Time deposits and the business cycle

Economics Economics Questions
1

This is a rephrasing of an earlier question that kind of veered off into ‘is fractional reserve banking a fraud’ direction. I’m studying Austrian Economics and trying to understand how a full reserve banking system avoids the business cycle when time deposits seem to suffer the same shortcomings as fractional reserve banking. So let me present my understanding of how money is created in a fractional banking system, how time deposits work in Austrian Theory, and hopefully someone can point out where I have taken a wrong turn.

In Fractional Reserve Banking, money is ‘created’ when a bank loans out a deposit and that deposit finds its’ way back into the banking system to be loaned out again, minus the fractional reserve requirement. For example, a $1000 deposit in a 10% reserve requirement system supports an initial loan of $900. That loan finds its way back into the banking system when the borrower purchases whatever and the sellers deposit the proceeds. There is now an additional $900 in deposits, supporting $810 in loans, which goes through the same cycle until the original $1000 deposit supports a total number of loans equivalent to ( $1000 + $910 + $819 + etc) = $10,000. More accurately, it is probably a little less as at each iteration some of the money is held as cash.

In Austrian Economics there is no lending of demand deposits, only time deposits. Presumably, there is no reserve requirement for time deposits though it doesn’t really matter. Now let’s say someone walks into a bank with a lucky $1,000 gold piece with what looks like a horse shoe scratched into its face. He deposits the coin into a one year time deposit and goes off on his merry way. A couple of minutes later, the bank loans this $1,000 gold coin to a customer, who goes out and purchases an ice cream machine with that coin. The ice cream machine maker rushes over to the bank and deposits the lucky $1,000 gold coin into a one year time deposit. Seconds later, the bank loans the same coin to another customer who runs out and uses the lucky coin to put a down payment on an organ grinder. The organ grinder maker rushes over to the bank and deposits the same coin into a one year time deposit. Moments later, the bank lends the very same coin to a customer who hires a barber to give him the world’s most awesome haircut, the same one John Edwards got. The barber then rushes to the bank and deposits the lucky coin, which the bank loans out.

It seems to me that this one lucky coin and one deposit of $1,000 is ultimately supporting the same pyramiding of loans as fractional reserve banking and the same creation of money limited instead of by fractional requirements, the amount that each person decides to hold in demand deposits instead of timed deposits and could be greater or lesser depending on the preference for time deposits to demand deposits.

If this is the case, then we are in fact back at the same starting point of credit creating money and therefore the business cycle.

So my question is what am I missing or getting wrong in Austrian FRB Theory? Someone referenced Soto earlier implying that this was a correct understanding, but I don’t pretend to know. I’m just trying to learn. Can anyone help me here and give me some direction? Thanks.

2

As far as can tell there’s no problem with your time deposit example. Money always changes hands many times; it’s a normal thing. Whether each successive person decides to use it for buying a hat or saving it in the form of a time deposit doesn’t really matter (even if somebody farther back down the road had already done this).

The only thing that matters is that there isn’t more than one person using a given sum of money simultaneously. That never happened in your example. Every time the money left one persons hand, it was gone, only to be used by the next.

3

That is, no new money/fiduciary media was/were ‘magically’ created.

4

Trying to answer your question : timed deposits do not create new fiduciary media so the money supply does not get inflated. That means there are no distortions in the price system and resources don’t get misallocated. Since there are no malinvestments (boom) no malinvestments need to be liquidated (bust)

5

I’m having a hard time grasping this point for some reason. In essence, what you are saying is that at the end of the iterations, 10% fractional banking has $10,000 in loans outstanding, $10,000 in demand deposits, and only the one $1,000 lucky coin sitting inthe vault. The time deposits have, let’s assume 90% -10% ratio of time to demand deposits to keep things simple, $10,000 in loans outstanding, $10,000 in one year time deposits, and $1,000 in demand deposits.

The main difference seems to be that in fractional banking the demand depositors can go and withdraw their money to spend on something instantly, while in the latter example, they have to wait a year to withdraw their money. So each time the demand deposits are withdrawn, the loan level has to be brought down to satisfy the 10% ratio again. But assuming they spend the money on something in the same banking system, it is then put back in the banking system, bringing the deposit- loan ratio back up to the original level. There has been a sort of equilibrium reached there.

It would seem that the main difference is the ability to withdraw deposits. But I am having a hard time understanding how this is an important difference. Obviously there is a perspective I’m not quite getting. If in both cases, an original $1,000 is supporting a multiplier in loans and a multiplier in bank deposits. Is this not the ultimate source of the business cycle?

I hate to seem stupid, but I guess its better to get it out of the way early and ask these questions so I can seem less stupid later on. Is there a specific passage somewhere that would answer this question for me?

6

We posted simulteneously. By fiicuary media, you mean M0, bank notes, coins etc? What is the difference between M0 and M1 in terms of not creating inflation and therefore malinvestments?

7

Edward nailed it down…

Let’s forget about the iterative process for a moment.

Fractional reserves :

You deposit $10 in a demand account. You can spend those $10 whenever you want. The bank uses your $10 thus : it loans out $5 to Smith and keeps $5 as reserves (reserves at 50%). So Smith has $5 he can spend right now and you believe you have $10 you can spend right now.

Your original $10 have somehow turned into $15 which can be spent now. If you and Smith try to use your money something has to give. Either the bank goes bankrupt or prices go up to reflect the fact that now more people are trying to purchase the same amount of goods.

Full reserves :

You put $10 in a timed deposit for a year. Smith borrows your $10 for a year. The total amount of money that can be spent during that year is $10. This system can’t go wrong, unless Smith fails to pay back, but that’s a problem inherent in all credit operations.

8

Thanks. I’ll think about that for a little while.

9

Moreover, that $5 may then again be deposited in another (or the same) bank, which will lend out another $2.50, assuming 50% reserves, this process can continue continually.

I suggest chapter 4 of Jesus Huerta de Soto’s Money, Bank Credit and Economic Cycles for a full description.

10

Congrats! You nailed it on your own. You are having hard time because there is none. There are differences in degree as demand deposits are more liquid, but the two things are basicaly the same.

11

I would hardly say they’re the same. I think a lot of people get confused because they have trouble reconciling how money can be created with a primarily demand deposit system like we have.

First, think of it differently. Suppose Smith puts 10 gold pieces in his bank and in exchange receives ten gold tickets (not an open account). Given that everyone is confident in his ten gold tickets, he can then go on and exchange those gold tickets as if they are really gold. Thus, they may circulate many times without anyone ever going to the bank and redeeming them (so the various receivers of the tickets don’t go to their own bank and deposit those tickets-- they just continue to use them like we use dollars). This allows for the original banker to lend out some of the real gold ten pieces, say 5 gold pieces. There has now sprung into existence five new gold pieces. Smith’s 10 gold tickets ciruclate as if they were ten gold pieces and Jones five gold pieces circulate as well (thus, there’s only 5 gold pieces in the bank), for a total of 15 gold pieces.

This does not happen with a time deposit. If you deposit 10 gold pieces for a year and in exchange receive a piece of paper which says, “this certificate is good for 11 ounces on X date (1 year from now)” you may only exchange that certificate/asset with others in accordance with the fact that it is not money but “credit money”, that is, an asset which is not immediately redeemable like the above example. Thus, no money creation results from this situation. There is no illusion created like there was with the money ticket example.

I think where a lot of people get tripped up is that when they try to extend the golden ticket example to our present circumstances, it doesn’t seem to apply. The way we use our debit cards doesn’t seem the same as exchanging the golden ticket numerous times without there ever being a withdrawal Everytime I use my debit card, my account, and thus my bank, are drawn down, and some other bank is soon equipped with more accounts.

But it has to be kept in mind that our system is not really a competitive system. All of the banks share a common reserve bank, the Fed. As a result of this, switiching money from one bank to another only switches who holds the reserves, it doesn’t switch the amount of reserves. If you consider this in the context of a single bank, it would be as if Jones wrote a check to Smith, and Smith simply went to Jones’ bank and had them switch some of Joe’s account to Smith’s account. It is obvious that this bank suffered no withdrawals, and that like the golden ticket example, the “open-account” or “debit” money exchanged hands without ever having to be the withdrawn. It circulated as if it were the real thing (in the modern example, paper dollars). Since we have a Central Bank Reserve, this is effectively what happens every time someone uses their debit card. The total amount of reserves aren’t drawn down, they are simply switched from one bank’s account at the Fed to another’s.

Now, it is true that, individually, banks may lose reserves and thus the ability to loan. But it has to be remembered that depositing and withdrawing are taking place simultaneously all of the time. Just because you just withdrew $10 doesn’t mean that the bank you withdrew from has to run and cancel out a bunch of loans so they fulfill the reserve requirement. It is likely that sometime soon $10 or more will be deposited so no action is required. Second, even if they are deficient in reserves at the end of the day, they can simply borrow from a bank with too many reserves, thus allowing them to not write down any of their loans (Federal Funds). Last, the fact of the matter is, the Fed may magically increase one’s reserves if it so desires without debiting a corresponding reserve. In this case, money is created simply by increasing the Monetary Base, and as result of this action, the effective money supply will increase ten-fold.

The only way for reserves to be drawn down, so that the whole money supply is required to contract, is when people actually withdraw from their accounts in the form of money and that money does not get deposited in any other account. Even then though, the Fed can simply remedy this by increasing the base correspondingly.

12

What, are they soft drinks or something ?

13

But you could still exchange those certificates as if they were gold. If there is a willing buyer the certificate is used as medium of exchange competing with the very gold it actually represents. Now this is the same with the ticket. Both are used as credit money. They are not gold coins but claims to them due some time in the future. With the cerrtificate it is a fixed date, with the ticket it is the time the holder bothers to redeem it in the bank.

14

Scineram’s ‘argument’ reduces to claiming that if people believe that pigs fly, then pigs fly. Yes, when the money supply is firstly inflated and ppl don’t know it yet, fake certificates trade as if they were gold. Now, when the scam is found out, paper trades at a discount. Of course, for FRAUD to be possible, ppl must think FOR A WHILE that things are not what they really are. Actually, that’s just what fraud is. To mislead people into believing things that are not true. Please stop advocating fraud. It’s quite annoying.

15

Credit money was the wrong word to describe the time-deposit certificate. Secondary media of exchange is what Mises referred to it as. There is money, which includes the real thing like gold, silver, fiat money (today), etc., and money substitutes like the tickets issued for immediately demandable real money deposits, and then there is everything else, i.e., goods. Bonds, securites, etc., like the time-deposit certificates, all fall into the goods category. Of course, there are many degrees of marketability among goods and these are of the most marketable, which is why they are referred to as secondary media of exchange. But they still exchange at a discount and they almost always must first be exchanged for money before they can be exchanged for other goods. As goods they are fundamentally different from money. Just because they are more marketable does not mean they serve as money proper (as money substitutes do).

Like Juan said, you assume away the very problem if you argue that the holder of the time deposit certificate tricks others into thinking it is an immediately redeemable certificate.

I suggest that you read pages 459-463 of HA, it should clear things up for you.

16

If they are traded in exchange then they are money by definition. That is why we have measures like M0, M1, M2. And they are not discounted, I have to pay the same amount of cash than with credit card.

I am not assuming anything. One matures at a fixed date, the other whenever it is redeemed.

17

That is a bizarre notion of money.

I think there’s a reason that Rothbard and Salerno constructed the AMS measure. They wanted to get a measure of what can be consistently defined as money. Just because M0, M1, M2 exist, that doesn’t for some reason prove their validity as all equally valid measures of the money supply. Are their differences not important? And are you saying simply you disagree with the Austrian notion of what the important determining characteristics of money are?

I believe the company that accepts your credit card receives from your card’s company the amount immediately, or nearly so. So that’s a bad comparison.

But this is the most important difference!!

18

See ? If Smith believes that 2+2 = 3, that means 2+2 = 3.

If Smith accepts a fake certificate and is a victim of fraud that mean that the certificate is authentic (he accepted it) so Smith is not a victim of fraud.

If you’re drinking a glass of water it logically follows you’re not drinking a glass of water.

And so on and so forth…

19

Money: 1: something generally accepted as a medium of exchange, a measure of value, or a means of payment

No disagreement. This just proves not only base money is money. Which was my point. There are qualitative differences between types of monies.

How would they? It just shows up in their bank account.

Not as important as you believe. And the difference does not have those implications you seem to believe.

20

Ding, Ding Ding, he shoots…he scores. Scineram very nice, absolutely it is so hard to figure out what the Austrians are saying because it isn’t true. The Austrians have created these artificial constructs and definitions that no one is actually required to be in compliance with so when it is obvious that there are alternatives to this narrow construct the whole thing doesn’t make sense.