An Economic Defense of Fractional Reserve Banking

Economics Economics Questions
1

The point of this topic is to defend fractional reserve banking along the lines that Avram, Jake and I attempted to in a recent thread on the topic. If one has other arguments against FRB that do not pertain to this line of reasoning, I would appreciate it if they were taken elsewhere.

To begin with, imagine the balance sheet of two banks. The first is a FR bank, the second is a bank that performs both bailments contracts and the role of a financial intermediary. For the purpose of simplicity, equity will be ignored and the chosen quantities are entirely arbitrary. The total assets and liabilities of the banks, however, will be the same for purposes of comparison.

The FR bank has, on the asset side, $10 worth of specie, and $90 worth of loans. On the liability side the bank has $50 worth of banknotes outstanding and $50 worth of demand deposits. The 100% reserve bank, on the other hand has $50 worth of specie and $50 worth of loans on the asset side. On the liabilities side the bank has $50 worth of demand deposits (corresponding with the amount of specie) and $50 worth of time deposits.

Now, the point of this is to illustrate that the balance sheets of the two banks aren’t really that different. For the FRB the demand deposits and the outstanding bank notes (more on this later) that aren’t being spent free up resources that the bank can lend to entrepreneurs. The bank must, however, keep some specie on reserve in order to meet the demand of depositors, holders of banknotes or the interbank clearing house. For the 100% reserve bank the resources are being directly freed up by the granting of gold in the form of time deposits. The demand deposits in the 100% reserve bank cannot be loaned out and therefore do not free up any resources.

Now, from the perspective of the 100% reserve advocate the problems arise because the FR bank grants loans that are not matched by savings (implying that the position of Block and Barnett, whilst in my opinion wrong, is the only consistent position for the 100% reserve advocate). Whilst the loans granting by the 100% reserve bank are perfectly matched by the loans given to the banks, the FR bank is granting loans when the savings required may be withdrawn beforehand implying an ex ante disequilibrium.

However, the important point to notice is that whilst the FR bank may, and will, miscalculate and grant more loans than savings will admit due to a higher rate of redemption than the bank anticipates, the bank will be made aware immediatly. The fact of the matter is that if the FR bank does indeed grant too many loans and people are returning their banknotes (reducing their savings in the form of money held) more than the bank expected, the bank will notice that its reserves will begin to fall below the rate it finds optimal. Accordingly the bank will seek to stop the outflow of specie and it will consequently raise its interest rate. The last sentence is especially important since is shows how the bank will react to miscalculations of saving preferences and how fractional reserves can still keep the time market in equilibrium.

Now, the point here is not that FR banking is superior (although, I believe it to be) but that the notion that banks in a FR environment will always set the interest rate below the natural rate is wrongheaded. It remains to be seen whether or not the banking system under 100% reserves will be more, or less, capable of responding to changes that are commonplace in the market.

2

GilesStratton,

I agree, thanks for sharing.

It seems to me that, in principle, fractional reserve banking is remarkably like 100% reserve banking. If an FR bank can operate safely with a 10% reserve ratio, then the equivalent 100% bank could lend out 90% of its deposits. An FR bank would issue one kind of money: an on-demand note with an option clause. And a 100% bank would issue two kinds of money: an on-demand banknote (without an option clause) and a time-demand note (which wouldn’t need an option clause).

The job of an FR banker is to figure out what his customers’ time preference is, i.e. at what rate they want to spend their money. The interbank clearing houses would be the major source of feedback providing the FR banker with this information. If his customers spend more frequently, then they are saving less and he must reduce lending, and vice versa. Meanwhile, a 100% banker receives the same information from depositors themselves, who adjust their rate of investment with their spending habits, (and thus causing the quantity of different kinds of banknotes to fluctuate).

The overall economic consequences would be very similar, though I think fractional reserve banking is superior where differences do emerge.

Lee Kelly

3

I found the paper where Block and Barnett discuss CDs being used as money substitutes. I was surprised at how little effort they put into rebutting it. They just gave a quote from Mises which said that people will not use fiduciary media unless they are absolutely certain it is redeemable. That was it- a single quote from Mises. Is there another paper where they go into the issue more rigorously? This paper was called “In Defense of Fiduciary Media- A Comment.”

4

I guess that’s why its title includes “A Comment”

5

Seems to me the whole thing misses the main point we usually make against FRB. It is simply fraud,no?

Correct me if I am wrong.

6

They will tell you that it’s not fraud if the depositor/customer is aware of, and agrees to, the conditions of the FRB. I’m not convinced, but I’ve kept quiet on the topic because I haven’t taken the time to develop a cogent argument supporting my “feeling.” I’m working on it, or rather, I was working on it, but it’s kind of a back-burner issue for me now.

7

As far as I remember, Rothbard handled that one basically by saying that if the customer agrees it is sure no fraud, but won’t go very far in a free market, which in fact is only a prognosis so far.

The question than is, what would be the benefits for a customer to agree to an FRB account?

8

An account in an FR bank as some distinct advantages, or so it seems to me, at least.

On average, customers of a 100% bank might be able to invest 90% of their deposits, but for each individual this could be quite risky. People are uncertain about the future, and scared that their money will not be there when they need it. In consequence, they will tend to invest less than 90% and so earn interest on a smaller fraction of their savings. But in an FR bank this problem is resolved by spreading the risk among all depositors. Since it is very improbable that all FR bank customers will need access to more than 10% of their “deposits” at any one time, interest can be earned on a higher fraction of deposits without significantly exposing any individual to more risk.

In other words, even where a 100% bank also offers financial intermediary services, my bet is that it would also struggle to match the rates of interest offered by FR banks. But there is a trade off --illiquidity; FR bank customers run the risk that a bank might exercise its “option clause” and temporarily withold redemption of its notes (perhaps during a financial panic of some sort). However, historical precedent, as well as good economics, suggests that a healthy competitive market in banking – or “free banking” – would severely punish FR banks which exercise their option clause, and it’s primary purpose would be to disincentivise bank runs and prevent staged bank runs by competitors.

9

Has there ever been FRB practiced voluntarily? I can haz sources?

10

Daniel,

Why wouldn’t fractional reserve banking be practiced voluntarily? Are people so risk averse? I don’t even understand why this would be a controversial matter. So long as people expect that banks which hold a fraction of their reserves will behave responsibly (as you would expect in a competitive environment), and there will be gold available when they, the bank customers, decide to spend their banknotes, what difference does it make to them whether “thier” gold is actually “in” the bank?

Suppose that you issued your own currency, and let’s call them Daniel Dollars (or “DDs”). Each DD is redeemable for a single one hour economics lesson from you, and for some reason or other this service is in high demand. You go into the community and start paying for goods and services with your DDs. Now, consider what constraints there are upon you increasing your money supply; when DDs begin to circulate they will eventually find their way back to you for redemption, and you will supply a single one hour economics lesson for each. But there are physical limits on the rate at which you can redeem DDs, so if you spend too many DDs you may start turning away people seeking redemption. Once word gets out that you aren’t redeeming DDs on demand, their value (i.e. purchasing power) will begin to fall, and even more will come back for redemption. Unless you stop spending DDs immediately, thus reducing their supply, and concentrate solely on redeeming them, they will soon lose even more purchasing power and cease to function as money. But, as long as you can correctly gauge the rate at which your DDs are redeemed, and adjust your creation of DDs accordingly, there is no inherent problem with the arrangement. In this scenario, the DDs are your debts, and although you cannot satisfy all your debts in any one day or week, so long as they called in over a long period of time, you can afford to pay them off.

The point of the above is to illustrate how a fractional reserve bank functions, but I wanted to focus on a service rather than a good. Holders of DDs are like depositors in a fractional reserve bank, and yet their DDs are not claims on some economics lesson stored in a vault, because how do you store an economics lesson in a vault? The fact that the economics lesson doesn’t physically exist until they redeem their DDs doesn’t matter, but merely that you are available to provide the lesson when they want it. In other words, it is up to you to figure out the time preference for economics lessons of DD holders, and you do this by monitoring the rate at which they are redeemed (when it increases, reduce DD supplt, and vice versa). So long as FR banks had a long history of responsibe behaviour and good investments, why would people be so averse? I wouldn’t be.

And, in any case, I have already tried to explain one reason why people might prefer a FR account to a 100% account in my previous post.

Regards,
Lee Kelly

11

I was simply looking for examples of when FRB wasn’t practiced as fraud.

12

It was a fifteen page paper. Quoting Mises and leaving it at that isn’t good economics.

Thinking about it, I don’t see why this idea is such a problem for people. M2 already includes small CDs and money market mutual funds as part of the money supply and M3 includes all CDs. Austrians don’t generally like M2 because many of the instruments it includes are not very liquid. They prefer MZM. But in a world without FRB many of these instruments would simply become more liquid. I would argue they are actually very liquid even today.

What this means, surpisingly, is that fraud is the main issue. If banks are committing fraud today, people in the 100% reserve world will put all of the money they currently have in checking accounts into warehouses instead of CDs. If banks are not committing fraud, they will put some of their money into warehouses and some of it into CDs. If this is the case then the story Giles, Avram, Lee and I have been describing is correct and the 100% reserve world will look a lot like the FR world.

Block and Barnett’s position makes no sense in light of the real world. It is ridiculous to say that absolute certainty is required for something to become money. People take checks as payment but there is no certainty there and the same goes for credit cards. The entire case for 100% reserves rests on massive assumptions about individuals’ ignorance and risk aversion that simply are not plausible.

13

Are you saying most people on this planet actually know what FRB is?

14

Let’s say that an individual has decided to save some of his paycheck (we are assuming that this is a non-FRB world), and so he puts $1,000 in a time deposit. According to arguments made here, that time deposit will be used as money if the individual in question suddenly changes his preference (which is, of course, possible). According to the contract signed with the bank, however, he has transferred ownership of that money to the bank for a select period of time, disallowing him from using those $1,000 for the specified amount of time. Nevertheless, it is agreeable that he can sell the contract in return for present goods, making the time deposit certificate money.

However, I do not see how this is, in any way, liquid. Let’s say that he wants to buy bread for $3. He is hardly going to trade his $1,000 (plus interest) certificate for a loaf of bread. He could sign a contract with the baker that guarantees that the baker will get $3 (plus some, as why would the banker be interested in the same amount of money in the future as he is in the present?) after that time deposit is returned to him. In this fashion, he uses his time deposit certificate as money. I fail to see how this is plausible, or even efficient. I fail to see why, after a few occurances, people would make such complex transactions. It would make much more sense for the person to pay the penalty fee and end the time deposit contract prematurely.

He could use that certificate to pay for a good that is worth $1,000+, though. But, the money is still owned by the bank. The sale of the certificate only guarantees that the new proprietor of the ownership will have entitlement to the money generated by the savings account (and the original $1,000) after the contract has been fulfilled. I simply do not see how time deposits would replace checking accounts with the same type of liquidity, assuming that there was no fractional reserve banking (besides, an individual does not save his entire paycheck; that individual still has to buy goods necessary to live, and other indulgences… he is likely to have a checkings account, as well).

Neither am I persuaded by Lawrence White. These topics have motivated me to further my reading, which I have been doing (although, I admit that I have not read as much as I should have; I wanted to avoid posting until I had a better understanding, but I think these questions are good, even if I’m wrong), and I have read White’s 2003 paper, Account for Fractional-Reseve Banknotes and Deposits. He claims that there is no way that banks could have defrauded clients over the past hundreds, if not thousands, of years. But, for those that believe in the Austrian Business Cycle Theory, it’s an acceptable theory that the reason why businesses are duped during credit expansion is because:

  1. They are not economists.

  2. The illusion of wealth is enticing.

  3. They believe that they can pull out in time.

Would it not be the same for banks and their clients? This goes two ways:

  1. Clients are not economists, nor are they bankers. They do not understand how a bank works, or how fractional-reserve banking works. The majority of clients that hold checking accounts still believe that their money is redeemable on demand. Bank runs show that this is not always the option. The Option Clause is an interesting concept, though, and I bought a book that I believe talks about it, so I am interested in knowing about it. I could see a client agreeing to such a contract because the bank might offer interest on that checking account, and the practice of FRB is no longer fraud; but bankers have never been so clear. In fact, interest rates, I think, actively dupe clients by making the client less interested in knowing the actual details of the contract, or the economic realities of the bank’s practices. Furthermore, there is the argument of whether or not fractional reserve banking catalyzes a recession, in which case although the Option Clause may lessen the secondary effects, the rallocation of misallocated resources would still take place.

And:

  1. In regards to the argument that banks would calculate the best reserve ratios based on the demand for money, there is still the question of whether or not FRB misallocates capital.

So far, the pro-FRB papers have failed to persuade me, but I will continue reading. I do, however, admit that their arguments have a lot of merit.

15

No example is forthcoming =P

16

Avram has addressed this very concern in the previous threads. Your error here comes from a lack of imagination. Why wouldn’t banks offer the option to trade a portion of a CD instead of the whole thing? The CD might be broken up into various standardized units that would act like banknotes.

This is true although I don’t think it poses much of a problem. A market trading between warehouse receipts and CDs might arise where people who want to save more can buy CDs from people who want more liquidity.

I think most people have a rudimentary understanding of the system but even that isn’t necessary. The bank just has to predict when people will actually withdraw the money. As I think about it more, even the fraud issue seems irrelevant from this standpoint. The bank could fraudulently loan out a depositor’s money but the loans made would be economically sound if the bank accurately predicted the time of withdrawal. Therefore, the stability of FRB (including its contribution to the ABCT) rests entirely on the calculation ability of banks.

You are right that certain aspects of the 100% reserve system with CDs acting as money substitutes would be inefficient but that is another argument for the superiority of FRB.

17

Aww…

18

I’m not sure why the bank is relevant, in this case. The person selling the contract is the proprietor of the certificate, not the bank. The bank has lent the money to an investor. What is being traded is the certificate for present goods. The proprietor of the certificate is trading his claim on future goods for less present goods. The bank is not giving a banknote to the proprietor; only a certificate for the time deposit. It is the depositor’s responsibility to divvy that as necessary if he wants to buy present goods. My argument is that nobody would accept small portions of the time deposit, because it would be too complex for the original depositor to keep track of, and it’s probably not worth the minor increase in profit for gaining a fraction of the interest that the time deposit will churn.

That’s what I said. I never said it was a problem. I was describing the fact, and you missed my point. The money is still owned by the bank, not the new owner of the certificate. By loaning money from a checking account, the bank does not own the money, and so the bank has no guarantee that it will have that money available for either the investor or the client who owns that checking account (because the money has been loaned, but it is also being demanded by the depositor).

I wonder why banks have failed to predict this in the past. I am not talking about American banking history. I am talking about banking in the classical world and during the Middle Ages. This still doesn’t take into consideration the “possibility” that FRB leads to the misallocation of resources, which makes any calculation irrelevant since the misallocation of resources already took place.

I never said that. I’m not sure where you reached this conclusion from.

19

Jonathan:

Regarding your passage above, please comment on the following re-statement of your intended idea, whether this gets at your point or not:

  1. We assume complete transparency in all transactions: every participant in the entire scenario is privy to all information as to the whereabouts and nature of all funds, moneys, contracts, promises, etc…

  2. We assume that all agreements/contracts include explicit and detailed mention of the intended use for all moneys, funds, etc..

  3. We assume that all promises and contracts are honored. This means that at any given point in time, the money (for example) is where all parties would expect it to be according to the contract or agreement.

What we have done here, for the purpose of analysis only, is to hypothetically take any fraud out of the equation. This is like an “imaginary construct,” in that in real life, it may be impossible not to have some “gray” shades at various points between transactions. But here, we make theses assumptions, for analytical reasons, so that fraud doesn’t enter into any of the transactions.

If “depositor” A, has his money loaned out (via a bank) to debtor B, then by our assumptions above, A knows this. But now, knowing this, he is not really a “depositor,” but a creditor of B, with the bank as an intermediary. Under these circumstances, how could A possibly believe that his money would be available upon demand ?? In this situation, B has spent the money (on his inventory, machinery, etc..), and this money cannot be available for A to “withdraw.” (expect as the terms of the loan specify)

Also, how could the bank possibly believe (again, assuming no fraud, deception, unclarity, ambiguity, etc…) that they will have the funds to provide A (except as per the terms of the loan to B) when A shows up and asks for his “deposit.” ?

That is how I read your passage above…

How does this square with your intended meaning ?

20

Have you guys read The History of Money and Banking in the US(pdf)? I think the chapter “A Free Market Central Bank” (page 115) is the example you are looking for. It shows an historical example of how FRB was naturally regulated in a market environment.