What’s exactly the problem with the fractional reserve system?
It’s true that people may ask for all the money they deposited and the bank face problems in returning it, but this is solvable through accurate forecasts on the amount of people that is likely to demand their money in a given period of time.
This problem is not different from that of insurance companies, which have not available money to compensate all covered people, in the very unlikely situation in which all its clients get involved in accidents at the same time.
Or am I completely wrong about the FRS and its problem is not, after all, the uncertainty on the availability of money demanded by depositors?
Lets start with the difference between Fractional Reserve Banking vs Fractional Reserve Insuring:
That difference is in who is the rightful owner of the deposited/paid premium. In the banking case of a demand deposit (No explicit contract on when the depositor can withdraw the money) the bank lends out some of the deposit and keeps the rest in reserve. This means that there are two owners of this money: 1. The depositor and 2. The borrower. So money paid to the borrower has been created out of nothing. This is different from insurance where the insurance company owns the premium. In the insurance case, there is always only one owner of the property. When there is a claim the insurer takes property from their reserve and pays the claimant still never having more than one owner of the property.
Another difference is in how the insurers vs banks “insure” themselves against risk. Insurance companies pay (According to the risk) re-insurers who in the case of a huge claim will front the money. Banks use the Federal Government who does not charge according to risk.
It is different. You cannot insure against events that the insurer himself may have control over. In general, human action and entrprenuership deals with uncertainty and not risk. Such uncertainy in not insurable. Any comparison between FRB and insurance completly misunderstand the roll of insurance, what it is, and how it works.
“That difference is in who is the rightful owner of the deposited/paid premium. In the banking case of a demand deposit (No explicit contract on when the depositor can withdraw the money) the bank lends out some of the deposit and keeps the rest in reserve. This means that there are two owners of this money: 1. The depositor and 2. The borrower.”
if ones deposit agreement never uses the words demand deposit how is there a difference???
my deposit agreement uses the funds, and and some levels of immediate availability, etc.
how many deposit agreements actually say demand deposit??? millions???
and i dont see where there are two owners of the same thing as has been stated here and on other so-called mises media. the more i listen to them the less i believe the peole saying such are even being honest.
it seems the currency system as it is now, and it may be a social ill, has a paper/coin component (owned) and a varying bank credit component (owned and insured via paper or credit in standby) dictated by fed rules governing bank reserves - so i have been told.
i am not sure if the govt blesses some money people more than others.
i guess the main difference is reserves mandated by govt and insurance has various market premiums.
He does in the sense that he holds the right to redeem it when he wants. Huerta de Soto explains this pretty well; it’s not a full transfer of ownership.
I understand the difference between money deposited in a bank (demand deposits) and that paid as premium to an insurance company. A demand deposit is a property of the depositor, the premium is a property of the insurance company.
But people covered by the insurance company will have right to the money if they get involved in an accident. How is this different from the case of a bank in a FRB? People have right over their money the bank in a FRB should have, but doesn’t, in case of a massive withdraw. Covered people involved in an accident have as well right over, say, 100X the money they pay monthly, which the insurance company should have, but doesn’t, in case of a massive accident involving all its insured.
And in case of a huge withdraw of money, a bank can borrow money from other banks.
But all the problem is reduced to making a good prediction on how many people are likely to withdraw their money, and then the bank lends according to this prediction. Likewise, the problem faced by an insurance company involves good analysis on how likely an accident is to happen, then it sets premiums according to this analysis.
This is not a defense of government. I’m not in favor of government regulating how much money banks would have to keep in reserve. I think in a free market banks would have a strong incentive to lend out only a reasonably fraction of the money deposited. Mistakenly estimating its depositor’s demand for money would be really bad for a bank’s reputation.
What if a bank wrote a clause in contract saying that “40% of all demand deposits will be lent out. In case of a bank run some of our depositors may not have their money at the time of their demand. By signing this contract you accept this risk”? That would eliminate the ethical problem concerning lending someone’s else money, and we still would have money “created out of nothing”.
Would you deposit your $1000 life-savings at such a bank assuming there’s no central bank to “save” everyone after a bank run by printing more currency? Or, would you rather put $600 at a 100% reserve bank (practically a vault for safekeeping) and invest (expose to risk) the remaining $400 yourself (or pay an investment expert for the advice)? What purpose would the 40% reserve bank serve that could not be better achieved by your own allocation of your savings among a 100% reserve account and an investment account?
Precisely! The insured party “owns” the premiums it paid just like a depositor owns his deposit: he is to take them back when and if even A occurs. For the insurance company, A=insured event. For the bank A=whenever I feel like it. its the very same thing. Free banking rules!
But a as side-note I’d advice against this idea that banks or insurance companies can somehow “predict” when events A are going to occur. I’m right now going through an actuarial course (predicting the loses an insurer will face) and I must say that it is a load of c..p! It al degenerates into a single-trial probability, and one should know how accurate are single trial application.
Shortly, every time a bank keeps les than a 100% reserve, or an insure has les capital than the total limit of claims policies outstanding, he does so at his own risk, and there is no way in which loses can be predicted. Ye be warned!
“What purpose would the 40% reserve bank serve that could not be better achieved by your own allocation of your savings among a 100% reserve account and an investment account?”
i have asked something similar to this before and never got an answer that made any sense.
i can only assume that fractional reserve banking or govt controlled reserve banking actually takes place…this is what people have said here.
as for the property issues it seems that deposit owners own a few paper/coin currency items and ‘govt’ mandated credit forms of currency. so i dont understand all of the previous square- circle audio comparisons at mises sites.
“Cameco Australia’s $4-million 1999 exploration program now equals Cameco’s uranium exploration program in Saskatchewan.”
i am not sure if the above linked info is true. but it mentions that a company called cameco spent 4 million on uranium exploration.
scenario…
if the 4 million was a bank loan…i guess loaned (as i have read at mises sites and others) from various types of deposit accounts and the bank added credit (based on 10 % RR) in the amount of 3.6 million would this be the process that could lead to boom/bust cycles described at mises.org?
some of a 4 million dollar loan is spent from a lending bank to set up a mining operation in the wilderness…but the townspeole where the lending bank was still spend credit as if it was money (3.6 million dollars) .
iow
the original 4 million dollar loan purchased distant capital goods for mining and many goods and items in the town along with the 3.6 million in bank credit now in depositors accounts…pushing up various prices of consumer goods
…
would the additional credit-spurred demand of consumer goods be the be the catalyst for malinvestment?
for instance, a sudden increased demand for office supples leading to additional malinvestmetns in office supplies?"
i dont know how the interaction of credit and hard money would differ from 100 percent reserve money that would be invested in a similar fashion.
aside from govt mandate would insurance companies want to be paid in various forms of credit money? that which isnt backed or in some way redeemable for paying for damages (body shops, masonry, etc) from policy holders?
it seems likely they wouldnt.
if a policy was drawn to pay out in gold i expect insurance premiums would be paid in gold.
so perhaps insurance premiums in a broad sense hedge payments for likely-coverage.
My point is that no insurance company has money to pay all people covered by it in a day. In a very unlikely but possible massive accident involving all people covered by this company - an “insurance run”-, it woud have no money.
In a possible but unlikely situation in which all customers of a bank withdrew their money an FRS bank would have no money. But this, as well as in the insurance company case, is unlikely. It’s less unlikely, of course, but it’s unlikely.
The point is not predict how likely A is to occur, since you defined A as a single customer’s withdrawal. The point is predict how likely is a massive withdrawal to occur.
MNR: The same reason insuring any bankrupt industry isn’t viable. You cannot insure entrepreneurs because they engage in uninsurable risk. You can reasonably predict how many fires there will be in New York; the unlucky few who get burned can dip into the pool of resources. But entrepreneurship is not heterogeneous; it is completely unpredictable, and each attempt is non-random. The entrepreneurs assumes the risk. If an insurance company insures it, it becomes the entrepreneur. Who then insures the insurer? In the case of banks, either they don’t need insurance, since they are 100% covered, or they are uninsurable because they are taking entrepreneurial risk.
AEN: You have been critical of White’s book on free banking.
MNR: The White book says the Scottish banking system was more successful than the English system. But he doesn’t say one word about prices, inflation, or business cycles. His only statistic is that were fewer bank failures in Scotland than Britain. But what’s so great about not having failures? An industry that doesn’t have failures might be doing poorly. What if we applied this test to the Soviet Union, where no industries fail?
When you say one banking system is more successful than another, it seems the test should be less inflation and fewer business cycles. Yet this is never mentioned.
What I mean is that the statistical models used to predict the total values of As happening this year, brings such a value back to a single-trial probability: “ given your fund size, there is a 0.1% chance that you’ll go bankrupt this year” the models say. Well, that sounds a lot like a single-trial probability case, no longer the pooling of individual probabilities into a larger whole. Only if we are interested in the total number of insurers that will go belly-up is this model good. Otherwise, it serves nothing to the individual company. I might be wrong though.
There will always be fools voluntarily agreeing to participate in foolish things. Nothing illegal about it. Whether the massive withdrawal happens or not, the risk of a FR bank’s insolvency is 100%, as it’s already insolvent even without the run – the claims don’t match the capital (assets), by definition. Would you knowingly participate in a publicly announced Ponzi scheme, if the interest on your “investment” was high enough for the “risk”? Would you buy a car (at a 20% discount) from a dealer who disclosed to you that there’s 40% chance for the car NOT to be there next week when you come to pick it up – since he may or may not have also sold it to someone else at the same time? Perhaps, for you, there’s an incentive level at which you’d enter schemes like this, and who am I to stop you? I just don’t think there’d be much demand for them in a free market, as the fools supporting them would quickly get bankrupted into oblivion.