Demonstrating the absurdity of fractional reserve banking

Economics Economics Questions
1

Today I was reflecting on how difficult it is to explain to the unfamiliar how absurd the idea is that government should protect fractional reserve banking, as it does in a variety of ways (lender as a last resort, FDIC, etc.). I realized that what was needed was some sort of analogous banking system that was functionally equivalent to the way FRB expands the money supply but absurd in a manner that is way more obvious at the outset. Here’s an analogy to FRB that I hope you might find useful when first delving into the subject with a newcomer to Austrian economics:

Consider a new banking system where the Federal Reserve still enforces a reserve rate of, say, 10%. But in this system, member banks are not allowed to lend out their demand deposits. Instead, the way the new system works is that, if a client deposits $100, member banks are allowed to print an additional $90 in counterfeit bills and loan them out to whomever, and even earn interest on the loans. The only restriction is that a bank cannot counterfeit more than 90% of its demand deposits, and in the instances where demand deposits decrease, leaving the bank with excess counterfeit bills, the bank is not punished, but is not permitted to print any more counterfeit bills until enough loan payments come back in (or demand deposits increase again) so that the bank’s current reserve rate equals or exceeds the 10% minimum “reserve” requirement. A bank is only punished if it knowingly prints more counterfeit bills than the enforced reserve rate allows.

The big alleged benefit of this system over traditional FRB is that bank runs simply cannot happen, since the demand depositors’ money is not lent out. As far as I can tell, this system is otherwise functionally identical to traditional fractional reserve banking: credit is still expanded in a way that is based on the amount of demand deposits and business cycles can still be generated. But, it is my hope that such an example would point out more poignantly the absurdities of traditional FRB to a newcomer:

  1. It hopefully shows more clearly how the money supply is increased in traditional FRB
  2. It demonstrates that there’s nothing better about loaning out demand deposits than there is about counterfeiting in a manner that is ultimately limited by demand deposits.

In rereading this post, I’m thinking that such a system might actually seem to a newcomer like an incredibly attractive alternative to FRB. But, early today, when I tried the reasoning out on a coworker, I think I got the desired reaction I was looking for: delighted bafflement. In fact, for being such a proponent of FRB and keeping idle money from just sitting around with no use, he couldn’t actually figure out what was “wrong” with my system, or how FRB could be considered a more attractive alternative. Yet at the same time, it was immediately apparent to him that something very, very fishy was going on, though he couldn’t put his finger on it. That very fishy feeling is the way everyone should feel about fractional reserve banking, but few fortunately do feel that way at first. I’m hoping this alternate banking analogy might aid you all in bringing the fishy feeling out from others.

That being said, I want to make sure the analogy is actually a fitting one. I can’t think of any ways in which the analogy is unfitting. As far as I can tell, it seems to result in the same economic effects: easy credit, rising prices from an increase in the money supply, low interest rates that can generate business cycles, etc. The only difference is that it isn’t prone to bank runs. Other than that, is there any way in which the analogy is inaccurate? What might you predict to be the objections of non-Austrians to this system?

2

The analogy seems to be useful for the uninitiated, but only to a degree. If this person ponders this analogy sufficiently, the question arises, “Why would anyone accept the bank’s ‘counterfeit’ money?” And that would be a good question.

I’m not sure how “bank runs” enter into this analogy. What is the meaning of a bank run in a fractional reserve / central banking environment? Under the gold system (with fractional reserves), bank runs are easy to understand: The banking system creates money from nothing, and there is therefore no backing when depositors try to redeem bank notes for gold. Under fractional reserve / central banking, the central bank simply prints more money (causing malinvestment and eventually hyperinflation), or the government simply indebts all taxpayers to repay depositors (crowding out, higher interest rates, etc.). When the banking system in the United States collapsed in Sept. '08, look at the response; the Fed and the Treasury did exactly as I described above.

So, what do you mean when you say the above system “isn’t prone to bank runs”?

3

The “counterfeit” money is indistinguishable from Federal Reserve notes and is declared as legal tender, the supply of which, in this contrived system, is only expanded when the member banks print more of these notes as permitted by the “reserve” requirement.

I guess I should have been more specific: there is no need for FDIC insurance and printing on the part of the Fed in this new system. There isn’t any need for government bailout at all, since the depositors’ money will always be there. So I’m saying, comparing the current system to this contrived system, if neither had any sort of FDIC or discount window, the current system would be prone to bank runs and my contrived system would not.

4

Fractional reserve banks will do just fine without deposit insurance and central banks. Indeed better for customers.

5

I thought about this a little more. It appears there is a problem with the structure of this “new” system. Tracing through debits and credits to analyze the expansion: 1) Debit reserves $100 (asset), credit demand deposit $100 (liability); 2) Debit loan $90 (asset), credit FRN’s issued $90 (a liability account); 3) I believe this is the missing component in your example: The FRN’s come back as a new demand deposit; the bank cancels the existing $90 FRN liab. and in its place books a $90 demand deposit (liability). This merely substitutes one liability for another.

Here is the problem: Each side of our ledger now has $190: $100 “reserve”, $90 loan as debits, and $190 in demand deposits. As you can see, there are $190 in demand deposits against only $100 in reserves. The bank is just as insolvent as it would be in the existing system. Also, the bank would look at it’s demand deposits: $190 x .9 = $171 in credit expansion capacity. Only $90 in loans are outstanding, so an additional $81 can be loaned out! Step #3 would repeat, and I think this system would blow up in a spectacular manner. The townsfolk would march down main street with pitch forks and torches asking for their “money” back. The banker would not be able to comply…either the banker gets his hide torn off, or the government creates a central bank, FDIC, bailouts, etc.

Let me know if I’ve missed something here…

6

A bank starts as full reserve, with $100 in demand deposits. It’s allowed to lend out $90, because there is $100 in demand deposit accounts and the “reserve” rate is 10%. It prints $90 of new FRNs. It either puts the new FRNs into a loan account (separate from the demand deposit accounts in regards to how much additional “counterfeit” FRNs the bank is allowed to print), or just gives all of the freshly printed FRNs to the loan recipient, or any combination of the two. At this point, the new money printed for the loan recipient is separate from the base demand deposit accounts that ultimately govern how much new money can be printed.

That said, the newly printed loan money will obviously circulate throughout the economy, and make their way back into the banks (other banks, or even the same bank that printed them) in the form of demand deposits, and yes, at that point, the bank will be able to consider those notes as part of the base demand deposit accounts, and an increase in base demand deposits by X will result in another 0.9*X increase in the money supply in the form of newly printed FRNs that are to be loaned out. But this is ultimately limited by the money multiplier, is it not?

You say that there’d be $190 in demand deposits with $100 in reserves to back it up, but actually, in this wacky system, the reserves actually increase along with the newly printed FRNs.

7

This is basically what the Fed describes in a document called Modern Monetary Mechanics.

8

Recall the historical origin of FRB: at one point there was no counterfeit money. Then one day, there was, and it was indistinguishable (by law) to legitimate currency. It’s a usurpation that goes relatively unnoticed. Also, at least under the current regime, you’re obligated to reckon your earnings, expenses, profits, etc., in this form of money, and you’re obligated to pay taxes with this sort of money, so there’s a sort of built-in “market” demand…

9

That’s not an analogous banking system, it is the banking system.

There is no difference between the treasury printing numbers on paper and calling it money, and banks printing numbers on ATMs and calling it money.

10

Hehe, the full reservists are hilarious as always. A continuous source of delight they are.

11

The reserves do not increase with the newly printed FRN’s. At step #1 and #2, I think things are what you say. The bank has issued non-redeemable bank notes, FRN’s. It is step #3 that you and I disagree. I believe you are saying that when the FRN’s come back as a new deposit, the entry will be: Increase “reserve” (asset), increase deposit (liability). I am saying it cannot work that way. The bank already issued those FRN’s (a liability) in step #2. It cannot simultaneously consider those SAME FRN’s as an asset when the FRN’s are redeposited. That is a fictitious entry that is over the top even for corrupt fractional reserve bankers. Rather, it must decrease the existing FRN liability for notes previously issued, and increase a deposit for that particular person (also a liability). There we have it, the deposit liabilities are now $190 and the reserve asset is only $100 (the remaining $90 asset is the loan). AND, the banker is free to expand credit again!

The problem is you are calling the redeposited FRN’s a “reserve” instead of recognizing that it is merely a reclassification from one liability to another. Your system is essentially the same as what we have now. The only difference is that the central bank (the Fed) has monopoly power to issue FRN’s, not the banks. The effect is the same in either case: The system is insolvent.

12

What meaning does this debate (full-reserve vs. free banking) have in anarchy? Isn’t this only a relevant topic under a state?

13

What happens when a fractional reserve bank defaults on its deposits? People will try to seize the bank’s assets, and then some form of legal process of bankruptcy has to be defined.

14

Absolutely it is only relevant under the state. The whole point of this thread is to think of a monetary system that is the functional equivalent to fractional reserve banking with the benefit of seeming more blatantly preposterous at first look. The argument against FRB is subtle, and it is one of the most challenging tasks to convince other non-Austrians that it is unsustainable/insolvent/undesirable, and that no government should protect it. It is my hope that presenting this alternate but functionally equivalent system to non-Austrians will make it more clear to them how such systems are preposterous. While it isn’t immediately obvious to non-Austrians why it isn’t a good idea to let banks loan out demand deposits, I think most non-Austrians would consider the notion of letting member banks print up and loan out the equivalent number of counterfeit bills as allowed by a reserve requirement to be utterly ridiculous, yet the effects on the money supply and economy as a whole are, as far as I can tell, identical.

15

Not so. The bank printed entirely new FRN’s in step #2. It is not a liability to anyone since it came from the printing press, not from anyone else’s demand deposits. The only “liability”, if you can call it that, is to promise to either destroy or not lend out these bills in the future if the base demand deposits decrease and the bank’s “reserves” fall under the legal limit.

Here’s another way to think about this: what if the government created a program that gave licenses to businesspeople to print their own counterfeit FRN’s to fund some investment, and that after, say, 10 years, the businessperson would have to burn the amount of money printed, plus “interest”. This is the functional equivalent to my other wacky system I proposed (and therefore to traditional FRB also), and as you can see, it doesn’t really make sense to bring the term “liability” into this. In this case, the only “liability” is to burn the principle + interest after the predetermined amount of time.

edit: it doesn’t really make sense for them to have to burn the interest in this case… they’d probably just have to pay the government as a fee for the license.

16

What are you talking about? Did you accidentally post in the wrong thread?

17

You can’t issue a loan (an asset) without a corresponding credit to something; you can credit either another asset, a liability, or an equity account. From the above quote, it sounds like you are directly creating “equity” upon approving the loan. In my opinion, there are better ways to explain the problem of fractional reserve lending, ie, by reference to Rothbard, etc.

I surrender. I think I tried to analyze something that cannot be analyzed.

18

Agreed. But I meant, within the context of anarchy, what is the use of arguing that one is OK while the other is not?

19

Ah, I see. This could be an interesting line of inquiry.

20

We still need a body of law that is economically sensible.