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Fractional reserve banking

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dmuldoon posted on Mon, Feb 9 2009 11:38 AM

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

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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?

 

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Answered (Verified) Bogart replied on Mon, Feb 9 2009 12:12 PM
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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.

 

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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

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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.

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DD5 replied on Mon, Dec 28 2009 11:23 PM

Wilmot of Rochester:
What I've been taught is that the velocity of money is related to the level of inflation and deflation in the economy relative to the price of money

 

Velocity of circulation is an ill defined term because money doesn't circulate.  Money is exchanged between individuals but at all times, the money is held by somebody. 

The demand to hold money is basically your check balance and the money in your wallet.  It is hoarding.  All money that is in your possession right now is being hoarded by you.  The demand to hold can be considered the counterpart of  your "velocity" but it is more accurate in its description of the human action that involves in handling money. 

The error of monetarists is that they neglect the micro-effects of the change in money supply and change in individual demand to hold preference. 

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DD5:

Wilmot of Rochester:
What I've been taught is that the velocity of money is related to the level of inflation and deflation in the economy relative to the price of money

 

Velocity of circulation is an ill defined term because money doesn't circulate.  Money is exchanged between individuals but at all times, the money is held by somebody. 

The demand to hold money is basically your check balance and the money in your wallet.  It is hoarding.  All money that is in your possession right now is being hoarded by you.  The demand to hold can be considered the counterpart of  your "velocity" but it is more accurate in its description of the human action that involves in handling money. 

The error of monetarists is that they neglect the micro-effects of the change in money supply and change in individual demand to hold preference. 

 

ok

 

existence is elsewhere

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Jonathan M. F. Catalán:

Within the context of your original post, that they are not proportional or equal.

 

You wrote:

Say there's no increase in the money supply at all, but velocity increases ten fold. What's the difference?

Shostak actually engages the mainstream view on the velocity of money.  If you read the article, he explains why the velocity of money does not effect money's particular purchasing power.  Shostak is not the only Austrian economist to critisize the theory of velocity as a determinant of prices:

 

Well then if that's what Shostak, Hazlitt, and Anderson are saying - that velocity has nothing to do with the price level, then they are all demonstratively and factually wrong.

http://www.sjsu.edu/faculty/watkins/infldynamic.htm

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Esuric replied on Wed, Dec 30 2009 6:59 AM

Wilmot of Rochester:
Well then if that's what Shostak, Hazlitt, and Anderson are saying - that velocity has nothing to do with the price level, then they are all demonstratively and factually wrong.

Velocity is an illusion because money is never exchanged for itself; it's either exchanged for a good/service, or for time (where interest is present). Now, money demand is indeed real (represented by k), but it is not constant, easily measurable, controllable, nor is it the reciprocal of the illusory term stolen from quantum mechanics.

"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."

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Esuric:

Velocity is an illusion because money is never exchanged for itself

 

I don't see how that makes velocity an illusion. Velocity of money relates to the price level. What is the price level measured by? Money.

 

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Price level. A confused concept which implies that all prices rise and fall uniformly with changes in the quantity of money or the total of goods and services offered for sale, somewhat as the level of a liquid rises and falls with changes in its quantity or the size of its container. Actually, the term "price level" usually refers to an average of selected prices which individually move quite differently from each other and their average. Acting men are more interested in the interrelationship of different prices than in the movement of all or average prices. When all, or almost all, prices move in the same direction, it is usually a sign of inflation (q.v.) or deflation (q.v.). Continued use of the term "Price level" frequently leads to the notion of the neutrality of money (q.v.).

HA. 219-23,398-401,408-22; M. 137-45, 188-94.

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Esuric replied on Thu, Dec 31 2009 5:49 AM

Wilmot of Rochester:
I don't see how that makes velocity an illusion. Velocity of money relates to the price level. What is the price level measured by? Money.

The velocity of money is how many times a unit of money circulates (as this increases, prices should rise), while transactions are how many times money is exchanged for goods/services. Thus, "V" and "T," are really the same thing, making the equation of exchange (MV=PT) quite superfluous; MT=PT => M=P (which is incorrect). Again, money demand is real, but it's not stable, controllable, or predictable. I like the Cambridge equation more, M=KPY(T,Q). Either way, equations don't really explain why prices change.

"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."

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Esuric:

Wilmot of Rochester:
I don't see how that makes velocity an illusion. Velocity of money relates to the price level. What is the price level measured by? Money.

The velocity of money is how many times a unit of money circulates (as this increases, prices should rise), while transactions are how many times money is exchanged for goods/services. Thus, "V" and "T," are really the same thing, making the equation of exchange (MV=PT) quite superfluous; MT=PT => M=P (which is incorrect). Again, money demand is real, but it's not stable, controllable, or predictable. I like the Cambridge equation more, M=KPY(T,Q). Either way, equations don't really explain why prices change.

Transaction levels are about total volume. Velocity is about circulations and relates more to nominal schtuff. 

 

They aren't the same.

 

 

Also, there are a lot of equations of exchange out there, I don't want to make it seem like there's only one anyone will ever learn about, but MV=PT is a basic one.

 

 

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nirgrahamUK:

Price level. A confused concept which implies that all prices rise and fall uniformly with changes in the quantity of money or the total of goods and services offered for sale, somewhat as the level of a liquid rises and falls with changes in its quantity or the size of its container. Actually, the term "price level" usually refers to an average of selected prices which individually move quite differently from each other and their average. Acting men are more interested in the interrelationship of different prices than in the movement of all or average prices. When all, or almost all, prices move in the same direction, it is usually a sign of inflation (q.v.) or deflation (q.v.). Continued use of the term "Price level" frequently leads to the notion of the neutrality of money (q.v.).

 

HA. 219-23,398-401,408-22; M. 137-45, 188-94.

Is that all you guys do? Repeat Mises like preachers quoting scripture?

I would agree that the quantity of money and all that's involved with it isn't the whole story as far as prices are concerned, but it should be noted that it plays a part, at least nominally.

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Wilmot of Rochester:
Repeat Mises like preachers quoting scripture?

no its not all i do. i understand it also.

is it a reason for you to be upset? Its almost like you don't like learning true things....

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

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nirgrahamUK:

Wilmot of Rochester:
Repeat Mises like preachers quoting scripture?

no its not all i do. i understand it also.

is it a reason for you to be upset? Its almost like you don't like learning true things....

I'm not upset, it's just unsettling to see it.

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its unsettling to refer to respected scholars in their field of expertise? maybe you need to find yourself other fora....

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

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http://blog.mises.org/archives/011369.asp

Free Banking and Maturity Mismatching

Much confusion reigns over what the defenders of 100 percent reserves for banks would imply for the investment community. Free bankers argue that fractional reserves are necessary and beneficial for a healthy financial system. Credit (via fractional reserves) must be allowed lest the financial community find themselves with a dearth of capital.

The arguments in favor of 100 percent reserves for banks, when properly understood, lead to no capital shortage. The argument centers on loan and deposit contracts. There are three specific differences between the two.

First, loan contracts involve an exchange of present for future goods. A borrower receives a good now, and will pay something back in the future. Loans entail a transfer of the availability of the good lent. The lender renunciates the availability and use of a good until the termination point of the contract. Finally, as loans represent a transfer of present for future goods, an interest payment is involved (although this can be waived out of a myriad of reasons).

The result of an adherence to the legal norms surrounding the distinction between deposit and loan contracts is that deposits must be available on demand. As such a full and continual reserve must be kept. In the banking system, this implies a 100 percent reserve to back up the redemption requests of demand deposits.

This in no way curtails financing availability for the investment community. Guido Hülsmann points out in his The Ethics of Money Production that a shift to equity financing would result if banks adhered to these norms. No longer would debt be the primary means to fund projects. Philipp Bagus and I have recently clarified the point that the legal norm in no way impedes bank lending in an article in the Journal of Business Ethics. Time deposits, which are not available on demand, will entail no such reserve requirement. Lending practices as exist today could continue uninterrupted provided that the money they are based on was lent (or available via a modern "time deposit").

Full reserve banking would involve no curtailment of credit. Businesses would still have full access to funding based on either equity or time deposits. Adherence to 100 percent reserves fulfills legal obligations, thus diminishing the ambiguity of modern banking. In no way does this also entail a denial of financing for businesses in need.

* If anyone wants the full journal of Business Ethics piece, let me know - i.e convo, pm, email and I'll send it over. Smile

Ron Paul is for self-government when compared to the Constitution. He's an anarcho-capitalist. Proof.
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nirgrahamUK:

its unsettling to refer to respected scholars in their field of expertise? maybe you need to find yourself other fora....

No it's unsettling to see anytype of political dogma.

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Question. how is Mises' take on 'price level' an example of a political dogma?

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

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