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.
Interesting collection of quotes from Marxism Unmasked:
The situation that came about in the nineteenth century with the development of modern methods of banking, with the issue of banknotes and of deposits subject to check, led to two serious problems: fiduciary media and credit expansion. (p. 78 [all pages refer to PDF]; all bolding mine)
The following quote provides the context over the passage we are currently debating:
The second very questionable business consists of the institution of credit expansion, which may be called the most important economic problem of our age. This means that the banker lends more money to people than he receives from his depositors. This surplus of banknotes issued by the banker, or of deposits subject to check which he opens for his customers, is credit expansion. The question is, “What are the consequences of such operations?” At the beginning, credit expansion of this type was not very critical, not very dangerous, because it was done by individual bankers who had a good standing in the city and their notes could be taken by people, or they could be refused.You could go to the banker and receive from him a loan made up completely of additional banknotes, fiduciary media, made up completely of credit expansion. But then the question was, would your customers and your creditors really be ready to accept as payment the banknotes issued by this banker? We may assume that a creditor who has a questionable deal would answer, “It is better to take these notes than to wait any longer for payment.” But then, he would have gone immediately to the banker who issued the notes and would have redeemed them, thus reducing the number of surplus banknotes outstanding.
What it seems that he is saying is that superfluous bank notes would be immediately redeemed, and so in relatively small quantities banks could deal with this. If you do a search for the words "credit expansion" and read the passages, it becomes clearer that what Mises is arguing is that government allowed for credit expansion to take place on a much grander scale. He clearly argues that while credit expansion is necessarily bad, in small quantities it can be dealt with.
Jonathan M. F. Catalán: 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.
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.
I'm not making an argument for FRB, I merely arguing that Mises wasn't a 100% reservist. You seem to be assuming that I'm arguing that he thought FRB would succeed in a free market, even if that wasn't true that still isn't the point. However...
"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."
...This isn't necessarily true at all. You are stating what the contract must say, while apparently ignoring what it can say. The demand deposit's contract can state that the depositor has the explicit right to demand the assets deposited at any time unless... in which case his demand will be redeemed by date X... if needed the form of Y... etc.
Thats the beauty of the option clause.
Jonathan M. F. Catalán: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: 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.
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.
My point exactly. "He didn't simply say" means he did not say, I'm not attributing the quote to him as he didn't say anything like that.
Jonathan M. F. Catalán: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).
I'm not sure how you could assume that he's building off of TMC as his opinion of free banking seems to change by HA (but I'm not convinced). I didn't think that there was any doubt that there are dangers in credit expansion, just as there are dangers in driving, thats why its crucial it only be in good hands (private). He makes this point clear in HA:
Free banking is the only method available for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all information required about their financial status.
It seems pretty clear that he found "slow" credit expansion to be safe. And as already shown he clearly defined "credit expansion" as the banker lending more money than deposited.
Jonathan M. F. Catalán: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.
And that is the same basic argument that all free bankers use. Regardless, he makes my point about him not being a "crank" a la Rothbard, as he clearly isn't demanding 100% reserves, hes advocating Free Banking.
Jonathan M. F. Catalán:What it seems that he is saying is that superfluous bank notes would be immediately redeemed, and so in relatively small quantities banks could deal with this. If you do a search for the words "credit expansion" and read the passages, it becomes clearer that what Mises is arguing is that government allowed for credit expansion to take place on a much grander scale. He clearly argues that while credit expansion is necessarily bad, in small quantities it can be dealt with.
Thats the free banking argument in a nutshell, minus the "bad" part. What he seems to be saying is that only in a free market can credit expansion be correctly maintained, thus not starting a business cycle (a danger). I don't see any calls for 100% reserves.
Angurse: I'm not making an argument for FRB, I merely arguing that Mises wasn't a 100% reservist. You seem to be assuming that I'm arguing that he thought FRB would succeed in a free market, even if that wasn't true that still isn't the point. However...
No, but he is at least extremely close to one. He admits that the circulation of fiduciary media would be kept to a bare minimum in a free market for banking.
If the contract is any different, then it is not a demand deposit. Demand deposit contracts are the way they are for a reason; they make warehousing and usage of money much easier than just holding on to your cash and doing the accounting yourself.
I have already made the argument that banks that require the use of option clauses would most likely fall into disfavor with their clients. Obviously, a client who deposited his money in a bank to warehouse it while he thinks on what to spend it on and then suddenly is cut off from his money, because the bank cannot meet his demand (too much fiduciary media being returned for redemption) will probably move to another bank. So, while the option clause may exist as a caveat in a contract, I think that it becomes pretty clear that banks who have to make use of it will not survive for long periods of time.
I'm not sure how you could assume that he's building off of TMC as his opinion of free banking seems to change by HA (but I'm not convinced).
You should re-read what I wrote. I didn't say that he's building off The Theory of Money and Credit; I explicitly said that he is probably building off of prior arguments. I will quote myself just so that we're clear:
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).
It seems as if your ability to misinterpret extends beyond Ludwig von Mises.
I didn't think that there was any doubt that there are dangers in credit expansion, just as there are dangers in driving, thats why its crucial it only be in good hands (private).
That is a bad metaphor. That is like saying that credit expansion can be good if it's done by the right people. That is not what Ludwig von Mises is claiming at all. It is clear that what he is saying is that credit expansion would be kept to a bare minimum.
He makes this point clear in HA: Free banking is the only method available for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all information required about their financial status. It seems pretty clear that he found "slow" credit expansion to be safe. And as already shown he clearly defined "credit expansion" as the banker lending more money than deposited.
You should continue the quote:
But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular—one is tempted to say normal—feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.
Just so that it's clear, credit expansion is still at the heart of "crises and depressions", and Mises still supports the notion that in a free banking environment credit expansion would not just be "slow", but would be extremely limited (admittedly, in this case I might be misinterpreting the use of the word "slow"—I'm not sure if you are meaning to use it in the sense of velocity or using it as a synonymous of "limited". The way it is used seems to imply that credit expansion would continue, just at a slower pace. I don't think that is accurate; Mises is stating that while there may be cases in which superfluous notes are distributed, they would be quickly returned and the supply of money substitutes returned to its previous volume).
I agree with you that economists such as Murray Rothbard and (please forgive me) Jesús Huerta de Soto (one of my favorite economists, though) are incorrect in supporting forced 100% reserves. In my "article" I concluded with:
Admittedly, there should be no legal bar against fractional-reserve banking. The legal question is easily avoidable. Larry Sechrest has a valid point when he states that fractional-reserve banking may arise as a result of offering a better deal to the customer. In other words, the fact that banks issue interest on checking deposits may lure depositors to trust these banks over simple warehouse banks, because the promise of interest in enticing. Is this type of banking tenable over the long-run?
There is more, but it simply restates the case I've been making in this thread insofar, so I will skip some parts:
Despite these theoretical disagreements between various economists who support free-banking, they can all agree on the fact that the current cartelized banking system must be dismantled and exchanged with one that is free. This includes the freedom to mint coins, or print money, and the freedom from a central bank’s sway. This also includes the freedom to fail. Only by eliminating this bank of last resort can a truly stable banking system evolve and only by these means can society finally enjoy stable economic growth and prosperity. In a free market, poor banking systems would quickly fall out of place and stable accounting measurements come to the forefront. Certainly, on this all free-banking economists can agree.
I would not, however, call Murray Rothbard a crank. His theoretical insights are valuable. This must be admitted, even if you disagree with him (I disagree with Larry Sechrest and Lawrence White, but that does not make them cranks). Speaking of Larry Sechrest and Lawrence White, their arguments are not that fractional-reserve banking would be kept at a bare minimum. Their argument is explicitely that it would be an acceptable and healthy form of banking, which I disagree with. It is true that they admit that perpetual credit expansion would be impossible, and that it could only occur as long as the issues can be redeemed without conflict of interest, but the major theoretical disagremeents are mainly on the extent of possible credit expansion (this is, at least, what I have read through out White's articles and Sechrest's book Free Banking). Furthermore, the free banking school does not believe that fractional reserve banking is necessarily inflationary, while Mises obviously does. The latter simply believes that the inflation is self-regulating, so that generally if it occurs there are natural checks which cause the money supply to return to its previous volume.
Finally, if the first quote was initially included in the thread as a means of proving that Ludwig von Mises was not a supporter of forced 100% reserves then I can admit to not necessarily misinterpreting your posts, but at least driving it off through an off-topic tangent.
I am surprised that DD5 has not made his case in regards to defrauding the "third party". This was the one criticism of my above stated position on free banking (in the paragraphs quoted), and I was interested in hearing more (this is not a challenge, just a genuine inquiry of interest).
nirgrahamUK: 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 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.
So whenever money demand or supply changes a business cycle occurs?That's a tough sell.
existence is elsewhere
Jonathan M. F. Catalán: 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.
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.
I don't see why that is the case. Why would an increase in the supply of money necessitate first order goods to look more profitable? Is it because an increase in money supply brings a decrease in the interest rate?
If this is true, couldn't that simply be thwarted if the increase or decrease of money supply was known and accounted for? Even so, I don't see how this problem is at all solved with full fractional reserve banking. Money supply and demand can still fluctuate, so if this is the of the business cycle, it seems like the business cycle is just a natural part of the economy that can only be tamed and not conquered.
I personally am unsure as to whether or not an increase in the supply of money needs to increase or decrease interest rates, as long as demand for money increases at the same pace.
Wilmot of Rochester:If this is true, couldn't that simply be thwarted if the increase or decrease of money supply was known and accounted for?
How would it? If a bank has a surplus of credit it lowers interest rates. It's not as if an entrepreneur has a choice; or, do you suggest that all investment come to a halt?
Even so, I don't see how this problem is at all solved with full fractional reserve banking. Money supply and demand can still fluctuate, so if this is the of the business cycle, it seems like the business cycle is just a natural part of the economy that can only be tamed and not conquered.
I'm not sure how you come to such a conclusion. In a 100-percent reserve system there is no monetary expansion, apart from the physical mining of actual money (not money substitute). It is true that a large amount of incoming specie can set off a cycle (see: Tulipmania and the Crisis of 1937), but these are less recurring.
Credit expansion does not respond to an increase in the demand for money. Judging from your response to NirgrahamUK, you equate "demand for money" with "demand for capital". They are not the same.
Wilmot of Rochester:So whenever money demand or supply changes a business cycle occurs?That's a tough sell.
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
nirgrahamUK: explain in greater detail (than none at all) how your question relates to the sentence of mine that you quoted?
explain in greater detail (than none at all) how your question relates to the sentence of mine that you quoted?
Why is it that only an increase in money unnaturally changes the course of interest rates? If the supply of money increases, does it necessitatate that a "boom" is occurring?
Jonathan M. F. Catalán: I am surprised that DD5 has not made his case in regards to defrauding the "third party". This was the one criticism of my above stated position on free banking (in the paragraphs quoted), and I was interested in hearing more (this is not a challenge, just a genuine inquiry of interest).
Consider as an example a modern day seller of gold bullion who offers to sell gold stored in his own vaults in order to save the buyer the hassle of storing the gold himself and to offer him other services of transaction for convenience. The seller issues a paper claim ticket or perhaps opens a digital account for the buyer. If the seller notices that most customers do not ever redeem their physical gold, he may be tempted to commit fraud and issue multiple tickets for the same amount of gold. At this point, the “free banker” will immediately object and claim that no fraud necessarily needs to take place if the buyer is aware of the practice. However, all other owners of gold are still clearly defrauded by having multiple gold accounts being created out of nothing. The buyer agreeing to the seller's terms hardly eliminates the fraud, but only makes him a collaborator in the fraud along with the seller against all other owners of gold. Now of course, if these new gold accounts are NOT introduced into the market as real gold substitutes backed up by 100% the face amount and safely secured in some vault, then no fraud takes place at all, but then we are no longer talking about anything even remotely related to fractional reserve banking.
All those holding the money commodity are being defrauded by having its value debased as a result of the multiple new demand deposits created out of nothing. They are the 3rd party. Thus, Rothbard was correct when he pointed out here (pp. 98):
"Where did the money come from? It came—and this is the most important single thing to know about modern banking—it came out of thin air. Commercial banks—that is, fractional reserve banks—create money out of thin air. Essentially they do it in the same way as counterfeiters. Counterfeiters, too, create money out of thin air by printing something masquerading as money or as a warehouse receipt for money. In this way, they fraudulently extract resources from the public, from the people who have genuinely earned their money. In the same way, fractional reserve banks counterfeit warehouse receipts for money, which then circulate as equivalent to money among the public. There is one exception to the equivalence: The law fails to treat the receipts as counterfeit."
The "public" in this case is the third party.
Jonathan M. F. Catalán: How would it? If a bank has a surplus of credit it lowers interest rates. It's not as if an entrepreneur has a choice; or, do you suggest that all investment come to a halt? I'm not sure how you come to such a conclusion. In a 100-percent reserve system there is no monetary expansion, apart from the physical mining of actual money (not money substitute). It is true that a large amount of incoming specie can set off a cycle (see: Tulipmania and the Crisis of 1937), but these are less recurring. Credit expansion does not respond to an increase in the demand for money. Judging from your response to NirgrahamUK, you equate "demand for money" with "demand for capital". They are not the same.
On investments, it's a question of factoring in the change in the supply of money to get the real interest rate. Something like modern adjustments for inflation.
Also, an increase in mining isn't the only way money supply changes. If money demand changes or if velocity of exchange changes, then it has comparable consequences.
Wilmot of Rochester:Why is it that only an increase in money unnaturally changes the course of interest rates? If the supply of money increases, does it necessitatate that a "boom" is occurring?
no, we are not only talking about increases in money.... but rather about the effect of creation of fiduciary media which is introduced into the economic system through the extension of loans.
nirgrahamUK: Wilmot of Rochester:Why is it that only an increase in money unnaturally changes the course of interest rates? If the supply of money increases, does it necessitatate that a "boom" is occurring? no, we are not only talking about increases in money.... but rather about the effect of creation of fiduciary media which is introduced into the economic system through the extension of loans.
Why would the creation of dollars be any different than the increase of gold? Either way, money in the economy is increasing and, according to the theory, the interest rate is changing. Why is gold special?
Also, why shouldn't similar consequences occur when anyother variable in the exchange equation changes? Say there's no increase in the money supply at all, but velocity increases ten fold. What's the difference?
Wilmot of Rochester: On investments, it's a question of factoring in the change in the supply of money to get the real interest rate. Something like modern adjustments for inflation.
I'm still not sure how an entrepreneur would factor these changes in the supply of money in. It's easy to present it as a solution, but the fallacy is uncovered when you find out there is no appreciable way for entrepreneurs to really know (besides the fact that entrepreneurs are not economists). If an entrepreneur wants to invest he will base his decision on what seems to him a juxtaposition between benefits and costs. Low interest rates make higher order production seem more beneficial. What is the entrepreneur to do in the case of artificial interest rates? Cease investment for the length of the boom? That can be many, many years. I think the lack of sensibility in this objection to the Austrian Business Cycle Theory is quite obvious.
What does velocity of money have to do with the supply of money? Money, or tangible assets used as a common good for trade, can only increase if the volume of these "tangible assets" increases. If the velocity of a particular piece of money increases it does not multiply into more money, it remains the same. Besides, the concept of velocity of money has already been refuted:
According to popular thinking, the idea of velocity is straightforward. It is held that over any interval of time, such as a year, a given amount of money can be used again and again to finance people's purchases of goods and services. The money one person spends for goods and services at any given moment can be used later by the recipient of that money to purchase yet other goods and services.
From the equation of exchange, it seems that money together with velocity is the source of funding for economic activities. Furthermore, from the equation of exchange, it would appear that for a given stock of money, an increase in velocity helps finance a greater value of transactions than money could have done by itself.
As logical as it sounds, neither money nor velocity has anything to do with financing transactions. Here is why.
Consider the following: baker John sold ten loaves of bread to tomato farmer George for $10. Now, John exchanges the $10 to buy 5kg of potatoes from Bob the potato farmer. How did John pay for potatoes? He paid with the bread he produced.
Observe that John the baker had financed the purchase of potatoes, not with money, but with bread. He paid for potatoes with his bread, using money to facilitate the exchange. In other words, money fulfills here the role of the medium of exchange and not the means of payment.
The number of times money changed hands has no relevance whatsoever on the baker's capability to fund the purchase of potatoes. What matters here is that he possesses bread that can be exchanged by means of money for potatoes.
How is it that the fact that the same $10 bill used in several transactions can add anything to the means of funding? By what means does the speed of money circulation add to the real pool of funding? Imagine that money and velocity would have indeed been means of funding or means of payments. If this was so, then poverty worldwide could have been erased a long time ago. Moreover, since rising velocity is supposed to boost effective funding, then it would have been to everyone's benefit to make sure that money circulates as fast as possible. This implies that anyone who holds on to money should be classified as a menace to society, for he slows down the velocity of money and hence the creation of real wealth.
Austrian arguments against the mechanistic equation for velocity of money have been provided as early as Ludwig von Mises and Benjamin Anderson (who published his refutation as early as 1917).
Wilmot of Rochester:Why would the creation of dollars be any different than the increase of gold? Either way, money in the economy is increasing and, according to the theory, the interest rate is changing. Why is gold special?
the expansion of gold where the money first enters the economic system as new loans (rather than being spent to make purchase) would have the perverse effect on the market rate of interest as the extension of fiduciary media.