Fractional Reserve Banking

[Juan]

@Adam Knott

In my example, the banknotes are inflated within the bank family prior to being offered to a prospective debtor. There are now 200 notes that claim to the money instead of 100 notes that claim to it. So now each note may be redeemed for 1/200th of the amount of the money instead of 1/100th of the amount of the money. This devaluation of the notes has not devalued the money in the bank’s vault. The money in the bank is still the same.

When the prospective debtor approaches the bank for a loan, it is not pieces of paper he is asking for, but rather a definite amount of money (as Giles refers to it, base money). When the debtor goes into the wider marketplace to purchase goods (let’s assume he is building a home), the bank notes he spends to purchase supplies will be redeemed by the retail merchant for the money in the bank.

You are leaving out one(or more) fundamental piece(s) of information.

How are the notes denominated ? That is, the debtor is getting exactly what ? A piece of paper saying “this will be exchanged for 1/X ounces of gold” ?

Let’s say the bank had 100 ounces of gold and had printed 100 notes - 1 ounce face value. So they now print 100 more notes with a face value of ? And what about the old 100 notes ? Surely they need to change the face value in those ?

But how this money is denominated—whether for each ounce of money there are two notes, or ten notes—isn’t important.

Quite the contrary. It’s the heart of the matter.

To the prospective debtor and the retail merchant, it doesn’t matter how many pieces of bank paper correspond to each ounce of base money. All that matters is how much base money their notes entitle them to.

That’s rather confusing. How do the debtor and the retail merchant know that ?

The inflation of the notes happened before the debtor received the notes

So, again, either the process is just an accounting device which has absolutely no implications for economics, or there’s a flaw somewhere.

He doesn’t care whether the bank hands him 100 pieces of paper per ounce of money or 200 pieces of paper per ounce of money.

The notes have a face value. It either matches the amount of reserves … or the bank is lying - also known as - fraud.

Because all that matters is that the retail merchant who will be receiving and then redeeming these notes is confident

No, what matters is that the merchant REALLY receives the amount of money he thinks we will receive.

The number of pieces of paper that correspond to each piece of money is irrelevant.

The number printed in them is not irrelevant at all.

There’s yet another point. Paper notes will sooner or later be replaced by electronic clearing systems. So part of this discussion is assuming an obsolete banking system.

[hayekianxyz]

Adam, I don’t really know how else to clarify. What I mean by an IOU is a loan. So, whereas you presumably intend a deposit to mean a bailment. Albeit, one whose value may decrease. I mean it to be a transfer of property titles to the bank. I think that could help clear up your conclusion. As for the printing of more notes being fraudulent, I’m not sure it is. Consider that nobody is forced to accept the bank notes, rather, people accept them voluntarily. But if this is the case then how can the bank be held liable for selling them (which is exactly what the bank does).

@adam knott

Could you clarify? Do you mean an individual’s demand for base money or the money substitute (the note)? And are you referring to an a priori law of economics about an individual person’s demand for something and a necessary provision of that thing by another person? I’m not sure what you are saying, so I don’t know whether to agree.

Ah, OK, sorry for the confusion. What I meant was that they increase their demand for banknotes. It’s an a priori law in the same sense that it would be with any other law. This is my major disagreement with the Rothbardians in this regard. For some reason money is to be the only good for which supply should not increase with demand.

[nirgrahamUK]

@GilesStratton

For some reason money is to be the only good for which supply should not increase with demand.

false, if commodity money is demanded then commodities are free to be supplied. of course, counterfeits are not commodities.

[adam_knott]

Hi Juan.

It’s difficult for me to respond clearly and succinctly to your questions above, because I’m not sure whether we’re talking about the case where the debtor accepts the notes, or does not accept the notes.

If you mean to refer to a natural rights question of whether the loan making enterprise my example envisions should be allowed to operate, or whether such an enterprise should be prevented by government intervention, I believe this exceeds the scope of my argument.

My argument assumes a free market atmosphere with no laws against private note issue.

If, granting that assumption, you mean a situation where the debtor accepts the notes, then maybe you can provide an example of how that must necessarily lead to a problem.

Adam

[hayekianxyz]

@nirgrahamUK

@GilesStratton

For some reason money is to be the only good for which supply should not increase with demand.

false, if commodity money is demanded then commodities are free to be supplied. of course, counterfeits are not commodities.

Why must they be counterfeits, in any case, if the demand for bank notes increases, I don’t see why there can’t be a consequent increase in supply.

[Juan]

@Adam

It’s difficult for me to respond clearly and succinctly to your questions above, because I’m not sure whether we’re talking about the case where the debtor accepts the notes, or does not accept the notes.

Adam, I think I asked what’s the face value of the notes. The face value is independent of the notes being accepted or not.

If you mean to refer to a natural rights question of whether the loan making enterprise my example envisions should be allowed to operate,

I think it’s rather clear that your system is confused and confusing when considered from a practical point of view. That’s what I’m trying to get at for now.

My argument assumes a free market atmosphere with no laws against private note issue.

I said nothing about that. Again, you have not explained how the system really works. A BASIC piece of information, the face value of the notes, is missing.

[adam_knott]

@GilesStratton

Adam, I don’t really know how else to clarify. What I mean by an IOU is a loan. So, whereas you presumably intend a deposit to mean a bailment. Albeit, one whose value may decrease. I mean it to be a transfer of property titles to the bank. I think that could help clear up your conclusion. As for the printing of more notes being fraudulent, I’m not sure it is. Consider that nobody is forced to accept the bank notes, rather, people accept them voluntarily. But if this is the case then how can the bank be held liable for selling them (which is exactly what the bank does).

@adam knott

Could you clarify? Do you mean an individual’s demand for base money or the money substitute (the note)? And are you referring to an a priori law of economics about an individual person’s demand for something and a necessary provision of that thing by another person? I’m not sure what you are saying, so I don’t know whether to agree.

Ah, OK, sorry for the confusion. What I meant was that they increase their demand for banknotes. It’s an a priori law in the same sense that it would be with any other law. This is my major disagreement with the Rothbardians in this regard. For some reason money is to be the only good for which supply should not increase with demand.

Giles:

There may be an inherent problem that occurs when we accept a definition that has a fixed meaning according to a particular theory which then precludes our conceiving of things differently.

For example, in the loan making enterprise of my original example, why aren’t the bank clients considered “investors” ? This is an association of individuals who pool their wealth for the purpose of making profits on loans. So maybe we could say that this enterprise is a bank in the sense that the debtor may obtain loans from it, but it is not a bank as this term is traditionally understood, from the point of view of the “depositors,” since they are pooling their wealth for the express purpose of making profits on loans. Because this is a business formed for making profits, all understand that they may incur losses. Those losses will manifest in the members of the bank family recovering less than their original investment.

Regarding the fraudulent nature of note devaluation, I guess my point was that the devaluation of the notes can be transparent. My intention was to provide an example of a note issuing enterprise where the devaluations are transparent. If the devaluations are transparent, and the participants accept such devaluations as means to their ends, then this may help bridge the difference between Misesian free banking advocates and Rothbardian natural rights advocates.

“This is my major disagreement with the Rothbardians in this regard. For some reason money is to be the only good for which supply should not increase with demand.”(underline added, AK) I believe the reason is Rothbard’s natural rights theory as put forth in The Ethics of Liberty.

[nirgrahamUK]

they are counterfeits if the say the are the deeds to gold in the vault, and there is no such gold.

@GilesStratton

in any case, if the demand for the bodies of dead innocents increases, I don’t see why there can’t be a consequent increase in supply.

how curious.

[Wade]

@nirgrahamUK

they are counterfeits if the say the are the deeds to gold in the vault, and there is no such gold.

@GilesStratton

in any case, if the demand for the bodies of dead innocents increases, I don’t see why there can’t be a consequent increase in supply.

how curious.

Having read this whole thread so far, I would like to offer a more general perspective on the arguments presented. From a very generalized standpoint, and not getting into the details of the particular examples of various human actions, it appears that there may be 2 general approaches being presented.

On the one hand there is an argument that hinges on the concept of marginal utility, and on the other hand there is an argument that hinges on a value judgment.

[adam_knott]

@wade

@nirgrahamUK

they are counterfeits if the say the are the deeds to gold in the vault, and there is no such gold.

@GilesStratton

in any case, if the demand for the bodies of dead innocents increases, I don’t see why there can’t be a consequent increase in supply.

how curious.

Having read this whole thread so far, I would like to offer a more general perspective on the arguments presented. From a very generalized standpoint, and not getting into the details of the particular examples of various human actions, it appears that there may be 2 general approaches being presented.

On the one hand there is an argument that hinges on the concept of marginal utility, and on the other hand there is an argument that hinges on a value judgment.

Wade:

Thank you for these comments.

After thinking through my example due to comments and questions provided by posters, I believe my example may be faulty for the following reason:

In my example, the bank clients provide their money as a business enterprise for the purpose of making loans for profit. But then, why are the clients holding bank notes? This may touch on what Giles was saying–that my example was unnecessarily complex. What the clients would have in my example would not be notes, but a defined claim to their investment + a return if the business was successful. In my example, the prospective debtor receives notes (I assume), which are then redeemed as he spends them in the marketplace. The ostensible reason for issuing notes as opposed to money to the debtor is so the debtor doesn’t have to take a large amount of money to his home.

If this is the case, then this removes the novelty of my suggestion that the clients could voluntarily devalue their notes, since they have no notes.

Then, my example seems to reduce to an examination of any inherent effects of such a bank issuing/creating notes that are redeemable for the base money it holds, and which base money is loaned out to the debtor (via the notes as mechanism or vehicle) with the expectation he will pay it back with interest.

What I was trying to arrive at was an example where full transparency is assumed in all transactions to the extent practically possible. And this transparency was applied to the devaluation of the notes held by the clients. But now, the clients seem to have no notes.

The devaluation in my example—when the example is rightly conceived—happens to the defined claim of the bank investor in his capacity as an investor, if the investment fails.

As I see it, for my example as currently construed to be resuscitated, I would have to begin by showing why or how the bank clients come to hold notes as opposed to a defined claim regarding their investment.

My intention was to impart an insight as to how a devaluation of a money substitute could be voluntary. But currently, I don’t see how my example accomplishes this, since as a beginning point, I haven’t shown how or why the clients come to have notes as claims on their investments. The novelty of my suggested approach may vanish if I only show that one’s investments can increase or decrease in value.

This brings to mind one of my favorite quotes regarding such attempts and their possible failure:

“There are many salmon swimming up the stream, but sometimes life is a bear.”

If the application of marginal utility analysis to private note issue is faulty in the sense in which I had intended it, this seems to leave private note issue as a vehicle or mechanism for loaning the money to the debtor. The context would be: the bank as a business enterprise where the investors provide the money to be loaned out for profit. The debtor “demands” notes as opposed to money for the ostensible reason that bringing a large quantity of money home is unsafe or inconvenient. Perhaps this is what Giles had in mind in claiming that my example was needlessly complex.

This circumscribed issue could perhaps be discussed on its own merits, separate from the original idea of a voluntary devaluation of notes, and may lead to a more clear understanding of the controversy surrounding private note issue and free banking.

[david_z]

@adam knott

For some reason money is to be the only good for which supply should not increase with demand.

Nope. Rothbard’s objection is not dependent upon a desire to keep the supply of money static, only to keep the supply of currency representative of the supply of money.

The supply of currency should not increase with the demand for money proper. Money, like any other economic good is and involves real investments, costs, and risks. It cannot be simply demanded in to existence, unlike currency which can be created willy-nilly. C**urrency is, or represents itself to be a title to real property (money), and so the supplies thereof should rise in tandem. Never should the supply of currency augment without an increase in the supply of the monetary commodity/commodities.

[liberty_student]

Bravo!

[Wade]

Adam:

I like that quote. Just to be clear I was referring to the entire thread not your posts specifically in my previous comment. I think that your arguments were all interpretable in terms of marginal utility. It was insinuations like nirgraham’s statement about “bodies of the dead innocents” that hinge on value judgments and not marginal utility.

[Wade]

Regarding the distinction between claims on investments and notes, I don’t necessarily see the difference.

If notes are given to a debtor, then the debtor can use the notes as if they were claims to the actual assets they represent. I don’t see the difference in the “note” versus “the claim on investment”, since in both cases they are a claim on the same assets. The bank clients are merely loaning out their claims on investment for a set period of time to the debtor. The debtor gets to use the assets as if he owned the assets himself at least for a period of time at a certain amount interest.

If the bank or clients issue more claims than there are assets, then I guess this is where it becomes “fraudulent”. This is assuming that the notes are claims on a set amount of assets, and that the bank or clients distribute claims on assets that don’t actually exist. But this is just 1 particular contractual arrangement. This does not rule out the possibility of the scenario Adam is describing in a society with free banking.

There may be another way of looking at this. Instead of having assets that are stored and claims on those assets being issued as notes, say that someone starts a paper currency product that is a claim in and of itself. Meaning that the money is not a claim on something else, but a just a very unique piece of paper that people value.

For instance, the design of the paper could be so unique that it would be almost impossible to replicate, or where there was a system in place where it was impossible to duplicate. Lets assume that the designer of this product built a system so that only he would be able to duplicate this unique paper product. I won’t get into the details of the technology that might enable such a system, but it is certainly within the realm of entrepreneurial possibilities.

So then lets say that the designer of this unique paper product starts to trade it for other things he desires in a voluntary transaction where others desire his unique paper product. Lets call this paper product “Alphas” just for simplicity.

Now say more and more people desire to attain Alphas, and so the designer begins to produce more in order to meet the demand (in exchange for things he desires of course). As time goes by, designing and selling Alphas becomes a very profitable business, and so as others in society see potential profits to be made you see another paper product emerge called Beta. Both companies that are designing and producing the unique paper products adjust there production levels according to the demand for their products. If there is more demand, then more Alphas and Betas are produced as they don’t want the competition to start eroding their market share. As supply catches up and demand slows, less Alphas and Betas are produced as they don’t want to overproduce and be left with large inventories and production costs.

As time goes by, another currency emerges claiming that they have discovered a new technology that allows them to predict supply and demand better than the Alpha and the Beta. This new currency called, the Stable, revolutionizes the currency industry and introduces a new online open trading system where all three products can be exchanged and bought over the internet. Exchange ratios emerge between all 3, and anyone in the world can participate in the exchange.

What is the primary difference in such a market described in this hypothetical world versus something very similar we have today like the Forex.

The primary difference in the currencies I described in this hypothetical market is that I never mentioned anything about only 1 of them being allowed to be used over a particular geographic region. If the currencies in this hypothetical world were free to be used and exchanged all over the world with no legal tender laws over specific geographic regions, then the only difference between this hypothetical market and the Forex market we have today is that only 1 currency can be used over a particular geographic region in the currency market we have today.

From an Austrian School perspective, does the hypothetical market not seem more ideal? Does it really matter what type of material the currency is if people choose to value that product?

What I am proposing here is that it does not matter what type of system or currency we have as long as the individuals in that system are free to choose the type of system or currency they desire.

[scineram]

@david_z

Nope. Rothbard’s objection is not dependent upon a desire to keep the supply of money static, only to keep the supply of currency representative of the supply of money.

The supply of currency should not increase with the demand for money proper. Money, like any other economic good is and involves real investments, costs, and risks. It cannot be simply demanded in to existence, unlike currency which can be created willy-nilly. C**urrency is, or represents itself to be a title to real property (money), and so the supplies thereof should rise in tandem. Never should the supply of currency augment without an increase in the supply of the monetary commodity/commodities.

Why should not the supply for currency keep up with demand? The demand for base money is somthing else.

[david_z]

@scineram

Why should not the supply for currency keep up with demand? The demand for base money is somthing else.

Why should not the supply of titles to real property (i.e., housing, land, etc.) keep up with demand?

[Wade]

@scineram

@david_z

Nope. Rothbard’s objection is not dependent upon a desire to keep the supply of money static, only to keep the supply of currency representative of the supply of money.

The supply of currency should not increase with the demand for money proper. Money, like any other economic good is and involves real investments, costs, and risks. It cannot be simply demanded in to existence, unlike currency which can be created willy-nilly. C**urrency is, or represents itself to be a title to real property (money), and so the supplies thereof should rise in tandem. Never should the supply of currency augment without an increase in the supply of the monetary commodity/commodities.

Why should not the supply for currency keep up with demand? The demand for base money is somthing else.

I’m assuming that when you are saying “currency” here you are talking about a note that represents the base money. So the demand would be for the base money not the note. Because the note is just representative of the base money. So to increase the supply of claims on base money beyond the actual amount of base money would be fraudulent, or at least in a free banking environment wouldn’t attract too many customers once knowledge of this practice got out.

[david_z]

sorry, I forgot to include my /sarcasm tag.

[Wade]

@david_z

sorry, I forgot to include my /sarcasm tag.

ah. I missed that, i just thought you were really confused, but I think that was me now. : D

[hayekianxyz]

@david_z

Why should not the supply of titles to real property (i.e., housing, land, etc.) keep up with demand?

If there was demand for that, why not indeed? The fact is that there is no demand for titles to houses etc. because it doesn’t serve well as a medium of exchange and people need control over it in order for it to serve their purposes. OTOH, it isn’t necessary to have control over the physical units of gold for it to serve the purposes of the individual.