Contractual Fractional Reserve Banking

Economics Economics Questions
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1

Just tonight, I was talking to someone about how the market entails natural regulations, regulations which the government perverts and negates through its own coercive regulations. I gave the example of our banking industry which, thanks to Big Government, is essentially completely unregulated. Banks can do whatever they want and face virtually no repercussions.

Conversely, on a truly free market, any bank that lent out too much of the money it had on reserves would run the risk of losing customers and, thus, going out of business. This will therefore keep otherwise fraudulent banks in check. Hence, a natural regulation.

But I have to wonder, would there not probably be some banks in a free society which opted to still engage in fractional reserve banking, perhaps by contractual aggreement with their customers so as to avoid committing fraud?

I would suspect this to be the case, as a bank which opted to hold only 90% reserves would be able to offer better deals to customers than banks which opted to maintain 100% reserves. Some consumers would, of course, gravitate to the 100% reserve banks for the security alone, but others may be willing to sign contracts permitting a less absolute standard.

I would suspect that the average reserve ration would be set by the market in the same way the market sets other values. Few would want to contract with the banks that offer a 50% reserve, after all.

But, as long as voluntary fractional reserve banking is taking place, as it almost surely would in a free society, wouldn’t we still, therefore, have a business cycle? Perhaps not one as violent as ours is currently, but it seems one would exist nonetheless in a free society.

2

I’d love to see how such a contract would look like:

“The money deposited will be available on demand, except for when it won’t”?

3

That’s not so unreasonable. Millions of people today put their money in CDs.

4

Yes, but in the case of CD’s, the money is not available on demand.

5

I think the original poster’s point was that some people would voluntarily let their money be unavailable at times, for a better rate. The way they do today.

6

Ok, but then you have a simple loan bank, not a fractional reserve hybrid bank.

7

Where would all the extra money they are loaning out come from? They run up the printing press and poof, money to lend.

We had business cycles before the days of fiat currency and central banks. They were always(?) caused by the same thing, inflating the money supply leading to a economic boom followed by a bust.

Ignoring the Real Bills Doctrine folks, anything less than 100% reserve banking is fraud and counterfeiting – just because you can (and currently are) doing it doesn’t make it any more right.

I would think the people who the bank would have to convince to accept the imaginary money would be the people who trade it for some other commodity as the people who deposit their money in the bank already have a contractual ‘understanding’ that it is to be returned on demand.

8

You have a good point. A money market is a good example where people expect their money to be available on demand (they can write a check from their money market account), but they also are fully aware that their funds are being lent out.

As far as the business cycle goes, I would say that those will continue to exist. Time preferences can change on their own without government forcing them to, but the swings would not be near as extreme, because while there may be some artificial stimulation coming from increasing bank credit, there would most certainly not be the extreme amount present today. What we have today is virtually unchecked credit expansion backed by the promise of the government that banks will not be allowed to fail.

One interesting thought is that today, changes in the reserve requirement has very little to do with how much money is created. Financial engineering has played a huge role in this, but I am not that clear on this last point here.

9

A voluntary fractional reserve bank? It’s an interesting concept. Assume for a minute that such an institution could actually exist in a free market (not certain in my opinion). Would such banks increase the money supply and thereby be a cause of business cycles? I think the answer is no for the following reasons:

Consider what Austrians mean when they talk about the money supply. What would the money supply consist of in a free market economy? First take a look at the difference between demand deposits (which are considered part of the money supply) and genuine savings accounts (which are are not). Demand deposits are money substitutes, redeemable on demand at par. The owners of such accounts treats them as a surrogates for cash because they’re really warehouse receipts. Genuine savings accounts, however, are not redeemable on demand. They are credit instruments rather than warehouse receipts. The crucial difference is that the owner of a demand account believes that the money is available whenever he wants it. So long as the market holds this belief, the market acts as though it were cash. (Even though under the present day system of fractional reserve banking, demand deposits are not in fact all redeemable in cash, so long as people believe that they are, they fully function as part of the money supply).

Now let’s turn to the original question. If we had a voluntary fractional reserve banking system, customers would have to be made fully aware of the nature of these accounts, otherwise the banks would be committing fraud. Let’s say that a bank was offering 50% reserve accounts. Depositors would have to know; a) that these were indeed fractional reserve accounts; b) that the money held in these accounts might not be as safe as in 100% reserve accounts; c) that the money might not be available on demand; and d) payments made using checks drawn on such accounts might be unacceptable to creditors. The market, therefore, would not treat these accounts as though they were fully redeemable in cash. We return therefore to the subjective estimation by the market. Put simply, if people don’t believe that these accounts are as good as cash they won’t be treated like cash. A fractional reserve account would not have the same effect on the money supply as a 100% reserve account. And it’s contribution to the money supply would be in direct proportion to the level of reserves that it held. A 50% reserve account, for example, would not be viewed as a true demand account (unlike the present day fractional reserve system), and it’s contibution to the money supply would carry only 50% of the weight of a 100% reserve bank.

Voluntary fractional reserve accounts, therefore, would be thought of as being neither geniune demand deposit accounts nor genuine savings accounts, but in between. The net contribution to the money supply would be in direct proportion to the underlying reserves, and they would have no inherent tendency to inflate or contribute to business cycles, provided (and this is crucial!) the market evaluated them correctly for what they were.

10

Can banks even offer credit under a 100% reserve system? They can loan out what they currently have deposited, acting as middlemen, but they can’t extend that any further without creating money.

The changing time preference would be taken care of by changing interest rates directly reflecting that. Entrepreneurs wouldn’t have a tendency to invest in capital projects that don’t make economic sense without an artificially lower interest rate and then realize later, when the interest rates rise, that it wasn’t a good decision leading to massive reallocations of capital – the Austrian business cycle.

There would be some malinvestment here and there but nothing like the massive levels seen today and limited to individual business decisions instead of industry wide trends.

I’m not saying it would be all rosy…there are many, many reasons an economy could contract that have nothing at all to do with money.

I think sweeps play a large role in this, they take money from your checking acount, subject to reserve requirements, and ‘sweep’ them over to your linked savings account, which has no reserve requirement, based on your spending habits. I looked into it a bit and from what I gather they can do six transactions a month without having the money fall under the checking account reserve requirements or something like that.

11

A voluntary fractional reserve bank? It’s an interesting concept. Assume for a minute that such an institution could actually exist in a free market (not certain in my opinion). Would such banks increase the money supply and thereby be a cause of business cycles? I think the answer is no for the following reasons:

Consider what Austrians mean when they talk about the money supply. What would the money supply consist of in a free market economy? First take a look at the difference between demand deposits (which are considered part of the money supply) and genuine savings accounts (which are are not). Demand deposits are money substitutes, redeemable on demand at par. The owners of such accounts treat them as surrogates for cash because they’re really warehouse receipts. Genuine savings accounts, however, are not redeemable on demand. They are credit instruments rather than warehouse receipts. The crucial difference is that the owner of a demand account believes that the money is available whenever he wants it. So long as the market holds this belief, the market acts as though it were cash. (Even though under the present day system of fractional reserve banking, demand deposits are not in fact all redeemable in cash, so long as people believe that they are, they fully function as part of the money supply).

Now let’s turn to the original question. If we had voluntary fractional reserve accounts, customers would have to be made fully aware of the nature of these accounts, otherwise the banks would be committing fraud. Let’s say that a bank was offering 50% reserve accounts. Depositors would have to know; a) that these were indeed fractional reserve accounts; b) that the money held in these accounts might not be as safe as in 100% reserve accounts; c) that the money might not be available on demand; and d) payments made using checks drawn on such accounts might be unacceptable to creditors. The market, therefore, would not treat these accounts as though they were fully redeemable in cash. We return therefore to the subjective estimation by the market. Put simply, if people don’t believe that these accounts are as good as cash they won’t be treated like cash. A fractional reserve account would not have the same effect on the money supply as a 100% reserve account. And it’s contribution to the money supply would be in direct proportion to the level of reserves that it held. A 50% reserve account, for example, would not be viewed as a true demand account (unlike the present day fractional reserve system), and it’s contibution to the money supply would carry only 50% of the weight of a 100% reserve bank.

Voluntary fractional reserve accounts, therefore, would be thought of as being neither geniune demand deposit accounts nor genuine savings accounts, but in between. They would have no inherent tendency to inflate, or to contribute to business cycles, provided (and this is crucial!) the market evaluated them correctly for what they were.

12

A contract presupposes property rights. Fractional reserve banking violates private property rights because two or more people claim ownership of the exact same thing (e.g. person A deposits $2000, the bank sets aside 10% (200) and loans out $1800 to person B; A and B claim ownership of the same $1800). Therefore a contract that entails fractional reserve banking is an invalid contract. Hoppe had an essay about fractional reserve/free banking in Economics and Ethics of Private Property.

13

A contract persupposes property rights. Fractional Reserve Banking by its very existence violates property rights. For example: Person A deposits $2000 into bank X, and it sets aside 10% ($200); bank X then loans out person A’s $1800 dollars to person B; A and now B claim ownership of the exact same $1800 which is incompatiable with property rights. Hoppe had an essay about fractional reserve banking/free banking in Economics and Ethics of Private Property.

14

I agree that fractional reserve banking, as it occurs now, does violate property rights, and is unethical. Essentially it’s a fraud. Of that there is no question.

I tend to agree with you that even if a fractional reserve system were voluntary, and depositors were fully apprised of the risks, it would still be unethical.

15

DSnead,

I would think that it would be a conditional transfer of property from the owner to the bank, the condition being that A) the bank may not loan out more than X% of its reserves, and B) the bank must transfer the ownership of the property back to the former owner upon demand by the former owner except where the bank has gone bankrupt.

In this event, it would not be fraud (assuming the consumer is fully aware of the risk that he/she may not get the money back), as there would be only one claim to ownership, albeit a conditional ownership.

A bank has contracted to hold a 90% reserve. It has $100 in storage, and therefore creates $110 bank notes. (Each bank-note, so as to avoid fraud, makes it clear that the bank that issued it is a 90% reserve bank.) This bank has given out $10 bank notes, one to each of 11 persons. If 10 come to collect, the eleventh guy is SOL given the contract he signed.

I find the comments by leonidia interesting. Not many places of business would accept a bank-note that said the bank was a 50% reserve bank. And if the bank-note did not list the reserve ratio, then the business would be able to sue the bank for fraud. A business would likely have little fear, however, in accepting a bank-note that listed itself as coming from a 99% reserve bank; although as a matter of practice, some businesses might accept such notes at 99% of the face value to account for the risk, simultaneously accounting for the inflated money supply (thereby ensuring that the business cycle would be virtually no different from what would exist under a system of compulsory 100% reserves) and discouraging customers from contracting with fractional reserve banks (as the $100 reserve note would effectively be the value of the reserve, in this case $99).

16

Why are the supposed libertarians on this website so keen to have the government dictate the terms of the deal between a bank and its customers? If I want to hand $100 to a bank that will keep $10 on hand, and lend out $90 at interest, and reward me with some of that interest, that is between me and the bank.

More at:

www.csun.edu/~hceco008/realbills.htm

17

I don’t think anyone here said anything anout the government dictating anything. You’re right, it’s between you and the bank, just like it would be between you and mr. Ponzi if you wanted to ‘invest’ in his scheme.

Thing is, this isn’t how fractional reserve banks work. They not only lend out the $90, they also allow others to lay claim your $10 that still are in the reserves. Any contract that wouldn’t try to make this kind of institution look like a bank, rather then a gambling house, would be self-contradictory.

18

Agreed.

19

Thats not fractional reserve banking. Fractional reserve banking is when you give a bank $100 dollars and they loan out $110.

The people you are disagreeing with are mostly anarchists, so no need to play the government card.

20

Even with fractional reserve banking, a bank can’t lend out more than it receives in deposits. With a $100 deposit, a 10% reserve requirement will allow the bank to lend out $90. If that $90 is redeposited at the same bank, the bank can lend out 90% of that amount, and so on. Ultimately the $100 deposit will generate up to $900 in loans.