Thank you all for your input and insight. I will mull over all the responses posted.
Remember that fiat currencies have led us into numerous boom-bust cycles, something that didn’t exist when we had a 100% gold standard.
The stock market crash of 1929 and the subsequent depression is a great example of credit expansion failing on a huge scale.
Thank you for this reply. There is so much rich information in this post that has made me think of an example to explain it. Would it be possible for you to explain what you described by giving an example of a product or industry in light of the content posted?
In what chapters of Principles of Economics and Economics for Real People would I be able to find specifically information about capital formation and research and development?
Would you be able to explain the above information by giving an example of a product or industry? I think tha would help me understand and explain the richness of the content to others. Thanks!
Inquisitive -
You are asking a very tough question. First, please realize that no matter what, a great deal of research and development would take place in a world of 100% fractional reserves. Any R&D that, on average (pooling investments and the like) was expected to be profitable under such a system would be funded. And that is the majority of R&D in any system, period (except full out socialism of any kind - see much R&D in China prior to the '80s? North Korea today?).
The only additional R&D that takes place in a world of fractional reserve banking is R&D that has a profit expectation below the interest rate without expansion of the money supply and the lower interest rate that occurs due to expansion of the money supply.
This is confusing, so let’s make it a bit simpler: Interest rates would be higher, today (but possibly lower in the long term), without the Federal Reserve’s continual inflation of the money suppy. They are lower than they would be.
This means that there are investments of all kinds that are dependent on lower interest rates than the ‘natural’ rate (here ‘natural’ rate means the rate that would prevail without fractional reserve banking) that take place. But guess what? Investments that are dependent on lower interest rates than the ‘natural’ rate are, on average, doomed to fail. This is the essential cause of the boom bust cycle.
So we’ve established that there is some amount of R&D that takes place right now beyond what would take place if we immediately moved to a 100% reserve backed system.
But guess what? This R&D is bound to be unprofitable. As real profit (not to be confused with short term paper profit in the up cycle of an economic cycle) is the only thing that drives economic growth and increases the amount of available resources (without profit, investment and savings cannot take place in the long run), unprofitable means the total amount of available resources has gone down.
Now, is it worth it that this marginal unprofitable technology is discovered before it would have been under a 100% reserve backed system? Well, let’s see at what it costs us:
- A smaller overall pie - the wasted capital and resources would have been put into investments with higher real returns, ones that were expected to be profitable based on ‘natural’ interest rates.
- The inflation of the money supply that funded these malinvestments transfers money to the hands of the bankers and those they lend it to (who benefit by spending this money before its value goes down) - ie a form of stealing has occured to fund these marginal investments
- In the long term, with fewer available resources due to a smaller pie, there will be less capital and R&D investment.
Do you think that some marginal technologies being discovered ahead of schedule is worth this?
You might want to read pages 409-417 (PDF pages 439-447) of Jesus de Soto’s Money, Bank Credit, and Economic cycles (if you can read the whole thing, it would help a lot more in your understanding of fractional reserve banking). It addresses whether expansion of the money supply can utilize ‘idle’ resources, which is basically what your professor is arguing if he believes that the creation of new money by banks can spur new investment - after all, increasing the money supply doesn’t increase the amount of capital or resources in an economy, it can only change who has access to them and how they are used.
http://mises.org/books/desoto.pdf
(warning: PDF / large document)
I just wrote a history paper on this very topic. Over the course of my research, I read Murray Rothbard’s America’s Great Depression. This book was eye-opening in showing the danger of national banks and credit exansion.
Menger covers it in his chapters on use and exchange value, price formation and money. I recommend you read the entire book to understand what capital is, what money is and so on. The chapters will not make sense taken in isolation. Callahan has chapters specifically devoted to money, capital and business cycles, although I can’t recall which they are right now, since he has rather ‘creative’ names for some of them.
Let me raise one extremely minor objection. The gold standard would not eliminate speculative bubbles, e.g., the Dutch Tulip Bulb Crisis. But under a gold standard, the malinvestment would be recognized and liquidated far more quickly.
To add to the fine responses to Inquisitive, there is a pool of real capital available to fund profitable endeavours that is accumulated through savings. Fractional reserve banking adds to the pool in nominal terms but in real terms, there isn’t any capital backing up the endeavours. Thus, this “bubble” part of the economy requires ever more nominal dollars to stay intact. Inevitably, interest rates and prices must rise and at that point, what is the “real” economy that keeps chugging along and what is the “bubble” economy that wouldn’t otherwise exist becomes apparent: houses, dot-coms, stocks, etc.
But what about private detectives and private military companies (PMCs) such as Blackwater that the government has employed in Iraq?
This post is very enlightening. Thank you, WisR. In essence you’re saying that in due time funding in a 100% reserve system would eentually go toward the needed research and development. But if research and development done sooner with fractional-reserves might save more lives in, say, the health industry, then it would seem the cost/benefit would be worth it because more lives are affected.
Hi Inquisitive,
You can draw the conclusions you want to, but in essence I’m saying that there is no market benefit whatsoever from marginal reserach funding from fractional reserve banking, when weighed against the costs.
Is it a good thing to save more lives, improve more lives? Sure - but at what cost? Is it a worthwhile tradeoff to:
- Steal a little bit from everyone through devaluing our money,
- Transfer wealth to bankers (who after all will receive interest payments on this money that didn’t exist before they created it, like a counterfitter who made some money and lent it out)
- Cause malinvestments and hence the business cycle and a smaller overall economy than would exist without such interference?
I don’t think so, and beyond the point you are destroying capital that could be used for future research when you distort the market to perform additional marginal research today. But good luck getting your professor to agree on any of these points, it’s hard to suddenly change your view of the world.
Actually, when reading through De Soto’s book, the main question that kept running through my mind was: Yeah, fractional reserve banking causes the business cycle and waste and all, but isn’t there a benefit to discovering new technology and processes ahead of when they would otherwise have been discovered? After a lot of thought and careful consideration, the answer now seems clear - the possible benefit is far outweighed by its costs.
WisR,
I agree with your assessment, although I’m still trying to understand it in the micro level with respective to any given industry. I downloaded Huerta de Soto’s book and read the parts you recommended. I’m also reading Menger’s Principles of Economics to try and articulate some things.
Inquisitive, you’re falling into the trap of omitting the unseen, and only accounting for the seen. What is seen are the allegedly obvious benefits of funding certain research at the expense of all other research. What is not seen are the distortions in the market this causes, the potential technologies and research (that might’ve been even more fruitful) that must be forfeit and so on. In addition, there are the very visible downsides to FRB that WisR mentioned.
So long as they’re being paid by tax dollars, they cannot really be called “private.”
This has got to be one of the most ignorant statements I’ve ever read on these forums.
But Blackwater employees get paid by Blackwater itself even though the government is their client. How can they not be called private just because the government is their customer? They are not under the purview of the U.S. military.
WisR,
I was reading Carl Menger’s Principles of Economics. On page 304 in one of the appendixes, Menger writes the following as he says money is also capital. I was wondering what your thoughts might be. Thanks!
The fact under developed trading conditions capital is usually reckoned in terms of money and also most frequently offered in the convenient form of money to persons requiring it, has resulted in capital generally being interpreted in ordinary life as a sum of money. It is plain that this concept of capital is much to narrow, and that a particular form of capital has been elevated to the status of the genus itself. On the other hand, the opposite error has been made by those who do not regard money capital as true capital at all, but only as representing it. The first of the two views is analogous to that of the mercantilists who regarded only money as wealth, while the latter view is that of a number of opponents of mercantilism who have gone too far in their opposition and do not even accord sums of money the status of true wealth.
Block and Barnett II have a paper that actually stipulates that money is a capital good. However, this again applies to sound money and in effect will not yield the conclusion you might want it to. In the case of a FRB system, you have multiple claims chasing the same goods. Increasing their supply will not alter the real variables in the economy. Under a commodity standard, money will only increase in step with increases in the commodity’s supply, and thus productivity. The latter may be said to be a capital good. FRB money is not.
How about this definition of money:
Money cannot but originate as a commodity, such as gold. Gold, then, as money, is defined as “the generally acceptable medium of exchange,” and as such is uniquely characterized by its “supreme salability in comparison with all other assets” (such that its “possession puts one in the position of being able to make any potential purchase with minimum inconvenience”) (White 1989, p. 247). Money substitutes, in turn, are defined as claims or titles to specified amounts of money (gold). If money substitutes (paper notes) are fully covered by reserves of money (gold), Mises denotes them “money certificates,” and we will refer to them here simply as money substitutes. If money substitutes (paper notes) are uncovered by money (gold), they will be referred to as fiduciary media instead.
So money substitutes are capital while fiduciary media isn’t.