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.
Err, I meant "and no one receiving interest would assume that they did".
Is there no edit post function on this site?
Jrgen:FRB is not the cause of business cycles, not even in Austrian theory.
This is correct.
Jrgen:The currency monopolies of central banks are.
This is incorrect. The cause of all cyclical activity is the divergence between the market rate of interest and the natural rate of interest. This can happen many different ways. You can have a real endogenous change which elevates the natural rate above the market rate (mass immigration, for example), or you can have some exogenous authority suppress the market rate below the natural rate. Either way, you will get an inflationary induced boom, and deflationary correction/contraction.
Jrgen:Assuming the bank does not pretend to have full reserves, then why is FRB fraud?
It's not. The moral argument against FRB is akin to saying that makeup should be banned because people don't know that it contains carcinogens.
"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."
Yes, you are right.
I'm guessing Esuric is one of those "Free Bankers".
Caley McKibbin: I'm guessing Esuric is one of those "Free Bankers".
Nice to know that there are plenty of clowns who think that this forum is a pop-up book.
Caley McKibbin:Nice to know that there are plenty of clowns who think that this forum is a pop-up book.
Even pop-up books can get things right.
If a novice who discovered AE 2-3 years ago and thinks that he knows something and a guy who doesn't even know AE are going to spam giant jpgs, I need not wonder why Liberty Student left.
Possibly. Have you considered all the full-reserve "experts" and members who call others "clowns?"
Caley McKibbin:If a novice who discovered AE 2-3 years ago and thinks that he knows something and a guy who doesn't even know AE are going to spam giant jpgs, I need not wonder why Liberty Student left.
What does this have to do with your ridiculous comment?
Esuric: Jrgen:FRB is not the cause of business cycles, not even in Austrian theory. This is correct.
This is incorrect. Unless you mean that in theory, it doesn't have to necessarily originate with FRB - then I agree. But then you are just trying to prove too much here.
Jrgen: This is incorrect. The cause of all cyclical activity is the divergence between the market rate of interest and the natural rate of interest. This can happen many different ways. You can have a real endogenous change which elevates the natural rate above the market rate (mass immigration, for example), or you can have some exogenous authority suppress the market rate below the natural rate. Either way, you will get an inflationary induced boom, and deflationary correction/contraction. Yes, you are right. Not quite. I think his response is a bit misleading. The issuing of loans unbacked by real savings is what sets in motion the business cycle. All such loans originate in the banking system when banks engage in joint credit expansion that is coordinated by the Central Bank, and is further exacerbated by Central bank injection of new liquidity into the system so that bank can further expand on. However, there were business cycles before Central banks, precisely because banks operated with fractional reserves, although they were always privileged by the State. It is true that if we had a free banking system that still allowed to operate with fractional reserves, that the natural checks of the free market, i.e., bank runs and inter-banking clearance mechanisms, would keep the amount of fiduciary media to a minimum. This would be a far more stable system. "You can have a real endogenous change which elevates the natural rate above the market rate" This implies a market failure of some sort. Ensuric insists that a purely hypothetical radical change (I would say very unlikely to occur in the absence of government interference) in either demand for money or influx of new money can cause similar intertermporal distortions in the market rate. But the error in his reasoning is the failure to recognize that such a radical scenario is the outcome of voluntary action on part of the individual participants in the market. If market participants lower their time preferences only temporarily and entrepreneurs were deceived, then yes, there would need to be corrections. However, if banks had not operated with fractional reserves, no wide scale banking crises would occur, and no contraction of the money supply could possibly take place, as always does today following the credit expansion of FRB. "or you can have some exogenous authority suppress the market rate below the natural rate" As in a government authority issuing the loans directly with fiat money. I would agree, although I think that such bubbles would take on different forms from today's typical ABCT.
The issuing of loans unbacked by real savings is what sets in motion the business cycle. All such loans originate in the banking system when banks engage in joint credit expansion that is coordinated by the Central Bank, and is further exacerbated by Central bank injection of new liquidity into the system so that bank can further expand on. However, there were business cycles before Central banks, precisely because banks operated with fractional reserves, although they were always privileged by the State.
It is true that if we had a free banking system that still allowed to operate with fractional reserves, that the natural checks of the free market, i.e., bank runs and inter-banking clearance mechanisms, would keep the amount of fiduciary media to a minimum. This would be a far more stable system.
"You can have a real endogenous change which elevates the natural rate above the market rate"
This implies a market failure of some sort.
Ensuric insists that a purely hypothetical radical change (I would say very unlikely to occur in the absence of government interference) in either demand for money or influx of new money can cause similar intertermporal distortions in the market rate. But the error in his reasoning is the failure to recognize that such a radical scenario is the outcome of voluntary action on part of the individual participants in the market. If market participants lower their time preferences only temporarily and entrepreneurs were deceived, then yes, there would need to be corrections. However, if banks had not operated with fractional reserves, no wide scale banking crises would occur, and no contraction of the money supply could possibly take place, as always does today following the credit expansion of FRB.
"or you can have some exogenous authority suppress the market rate below the natural rate"
As in a government authority issuing the loans directly with fiat money. I would agree, although I think that such bubbles would take on different forms from today's typical ABCT.
DD5:This is incorrect. Unless you mean that in theory, it doesn't have to necessarily originate with FRB - then I agree. But then you are just trying to prove too much here.
It's incorrect but you agree?
DD5: "You can have a real endogenous change which elevates the natural rate above the market rate" This implies a market failure of some sort.
Have you ever read anything Hayek has written? Because whenever I express Hayekian ideas, you seem completely shocked.
"The situation in which the money rate of interest is below the the natural rate need not, by any means, originate in a deliberate lowering of the rate of interest by the banks. The same effect can be obviously produced by an improvement in the expectations of profit or by a diminution in the rate of saving, which may drive the "natural rate" (at which the demand for, and the supply of, savings are equal) above its previous level; while the banks refrain from raising thier rate of interest to a proportionate extent, but continue to lend at the previous rate, and this enable a greater demand for loans to be satisfied that would be possible by the exclusive use of the available supply of savings." -Hayek, Monetary theory and the trade cycle, pp. 77-78
This is basically the main theme of the book. Also, here is talking about increasing the supply of money as capital.
DD5:Ensuric insists that a purely hypothetical radical change (I would say very unlikely to occur in the absence of government interference) in either demand for money or influx of new money can cause similar intertermporal distortions in the market rate. But the error in his reasoning is the failure to recognize that such a radical scenario is the outcome of voluntary action on part of the individual participants in the market. If market participants lower their time preferences only temporarily and entrepreneurs were deceived, then yes, there would need to be corrections. However, if banks had not operated with fractional reserves, no wide scale banking crises would occur, and no contraction of the money supply could possibly take place, as always does today following the credit expansion of FRB.
This is how I understand free banking (I have never read anything from the modern day free bankers):
There are three types of economic goods: “consumer goods” (current goods), “producer goods” (future goods), and "media of exchange," or what is commonly understood as money. No good is trapped within these classes for any definite period of time. They can freely move from one class to the next (classes are not fixed). The rate of interest is expressed by the time preferences of society—that is, by the ratio of demand between current goods and future goods. But there is also a demand for money, the facilitator of exchange. And stable economic activity will exert an influence over this demand, as normal and day-to-day transactions become routinized. When the demand for money increases, and if it is not met by a corresponding increase in the supply of money, then market actors will adjust their purchases and sales in order to achieve the level of liquidity they deem necessary. This will exert an influence on the demand side in the markets for loanable funds, which will elevate the market rate of interest above the natural rate (prices fall faster than costs). Notice, though, time preferences have not truly changed--just the demand for money has changed (ratio of demand between current and future goods remains unchanged). The banking system can also move funds so that the ratio between the demand for current goods and future goods remains basically unchanged (no inter-temporal misallocation). This leaves us with two options (when the demand for money experiences dramatic changes): allow prices to adjust (painful), or satiate the demand for money as money and prevent the unnecessary (bad) deflation.
This is why Hayek says that satiating the demand for money as money is legitimate (but satiating the demand for money as capital is illegitimate). Hayek, though, doesn't appear to be as optimistic as the free bankers when it comes to free banking itself. But, he makes it clear that it is the best practical option. Also, Bohm-Bawerk states that the entire subsistence fund does not need to be available during the process of production due to its inter-temporal nature. Since capital must flow incrementally, there is no need for a 100% supply of capital for the process of production at all times (I've only heard Bohm-Bawerk mention this though).
The key, though, is that I've never heard 100% reserves mentioned in any of the pre-Rothbard books/articles I've read (Hayek mentions it in Monetary Nationalism and International Stability, but he calls it the "Chicago plan," and says it's untenable and "overly simplistic." Another Issue I have with Rothbardians is that they seem to have moved away from the fact that money, by its very nature, can never be neutral. It always exerts an influence over "real" economic activity, as the demand for money and capital are intrinsically connected in modern economies (Mises stresses this point). Thus, the Rothbardian claim that "any supply of money is optimal" only makes sense in the very long run, when prices completely adjust. Cutting the money supply by 75% will have dramatic and negative consequences. And, again, Hayek mentions that the money supply may fall too dramatically during the cyclical downturn (secondary phenomena).
DD5: "or you can have some exogenous authority suppress the market rate below the natural rate" As in a government authority issuing the loans directly with fiat money. I would agree, although I think that such bubbles would take on different forms from today's typical ABCT.
This is what happens today. The FED buys bonds on the open market, with money it creates, and then increases reserves and pushes down the rate of interest.
DD5: But the error in his reasoning is the failure to recognize that such a radical scenario is the outcome of voluntary action on part of the individual participants in the market.
The process mentioned in the post above is as voluntary as the phenomenon of forced savings.
Hayek may not have been a 100-percent reservist, but it's obvious in Monetary Theory and the Trade Cycle that he considers fractional-reserve banking the root of the business cycle. I don't want to look through the book now, but here are some quotes I've written down in an old blog post:
The determining cause of the cyclical fluctuation is, therefore, the fact that on account of the elasticity of the volume of currency media the rate of interest demanded by the banks is not necessarily always equal to the equilibrium rate, but is, in the short run, determined by considerations of banking liquidity.
He does consider 100-percent reserves as "utopian":
If it were possible, as has been repeatedly asserted in recent English literature, to keep the total amount of bank deposits entirely stable, that would constitute the only means of getting rid of cyclical fluctuations. This seems to us purely utopian. It would necessitate the complete abolition of all bank money—i.e., notes and checks—and the reduction of the banks to the role of brokers, trading in savings.
But nevertheless concedes that fractional reserve banking is the problem:
The stability of the economic system would be obtained at the price of curbing economic progress.
These are not the best quotes, but that Hayek considered fractional reserve banking the problem should be obvious by reading Monetary Theory and the Trade Cycle.
Jonathan M. F. Catalán: Hayek may not have been a 100-percent reservist, but it's obvious in Monetary Theory and the Trade Cycle that he considers fractional-reserve banking the root of the business cycle. I don't want to look through the book now, but here are some quotes I've written down in an old blog post: The determining cause of the cyclical fluctuation is, therefore, the fact that on account of the elasticity of the volume of currency media the rate of interest demanded by the banks is not necessarily always equal to the equilibrium rate, but is, in the short run, determined by considerations of banking liquidity.
The elasticity of the money supply is a necessary but not sufficient cause of trade cycle fluctuations. When the money supply expands beyond the demand of cash holdings then it will exert an active influence over the demand for consumer goods and investment (producer goods), necessarily altering the ratio between the demand for current goods and future goods. Thus, fractional reserve banking is not the root cause of anything. You have to read Monetary Theory and The Trade Cycle with Prices and Production. The books are somewhat vague (had to read both of them twice). And reading Wicksell is extremely useful since he laid down the framework for Austrian monetary theory (and he's frequently ignored/dismissed, for whatever reason).
Jonathan M. F. Catalán:If it were possible, as has been repeatedly asserted in recent English literature, to keep the total amount of bank deposits entirely stable, that would constitute the only means of getting rid of cyclical fluctuations. This seems to us purely utopian. It would necessitate the complete abolition of all bank money—i.e., notes and checks—and the reduction of the banks to the role of brokers, trading in savings.
That's only one condition: "It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, first, the total money stream remained constant, and second, all prices were completely flexible, and, third, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy." –Page 304, Prices and Production.