires, the height of originary interest varies, and this change can also be caused by the inflationary or deflationary process which brought about the deviation. Then the final rate of originary interest determining the final market rate toward which the readjustment tends is not the same rate which prevailed on the eve of the disarrangement. Such an occurrence may affect the data of the process of adjustment, but it does not affect its essence. The phenomenon to be dealt with is this: The rate of originary interest is determined by the discount of future goods as against present goods. It is essentially independent of the supply of money and money-substitutes, notwithstanding the fact that changes in the supply of money and money-substitutes can indirectly affect its height. But the gross market rate of interest can be affected by changes in the money relation. A readjustment must take place. What is the nature of the process which brings it about? In this section we are concerned only with inflation and credit expansion. For the sake of simplicity we assume that the whole additional amount of money and money-substitutes flows into the loan market and reaches the rest of the market only via the loans granted. This corresponds precisely to the conditions of an expansion of circulation credit.5 Our scrutiny thus amounts to an analysis of the process caused by credit expansion.
Whatever the ultimate effects of an inflationary or deflationary movement upon the height of the rate of originary interest may be, there is no correspondence between them and the temporary alterations which a cash-induced change in the money relation can bring about in the gross market rate of interest. If the inflow of money and money-substitutes into the market system or the outflow from it affects the loan market first, it temporarily disarranges the congruity between the gross market rates of interest and the rate of originary interest. The market rate rises or drops on account of the decrease or increase in the amount of money offered for lending, with no correlation to changes in the originary rate of interest which in the later course of events can possibly occur from the changes in the money relation. The market rate deviates from the height determined by that of the originary rate of interest, and forces come into operation which tend to adjust it anew to the ratio which corresponds to that of originary interest. It may happen that in the period of time which this adjustment requires, the height of originary interest varies, and this change can also be caused by the inflationary or deflationary process which brought about the deviation. Then the final rate of originary interest determining the final market rate toward which the readjustment tends is not the same rate which prevailed on the eve of the disarrangement. Such an occurrence may affect the data of the process of adjustment, but it does not affect its essence.
The phenomenon to be dealt with is this: The rate of originary interest is determined by the discount of future goods as against present goods. It is essentially independent of the supply of money and money-substitutes, notwithstanding the fact that changes in the supply of money and money-substitutes can indirectly affect its height. But the gross market rate of interest can be affected by changes in the money relation. A readjustment must take place. What is the nature of the process which brings it about?
In this section we are concerned only with inflation and credit expansion. For the sake of simplicity we assume that the whole additional amount of money and money-substitutes flows into the loan market and reaches the rest of the market only via the loans granted. This corresponds precisely to the conditions of an expansion of circulation credit.5 Our scrutiny thus amounts to an analysis of the process caused by credit expansion.
Where there is no property there is no justice; a proposition as certain as any demonstration in Euclid
Fools! not to see that what they madly desire would be a calamity to them as no hands but their own could bring
There he is talking about the effects of inflation and deflation. Credit expansion and contraction are not always inflationary and deflationary.
I edited my post by adding bolding and underlining, so that you can understand what he does state at the opening of part 6 and therefore understand the context of what he goes onto analyse in greater detail. he is talking about the use of fiduciary media to extend loans to business.
Wilmot of Rochester: I'm uncertain why an increase in the supply for money should cause malinvestments, all things remaining equal.
I'm uncertain why an increase in the supply for money should cause malinvestments, all things remaining equal.
The key to Austrian business cycle theory, I think, is capital theory; that is, that an increase in the money supply will make investment in first-order goods relative to consumer goods look profitable.
Jonathan M. F. Catalán: Wilmot of Rochester: I'm uncertain why an increase in the supply for money should cause malinvestments, all things remaining equal. The key to Austrian business cycle theory, I think, is capital theory; that is, that an increase in the money supply will make investment in first-order goods relative to consumer goods look profitable.
Production of first order goods requires long term investment (eg. Intel chip fabrication plant). The net present value cost of that investment will deceptively appear to be low due to lower interest rates caused by the fiat money supply increase. The appearance of saved real resources available to complete the project is what creates the malinvestment: as the project nears completion, the malinvestment becomes obvious as resources start running out. On the contrary, an increase in the money supply as a result of people saving more than consuming creates a non-deceptive lower interest rate. Long-term capital projects that are initiated can actually be completed. Savers indicated their intention to save in the present and spend in the future...in the future the first order good investment will be completed in order to satisfy supplies needed for their future consumer spending. Perfect! Voila, no malinvestment.
Saving does not cause an increase in the money supply, it only causes an increase in the supply of capital (capital accumulation). The money supply remains constant, unless more money or money substitutes are physically created. There is an explicite difference between a redistribution of money under a change in time preference, and an increase in the amount of money in circulation.
smokedgoldeye:Production of first order goods requires long term investment (eg. Intel chip fabrication plant).
Higher order produce the inputs required for the intel chip fabrication plant. The intel chip fabrication plant is merely one phase in the production process.
smokedgoldeye:The appearance of saved real resources available to complete the project is what creates the malinvestment: as the project nears completion, the malinvestment becomes obvious as resources start running out.
No, the saved resources is what allows the investment projects to come into fruition. The problem is that the artificially reduced interest rate tells market actors that time preference is low, and that there's plentiful resources for more roundabout methods of production (savings--subsistence fund). You're confusing causality--the reduced interest rate causes the malinvestment, and the forced savings attempts to correct the distorted structure of production.
smokedgoldeye:On the contrary, an increase in the money supply as a result of people saving more than consuming creates a non-deceptive lower interest rate.
No. Pure confusion.
smokedgoldeye:Long-term capital projects that are initiated can actually be completed.
Increasing the money supply does not increase the amount of resources in the economy, but only prolongs the malinvestment and leads to increasing prices, both in the higher and lower orders.
"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."
The production methods are determined by the supply of subsistence funds less consumption after each production period. The higher the supply of subsistence funds (savings), the longer the production method may be (more productive). This subsistence fund is expressed in the lonable funds market through the interest rate. If consumption diminishes the subsistence fund to a point where previous methods of production are too long, that is, where there's not enough goods to sustain the economy for the production process, then the price of current goods will rise to a point where the extended production process is no longer profitable. Thus, if the interest rate is arbitrarily reduced, as if the supply of savings had actually increased, and producers begin to extend the production process, they will be met with increasing costs and scarcity.
How did I do with this new children's book draft? Thanks.
https://docs.google.com/present/edit?id=0AcRoi3t5YXTeZGZ0ZnF6bmdfMTM4ZnFqdGZjZHQ&hl=en
Jonathan M. F. Catalán: 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 long as the surplus banknote could be returned to the bank of issue for redemption,... 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.
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 long as the surplus banknote could be returned to the bank of issue for redemption,...
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.
I don't see that says FRB is bad at all. As the banknote can be returned for redemption, he never says returned at all times any times. He even says in HA, "What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligation in full compliance with the terms of the contract." And his concern over banknotes, is just that. It says nothing about deposits.
Angurse: I don't see that says FRB is bad at all. As the banknote can be returned for redemption, he never says returned at all times any times.
I don't see that says FRB is bad at all. As the banknote can be returned for redemption, he never says returned at all times any times.
Okay, but you can't return fiduciary media for redemption at any time (which is probably why fiduciary media's modern value is just the promise that it is worth a certain amount). If you are loaning out from checking deposits, at any time when there is a superfluous note circulating for that deposit then there are two claims. The bank cannot fulfill both claims, because it would be physically impossible.
He even says in HA, "What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligation in full compliance with the terms of the contract." And his concern over banknotes, is just that. It says nothing about deposits.
Re-read your quote:
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.
When he is referring to "credit expansion" he is referring to fractional-reserve banking. Even in this nebulous quote, it's clear that he is attributing the adjective "dangerous" to the concept of credit expansion. Not only that, but he doesn't say that the dangers of credit expansion are non-existant, he says, "are not very great".
He continues:
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
Ludwig von Mises is right. That quote, in fact, can be attributed to fractional reserve banking (like I did), because you cannot redeem a superfluous note if there are multiple claims on the same deposit. That is the "check" he is referring to. The quote in Human Action supports this position:
...compelling every individual and firm to fulfill all obligation in full compliance with the terms of the contract.
Jonathan M. F. Catalán:Okay, but you can't return fiduciary media for redemption at any time (which is probably why fiduciary media's modern value is just the promise that it is worth a certain amount). If you are loaning out from checking deposits, at any time when there is a superfluous note circulating for that deposit then there are two claims. The bank cannot fulfill both claims, because it would be physically impossible.
Sure. But nowhere does Mises say at "any time though" the passage from HA made it even more clear.
Jonathan M. F. Catalán: Re-read your quote: 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. When he is referring to "credit expansion" he is referring to fractional-reserve banking. Even in this nebulous quote, it's clear that he is attributing the adjective "dangerous" to the concept of credit expansion. Not only that, but he doesn't say that the dangers of credit expansion are non-existant, he says, "are not very great".
And thats a positive, not a negative. Contrast that with the idea that FRB (credit expansion) inherently causes bubbles (as has been espoused), FRB constitutes fraud, or "the benefits are not very great." Accepting that there are dangers within banking hardly makes one a full-reservist.
Jonathan M. F. Catalán: Ludwig von Mises is right. That quote, in fact, can be attributed to fractional reserve banking (like I did), because you cannot redeem a superfluous note if there are multiple claims on the same deposit. That is the "check" he is referring to. The quote in Human Action supports this position: ...compelling every individual and firm to fulfill all obligation in full compliance with the terms of the contract.
Yes, the last sentence especially makes it completely in compliance with free banking theory.
Angurse: Sure. But nowhere does Mises say at "any time though" the passage from HA made it even more clear.
I'm not sure you are interpreting my use of that word correctly. There is no time at which that banknote can be redeemed, if there are multiple claims on it.
I'm not sure how you can interpret that "credit expansion" is "dangerous" as being "positive". What all the quotes you have provided do suggest is that Mises did not believe that banks should give banknotes which have to be redeemed by defrauding another client (i.e. fractional reserves on demand deposits).
You cay say that by ignoring the rest of my post, and ignoring the fact that two claims on one asset cannot be fulfilled (because it is physically impossible). But, it does not make you right, it just makes you delusional.
Jonathan M. F. Catalán:I'm not sure you are interpreting my use of that word correctly. There is no time at which that banknote can be redeemed, if there are multiple claims on it.
Then you have stepped out of the realm of FRB all together. As all notes can be redeemed within the contractual time period expressed with each client. Mises' quotes show that free banking is the way to avoid the over-issue of fiduciary media.
Jonathan M. F. Catalán:I'm not sure how you can interpret that "credit expansion" is "dangerous" as being "positive". What all the quotes you have provided do suggest is that Mises did not believe that banks should give banknotes which have to be redeemed by defrauding another client (i.e. fractional reserves on demand deposits).
He didn't simply say "credit expansion is dangerous," as in something to be avoided. Hes saying that "credit expansion," while dangerous, isn't necessarily bad. Fractional reserves hardly defraud another client, especially given the contract entered into by all parties involved. (Which Mises has shown support for). If you continue reading, Mises goes on to explains how the situation could be bad. (Government interference)
Jonathan M. F. Catalán:You cay say that by ignoring the rest of my post, and ignoring the fact that two claims on one asset cannot be fulfilled (because it is physically impossible). But, it does not make you right, it just makes you delusional.
You are either 1) confused about FRB, 2) confused about Mises, 3) confused about FRB and Mises.
Angurse: Then you have stepped out of the realm of FRB all together. As all notes can be redeemed within the contractual time period expressed with each client. Mises' quotes show that free banking is the way to avoid the over-issue of fiduciary media.
What you are referring to is the product of fractional-reserve banking. You continue to treat the two separately, but you haven't really made a case for it (I mean, if you actually made an argument I might eventually agree with you). In fractional-reserve banking, when you are loaning out of demand deposits, you create multiple claims for the same assets. The demand deposit's contract states that the depositor has the explicit right to demand the assets deposited at any time. When you loan money, the debtor has rights to those assets within the time of the contract. But, the contract with the debtor and the contract with the depositor are running simultaneously, and therefore one of the two cannot redeem their banknotes.
As a result, one of the two clients are being defrauded. I have not seen any "free banker" reconcile this fact. Even Lawrence White ignored it when responding to a blog post of mine.
He didn't simply say "credit expansion is dangerous," as in something to be avoided. Hes saying that "credit expansion," while dangerous, isn't necessarily bad.
Not to cut you off, but he did not say that at all. You are interpreting that, and adding words to the quote. I'm not sure how you can so badly misinterpret Mises:
Nowhere there does is say that credit expansion is not necessarily bad. He explicitly cites that there are dangers. I have not read Marxism Unmasked, and so I am guessing that he is building on opinions established prior to this publication (such as in Human Action or The Theory of Money and Credit). The quotes clearest interpretation is that private banking has natural checks to credit expansion, and so credit expansion is not as bad as it would be in a regulated or monopolized market.
But very soon governments invaded this field of action.They invaded it under the erroneous idea that by issuing circulation credit, additional credit, fiduciary media, by issuing more money than they had received from the public, the banks were in a position, precisely on account of this credit expansion, to reduce the height of the rate of interest. (Bolding mine.)
Fractional reserves hardly defraud another client, especially given the contract entered into by all parties involved. (Which Mises has shown support for). If you continue reading, Mises goes on to explains how the situation could be bad. (Government interference)
Mises never showed support for fractional reserve banking (the only "free banking" case that I is commonly stated is Mises' definition of inflation, which has little to do with fractional reserve banking—it is not inflation is the money supply is being expanded to meet demand for money [Mises states this in The Theory of Credit and Money; I don't want to go into this, since it is off-topic, but I am just stating for clarity). None of the passages you have quoted show this—it seems to me that you are making inquitous misinterpretations.
Given that it seems that the argument has devolved into interpretation versus interpretation, I'm not sure it is worth continuing. Whether your interpretation is correct or not, it becomes irrelevant when it is clear that one of our interpretations is wrong and we are obviously unwilling to budge on the issue. So, in regards to Mises I can agree to disagree.
You did a great job of avoiding what I actually said. Like I have said above, you have failed to make a concrete case that fractional reserve banking does not defraud at least one contract.