Fractional reserve banking question

Economics Economics Questions
101

There’s a big, huge as de Nile, difference between a producer of corn selling a promise to their future crop and the grain silo they have a storage contract printing up some warehouse receipts over and above what is actually in their care because they noticed at some time in the past that all the corn never gets withdrawn all at once.

Two entirely different concepts that you are trying to equate which simply isn’t the case.

Yet another entirely different concept than FRB.

The insurance companies are in the business of pooling risks of all the members and aren’t in a bailer/bailee relationship like banks. You aren’t entrusting ‘your’ money to them but are buying a service from them where they manage the pooled money of all the individual clients and pay it out to those who suffer losses covered under the conditions of the contract.

I can’t (well, if I actually had auto insurance) go to my car insurance carrier at the end of my six month contract and demand payment of the funds that I paid them because I had no claims during this period and wish to move my money in another risk pool. This isn’t the way it works.

What?

You borrow the stock from the owner, under the promise that you will return it at a future date, and sell it at the current market price. When the end of the agreed upon time expires you buy the stock at the current market price and return it to them.

At no point during this transaction is there multiple claims to the same property since it is merely a loan from one individual to another.

Now if the original owner printed up a counterfeit stock certificate and loaned that then you would have a good analogy with FRB but that’s not not how the system works.

Nice try though…

102

Sorry, but bank notes started out as exactly that: a bailment contract—a contract that specifically said “I will store your gold for you.” Under free-market conditions, banks that tried to slime their way along with a mere “promise to deliver x ounces of gold on demand” found themselves going out of business. The unsustainability of FRB under free-market conditions is not a mere matter of theory, it is historical fact. Apologists for the plutocracy try to portray bank runs as some sort of random tragic economic natural disaster against which a benevolent government must provide protection. It wasn’t. A bank run was a bank being caught in an act of fraud. It’s that simple.

It is also a historical fact that banks did offer exactly the kind of non-fraudulent pooled-savings services people have been trying to describe here. That piece of paper basically said: “You are part owner of the money we lent out at interest.” That piece of paper was called a ‘share.’ Under free-market conditions, no one confused that piece of paper with actual money. There is a fundamental difference between credit and bailment. In other words, that piece of paper may have been an asset against which people might lend you money, but that piece of paper never itself functioned as money. Again, this is not a mere matter of theory. This is historical fact.

As I said, banks could only get away with fractional-reserve banking by seeking very specific privileges from the government in exchange for fincancing government spending—typically to finance war. The very first central bank in the western world was exactly this. In 1694, William Patterson offered to loan William III money to fight France in exchange for a monopoly on bank note issue in England. He sought this privilege exactly because he knew it would allow him to get away with fractional-reserve banking, i.e. making money by lending and investing money he didn’t really have. Thus, the Bank of England was born.

This is what central banks and fractional-reserve banking have always really been about. Everything else is deliberate obfuscation.

103

This must be the third time you’ve cited Money as Debt. It pertains to the fiat FRB system IIRC, which is already heavily regulated and controlled. I find it peculiar that you argue that under this arrangement there is no fraud nor any multiplication of claims to a given good. It might not be the case under free-market FRB with full disclosure, but you do not make enough of an effort to differentiate the two, which I think increases people’s hostility here to your arguments.

-Jon

104

Again, the note does not say it’s worth 1oz of gold. It contains a promise to pay 1oz of gold. So you’re right, they shouldn’t be treated as the same commodity because they’re not. It’s up to the market to determine the difference in “worth”, knowing full well it runs the risk of not being able to redeem the note on demand. I think that’s the source of us seeing this issue differently. If you treat a promise to pay one ounce of gold as you would an actual ounce of gold, then that’s on you.

The airlines are heavily regulated, but it’s a cop-out to dismiss anything related to the airlines without looking at how regulation affects the issue. The government is not forcing airlines to overbook flights. There is nothing that’s preventing airlines from stopping this practice yet it continues.

105

hjmaiere,

Arguing that the practice of FRB is evil because it has been mis-used is like arguing guns are evil because they have been mis-used.

The way that banks and governments have controlled money now and throughout history is an abomination, but I don’t blame that on FRB. I’m not arguing that the current system is valid, but that under a free market with full disclosure, there’s nothing inherently evil or implausible about FRB.

Can you address my comparison to airlines overbooking flights as well as DriftWood’s examples? Do you believe those are legit practices?

106

You need to address the fact that a “promise to pay” an ounce of gold doesn’t magically create an ounce of gold. If you use that fact as a premise for further reasoning, maybe you’ll understand what’s wrong with FRB and similar fraudulent financial practices.

107

I’ve tried to point out, perhaps not vehemently enough, that the notes are not property claims, but performance claims, with the implication in my examples that they are “backed” by some combination of reserves and debt assets of a fully solvent bank. Peter Wellington gets at this just below your post.

It is the mistken blurring of the difference that actually leads to the worst problems we have, in that the debt backed liabilities themselves are currently counted as reserves under the assumption that they are true receipts, or property claims, and thus “as good as gold” -and, of course, following on that the elimination of the backing altogether and the counting of pure fiat notes as reserves backing up other fiat notes. In my examples, I hope it was clear that this could not happen and still conform to the contract, but in any case, I’ll get to it in more detail later (just taking a short break from work right now).

Probably.

108

As I’ve tried to point out several times, the argument is not that FRB is evil and should be outlawed. The argument is that fractional-reserve banking won’t happen, and never has happened under conditions that lack fraud or coercion. You can issue all the Peter’s-Fractional-Reserve-Bank-Notes (PFRBNs) you want. I don’t care. People, as a rule, won’t use them as money.

There are praxeological reasons why this is the case. Money is anything used to facilitate indirect exchange. In theory, almost anything that someone somewhere values can function as money. So I suppose it is possible that someone somewhere sometime might use a PFRBN as money, just as it is possible that someone somewhere sometime might use a chicken, or a Shania Twain CD as money.

In practice, certain things have certain qualities that make them serve really well as money: portability, divisibility, fungibility, durability, and market demand independent of its function as money. Absent coercion, markets tend to settle on precious metals for use as money, because they satisfy all of these qualities.

There were situations where people found it more convenient to trade warehouse receipts for gold in place of the gold those warehouse receipts represented. But, those situations were contrived and depended heavily on the trust placed in the institutions that issued those warehouse receipts. In the case of PFRBNs, they might be a great way to save money and make a little interest, but even in purely non-fraudulent conditions, backed by ‘safe’ investments (which, back when these things were called ‘shares’ included things like house loans ironically enough), there is little reason people would accept these things as money. There’s zero reason to think that a competing bank would accept them as money. Banks accepted the notes of competing banks out of a duty to customer service, but they redeemed them for specie or their own notes as immediately as possible. There’s no way they would ever consider them an asset against which they could issue further deman-deposits.

In short, the notion of fractional-reserve banking under truly free-market conditions really is absurd once you think it through.

109

hjmaiere,

I agree with most of what you wrote about money, but I don’t agree that FBR under a free market is absurd. I think we already see several similar practices in our market today that were not brought about by government (as DriftWood and I have mentioned). Let’s take a company that does world-wide business insuring home owners against fire damage. Do you require that the company be solvent in case of some type of monumental disaster that burns down 90% of the homes on the planet? Personally, I wouldn’t demand that, but you may. I would take advantage of lower rates while you would pay more for peace of mind. In other words, as long as the insurance companies are divulging this information, there’s no fraud and the market can decide. The same can be said of FRB.

It seems as though the belief that FRB isn’t viable stems from the notion that wealth is somehow being created out of thin air. The only thing being created out of thin air are the notes promising to deliver gold (or whatever other commodity is being used). Real wealth can be created over time. If we consider gold as a form of wealth, then the simplest example would be prospecting for and finding gold. This makes it possible to pay back loans with interest without anyone getting screwed over. But “finding gold” can be replaced with any productive activity that creates value.

This is why FRB isn’t a Ponzi scam. It’s based on statistical behavioral patterns of depositors and borrowers, matched in such a way that it’s unlikely there will be a conflict (when managed properly), much in the same way as insurance companies operate.

110

Insurance and banking are wholly different things. Insurance is a means to spread risk. Banks are supposed to work as a middleman between people loaning capital and people borrowing capital (and NO, paper is not capital and capital can’t be both available on demand and loaned at the same time, contrary to what FRB advocates seem to believe)

111

No, your analogy is flawed. Fractional-reserve banking presumes far more than merely that Peter’s-Fractional-Reserve-Bank-Notes (PFRBNs) be of value. That’s not in question. It presumes that PFRBNs will serve as a money—as a medium of indirect exchange. That’s the absurd part.

Money (by the Austrian definition) is anything that facilitates indirect exchange. If someone accepts something in trade not because they intend to consume it (in the economic sense), but because they intend to trade it for something else, that thing is functioning as money. As I said, things that are portable, fungible, divisible, durable, and have value independent of their use as money tend to serve well as money. Together, these properties could be described as remarketability. (Economic text books will add that money is used as a unit of accounting and a store of value. But this is only a cororllary of their use as a common medium of exchange.)

For Peter’s Fractional Reserve Bank to practice fractional-reserve banking, it must have the ability to issue pieces of paper (representing shares on the bank’s assests) as if they were money. This requires not only that regular people accept these pieces of paper as money (which is absurd), but that other competing banks accept them as money (which is doubly-absurd).

If a bank accepted the bank note of another bank as if it were money, it would be favoring the other bank (which is making double interest on a title to real money) at its own expence (whose assets now include risky titles to another bank’s outstanding loans). And no customer of a bank is going to allow a bank to redeem its notes in some other bank’s notes. It simply will not happen.

But this provides insight into the true function of a central bank. If by law there is one and only one legal kind of bank note, then banks are no longer in competition with each other for the trust of their depositors. The banks have effectively been cartelized. The banks win, and by no coincidence, the government wins, because (at least originally) the primary legal way to create new bank notes out of thin air was to ‘buy’ government securities.

Can you provide a single example from history where fractional-reserve banking operated under free-market conditions in the way you describe?

112

Can you let me know in what countries and in what time periods you consider free markets to have existed?

I know we’re going back and forth a little here, but the most important thing to me is the issue of force/fraud. I think we both agree that we don’t want a government or anyone else forcing a currency or bank notes on us. It seems like you also agree that FRB practiced in a free market with complete and honest disclosure is not fraud (putting aside the issue for a moment of whether or not people would actually partake in it). Please correct me if I’m wrong there.

If that’s the case, then the debate over FRB being feasible is interesting, but really a moot point as the market will decide, as neither of us would forcefully interfere.

I think our main point of contention is the use of these notes as money.

If you look back on my posts, I’ve consistently said that these types of notes would not function as gold itself (or whatever), but merely as a promise to deliver gold. I think our only real disagreement is what value these promissory notes would have. You think the gold/PFRBN parity would be huge, I think it would be fairly small for a trusted, well-run, and honest bank that completely discloses the nature of the notes. Again, the market would decide.

113

That is the presumption behind the issuance of the note.

The fact that a practice continues does in no way reflect the validity nor the morality of said practice, just look at taxes.

Bit of a red herring anyway hence the reason I dismissed it out of hand.

114

But if PFRBNs are not fradulent, then they are not a promise to deliver gold. They are merely a claim on the assets of a bank (i.e. its outstanding loans and investments). This is not a promise to deliver gold. A bank may offer to buy that PFRBN from you when it can (that is, ‘redeem’ it when it can), but it is not, and cannot legally be a promise to deliver gold on demand.

More importantly, none of this has anything to do with the gold/PFRBN parity. It might occasionally be the case that PFRBNs preserve and even grow wealth better than gold, at least over time. That’s completely irrelevant. PFRBNs still won’t trade as money any more than any other equity will. People don’t trade Google stock as money. The reason is because it takes too much localized knowledge to know the true worth of PFRBNs at any given moment. It takes a long time for something to broadly establish people’s trust in its remarketability and thus allow it to serve as a medium of exchange. It took the touchstone for gold to establish itself as a truly practical medium of exchange. And there is a huge accounting advantage to using a common medium of exchange. For PFRBNs to displace gold as a common medium of exchange, it needs to be more remarketable than the gold it supposedly represents. And this is logically impossible.

You need to really understand what money is to understand why PFRBNs won’t be money under non-fradulent, non-coerced conditions. Money is not merely an asset. It is not merely a (present or future) claim on an asset. It is a medium of exchange, and this something very very different.

115

Couldn’t the same be said of a non-fractional reserve bank? Let’s say there’s a new bank in town that has 5 ounces of gold reserves. You deposit 10 ounces of gold and it provides you with 10 notes, each can be redeemed for an ounce of gold at any time. If it lends your 10 ounces of gold to a borrower, you would only be able to redeem 5 of your notes until the loan was paid off. In other words, you can’t redeem all your notes on demand as promised. And who’s to say the loan will be paid off? What if the borrower defaults? Aren’t you, in essensce, holding a fractional reserve note now?

But you’ve said that anything of value can technically function as money. So what we’re really debating is the degree of remarketability. Again, this is very difficult to determine. Your opinion may be closer to the truth, who knows, it’s up to the market to decide and again, if you wouldn’t use force to stop such a practice then I think all’s well and good.

116

I’m very late to this dance, but the issue in my mind seems to come down to consent of the currency user.

It is not by accident that currency over the centuries has gravitated always to that which best retains the purchasing power of the user. To the extent some bank wishes to issue fractional reserve notes vs. ones that are backed by some type of commodity – be it precious metals or some kind of basket of commodities – that’d be for the market to sort out, and there’s little doubt that competing currencies would be quite healthy for any economy.

I could also imagine a fractional reserve note being issued into the marketplace and used, but not without some type of compensation for the portion of unbacked risk. Why would one otherwise accept the risk? Granted, one accepts the risk that the exchange rate of whatever is backing your currency of choice could lose value vs. whatever you intend to buy, and that is a risk on invariably must take. But it should at least be up to the user of a currency and not for some corrupted, self-serving institutions to decide.

I suspect this is why most any fractional reserve currency in history must always be fiat, and always created on the earned trust of a unit of currency that was previously backed. Rothbard beats that point to death in his books. And, it is also why inflation permeates fractional reserve currencies and goes hand in hand with every central banking apparatus ever created.

Surely, one can conceive a FRB that does not abuse the trust of the public, but the inherent corruption of such organizations and their creators tells a different story. The analogy someone made to guns (that its the user that is the problem) is apples to oranges. And nobody is saying “outlaw central banks” or the FRB.

We are saying just put it up to competition and let it survive on its own merit and track record. No chance of that IMO, should we be released of those shackles.

117

Be careful. What do you mean by “note” in this case? Is it a warehouse receipt? If so, the bank has committed fraud by lending out my gold. Is it merely a promise to pay back a certain amount of gold any time I demand it, but oh, by the way, only if the bank happens to have enough reserves on hand at the time? If so, why would I accept such a note? I might if it paid interest (in which case it would really be a timed deposit), or if it represented not gold, but partial ownership of the bank itself (in which case it would be stock). In either case, the note wouldn’t function as money. I couldn’t just expect just anyone to accept it as a form of payment. I might be able to find someone I could sell it to, but it would be valued as if it were a timed-deposit or as stock. It wouldn’t be valued as a warehouse receipt for gold. Specifically, it wouldn’t be valued as an asset upon which further bank credit would be further pyramidded. It wouldn’t facilitate fractional-reserve banking. No new money is created.

Fractional-reserve banking is when a bank somehow issues claims on its assets (outstanding loans and investments) and people treat them as if they were warehouse receipts for gold. This doesn’t happen in a free market.

No, it’s usually pretty obvious in a given market what’s functioning as the common medium of exchange and as the unit of accounting. At one time salt functioned as a common medium of exchange. And while it is conceivable that you could find someone somewhere that would accept salt in trade for something (in which case, for you, salt would be functioning as money), fractional-reserve banking presumes not merely that PFRBNs could function as money in some conceivable situation, but that they are functioning as money.

I would not use force to prevent someone from non-fraudulently trying to practice fractional-reserve banking. But I would know for a fact that if someone was actually getting away with it, that somewere someone was lying or pointing guns at people—probably both.

118

Yall need to cut Histhasthai and Driftwood some slack. They are essentially correct.

I believe Mises himself wanted to allow competitive FRB, as he thought that was the only means to keep banks from keeping insufficient reserves. 100% reserve requirement would mean the government could just as simply litigate a 50% or a 1% reserve requirement…then bail them out with tax money if they faced a bank run. If the market were in charge, individuals would manage the risks and rewards of FRB in the case of individual competing banks.

The most important thing is that banking and government are separate. The Panic of 1819 was caused by the government allowing banks to refuse note redemption in specie after the banks funded the government through the War of 1812, allowing basically 0% reserve (although I’m sure no banks operated as such). Also, we got the 2nd National Bank, who operated similarly in principle, until it had to contract credit to repay the LA purchase, due completely in specie. Government intervention allowed artificial credit expansion throughout most of the nation. You’ll notice the Panic of 1907 was particularly caused by stricter regulation and chartering of banks as opposed to the trusts, who operated essentially as much riskier fractional reserve banks. The market took it to them in the panic, but JP Morgan claimed to be savior, doing the worst possible moral hazard and bailing them out. Of course, his intention was to pave the way for a central bank, thus legitimizing the system of insolvency as opposed to policing it. The prior system of wildcat banking, while still far from ideal, was probably the closest.

As a side note, in Rothbard’s America’s Great Depression, he mentions that at the time there was virtually no difference in demand and time deposits, other than their reserve requirements. Banks basically allowed them to be used as demand deposits. Thus, they offered larger pay-outs for time deposits, as they carried a smaller reserve requirement.

Also, let’s not pretend that physically keeping gold on hand is completely safe. You can be robbed, or you may simply lose it. You may feel safer keeping it in a fractional reserve bank. Essentially, you must weigh the risk with the institution, not the system. And FRB is not dependent upon bank notes that circulate as currency. My bank doesn’t trade out the Federal Reserve Notes I give them with Regions or Capital One Notes. It simply keeps an account balance for me, which identity is required to change (of course there’s always identity theft). In this manner, a bank account may be more secure than physical possession.

And bank werehousing still exists, if you want to do that instead of time deposits, fractional reserve demand deposits, or physical possession: they’re called safety deposit boxes.

119

I’ve been think on this point a bit and have come to the conclusion that any parity between a ‘promise to pay’ and the commodity promised would present a arbitrage opportunity. Sort of like selling a bond at auction with the difference between the redeemable price and the paid price being the interest rate.

So basically what we have here is a situation where the banks are giving you a debt instrument and expecting repayment in specie or fungible equivalent while also expecting you as the buyer of their debt to pay not only full parity price with the underlying currency but also pay interest on top of this for the privilege of ‘borrowing’ their debt for your own uses.

All I really see happening here is that the bank is charging a premium to the loanee for the privilege of undersigning their ‘promise to pay’ to the merchants who they buy goods and services from. In essence all that is happening is that the bank is borrowing from the merchants indirectly through the person who receives these goods and services.

If through time the bank has developed a good reputation and has shown their ability to redeem these debt instruments then people will accept them as a substitute for cash the same as if you were to run a tab at the bar until payday.

If this is a correct analysis then I would have to say that this system isn’t really FRB but something entirely different, more like the bankers acting as a co-signer for a whole lot of individual loans made to their customers.

What say ye, yay or nay?

120

There is really not much of a difference between these different types of deposit notes.. and types of gold debt.

A deposit note that is redemable for gold on demand, where the collateral is gold locked into someones safe.. compared to one where the collateral is gold mortages are not that different. Both deposit notes have value, and can be used as money. They are not gold, but contracts of exchangeable for a certain amount of gold. The deposit note backed by gold mortage.. can be just as stable in value as the other. It all depends on the bank, how it well it manages its contracts and how trustworthy it is. Even if the bank says it keeps all its customerts gold in vault. It would be practically impossible to know, imagine people regularly go to the bank and demand to see that their gold coins are still in the vault. How does the customer know that those gold coins that he gets shown and gets to count are his? How does he know that the next customer wont be shown the same gold, thinking its his. It would be very hard if not impossible to enforce a law that made fractional reserve banking illegal.

Back to the topic about fractional reserve banking being evil because it creates money. It no more creates money, than any other form of lending and borrowing. Say you lend gold to your friend (on a time fixed basis or a until you need it back basis.. does not matter). Your friend gets to use the gold, thats clearly money. And you have a contract denominated in gold, that says your friend will buy that contract for a fixed amount of gold on request or at some future date. You might be able to trade that debt contract for goods, with people who trust your friend. If a bank was used as a middle man. You might be able to trade that contract with people that did not know your friend but trusted the bank. This contract is not money, its a debt bond. Its not gold, its debt. You see what im getting at?

The gold debt that happens trew fractional reserve bank lending is no more gold, than any other gold debt is gold. Other banks would not accept these gold debts as a replacement for real gold, than any other form of gold debts. If a bank got a hold of another banks gold debt bond that could be redemed on demand, it would redeme it and get the real gold. Why wouldnt they?

You see, this distinctions between these different gold contracts.. be it irregular deposit notes that are backed by gold in gold vaults, irregular deposit notes backed by gold mortages, and timed deposit notes backed by gold mortages.. makes little sense when it comes to gold or money. None of them are gold, and none of them are money in this sense. But all of them could be easily traded for gold, and in this sense they are money. Deposit notes backed by gold mortages are only a worse money than if the mortages that backed them where to risky borrowers at low interest rates.

Cheers