fractional reserve banking :: really a problem?

Economics Economics Questions
1

I have given thought to this and I can’t find any a priori demonstration that fractional reserve banking is bad. Sure, it multiplies money in the economy and may create inflation, but it might very well be equilibrated with the investment-spending-saving behaviors of the people.

I usually check any issue by asking if it violates some hardcore axiomatic principle, but I can’t think of any principle violated by fractional reserve banking.

People who deposit money in a bank already know the money will be used for loans. If they had a problem with that they would put the money in a safe box instead. So there is no moral problem involved.

Then there is the inflationary issue.

Some guy deposits money in the bank, the bank will pay a fee to the first guy (being a intermediary) and could lend all the money at a higher fee to someone else. The second guy uses it to buy a new car for his taxi company. The car dealer will pay for his expenses (including buying more cars) and deposit the rest of the money. The car manufacturer, at his time, will pay his expenses and deposit the surplus. The same will happen with every other person who becomes and indirect receiver of the loan. Most of the money will be flowing through the market, only a small part will be saved. An equilibrium will be achieved sooner or later. The bank (if it expects to recover the money) can only lend to people with guarantees and projects that have a sound plan, which are scarce. The surplus of money in any economy is scarce too. The lending doesn’t go on ad infinitum, it will stop at a point that depends on the current situation of the economy.

The only problem could occur when someone doesn’t really want to loan the money, but just it keep there to facilitate the handling of money by issuing checks instead of having to carry (for example) gold or silver with him all the time. Then he agrees to pay a fee to the bank, and expects to be able to withdraw the money at anytime. If the bank makes loans using that money then the banker really is committing fraud. Otherwise, he is not.

The issue really comes down to sound banking practices. Fractional reserve, as based in fixed term deposits, isn’t immoral at all. The danger for any person making a deposit would be the same as if he was lending it directly to some friend. His friend’s project may fail and he may have to execute the guarantee, maybe will lose his money, maybe will have to go to a trial to recover something.

Actually, informal loans could be considered banking operations with a zero-reserve.

So, what’s the problem? What am I missing here? Why is everybody against it?

2

  1. Fractional reserve banking = bank failures. Before gov’t intervention, fractional reserve banking was a death sentence for bankers: if you did it, you were almost bound to fail. Thus, fractional reserve banking is unlikely to exist in a free market.

  2. Fractional reserve banking creates investment unbacked by saving. If I make a $100 deposit and $90 is loaned out and then I transfer $50 to another account, the bank essentially just created $40 of electronic money. This money is fed directly into the economy via loans, creating a higher demand for higher order goods, thus lengthening the productive structure. When inflation occurs due to a “pulling” of the natural factors of production from both ends of the structure (since consumption was not given up for investment), we will have an inevitable recession in the economy. The only way the credit creation will not create a business cycle is if all of the newly created credit is saved - which is impossible, since that credit is borrowed for a reason - to spend on higher order goods.

3

What you have just described as “fraud” is fractional reserve banking.

“Fractional reserve, as based in fixed term deposits” doesn’t make any sense.

4

I agree with Paul in that I don’t see how frb harms things more than fiat currency itself. If there aren’t bank runs (99% of the time), doesn’t it mean that depositers would not touch that money and thus allow it to be loaned out in a free market?

And couldn’t money still be multiplied in a similiar in a free market if banks considered promises of gold in the future by other banks to be money?

5

It’s the fractional reserve system, not fiat, that’s the problem - in theory, you could have 100% reserve banking with fiat money, and it wouldn’t be a problem. I’m just saying it doesn’t make sense to talk about “fractional reserve” on term deposits (even in a strong 100% reserve system, term deposits would have “0% reserves” - it doesn’t make sense not to loan that out)

Not necessarily, because money can be transferred from one account to another without being withdrawn and redeposited - i.e., it doesn’t have to exist to be used in payment. Given Internet banking, etc., a modern bank could allow you to specify how much you want to keep on demand for immediate use and let you put different amounts in various-length term deposits (e.g., they could offer 24 hour, 7 days, 30, 60, 90 days, 6 months, 1, 2, and 5 years, say), where they’d offer continuously varying higher or lower interest rates on each length depending on their need for loanable funds, etc. (I mean the offered rate would vary perhaps several times a day; once you committed some money to it, you’d get whatever rate was offered at that time); when you put some money into, say, a 7 day account, it would disappear from your current balance and be returned (with interest) 7 days later (you could have some sort of calendar display showing your future balances as well as the current balance) - now the banks could legitimately loan out your money (with no reserve requirement!), except whatever you keep on demand (for which you’d pay a fee), and hardly anybody would keep any significant amount on demand, and bank runs would be impossible. But that’s not what they do today.

6

Sorry, Mechanical Engineering is my job and Spanish is my mother tongue. I don’t know the exact banking terms in English and just have to guess.

Then, Paul, let me further exaplin.

I have read many articles from critics of the Austrian - Libertarian view, saying that what Austrians really oppose is the act of lending. If the lending of money in length term deposits isn’t considered fractional reserve, then the criticism isn’t valid. If the lending of money in Current Accounts as if it was the bank’s property is what Austrians consider evil, then I agree with the Austrian view.

7

Austrians don’t oppose lending per se. They don’t even oppose lending someone else’s money. But they do oppose lending money while making guarantees that they’re still available instantly and on-demand.

So, if I understood your point correctly, you already agree with the Austrians :).

8

This is a matter of cash management and not an underlying principle.

9

Yes, I agree. Austrians think this kind of banking would disappear by itself on the free market, but that no norm should forbid it. Although some regard it as theft.

10

It’s a matter of not having the right to lend money that wasn’t lent to you in the first place.

11

This may be beating a dead horse at this point, but the way I think of it, the problem with fractional reserve is one of incompatible contractual obligations. The depositor has a contract that says he can get his money back at any time. The borrower has a contract that says that he can pay that same money back in monthly installments over a fixed period of time.

As long as the money coming in more or less equals the money going out, the banks can keep a handle on it. Any boulders in the stream of money though can wipe them out.

12

Look at the run on the bank in the movie “It’s a Wonderful Life”, the customers all want their money. Our hero Jimmy Stewart tells them that their money is invested in the houses of their neighbors and if they want their money they will have to wait the sixty days they agreed too when they opened the account. However, Jimmy Stewart still has cash on hand that he doles out to get through the crisis. Why, does this scenario seem impossible in a free market?

Fractional reserve banking as it’s being discussed here would be a competitive advantage in a free market and I see no reason why it would not occur.

These universal declarations about what is not possible in a free market really surprise me coming from this group.

13

Crime is bad.

14

Where is the crime in fractional reserve banking as described here? This is simply a business model we are discussing. If you put your money in the bank and you know that your money is being loaned out but the bank also provides the service, when possible, of instant access to your funds, why is that a crime?

This is basic cash management. What is your arguement why this will not exist in a free market? What priniciple is violated by the scenario as outlined above?

15

This is nonsense. Under frb he does not agree to pay a fee to the bank. So that fraud has nothing to do with frb.

16

Just once, Maxliberty makes sense

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Say after me: money is FUNGIBLE. If the bank has more reserves than you personally can demand from your account then “they’re still available instantly and on-demand.”

17

Up until the bank run that is…

In theory this is only true for 10% of their customers at any given time so does that mean they are only engaging in 90% fraudulent activities? I suppose it’s only fraud if they can’t pay back 100% of their demand deposits then?

Oh, and the whole bailment law that banks are immune to for some odd reason while any other warehouse that store fungible goods are universally accepted to be committing fraud if they issue more certificates than goods they store. Who in their right mind is going to store their corn harvest in a 10% fractional reserve grain silo?

The only reason we don’t see bank runs today is because the risk of failure has been socialized through the FDIC who steps in to nationalize the bank and perform an orderly liquidation of assets to pay whatever portion of the debts that the taxpayers don’t have to cover. And the ‘lender of last resort’ who can provide banks with almost unlimited liquidity to pay down their accounts to keep the run from picking up steam.

Up to the point of failure it is just a case of money management as Max says. But, then again, the same can be said for any other ponzi scheme.

The real question is if he intends to practice fractional reserve banking on his proposed gold backed interweb bank???

18

Here we go again…another endless thread about how magic and wonderful unbacked paper money is… =]

19

I think the people who deposit at length terms already know (and approves) the money won’t be there. So there isn’t any problem. The fraud happens only when the bankers touch the current accounts.

So it’s just current accounts that shall be 100% reserve. I don’t know if they already are but I suspect not from what I have researched.

By the way, I just wrote an article on this subject, in Spanish. If someone can comment (I could have made some mistakes or even a reeaally big fat one) I will appreciate it.

I loved your grain storage example. [8-|] It’s my area of business. [:D]

20

My quick take on things.

the “Fractional reserve banking” system isn’t a problem so much as the creation of new money to loan out under a fractional reserve banking system (which Rothbard and I both perceive as fraud). If system worked where-in banks loaned out money they had on hand (up to the reserve amount, of coures), and created no new money, the only issue would be that of bank runs.

However, that’s not the case; under our FRB system, banks create new money when they issue loans (Ie: if they have $1000 in deposits, and they have a 10% reserve ratio as dicated by company policy, they could loan out up to $900…however, if they did loan out $900, it would not be of their actual deposits, and would, in fact, be completely new money created out of thin air).

If we had a FRB system in which NO new money was created, I could probably tolerate it; there would definitely not be any inflation (except from a central bank, of course), just the risk of bank-runs.

That said, at the end of the day, I agree whole-heartedly with Rothbard; Common Law needs to recgonize any system of FRB as fraudulent in nature.

That’s my opinion, anyway.