Full reserve banking and interest rates

Economics Economics Questions
21

The key is to understand the difference between a deposit and a loan. This difference has been deliberately blurred by banks, governments and (in recent times) the legal system.

If money is deposited for safekeeping, like a warehouse, then the bank will not pay the customer an interest; the customer will pay the bank to keep the money safe.

If a customer wants to borrow money, to take out a loan, he may do so from people willing to lend out their capital, and this may be done through a bank acting as an intermediary. But the bank would not be lending out any of the money it has deposited for safekeeping.

22

I have always understood that full reserve banking makes money by acting as a warehouse for customer deposits. I also understand that in full reserve banking, borrowing money from an individual or a bank causes the individual or bank to reduce their capital by that amount. I also understand that the interest initally comes to the borrower from others. I’m trying to extend the chain though and determine where the interest originally came from.

Consider this scenario:

Person A = $0

Person B = $0

Person C = $100

Let’s say Person A borrows the $100 from Person C at an interest rate that equates to $10 in total interest. Person A and Person B can do business back and forth exchanging goods and services until Person A has re-accumulated the $100 needed to pay back the principle (for the sake of simplicity, let’s ignore the fact that person C could get involved as the principle begins to be paid off). But the $10 which was charged in interest never existed in the system so the only way Person A can pay the interest is to either take out another loan and pay interest on that or, if he is lucky, Person B will take out a loan of $10 from Person C, pay it to Person A, and Person A pays back the interest. But at this point, Person B is in the same predicament. To pay back the $10 loan, he can either borrow the interest from Person C, or if he is lucky, Person A will borrow the interest, pay it to Person B for goods or services, who in turn pays it back to Person C. And so this debt-cycle continues with money only exchanging hands and there is always somebody in debt.

Am I correct in saying the only way the cycle breaks is if Person C gets in on the action and uses the principle paid back to spend the amount of interest money for a good or service from Person A or B? What if the interest is more than the principle? What happens if Person C loans $100 and the interest grows to $300? Is Person C forced to take the hit because it was a bad loan (or accept an alternative good or service in place of money)?

Now in terms of full reserve banking, you need only to exchange “Person C” with “Bank” and we have the same thing. Would full reserve banking cause constant passing around of who is in debt and regular bankruptcies unless the banks gave the money back to the people for free and interest free (good luck) or in exchange for goods and services (Banks have limited needs for goods and services)? (This is certainly not to suggest perpetually growing debt and constant inflation is any better alternative of course)

23

exile: I had this confusion at first, too. The solution is so simple that it’s almost childish. If you have a pure, full-reserve banking system (this is only hypothetically possible, since any uncovered future loans violate the “full-reserve” principle, but that’s a more pedantic point for this discussion), there are two kinds of deposits - demand deposits and time deposits (like CDs).

A demand deposit is just money that the bank is warehousing. The bank may not loan this money out because it must be available on demand, just like the name says.

A time deposit is a contractual transfer of possession (not ownership) of the deposited money to the bank. The bank now controls the time deposit money and may loan it out at interest. Presumably, the bank will also offer interest to the depositor to encourage him to place his money in a time deposit in the first place.

So, there would only be a problem with insufficient money to pay interest on loans if the interest on the outstanding loans made from time deposits exceeded the amount of money in demand deposits. So, if all loans were at 5% interest and only 1% of all money were held in demand deposits, then you have a problem. But this would never happen in a free market of lending since, as more and more money is moved into time deposits, the interest rate will fall closer and closer to zero as the supply of credit saturates the market.

Let’s take your Person A, B, C scenario and rework it a little:

Person A: $10/$0 (entrepeneur)
Person B: $10/$0 (capital equipment supplier)
Person C: $10/$100 (lender)
Persons E - N: $10 / $0 (consumers)

… where $X/$Y means $X demand deposits and $Y time deposits (assume all time deposits and loans are 1 year, all beginning/ending Jan. 1 for simplicity). Note that there is exactly $230 in the entire economy. A takes a $100 loan from C (he can because C has time deposited that $100):

Person A: $110/$0
Person B: $10/$0
Person C: $10/$0
Persons E - N: $10/$0

… and uses his investment to purchase capital equipment costing $100 from B:

Person A: $10/$0
Person B: $110/$0
Person C: $10/$0
Persons E - N: $10/$0

Persons E-N are very frivolous and spend all their money ($10 each) on A’s goods manufactured with his shiny new capital equipment:

Person A: $110/$0
Person B: $110/$0
Person C: $10/$0
Persons E - N: $0/$0

Eventually, the loan is repaid with 10% interest, yielding:

Person A: $0/$0
Person B: $110/$0
Person C: $120/$0
Persons E - N: $0/$0

As usual, the dirty banker and the dirty capitalist end up with all the money. [:P] You can count it, there is still exactly $230 in the economy. With no money created or destroyed, there was interest paid, capital invested, goods consumed and profits earned. :slight_smile: Keynesian monetary theory is rooted in the most elementary confusion about the nature of money.

Read North’s Mises on Money for more information.

Clayton -

24

The problem with this scenario is that no one has any savings. In reality you have Person D with $10 dollars in savings and a lawnmower. So, I’m person A, and I get the hundred dollars from person C. I use my $100 to buy person D’s lawnmower. Now the balance of savings looks like this:

Person A $0 + Lawnmower

Person B $0

Person C $0

Person D $110

Now I mow Person D’s lawn 10 times at $11 a pop. For that service, he gives me 10*$11 = $110.

So I (person A) take my newly earned $110 and I give to Person C to pay off my loan.

So you end with

Person A $0 + Lawnmower

Person B $0

Person C $110

Person D $0

So what’s happened here is that I’ve transferred $10 in savings from person D to Person C.

That’s why savings are crucial to the economy…

25

Okay, sounds to me then that the interest payments are dependent on the amount of capital in the community. I still have a bit of a problem about the situation where the borrower cannot gather the interest amount from others. So let me see if I have this right:

My real question then is what happens if the interest money is scarce (or non-existant as is the case when it exceeds the total demand deposits)?

When the interest payments are scarce (or non-existant), In the case of fiat currency/fractional-reserve banking, it is possible to produce the interest payments and lend them at a lower interest rates so the first loan can be paid off, and then as the principle and interest in the system cycle through the economy, they can eventually pay off the new loan.

In the case of hard money though, there doesn’t seem to be a built in solution. In such cases, the borrower will be forced to default and the lender will be forced to take the hit.

So if interest gets excessive, there is either perpetual debt to get out debt (in today’s system), or perpetual bankruptcies (in full reserve banking/hard money).

However, the contention is that excessive interest rates do not even occur under full-reserve banking because since people would control where their money is used, they would have a natural desire to put their money into time deposits (loan their money out for profit) and this would make loans easy to obtain and interest rates low as banks try to compete with each other?

And if that is true, is there a tipping point where people just don’t bother putting their money in time deposits because the profit earned from them is miniscule due to low interest rates? Would time deposits grow and shrink as demand for money (in demand deposit form) shrinks and grows (respectively)?

26

To answer the question of where the interest money “comes from,” in an example where there are only two people and Alan lends $100 to Bill and Bill must pay $105 back,

Bill takes the $100 and buys a lawnmower. He then mows Alan’s lawn seven times at the rate of $15 per mowing. He then pays Alan the $105 he got from mowing the lawn.

This example shows that there is no need for the $5 in interest to be created or added to the system. There is no paradox.

27

Yes, my question comes up where the interest is not $5, but, say, $105 on top of the principle amount of $100 (ie. $205 needs to be paid back in total).

28

The concept remains the same, you just need to mow the lawn a few more times.

29

For the purposes of this argument I don’t think this is a good conclusion. If there are $100 in deposits in the all of the banks, then there is a set amount of money that can be created in a fractional reserve system. For example the max amount under a 20% reserve is $457. There are only two ways to increase this number: deposit more money, or lower the reserve rate. Assuming that the latter is not allowed, the banks have to get new deposits, which you are saying don’t exist. If they did exist, then you could use them to pay the interest, right?

I’m trying to work out your hard money example.

Obviously if you have a great disparity in wealth A:$100 B:$0 C:$1 D:$1 this posibility is easy. A loans B $100 at 3% interest. Then B gets $2 from C and D, and then is forced to default. A still ends up with $102…he just calculated his interest wrong. The rest of society now has no money…but people are still working and exchanging goods..so a new money will just develop. People will trade cigarettes or whatever.

You could also do something where everyone loaned out everything they had. A:$1 B:$1 C:$1 D:$1. If everybody loans everybody a dollar at 10% then what happens is competition. There isn’t $4.40 in circulation, so everybody is not going to get paid back. Lets say B borrowed from A. And B is wildly successful and ends up with $4. Then you pays back A $1.10 and you get A:$1.10 B:$2.90 C:$0 D:$0. But..wow..ok, A borrowed from D and D borrowed from C and C borrowed from B so that $1.10 cycles back through to B and B ends up with the full $4. That’s weird. Now we’re back at scenario 1.

Is this even close to what you were asking? I think my conclusion is that the answer to your question is not that there are “perpetual” bankruptcies. There will be SOME bankruptcies, and some people will get their money back. The ones that made the best loans and the ones who are the best entreprenuers, end up with more money, and people who make dumb loans end up with less money. That checks out with the intuitive answer, I think. If instead of 4 people in the economy you have millions, you won’t ever end up in these extreme cases because everything can’t happen at once. Things kind of ebb and flow. No one is ever right all the time, you know what I mean?

30

I’ve read most of the responses here, and I think this is a tough question.

First of all, anyone who thinks that a free market bank would pay interest on a demand deposit, or a quasi-demand deposit, is kidding themselves. I think the “time deposit” idea is also mostly bunk: look, if you want to loan money to other people, then loan money to other people and accept the risk of possible default. If, on the other hand, you want your money to be available, then you need to forego the possibility of earning a return on it.

The question of whether interest could be charged on loans, we need to agree upon assumptions about monetary growth. If, there is some monetary growth, i.e., the supply of gold (or w/e) increases, then I suppose interest payments are possible. If there is no monetary growth, interest payments are possible only as part of a zero-sum game.Think about it: if there is only $100 in the world, and I own it, I can lend it to whomever I want, but I can’t possibly charge 5% on it, because there will never be $105 in the world.

In this sort of environment, you’d have to be content to receive your $100 back, in hopes that its purchasing power had increased during the loan interval. Now, you might say that if you chose not to loan the money, and the purchasing power increases, you’d be better off — but — if nobody loans money, and there is no economic growth (or far less econ. growth) then purchasing power doesn’t increase over time. What you need to do is buy productivity, in order to create an abundance, which makes goods and services cheaper, which in turn imbues greater purchasing power to your money.

In a free market, banks wouldn’t have a monopoly on lending, so there’s no reason to assume they’d be any better at it than anyone else. If you’re worried about portfolio diversification and reducing systemic risk, check out the idea behind Prosper.com where you can loan money in increments of (I believe) $50 to any number of people at agreed upon interest rates. People use prosper.com right now because they’re idiots, but in a free market, I think this is a good baseline idea.

31

There’s no paradox if you assume that the $5 exists elsewhere in the economy. What if it doesn’t?

32

Why would it be a zero-sum game with a fixed money supply? If prices are constantly falling due to growth in the economy, one can spend less on products they buy and come up with the interest.

-Jon

33

HEY! This is exactly my question! Thanks for putting it so succinctly.

In fractional-reserve banking, if it doesn’t exist elsewhere in the economy, the banks can pyramid reserves on top of what is in the economy to create the $5. This is what happens today and explains why we are perpetually in debt. In full reserve banking, the lender has charged more interest than is in the economy so will not get his/her money back. I’m not presenting this as an argument against full reserves, I’m just confirming that this risk exists (which I think is better than perpetual debt).

So based on what I’ve read in the thread, full reserve banking requires a firm grasp of how much money is in the economy and a standard part of deciding how much interest to charge on a loan must take into account the prospect of the debtor being able to get the money back from the other consumers or the loaner may lose money. With fractional reserves, this concern is not really taken into account because the loaner knows that if the money cannot be recovered by selling off assets, the debtor can still loan money from elsewhere because there will always be more money available to him/her.

From what I’ve also read, it seems like full reserve banking will care less and less about these concerns because full reserve banking encourages time deposits, which encourages low interest rates, which causes money to always be readily available.

34

You might have me on this one. But, merely spending less money doesn’t bring into existence the additional payment of interest. So we’re assuming that the interest money already exists somewhere in the system. My next question was, what if it doesn’t?

That brings us back to the point, that even if interest payments in-fact are not possible, “interest” in a real sense is still accrued because of productivity gains/technological advancements/lower prices and their effects on the monetary unit’s purchasing power.

Fortunately, we dont’ have to worry about a fixed gold supply (I don’t think).

35

I’m confused about one aspect of free market banking.

As I understand it in a bank that doesn’t allow FRB, a customer would have to authorise the bank to loan his funds out in order to generate interest on his savings. Otherwise, the bank would merely function as a storage facility.

However, would interest rates not be determined solely by the money that people have authorised to be lent and not the money that is merely being stored? If so, the interest rate wouldn’t necessarily correspond to the amount of money being saved.

If, for example, a lot of people put their money to save but do not authorise it being lent out, and very few did authorise this. Despite the large amount of saving going on in society the interest rates would be rather high wouldn’t they? And in this respect not reflect the preferences of the individuals in society.

Any help?

36

It is very unlikely that one person would borrow the entire money supply of the universe from one other person. However, if they did, they would just have to perform an extra $5 worth of work for the debtor. Or sell him $5 worth of wheat, and then give him back the $5 he paid you.

37

Why wouldn’t it reflect preferences? Most individuals who wanted to loan out money would do so, and this money would be available for present usage. Those who wished to make sure it was available in the future and not worry about failure of the debtor to repay &c. could just store it and consume it in the future. It’d only not reflect preferences if it were a coerced outcome.

-Jon

38

Lulz. If you’ve borrowed “all” the money, you can’t “sell him $5 worth of wheat” because there’s no more money! But that’s beside the point. In retrospect, I’m sorry I brought up the whole “incredible stable money supply” idea. I wanted to use it to illustrate the fact that even if the moneysupply does not grow, as long as an economy is productive there will be mild deflation, and this ensures a real gain, even if the nominal return is nil.

There is not a fixed money supply, and neither is there a fixed supply in a free market, where the money supply can be augmented by anyone with the financial wherewithal and propensity for bearing risk, who desires to invest in the production or extraction of (e.g.,) gold. Because gold is an [economic] good, it can be said that, so long as people continue to desire it, the production of gold (i.e., allocating scarce resources towards its location, extraction, and refinement) is therefore the production of wealth.

39

I think the problem is described well in this video (from about 3:00-4:00) (the graphics are exactly what I wanted to describe):

From watching all five parts, it seems like the difference is, in full-reserve banking, money will no longer carry inherent debt, but inherent value. So to pay off interest on a loan, the interest money becomes available by accumulating value, rather than accumulating more debt. If an individual cannot produce enough value and get money in exchange for it in time, he/she may default on the loan.

Sounds like a trade-off. In today’s world, we have to borrow to get the money we need to pay off interest. In full-reserve world, we have to increase value to get the money we need. I don’t know if it’s easier or harder to either borrow money in today’s world, or sell goods and services in a full reserve world.

At least when you sell goods and services, there is no extra interest that you must pay in the future like there is when we borrow in a fractional-reserve world.

40

It should read “give him $5 worth of wheat”. But if you’re pedantic, you might say that since there are no more money in the world, there is a tremendous demand for money. In any case, I can reply that in case of “loaning out all the money”, the loan terms would require payment in other kind of goods (mostly durable goods, since they can be deposited/kept). If you consider all such goods money, then you can repay it in work, as in working for free to repay debt. This makes sense, because it is inconcievable that work has already been loaned out.

Hope this makes sense.