Alternative to Fractional Reserve Banking?

Economics Economics Questions
1

Hello.

I apologize for being extremely new to economics. We don’t have any economics classes at my high school, however I have become extremely interested in the subject, especially the Austrian theories. Anyways…

I have a few questions regarding fractional reserve banking. I understand that a fractional reserve system inflates the money supply through the multiplier effect. Banks are allowed to lend out as much as 90% of their total reserves (leaving 10% untouched). The Federal Reserve is then needed, in part, to act as a safety net for the banks in case of a bank run.

Now here my questions begin…

  1. Austrian theory advocates the elimination of the Federal Reserve. Wouldn’t the elimination of the Fed thus necessitate the elimination of fractional reserve banking since there is no longer a safety net in place (lender of last resort)? Or would it be the bank’s prerogative to determine the reserve ratio? If it is left up to individual banks to determine their reserve ratio, then how could the bank’s customers be assured of the safety of their deposits (or would it simply be an investment risk that customers must take as it is in the stock market?)

  2. It would seem that the complete elimination of the Fed as well as fractional reserve banking would lead to a much more stable economy without the huge boom-bust cycles that are so common today. However, if this was implemented, how could businesses make loans? Wouldn’t credit be much too hard to come by? Could banks still make loans?

  3. In a full-reserve banking system, it doesn’t even make since that investors could still earn interest on their deposits (correct?). If this is true, what is the point in depositing your money in the bank in the first place?

Thank you very much. Also, if anyone could recommend some books that focus on these questions, I’d appreciate it.

2

  1. How could customers be assured of the safety of their deposits? Competition. I’m sure competing banks could come up with all kinds of things. If not, people won’t put their money there; it’s as simple as that.

  2. Wouldn’t credit be much too hard to come by? First, there would be much less need for credit. Second, credit is based on credit being made available by savers. If there are no savings, then yes, you couldn’t loan. That’s just reality. But a bank can invest wisely and so attract people to save. This is how an economy grows.

  3. I don’t understand the question.

I can recommend you lectures nr 3 and 4 by Hans Hoppe (resident Austrian Economist from the Mises Institute) here: http://www.vforvoluntary.com/austrian-economics

3

Wouldn’t the elimination of the Fed thus necessitate the elimination of fractional reserve banking since there is no longer a safety net in place (lender of last resort)?

There could still be fractional-reserve banking in absence of a central bank, it just wouldn’t be a healthy business practice. It should be illegal though, because it is fraud.

Or would it be the bank’s prerogative to determine the reserve ratio?

If fractional-reserve banking was still in effect banks would keep the reserve ratio as low as they think they can without causing a bank run.

If it is left up to individual banks to determine their reserve ratio, then how could the bank’s customers be assured of the safety of their deposits (or would it simply be an investment risk that customers must take as it is in the stock market?)

Fractional-reserve banking would be perfectly legitimate as long as they didn’t loan the same money out to x amount of people and lying to them by telling them they can take the money out at any time. The alternative to that is printing off the difference which is, in fact, theft.

However, if this was implemented, how could businesses make loans?

Businesses would still make loans as long as they had excess assets. They could only loan money they had, in effect, saved.

Wouldn’t credit be much too hard to come by?

A small price to pay for a stable, fraud and theft free banking system, no?

In a full-reserve banking system, it doesn’t even make since that investors could still earn interest on their deposits (correct?). If this is true, what is the point in depositing your money in the bank in the first place?

Individuals would still deposit money in return for interests except they would have to wait a certain period of time (that is mutually agreed upon) to demand the money and the interest back. All the interest rate is is a ratio of how much individuals value present consumption over future consumption, and that fact would not dissapear with the absence of fractional-reserve banking.

4

Some expansions:

Consider that stocks and bonds in shares/commodity markets are traded on 100% reserve. Online banks, like paypal, do not operate on fractional reserve banking.

In the status quo, all entrepreneurs have access to cheap credit, so in order to be competitive for resources, they have to borrow. The extra borrowing does not produce more resources; it merely drives prices up, further exacerbating the need to borrow.

Investment = reallocation of resources from consumption. Increasing the amount of money floating around won’t help you.

**

To keep it safe. I don’t think anyone uses banks for the interest :stuck_out_tongue:

If you want to earn interest on money you can still invest it, or put it in an investment bank where it is understood that they will loan it out. Usually this means that you can’t take out the money for a certain period of time, like with CDs.

5

“3. In a full-reserve banking system, it doesn’t even make since that investors could still earn interest on their deposits (correct?). If this is true, what is the point in depositing your money in the bank in the first place?”

They would deposit it for, say a year, and get 4% from the bank, and the bank would lend it for a year at 5%.

6

" In the status quo, all entrepreneurs have access to cheap credit, so in order to be competitive for resources, they have to borrow. The extra borrowing does not produce more resources; it merely drives prices up, further exacerbating the need to borrow.

Investment = reallocation of resources from consumption. Increasing the amount of money floating around won’t help you"

I’ve never understood this claim and I feel as though there is something extremley basic which I’m missing

Today the majority of major loans are lent by banks, this is because they have huge reserves with which to lend out money, whether or not this is secure. In a full reserve banking system suddenly banks have little to nothing to lend because they must keep the total amount of money which they are given, they may be able to take slight storage fees but this is suddenly far, far smaller. So where the hell is this “cheap credit coming” from (or indeed any credit at all) if you suddenly take the major lending institution in the world and cut off its ability to lend at the knees?

7

I am confused by the same thing. Also, I’m not understanding how using, for example, CD’s to make loans is any different than the current fractional reserve system. Wouldn’t the same problems still exist?

8

CD’s to make loans is any different than the current fractional reserve system. Wouldn’t the same problems still exist?

The problem is under our current fractional-reserve banking system banks can $100,000 in claims on a $10,000 deposit. And all of the deposits can be redeemed on demand.

With a CD, these deposits can’t be redeemed on demand.

9

When you deposit your money at a bank, you and the bank are entering into a legal relationship. If the bank cannot or will not repay your deposit, you may sue the bank at law for restitution. The CD and the demand deposit change the terms of this legal relationship. In the case of a demand deposit, you could (in theory, if we lived under honest law) demand all your cash back at any time and, if the bank failed to immediately (on demand) pay your deposit, this would be the basis for a lawsuit. It does not matter if all the bank’s other customers are also asking for their deposits back at the same time you are. The bank has a legal obligation to each and every depositor to repay them on demand or else face lawsuit. But in the case of a certificate of deposit, you have relinquished the use of your money for an agreed upon period of time, say 90 days or 180 days. If you were to demand your money back during this period of time and the bank refused to give it back, you would not have a basis for a lawsuit since the agreement was that you would relinquish the use of your money and not demand it for the specified period of time.

The difference is crucial. Rothbard in a lecture available online characterizes fractional-reserve banks as bankrupt almost by definition since the time structure of their outlays is out of whack with the time structure of their revenues. He uses the example of a business which has taken out a million dollar loan. In the normal world of business, if a business takes out a million dollar loan to be repaid in one year’s time, that business will structure its revenues such that it has a million dollars of revenue coming in the door before the loan must be repaid. That is, you don’t take a one year million dollar loan when you have a one million dollar payment due after two years, the timing just doesn’t add up. You have outlays due before you have received revenue. A certificate of deposit solves this problem by allowing the depositor to communicate to the bank the period of time for which that money is available for extension as credit. If you take out a 180 day CD, the bank can cover its loans out to 180 days in the amount of that CD. This permits a rational time-structure of credit.

Clayton -

10

It’s a matter of matching the terms of maturity between the liabilities (bank deposits) and their corresponding assets (loans). So if a liability, such as a time deposit, is due in 12 months, the bank should make sure there is money available also in 12 months or even before that. Demand deposits cannot, by definition, meet this criterion because the term of maturity is 0. They are due instantly.

11

“Today the majority of major loans are lent by banks, this is because they have huge reserves with which to lend out money, whether or not this is secure. In a full reserve banking system suddenly banks have little to nothing to lend because they must keep the total amount of money which they are given, they may be able to take slight storage fees but this is suddenly far, far smaller. So where the hell is this “cheap credit coming” from (or indeed any credit at all) if you suddenly take the major lending institution in the world and cut off its ability to lend at the knees?”

The key to understanding, the way I see it, is that when a businessman wants money from a bank, he doesnt really want money. He wants the things that money can buy, so he can use them in his factory to make something and sell it at a profit.

Now if he wants, say, 1000 tons of steel, well so do plenty of other people. There is only so much steel to go round. So a bidding war begins for the steel. And he needs money from the bank in order to bid.

Now let us imagine two different countries. In one there is a huge mountain of paper money and everybody has plenty of it. In that case, in the bidding war everyone has plenty of ammo [=money to bid with], so the winner will have to pay a very high price. In a second country, all they have to bid with is the small amount of money found in a Monopoly game. Since there is less ammo, the winner will get the steel he wants at a lower price than in country the first.

In other words, if the banks have “huge reserves”, that doesn’t help anyone get what they want any cheaper, or at all. Because EVERYONE is getting a piece of those huge reserves, so there is more ammo being fired in the bidding war.

Put another way, increasing the money supply does not increase the supply of wealth [=useful things].

12

Ok I finally understand everything that you guys have said. I have one final question:

Does completely eliminating the Federal Reserve and replacing fractional reserve banking with full reserve banking (using longer-term deposits such as CD’s to make loans) seem rational? This would demolish the primary sources of inflation and lead to a freer, more stable economy without the boom-bust cycles of today. Additionally, there would be no risk of bank runs.

What do you guys think?

13

We have to be careful with the word “eliminate” because it still implies some sort of centrally-planned financial system. What we really need is free banking and currency competition. Eliminating the Federal Reserve, legal tender laws and exempting gold, silver, copper and maybe some other metals from capital gains taxes would be necessary conditions to achieving the above.

Clayton -

14

reserves of what to what??? paper dollars to claims on the paper dollars or some other type of reserve???

does the fractional resevre banking even take place now???

The H.3 report has info on reserves, broken down as required and excess. The H.6 report has info on demand deposits, components of M1, currency in circulation.

“The vast majority of reserves are held as bookkeeping entries at the Fed Reserve banks. Currency in circulation is cash in bank vaults, but most of it is out in people’s pockets, mattresses, cash registers, and so on. I hear that half of the currency is outside the U.S.”

this doesnt make much sense to me. some articles call standard money reserves at mises…no a blog says reserves are bookkeeping entries…and not standard money.

15

“The excess reserves came from TARP (Bank Bailout), the banks have been sitting on the money until now.”

Read more: Are the Excess Reserves Finally Leaking Out? — Mises Economics Blog http://blog.mises.org/12541/are-the-excess-reserves-finally-leaking-out/comment-page-1/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+MisesBlogComments+%28Comments+on+the+Mises+Economics+Blog%29&utm_content=Google+Reader#comment-685751#ixzz0mzhGIeyI

perhaps new types of reserves ahve been created in the form of tarp.???

so if you are asking if fractional resere banking takes place currently…i cant tell. it may already ot be and you already have an alternative.