15 Jun 2010

How Many Austrians Does It Take to Understand Fractional Reserve Banking?

Financial Economics 110 Comments

(We also would have accepted, “How many bankers does it take to screw over their depositors?”)

This is pretty funny. It took several blog comment exchanges before Steve Horwitz and I finally understood where the other guy was coming from. (And in fact, we’re still not in agreement on the basic facts. Ah well.) Let me bring you up to speed. In the comments of my latest Mises.org article on fractional reserve banking, Steve wrote (with my text interspersed):

One last round Bob, then back to work for me.

BOB: But if, on the contrary, what actually happens when a banker issues a new loan, is that he “magically” increases the number in the client’s account balance, then the 10% reserve requirement definitely allows the creation of a multiple amount.

STEVE: “Allows” in the metaphysical sense, sure. The banker can press whatever computer keys he wants. Or the free bank can tell the printing press to run faster to physically create more banknotes. But “allows” in the economic sense, no. Isn’t it the latter that matters? Gravity allows me to flap my arms and try to fly to the moon, but gravity will also put a quick stop to the experiment. Banks can try to create the 10,000 but economic reality will drive them into the ground. What’s the point of trying to make an economic argument by what seems to me like reference to a metaphysical notion of “allow?”

BOB: This is presumably so elementary to you that you don’t understand why I’m stressing the point, but *I* didn’t fully grasp this aspect of FRB until about a year ago. Because of the standard textbook treatment, I was picturing the banks getting $1000 in new cash, then handing $900 of it (in cash) to the borrower, etc.

STEVE: Maybe that’s YOUR weirdness then. 😉 Every M&B text I’ve ever used has made this point quite clear: when banks make loans they do so by creating an asset and a liability: the loan that borrower must pay back is the asset and the electronic credit to their account that the bank owes the borrower is the liability. This is as old as banking: one of the key entrepreneurial insights of the early goldsmith/proto-banks was that they didn’t have to lend out the actual gold they had on hand, they could just print up receipts equal to those excess reserves and lend those.

I don’t see the magical weirdness here as long as one recognizes my point above: the bank is economically limited to lending out its excess reserves and it does so by creating that liability. What the Fed does is a lot weirder as it can bring reserves into existence ex nihilo by making a bookkeeping entry. Banks, under free or central banking, cannot do anything like that. It’s the Fed that’s responsible for the multiplier process, not the individual banks.

BOB:Whatever else you want to say about it, that process [where the fractional reserve bank physically hands over $900 of Bill’s initial deposit to the new loan applicant] seems a lot less “weird” than the case where the bank just decides to increase its assets and liabilities with the stroke of a pen by granting a client a new loan.

STEVE: To you maybe! I think this is just some kind of “yuck” factor on your part as I just don’t see the weirdness. I think the Fed’s ability to create reserves is the thing that really is “weird.”

How would a 100% reserve bank create a loan off a time deposit? Suppose I give Rothbard Bank a deposit and want a one-year CD. Presumably RB can then lend that $1000 (let’s say) to a business for one year. Do you think RB is going to hand over the exact $1000 in gold I deposit? What if RB gave the borrower money certificates instead because the paper was easier to use? Is going down to the basement and printing off 10 $100 money certificates any weirder than creating a demand deposit at the stroke of a pen? And why couldn’t Rothbard Bank actually give the borrower a checking account? The underlying reserves are still 100% in the bank, but perhaps negotiable IOUs that can be written for a precise amount are more convenient?

In either the money certificate case or the checkable account case, Rothbard bank creates both a new asset and a new liability that is no more or no less “out of thin air” than what the individual bank does under fractional reserves, no? And neither case would involve fractional reserves given that the original gold is still there and untouchable by the depositor for one year.

And note: RB could print up extra money certificates or over expand its checkable accounts in that situation in the same way that FRB “allows” banks to create multiplied loans off a new deposit. But in both cases, there’s a reality: for RB it’s the law saying they must keep 100% reserve and for FRB it’s the economic law that says that adverse clearings will lead them into a breach of contract and a liquidity crisis. What’s metaphysically possible is not economically or legally permitted. I just don’t see the difference Bob.

OK as I said, I think we are actually getting close to the heart of the dispute. (Or at least, to the heart of one of the disputes.)

This is what really intrigues me: I can understand if you are a 100% reserve guy who hates fiat money, OR I can understand if you are a (market-based) fractional reserve guy who has no problem with the concept of fiat money. But what I don’t understand is how Steve (and the guy who went ballistic on my blog a few weeks ago against Rothbard–maybe Cargocultist but I can’t remember for sure) can agree with me that it’s mystical/weird/fraudulent for Bernanke to write a check “out of thin air,” whereas it’s perfectly fine for the bank to advance a $900 loan to Sally.

Before I tackle that issue directly, let me first say this: How can it be OK for the entire banking system to do it, if we don’t think it’s OK for an individual bank to do it? To repeat, in principle any individual bank could have created the full $9,000 in new loans pyramided on top of Billy’s deposit of $1,000 in currency. Let me put it this way: Suppose for some reason the bank knew that the customer wasn’t going to spend the new loan. Maybe the customer for auditing purposes needed to show that it had a bunch of disposable cash on hand, and so it opened an account with the bank with $9,000 in it, even though it’s for show. (“Hey look, we’re a stable business. Why, we’ve got a $9k checking account at the local bank; we’re here to stay.”) In that case, would Steve agree that the first bank was fine to create the $9,000 in new loans in one fell swoop?

But let’s push that aside and go to the crux of the matter: Steve is seeing a world of difference between Bernanke writing a check for $900 drawn on the Fed, when he buys $900 worth of government securities. In contrast, when the commercial bank makes a $900 loan to Sally, Steve thinks that is perfectly legit.

What’s the difference? In the case of the Fed, it too is “merely” adding to its liabilities and assets. It buys $900 worth of Treasury bonds, and it creates $900 in new reserves–claims on the Fed–which technically are Fed liabilities.

So the difference between Steve and me (I believe) is that he is looking at the regulatory process (I don’t mean government regulations, I mean the forces regulating this activity which include market forces), whereas I’m looking at the essence of the transaction. In the same way that it seems weird/magical/fraudulent to me that Bernanke can simply buy assets by writing a check on himself, it seems w/m/f to me that a bank can all of a sudden acquire a $900 loan owed by Sally just by crediting her account with $900 in claims against the bank, when those claims are treated by the community as interchangeable with money proper.

Yes, Steve is right that under “free banking,” by which we both mean a market where property rights are enforced and no central bank props up failed banks, there would be no problem. But I think that’s because market forces would drive banks to 100% reserves.

To repeat an old analogy: I don’t think the government courts or police need to punish shoplifting. I think in a free market, stores would install cameras, hire security, etc. in order to drive down the incidence of theft to negligible levels.

But that doesn’t mean “theft is OK so long as it isn’t propped up by the government.” It doesn’t mean that I am just imposing my idiosyncratic preferences on the world by insisting that theft PER SE is bad and that it disrupts the market.

So same thing with fractional reserve banking. We can see that it is weird/magical/fraudulent when the government makes it happen “a lot.” I don’t think it’s analogous to the government causing house production to be higher than optimal, I rather think it’s analogous to the government causing “total amount of theft” to be higher than would occur in a free market.

110 Responses to “How Many Austrians Does It Take to Understand Fractional Reserve Banking?”

  1. J Cortez says:

    To my mind, the only thing that would ever make FRB ok is if there was consent of the depositors. If somebody understands and consents to inflation via fractional reserves, I can’t see how that can be theft.

    The current system is total theft as there’s nothing voluntary about it. There is some competition in money, but mostly fiat monies and no commodity money alternatives. If there is anything worthwhile, regulations and taxes make it less attractive. The system is set up against every one except the connected players.

    I don’t think free banking would drive the system towards 100% reserves. I don’t know what the ratio would be. I’m inclined to think it would be much higher, but I remember George Selgin talked about Scottish free banks as being around 2%. I don’t know all the details, so maybe what happened then couldn’t happen anywhere else, but who knows?

    • Doc Merlin says:

      The higher the trust level in the currency issuing bank, the less competition it has for the same customers, the larger it is, and the fewer odd legislative barriers in the system, the lower your ratio can be before you run into problems.
      Also, in order for people to buy your money, you must make it better than gold in some way. IIRC from Selgin’s book the Scottish bank’s tokens were well preferred over gold to the point that in some areas, no one would accept crown gold coins.

  2. Doc Merlin says:

    ‘But I think that’s because market forces would drive banks to 100% reserves.’

    History disagrees with you. The Scottish free banking experiment showed they kept far less than 100% reserves.

    One interesting thing is that the larger the bank, the less reserves they should need to keep, because more of their depositors are paying another of the bank’s depositors with a demand deposit from that same bank, so it doesn’t actually need to create new liabilities or assets.

  3. Jon O says:

    Just to make something clear: a bank is not restricted in the amount of loans(money) they can create, the banking system as a whole is(temporarily). As long as there is demand for loans a bank can expand their balance sheet ad infinitum, by bidding up reserves from the market(attracting new depositors) or from the inter-bank market. If enough banks start borrowing in the interbank market the effective fed funds rate will rise and the fed will either have to raise rates or defend the rate through temporary open market operations (REPOs), thus expanding the reserves of the banking system.

    This is why we’re not seeing broad money growth at the zero-bound, despite the fed blowing up the monetary base. Private borrowers are tapped out and are not demanding new loans even with longer term rates near historical lows.

    The two major issues with FRB are :1) customers believe their demand deposits are being whare-housed and are available on demand and 2) the banks entire business model consists of one giant duration mismatch where short term liabilities are used to support long term assets. #2 is exactly what Lehman was doing in the REPO market before there was a run on the (investment)bank by their counterparties…

  4. Contemplationist says:

    Bob

    You can simply check whether the most free-market banking system in history – the mid 19th century Scottish banking system drove the free banks to 100% reserves. My guess is not, so you could rethink that assumption. I have zero problem with fractional reserves as long as its done in the context of a free banking system.

  5. scineram says:

    You disagree because your scenarios make no sense. Bank accounts are not loans to depositors, they are loans to the bank. Banks do not create such liabilities just because. You were confusing currency and deposits already in step 2.

  6. ADA says:

    Those of you insisting that the Scottish system was free, should really have your sources and facts checked:

    http://mises.org/journals/rae/pdf/rae2_1_15.pdf

    But I have long stopped expecting people to actually be more reasonable and less religious on this issue. The fact is that 90% of the people who participate in this debate don’t give a crap about the validity of their theory or history. They except their position in blind faith and just sort of gamble that all opposition is wrong.

  7. Seth says:

    ADA,

    I have long enjoyed this piece by Rothbard. Thank you, kindly, for posting the link here.

    Bob,

    I simply cannot fathom the thought process of Horwitz. The questions you raise are perfectly legitimate, and otherwise, sensible.

    • Steve Horwitz says:

      Seth,

      I never said Bob’s questions weren’t legitimate or sensible. I consider Bob to be among the most sensible critics of FRB and free banking. But just because his questions are legit and sensible doesn’t mean that his answers to them are right.

      And if you can’t fathom my thought processes, then you can’t fathom the thought processes of almost every monetary economist on the face of the earth and the majority of Austrian economists with PhDs. We could all be deluded or insane, but I doubt it. Perhaps our thought processes are okay and the problem lies with how well you “fathom” them. 🙂

      There IS such a thing as honest intellectual disagreement among smart people after all.

      • bobmurphy says:

        By the way, since we’re kissing and making up, let me acknowledge that after I posted this, I realized that (of course) what the Fed does is “weirder” than what the commercial banks do. So Steve, I can understand why think it’s crazy for Bernanke to create new reserves out of thin air, whereas you don’t see a problem with a commercial bank creating demand deposits out of thin air (because they are constrained by calls on reserves).

        Even so, I think it’s the same basic problem. Bernanke creates high-powered money out of thin air, the commercial banks create regular money out of thin air. It’s weird, I tell ya…

        • Steve Horwitz says:

          Yeah, but that’s a difference that MATTERS Bob. It’s true, again metaphysically, that banks create it “out of thin air” by creating a liability against themselves, but they can only do so on the basis of a previously acquired asset, namely the excess reserves that came in via a deposit.

          What the Fed does is create a liability against itself with absolutely nothing having previously been acquired. Zero. When it buys bonds, it doesn’t need to acquire anything first, it just writes a check off of itself (essentially). Banks that make loans with bookkeeping entries are still constrained by having acquired the excess reserves.

          Think of it this way: in the most simple model, the Fed’s asset side consists pretty much of the *things it buys with the money it creates.* The money comes first, then come the assets. For FRBs, their asset side consists of both “outside money” (cash/gold and deps at Fed/clearinghouse, which under free banking are real stuff) and the loans they create after having acquired a deposit from SOMEONE ELSE. FRBs gain assets (loans) by using funds acquired elsewhere; the Fed creates the very funds it needs to buy its assets.

          The Fed is engaged in weirdness. The banks are just trusted enough to be able to write new IOUs on the basis of previously acquired assets.

          • Doc Merlin says:

            That is not the problem. The problem isn’t that they create assets out of thin air, you do that every time you lend anyone money. Their promise to pay is an asset you can trade to someone else, and they have a liability to pay you.
            The fed isn’t engaged in weirdness. Its debts work exactly the same way, it does create new money but the money is only worth something because they keep the total money creation relatively low.
            For a money issuing bank, their dollar bills /are/ their liabilities.
            The real problem (as Hayek noted) comes from the fact that the Fed doesn’t have domestic competition. This means market forces aren’t setting the money supply, but central planners are.

          • Doc Merlin says:

            “The banks are just trusted enough to be able to write new IOUs on the basis of previously acquired assets.”

            That is exactly what a central bank does. It buys assets with its liabilities, the “IOU” notes, that have an expected future value. If they issue more than people expect, people will switch to other assets. (Remember one man’s asset is another’s liability.)

          • bobmurphy says:

            One more and then I think I’m done, for this battle. But the war rages on…

            I get what you’re saying, but of course the Rothbardian response goes like this: Those assets are already spoken for! So yeah, the commercial bank (in my example) got $1000 in assets, and it had a corresponding $1000 in liabilities (Bill’s checking account).

            Now, if it wants to expand its liabilities by another $900 by lending money to Sally, what pops up on its asset side?

            Why, the $900 loan to Sally!

            So that part of the operation seems very similar to what Bernanke does.

            I mean, maybe we can say it like this: You agree with me that 0% reserves (i.e. what the Fed does) is weird. We both agree that 100% reserves wouldn’t be weird.

            So I am saying that x% reserves is also weird, just not as weird as 0% reserves.

            For some reason you think the borderline of weirdness occurs at some point where 0 < x < 100%. 🙂

          • bobmurphy says:

            BTW I don’t know why the smiley faces are appearing on the left margin. I am placing them in the body of the text…

          • Current says:

            The “wierdness” of the central bank is that it’s asset pool is effectively infinite. It is backed by the taxpayer.

      • ADA says:

        I would say that the majority of economists with PhD’s certainly won’t fathom your thought process either, so what’s with the resorting to sheer number of economists and authority? If that’s the case then all of us here are insane.

        Also, I’m curious how you count your Austrian economists?

      • Seth says:

        Steve,

        I did not intend any sore feelings. I actually admire a good portion of your work, as well as your defense of many of the tenants of libertarianism. More than likely, in my haste to post my comment in between tasks at work, I chose to use words that were not fitting. You are correct in that these debates are healthy and honest. These debates should also remain civil and intellectual.

        I certainly don’t wish to turn this comments section into the bloodbath of vitriol that MIses.org seemed to morph into not so long ago. To be quite honest, I was more frustrated with the people purporting that Scotland had free banking in the 19th century, than of your talking points in conversing with Bob.

        I do not wish to hand the debate over to you 😉 however, I suppose my issue is the logical contradiction that FRB seems to inherently posess.

        Walter Block elaborates on this logical contradiction in numerous debates and articles. It has been quite a long time since I looked at his stuff regarding FRB but I believe I have one link where he explains this logical contradiction.

        http://www.lewrockwell.com/block/block111.html

        Also, I thoroughly enjoy Frank Shostak’s pieces over at Mises.org. Does anyone know Frank’s position on FRB?

        Again, Steve, my apologies for my improper words yesterday. I do fathom your thought process, but, like many people who feel passionately about a given topic, I chose to arrogantly ignore and otherwise toss aside your position. Thank you for kindly correcting me.

        Post Scriptum I do hope these arguments, as well as money supply definition debates can continue, though hopefully in a civil manner of discourse.

  8. azmyth says:

    I’m glad to see this post. FRB is weird, but I don’t see a reason to ban it outright. Something is fraud if and only if it deceives someone. People don’t understand that banks are taking risks with their money today because of deposit insurance – they have no incentive to educate themselves. I think under free banking, people would rapidly become educated about the risks they faced, or they would choose full reserve banks. There would not be all of one kind of bank or all of the other. Markets produce a wide variety of goods and services based on individual’s preferences. If someone wanted a bank to make loans with their money, they could give money to a fractional reserve bank, if not, full reserve would suit their needs better. Banks losing someone’s money due to bad loans is not any more fraudulent than a mutual fund manager losing their customers money due to buying bad stocks (if they do not misrepresent their product).

    • Current says:

      > If someone wanted a bank to make loans with their money,
      > they could give money to a fractional reserve bank, if not,
      > full reserve would suit their needs better

      Incidentally, I think you’re right about this. In a free system people would have to know something about the likely solvency of a fractional reserve bank. Some people could never figure that out, so full reserve banking, or holding coins, would be a better fit for them.

      I think FR banks would make their finances more easily understandable in order to reassure those on the marginal boundary.

  9. J Cortez says:

    ADA, didn’t the 2nd edition of Larry White’s Free Banking in Britain answer Rothbard’s critique?

    The Scottish system was as close to a free system that ever existed. Was it completely ideal? No, but that didn’t mean it was a useless episode in history that had no lessons to learn from.

    • ADA says:

      Oh yeah, great response. “as close” is a rather meaningless subjective measure. Don’t you think?
      It is then a form of intellectual dishonesty go go around and declare that history has proven this or that, or whatever…

      As far as the historical evidence is concerned, free banking in Scotland is a myth regardless of how you want to measure it as compared to other systems. Some basic minimal criteria would have to at least be met for us to even consider it as a valid free banking example. Rothbard clearly showed that the system lacked any such criteria. If you have some valid counter-argument as to why Rothbard errs, then by all means, share it with us.

      • azmyth says:

        Close is all you ever get. There has never been an ideal free market anything ever. All comparisons are subjective as well. The best we can do is look at similar situations and try to infer what is likely if we try something close. There has never been a totally laissez-faire full reserve banking system either. That doesn’t stop people from advocating it.

        • ADA says:

          Are you disagreeing with me or what? I can’t even figure that out since I have no clue to as why that response has responds to anything I’ve said.

          • azmyth says:

            I’m not disagreeing with your conclusions, I’m disagreeing with your tone and approach. Claiming your opponent’s arguments are “not objective” and “dishonest” does not advance the debate. You have to say what specifically disqualifies the Scottish banking system from being “free” and why that matters.

        • Roger Ritthaler says:

          Is a “flea market” close enough?

      • scineram says:

        That is just rant and misrepresentation. Free bankers explicitly rejected needs of trade doctrines for example.

        As far as historical evidence goes, rothbardians have exactly 0%, but ingoring that they are able to push false theories.

      • Current says:

        Someone wrote something similar on the Mises blog, I’ll repeat what I wrote there…

        I often here the argument from Communists that the Soviet Union was not a *sufficiently* Marxist place. That the Soviet leadership deviated from the path of true Communism. These Communists claim that if there had been “True Communism” then everything would have been sweetness and light. I find this dubious because although it’s quite true that the Soviet Union wasn’t true communism it was the nearest historical example we have.

        This is the problem with your argument. If we reject all historical examples where there wasn’t a “truly free market” then we have no historical examples remaining.

        The relevant historical fact here is that in the historical situation that is the nearest we have to a free market fractional-reserve banking prevailed even though 100% reserve banking was quite legal.

        If you reject historical evidence then surely we can still discuss the theory? Supporters of free-banking don’t claim that the history is the only evidence. We have a theory for why fractional-reserve free-banking works. If you don’t want to discuss history then the argument comes down to which theory is the most robust. So, what’s wrong with our theory?

        • ADA says:

          Nobody rejects historical evidence. Only the claim that you have such evidence to support your thesis. It doesn’t appear to be the case since I still haven’t heard a single counter argument against some of the major critiszms in that article.

          It sounds as if you are all saying: Well, Rothbard is sort of correct, but there is no perfect. It’s close enough for us.

    • Steve Horwitz says:

      Yes, Larry responds to Rothbard’s criticisms in the second edition. Perhaps people like ADA who shoot their mouths off about what others do and don’t know might like to take a closer look at that before claiming the case is closed while complaining about how close-minded everyone else is.

      • ADA says:

        Well, first of all.

        Why is it that your side always resorts to “this guy already responded in this book…” and “I talk about it in this book…”, etc… without ever being able to just make some good counter points that actually debunk the dame thing or punch a few holes in it. People on your side in responding to this ciritizm are not making any convincing points that make you just jump out of your chair and seek this rebuttal.

        And where is this response to Rothbard that Larry responded to. Can you please post it on your blog or provide a link, or at least take some of Rothbard’s main criticism and punch a few holes in them.

        • KP says:

          “Why is it that your side always resorts to “this guy already responded in this book…” and “I talk about it in this book…”, etc… without ever being able to just make some good counter points that actually debunk the dame thing or punch a few holes in it. ”

          Even free bankers need to make money, if you’d read their books you’d know that.

          • ADA says:

            I’m sorry, I didn’t know Steve shows up ever once in a while to simply promote his merchandise.

            Please, you presume to know too much.

        • scineram says:

          Well, you did just that. Linked an article and done with it.

        • Blackadder says:

          “Why is it that your side always resorts to “this guy already responded in this book…” and “I talk about it in this book…”, etc… without ever being able to just make some good counter points that actually debunk the dame thing or punch a few holes in it.”

          Given that your own response to the Scottish example was to simply cite an article Rothbard had written, this seems like a fairly weak argument.

        • Current says:

          Let’s look at what you’ve done in this thread. You’ve begun by saying “read this paper by Rothbard on Mises.org”.

          Then you’ve had a go at Steve for saying “Larry addressed this in his book”. That is supposedly not a good enough standard of argumentation, he should repeat his points here. Well, if he should then surely you should repeat Rothbard’s.

  10. Rui says:

    Prof. Murphy,

    I have recently been intrigued by the issue of fractional reserve banking and money creation/circulation when I read Mish’s blog stating that loans creates deposits and not the other way around – a position that is quite similar to Chartalists or MMT; so in essence, this debate appears to be focusing on an issue from the wrong side.

    I have also been readin Prof. Warren Mosler’s blogs and publications explaining MMT; it supposedly is a theory based on double-entry accounting indentities and justifies deficit spending and so forth in order to stabalize the economy, an issue that you appeared to discuss extensively in your book about the Great Depression and subsequent articles on Mises.org. However, from looking at both your positions, all I can conclude is that you both use similar statistics to solidy your argument, which is one reason that I find it very difficult to truly trust economic theory beyond some basic theories.

    Maybe a debate between the two of you will be a wonderful thing

  11. Alasdair Macleod says:

    Bob

    I am somewhat confused by this debate, so please excuse me if I miss the point(s) entirely.

    I think you are saying that commercial banks create credit. They don’t.

    If a bank takes a deposit, it is free to lend it out, which it usually will, if not to a borrower, to another bank through the wholesale market. Similarly, if a borrower initiates the transaction, it will be covered from other customers’ deposits on the same day, or by borrowing through the wholesale market.

    No money is created, because it already exists. The degree to which a bank can expand its balance sheet is limited by prudence and/or FRB rules, and/or the relationship between the overall balance sheet and the bank’s own money. This ratio does not lead to money creation, but merely limits the business gearing of the bank.

    Money or credit appears to be created when a borrower takes the borrowed money from Bank A and deposits it in Bank B. Both banks then make a statistical return for the same funds. This gives the appearance of credit creation, which only goes to show how useless banking stats can be in trying to understand / regulate the real world.

    • bobmurphy says:

      Sorry but I think this is simply wrong. In the simple example in my article: When Sally gets the new loan, there is $900 more in the community than before. She goes around, spending that money, and nobody else has to restrict his purchases.

      After Sally pays back her loan, if the bank sits on its excess reserves, there is then $900 less in the community.

      When you pay off a loan to the bank, the amount in your checking account goes down. But if it’s in the same bank, then it’s not like the bank’s account (with itself) goes up. That money just disappears from the system.

      • Alasdair Macleod says:

        Bob

        My past experience is as a director of a bank in Europe under a regulatory system that takes its cue from Basle rules, so I have no working experience of FRB, though for the purposes of this debate I can see little practical difference.

        We never created money. We had deposits and loans as well as the bank’s position in various activities, and in the late afternoon we would go to the interbank market to borrow or place the balance. Essentially, as a bank we were merely intermediaries (masquerading as principals), and the purpose of our own capital was to provide cover for the risks in our business in accordance with banking regulations. FRB is designed to do the same thing.

        Your example of Billy’s deposit is unusual. Almost all banking is recycling money that is already in the economy one way or the other. It is far more likely that Sally’s loan is funded by deposits already in the system, and when she repays it to the bank, the bank will at the very least be able to reduce its balance sheet. If the bank chooses to do this, it will also be able to reduce borrowing from its own depositors or from the interbank market. The funds released do not disappear, but are reused by depositors for other purposes, or redeposited at another bank.

        Very rarely does Sally’s repayment end up being hoarded by someone else; If it is hoarded, then I agree to the extent that money is temporarily taken out of the economy.

        • bobmurphy says:

          I hesitate to challenge you since I am an economist whereas you were actually in banking, but I really think you are not understanding what I mean when I say banks “create money” under fractional reserve banking. You say that my example is unusual, but on the contrary that is literally the textbook description (at least in US textbooks) of how FRB works. E.g. look at Steve Horwitz’s commentary above.

          You’re right, in a sense what the bank in my article did was to take Billy’s deposit and lend 90% of it to Sally. But the point is, Billy’s checking account didn’t go down by $900. So before the loan to Sally, the amount of money in the economy was X–the holdings of everyone besides Billy and Sally–plus $1000. Then after the loan to Sally, the total amount of money in the economy was X+$1900.

          Let me go the other way: Are you familiar with what happened in the US in the early 1930s? The quantity of money declined by about 1/3 from 1929 to 1933. This is partly why prices fell so drastically. The reason wasn’t that the Fed consciously destroyed reserves. Rather, what happened is that there were bank failures and so panicked depositors took their money out of the banks, preferring to hold dollars in the form of physical currency rather than checking deposits.

          But this destroyed money, because a given bank deposit was the basis for a multiple of checking balances. Using rough numbers, if $1000 in currency in a bank vault had been serving as the reserves for $10,000 in customer deposits, then when someone showed up at the bank and withdrew $1000 in currency, that meant $9000 in other customer deposits had to be eliminated. So the bank would tighten credit, not granting new loans and leaning on borrowers to repay their outstanding loans.

          So to repeat, I will fully admit that you understand the day-to-day operations better than I do, but I think you are not grasping the “big picture” if you don’t see there is a very real sense in which the banks create money. Last piece of evidence: Look at the definition of the monetary aggregate M1. One of its components is demand deposits at banks. So clearly, if demand deposits aren’t 100% backed by currency in the vault, then the banking system can influence the total size of M1 (and M2, M3, etc. since they include M1).

          • Alasdair Macleod says:

            We have an interesting conundrum. I shall have to think hard where banking ends and economics begins….

          • Alasdair Macleod says:

            Bob

            I think I’ve got it. You are saying there are two claims on the same money.

            That is undoubtedly true, and could be described as “credit”.

          • Current says:

            Alasdair,

            In the 19th century there was a British school of economists called the “Currency school”. You’re reinventing some of their doctorines here, and some of their rivals the banking school.

            The problem with the “two claims to money” idea is that the claims serve the purpose of money too. As Mises says Bread-tickets can’t serve the purpose of bread but money-tickets can serve the purpose of money.

            For this reason Mises splits money three ways.

            Money-in-the-narrower-sense is cash.
            Money substitutes are on-demand bank accounts (and banknotes too in the 19th century). Money-in-the-broader-sense is the sum of the two.

        • Doc Merlin says:

          Basel is an FRB system as are all banks in the western world.

  12. Michael Suede says:

    A widget maker produces a widget from working raw materials he extracted from the Earth.

    The market says his widget is worth 100,000 dollars.

    Consumer Fwank says, “I have no money, but I must have a widget now! I can not wait to have a widget later!”

    Mr. Fwank goes to the bank.

    Banker Bill says, “OK Mr. Fwank, I only have 10,000 dollars worth of assets in my vault to lend you, but through the magic of fractional reserve banking, I’m allowed to issue you a loan recipt for the full 100,000 dollars as long as you pledge the widget as collateral on the loan.”

    Praise Mao!

    Mr. Fwank is very happy.

    Banker Bill now enters the “asset” of a 100,000 dollar widget into his ledger and a liability of 100,000 in the terms of his loan.

    Does anyone see a problem here?

    What happens if Mr. Fwank defaults?

    Banker Bill gets the widget, which he never really gave up ownership of in the first place. He simply let Fwank have it as long as Fwank promised to keep making regular payments, until such time as Fwank finished paying him back.

    But did Banker Bill have a right to issue a loan to purchase that widget in the first place? – on top of this, Banker Bill gets to charge interest on this loan.

    Am I missing something here?

    What happens if the widget is an asset that gains in value over time at a rate faster than the interest charged? Isn’t it in Banker Bill’s best interest to see that Mr. Fwank defaults, since Banker Bill can then sell the widget for a profit?

    For example, the criminal congress decides it needs money to buy votes, so it tells the treasury to issue 1 google of treasury debt, which the Fed buys by creating money out of nothing. Now the widget, which is a real tangible good, will suddenly be worth far more far faster than the terms of the loan return in nominal terms.

    I must be missing something here because such a system seems indefensible.

    • bobmurphy says:

      I think this is basically right, but you might be exaggerating the benefits to Banker Bill. That outstanding $100,000 is going to come back and bite him. E.g. he might have to sell off the widget to raise the cash to pay off the claims on his bank assets.

      So it’s not as if he had a printing press and created $100,000 free and clear, with which he (indirectly) bought a $100,000 widget.

      Likewise, in the example in my article, the bank didn’t pocket the $900 it “created out of thin air,” instead it just pocketed the $45 in “old” money that Sally paid in interest on the $900 loan.

      • Doc Merlin says:

        Even if he had a printing press and was making money “free and clear.” He would still have problems because of trust issues for the future value of the notes he issued, if he made the habit of issuing too many. If his money is based on redeem-ability for some other asset then his troubles will come very soon. If his money isn’t based on redeem-ability, then what happens is more gradual, over time.

  13. KP says:

    “I’m sorry, I didn’t know Steve shows up ever once in a while to simply promote his merchandise.”

    Its not like books on free banking are just flying off the shelves, hes got to promote it somehow.

  14. Steve Horwitz says:

    Hey I’m not promoting MY book, but Larry’s. And Larry is available for free at the IEA site. So this whole ad hominem (which the 100% reserve crowd seems to specialize in) is irrelevant. Go read it for free.

    The problem, frankly, is that I’ve found that free banking types have read a lot more of the 100% reserve arguments than the defenders of 100% reserves have of free banking. It’s really good to have actually read the arguments you think you’re criticizing.

    And I count my Austrian economists quite well, thankyouverymuch. I’m willing to bet that among the PhDs economists who are members of the Society for the Development of Austrian Economics (which is the professional society for Austrians), only a small fraction think fractional reserve banking is inherently (as opposed to under central banking) problematic. That’s a Society of about 100 dues paying members, most of whom are PhDs or upper level graduate students who are near PhDs. That’s how I count. How do you guys count?

    • ADA says:

      So I’ve read the relevant part in White’s rebuttal to some of the criticism. What is interesting is that Larry clearly acknowledges some of the allegations although brushes some of them away by down playing their significance. I can’t right now get an honest assesement of how justified these responses are by Larry.

      Yet my first impression is that some of his attempts to debunk the criticism are rather unsatisfactory. For example, he acknowledges that the Bank of England played in some instances a lender of last resort but only ex-post and not ex-ante. So in other words, according to Larry, there is no proof that it played the role of lender of last resort ex-ante, which according to him is what really matter. But this is like saying that the federal government didn’t announce ex-ante that it would bail out Freddie Mac and Mae. So in that case, Freddie Mac/Mae were operating as if they would get no bail out? Come on..

      Also, he mentions that in one instance, the bank of England did not bail out the Scottish banks but instead, they bailed out directly the firms that had accounts at those banks. He even acknowledges that that the Scottish banks had made the request for the bailout. Yet, Larry doesn’t consider this as a significant example of the bank of England acting as a last resort.

      Look, since it seems that even Larry acknowledges that Scottish banking is not really “free banking” but simply “more free” then the English banking system, then whether these differences were indeed significant enough and whether the Scottish banking did really perform better, is indeed a relevant and interesting topic. But it is no proof of “free banking” out competing 100% reserves. And when it is simply asserted that history proves it or that free banking in Scotland proves it, then it is indeed bordering intellectual fraud because it is simply not true. The evidence is much more grayish then White. Ha.. get it… more grayish then “White”?

  15. Yogi says:

    Fractional Reserve Banking is definitely fraudulent.

    The bank has a contract with all its depositors saying that they can withdraw their money at any time. It is a CUSTODIAL contract (I will hold this money for you) not an ALEATORY contract (I will give you X amount of money if a certain event happens).

    By lending out the depositors’ money, banks have turned what is a custodial contract into an aleatory contract. (De jure: I will hold these $1000 dollars for you …… De facto: I will pay you $1000 if everybody to whom I owe money doesn’t come to collect at the same time)

    • Alasdair Macleod says:

      It is not a custodial contract, because ownership of money deposited passes to the bank. The depositor is left with counterparty risk, and should assess whether or not the bank can repay the deposit before making it.

      • Daniel Hewitt says:

        The ownership of the money passes to the bank only because there are laws that enable it. Rothbard covers this in The Case Against The Fed. Reference the chapter “Problems for the Fractional-Reserve Banker: The Criminal Law” from the link below.

        If you have the time, I think all of us non-bankers would benefit from hearing a real, live banker’s criticism of this chapter. Do you agree with Rothbard? Why or why not?

        http://mises.org/books/fed.pdf

        • Alasdair Macleod says:

          Daniel
          A quick look at Rothbard’s chapter on the FRB banker tells me that his argument is fundamentally correct, and in the real world will apply with a vengeance in a systemic collapse. By the way, I think this is now inevitable, and we are actually seeing it begin in Europe.

          His basic argument is that banking itself is a fundamentally insolvent business, since it relies upon depositors not withdrawing their money en masse. I agree. It is for this reason that a prudent banker ensures there is a diversity of deposit-taking business on his balance sheet. This minimises the risk of Rothbard’s example of Ace construction / Curtis Cement, which is a disproportionate commitment for the bank.

          Another defence is to grow the bank over time to be too big to fail. This guarantees that if this go wrong, the state has no alternative but to support you. For smaller banks, government deposit guarantee schemes make depositors complacent.

          Also, when banks are under stress, the Fed steps in and injects liquidity into the system. It does this all the time, but did so spectacularly when the interbank markets seized up in 2007, and on the Lehman collapse. So long as the Fed continues to print money to underwrite/replace credit, we don’t have a banking problem (we have to hope this is true).

          Of course, this is pure monetary inflation, to which the Fed is entirely committed, but that is another story. In short, I think Rothbard is about to be proved spectacularly right as financial risks are intensifying.

          • Daniel Hewitt says:

            Cool, thanks for weighing in Alasdair. I think, once the terminology is cleared up, that your view is more or less Austrian.

        • Current says:

          Daniel,

          The FR banker is only breaking the law if he *claims* that he is a custodian of cash.

          I agree that historically account contracts and note contracts have often been unclear. (They have also being sometimes quite clear).

          But, that’s only an argument for cleaning them up. It’s an argument against dishonest FRB, not honest FRB.

  16. Michael Suede says:

    After thinking about this for a while it seems clear to me that debate and criticism over fractional reserve banking is fairly pointless.

    We know its wrong because the market says its wrong.

    If we removed all government from the equation, in terms of fiat currency, legal tender laws, central banking, deposit insurance, regulations, and especially taxes on money, the system of banking that arises is not naturally one of fractional reserves fiat lending.

    People always migrate toward commodity backed currencies unless forced at gun point to accept unbacked paper.

    We know from this fact alone that unbacked paper is wrong, thus we know that any system of banking based on unbacked paper is wrong.

    This does not necessarily preclude fractional reserve gold backed banking, but when we look at how this plays out in the market, we can say fractional reserve gold backed banking is also wrong.

    When bankers lend out gold receipts at a rate over which they can fulfill delivery obligations, they become insolvent. This very thing caused bank runs in our past, which is the market telling bankers “don’t do that”

    The market is clear on this matter.

    • scineram says:

      Proof by assertion!

      • Michael Suede says:

        Where’s the contradictory evidence?

        I see none.

        Thus it is not proof by assertion.

        When markets are left to their own devices, commodities are used as money.

        History is quite clear on this, there is no evidence to the contrary.

        When commodities are used as money, fractional reserve lending becomes problematic and is reigned in by market forces.

        History is also quite clear on this fact.

        Its also clear that fiat currencies require legal tender laws, which require violence to enforce.

        If you have evidence to the contrary, I’d be happy to take a look at it.

        • Current says:

          > History is quite clear on this

          No it isn’t. Read Larry White’s stuff on Scottish Free banking.

    • KP says:

      “If we removed all government from the equation, in terms of fiat currency, legal tender laws, central banking, deposit insurance, regulations, and especially taxes on money, the system of banking that arises is not naturally one of fractional reserves fiat lending.”

      Because there is soooo much evidence of governments removing themselves from the equation?

      “People always migrate toward commodity backed currencies unless forced at gun point to accept unbacked paper.”

      What about Somalia?

      “This does not necessarily preclude fractional reserve gold backed banking, but when we look at how this plays out in the market, we can say fractional reserve gold backed banking is also wrong”

      Where are you looking exactly? What free market do you have to prove your assertion?

      “When bankers lend out gold receipts at a rate over which they can fulfill delivery obligations, they become insolvent. This very thing caused bank runs in our past, which is the market telling bankers “don’t do that””
      Its the market saying don’t do it carelessly. This line of thinking would lead to the market condemning any contract involving uncertainty.

      • Michael Suede says:

        How about Zimbabwe as an example instead.

        http://www.youtube.com/watch?v=7ubJp6rmUYM

        When fiat currencies fail (which they always do), people return to what the market demands.

        The market demands money have inherent value.

        The market demands gold.

        • KP says:

          Inherent value?

          Nothing has inherent value.

          So Zimbabwe is an example of a free market? Really?

          • Michael Suede says:

            Zimbabwe’s markets are an example of what happens:

            A. When a fiat currency fails

            B. when government enforcement of legal tender laws becomes moot.

            The purpose is to demonstrate that natural markets demand money have inherent value in and of itself.

            Since money is used to represent value, natural markets (anarchist) say it must inherently have that representative value.

            If one thinks about it, one will come to the realization that it is IMPOSSIBLE for money to naturally arise any other way. Money must originate in a commodity. It is only after pricing in this trade commodity for goods and services is established, that receipts for that commodity can be used to substitute trade of that actual commodity.

            In any other circumstance, violence must be used to force the currency on the markets.

        • Current says:

          In the Zimbabwe collapse many people shifted to using South African currency, not gold.

      • Michael Suede says:

        Oh by the way, since you brought up Somalia:

        http://english.aljazeera.net/news/africa/2007/03/2008525184610818999.html

        “Our money has been reduced to a commodity like rice and sugar which anyone can just print and bring into the market,” Abdikarim Fodere says. “The fake money has eaten into our economy.”

        They are transacting for the value of bulk paper and have been reduced to a state of barter.

        • KP says:

          “But despite this multitude of problems the Somali currency, oddly, survives and retains its service value.”

          • Michael Suede says:

            Yeah, it retains the value of bulk paper.

          • Michael Suede says:

            Oh yes, you may ask why the Somali’s choose to continue using bulk paper to transact with given its unwieldy properties.

            The reason is quite simple.

            There is a clear pricing structure already established for the cost of goods in terms of that paper.

            It takes a long time for a new commodity currency to make its way around in terms of pricing structures.

            Also, the Somali’s just don’t have enough gold/silver on hand to transact with. I can guarantee you though that someone wanted to barter in gold/silver with a Somali street vendor, they could do so right now.

          • KP says:

            Right, so Zimbabwe which just legalised the use of Hard currencies last year is proof that the market will naturally go flock to them, whereas Somalia which had about 10 years without a state doesn’t flock to hard currencies because they can’t re-structure their pricing.

  17. Michael Suede says:

    If anyone can tell me why violence should be necessary in a banking system, I’m all ears.

  18. Michael says:

    While I think I agree with you that the market would prefer 100% reserves, I believe you are missing your opponents arguement. Horwitz and other free banking people are not for the current, Fed controlled currencies; they just believe that a free market can and will contain a fractional reserve system of some kind, and that 100% reserves is not always in the market (i.e. people’s) best interest.

    That is the arguement (i think). Most libertarians (both free bankers and 100% reservers) are in favor of a non-violent banking system.

    • Michael says:

      I should add that most of the debate comes from whether or not fractional reserves are fraudulent or not. if fraudulent than fractional reserves would break the non aggression principle and some libertarians would say that means it isn’t truly “free.” The other side argues that to stop fractional reserve banking by force is in itself a violent aggressive act, making the market coerced.

      To be honest its a pretty good debate, one I am always on the fence about. I think that in a stateless society where property enforcement was the highest priority, we would have less “depositors” and more “lenders.” that is to say, when you “deposit” your money as you do now, you are actually investing it in the bank with the intent on drawing from the investment in the future (with a check card or something). It would be similar to now, only the “depositors” would have to share risk and liability in their investments; i.e. their would be no deposit insurance.

      • Michael Suede says:

        Free markets punish banks that engage in excessive receipt printing.

        I say “receipt printing” in terms of their gold holdings.

        If the customer base suspects the bank will not be able to pay in specie for the receipts, they will make a run on the bank and shut it down.

        Give this fact, whether or not it is fraudulent is moot.

        The market doesn’t like it.

        The market also doesn’t like fiat currencies since they require violence to enforce, so we can rule those out from the start.

        • KP says:

          That means that the market doesn’t like *all contracts* as well as there is always the possibility that one party may not be able to fulfill their obligations.

          • Michael Suede says:

            I’m not sure what you mean.

            I suppose we could say the market doesn’t like fraudulent contracts.

            If the bank issues a receipt worth 1/20th an oz of gold (money), yet the bank does not have the ability to make good on that receipt, we can say the bank has engaged in fraud.

            Fraud is a legal concept, one that I feel does not require laws to punish.

            In this instance, the market will punish the bank for its fraud when the customers realize the bank can not pay in specie for all of the outstanding receipts.

            At this point the customers will make a run on the bank and shut it down, as punishment for its fraud.

            Government intervention and laws are not required to regulate this.

          • KP says:

            If the bank issues a receipt worth 1/20th an oz of gold (money), yet the bank does not have the ability to make good on that receipt, we can say the bank has engaged in fraud.

            That depends entirely on the contract, as failure to pay doesn’t mean fraud. Otherwise, all contracts are fraudulent, as that possibility is always there. An insurance agency cannot possibly pay all of the claims (or even a small portion) if there was disaster. So obviously, the market hates insurance. You can go further, I’m only payed at the end of the week, its very possible come Friday, my employer won’t have the money on hand. So obviously the market doesn’t like work.

        • Current says:

          > If the customer base suspects the bank will
          > not be able to pay in specie for the receipts,
          > they will make a run on the bank and shut it
          > down.

          Just to follow on from KP’s comments (which I agree with entirely)…

          Because a bank doesn’t have enough specie to pay all it’s customers if they run doesn’t mean that a bank can’t operate. It can because it’s customers won’t run unless they have a reason to do so.

          It can operate on a fractional reserve as long as that reserve is big enough to meet the steady stream of redemptions. It must be solvent overall however, otherwise it’s customers certainly will run.

          • Michael Suede says:

            “Because a bank doesn’t have enough specie to pay all it’s customers if they run doesn’t mean that a bank can’t operate.”

            That’s exactly what it means in a hard money system.

            It means the bank must liquidate assets immediately to purchase gold on the open market in order to fulfill its obligations.

            While the bank may be able to survive this if they were short just a small amount, if they owed a substantial amount, they would have keep liquidating assets until there was nothing left.

            This isn’t something that is debatable.

            This is something we can see historically happened all the time for the exact reasons I described.

            If I thought there was a chance a bank wouldn’t be able to pay me my gold back, I’d freaking have it out of there in two seconds flat.

          • Current says:

            > That’s exactly what it means in a hard
            > money system.

            If by “a hard money system” you mean a system where fractional reserve banking is banned, then I agree with you. But it doesn’t mean that in a free market banking system.

            > If I thought there was a chance a
            > bank wouldn’t be able to pay me
            > my gold back, I’d freaking have it
            > out of there in two seconds flat.

            Well, of course there is always that chance, even with a 100% reserve bank.

            As others have said, historically when there has been free-banking fractional-reserves have prevailed.

            Consider what your saying about runs. Ask yourself *why* customers should run? If their banknotes serve the purpose of money, then why redeem them.

            The answer is: if there is fear that the bank is insolvent or illiquid or will soon become so.

            You may say “there is always a non-zero risk of that”. Certainly there is but FRBs compensate for that by offering free banking services, so the use-value of a bank account is higher than the same quantity of specie.

            So, how can a bank become illiquid or insolvent? There are two principle ways. If they make bad loans then they become insolvent. If they don’t hold enough reserves against regular redemptions they may be unable to make them. However, “enough” isn’t 100% because the pattern of regular redemptions isn’t unpredictable.

            Incidentally, Mises agrees with me here, see “The Theory of Money and Credit”.

  19. fundamentalist says:

    Alasdair Macleod, If you want further reading on the subject, check out Hayek’s “Monetar Theory and the Trade Cycle” and De Soto’s book on banking and money, both available in pdf in the literture section of the mises.org web site. Also, consider that the total amount of money credited to bank accounts in the US is about 30 times the total amount of paper money. There was some major credit creation going on to get that ratio. And credit is quasi-money because it spends just like paper money or gold and has the same effect.

    Personally, I find the debate about the ethics of frb a little boring. Scholars and religious leaders have debated it for centuries with good, honest men on both sides. Only one country in the history of mankind managed to achieve 100% reserves in banking, the Dutch Republic, and that lasted only about a century. Like Hayek, I don’t believe it’s even possible to get rid of frb. And as De Soto noted in his book, other companies, such as life insurance, do exactly the same thing as frb. In fact, I have read of credit bubbles in the 1700’s caused by bills of exchange that had nothing to do with banking. You might as well try to stamp out protistution and gambling. Maybe those repulsed by the idea of frb should learn a lesson from Baptist failures at both. You can preach agin it and warn people of the evil, but you’ll never stamp it out. If it became illegal, it would merely pop up in the black market.

  20. Michael Suede says:

    @ KP, there is a distinct difference between saying “This receipt can be exchanged for gold” which one does not have and a loan contract.

    In a loan contract, the borrower must put up collateral for the loan, typically for the full value of the loan itself.

    Thus, if he fails to pay, there is no fraud.

    The lender takes the collateral.

    While the lender may not want the collateral, this is a risk in lending.

    This is wildly different than printing fraudulent receipts, which is the same as cashing bad checks.

    • Current says:

      Loans need not involve collateral. Unsecured loans are quite possible.

      A banknote is only a fraudulent receipt if it claims to be a receipt. If it doesn’t claim to be one then clearly it isn’t necessarily fraudulent.

      • Michael Suede says:

        I never said bank notes were fraudulent, I said a bank note is fraudulent when it can not be redeemed for the specie the bank says its good for.

        As for unsecured loans, the amounts lent on unsecured loans are negligible and subject to high interest rates.

        Further, in the event of a bankruptcy, while the bank may not have claim to a collateral asset, they do still have claim to any excess assets through the courts.

        Lending also involves risk along with profit, this is not the same as receipt for a hard good. The lender is engaging in this activity fully knowing there is risk involved.

        Thus it is ridiculous to say loans are in any way related to a situation where the bank can’t make good on its deposit receipts in terms of fraudulent activities.

        • Current says:

          > Thus it is ridiculous to say loans are in any
          > way related to a situation where the bank
          > can’t make good on its deposit receipts in
          > terms of fraudulent activities.

          As others have pointed out, a banknote is a loan to the bank, that’s how loans are related.

          A banknote isn’t a deposit receipt.

          • Michael Suede says:

            Then why are you commenting?

            I’m talking about how the market perceives fractional reserve banking in a gold system.

            Have I not been clear or did you miss a post I wrote or something?

          • Current says:

            What you’ve said doesn’t relate to how the market perceives fractional reserve banking in a gold system.

            In all actually existing gold standards fractional reserves have been used. They have been driven out of existence as Rothbardians claim they would be.

            In the most free market situations that we know of fractional reserves were the system of banking used.

    • KP says:

      “@ KP, there is a distinct difference between saying “This receipt can be exchanged for gold” which one does not have and a loan contract.”

      Again, its no different (with respect to uncertainty) than insurance. A life insurance agency cannot possibly pay all the claims if, say, a freak accident occurs, nor do you put up collateral. Liabilities are greater than assets. The only way it constitutes fraud is if the bank knowingly misrepresents what they expect to have when your option is due, since people generally don’t have a specific date to die or have an accident, its at least less fraudulent then insurance. However, failure to pay itself doesn’t constitute fraud, its a breach of contract.

      • Michael Suede says:

        I don’t really care what you want to call it.

        If you want to call that fraud, go ahead and call that fraud.

        Ultimately I don’t really care how you define fraud, because as I said earlier, I don’t think the term has any meaning at all and it shouldn’t be punished by the courts.

        The market tells us what is fraud and what is not fraud.

        If a bank starts lending out receipts for specie it doesn’t have and its customer base finds out about it, they will yank their gold out, most likely resulting in the bankruptcy of the bank.

        From this we know the market does not like fractional reserve banking.

        Thus we can say fractional reserve banking is wrong.

        The market does not do this for insurance. The market says, I want to hedge my risk, so I will pay into a collective risk pool. This is not the same as a receipt for a hard good. The market knows that insurance companies have a limited pool of resources and the buyer of insurances hopes that the resource pool is enough to deal with any problems.

        People know this going into an insurance contract that the pool is limited to what is put into it. This is not true for a receipt of deposit.

        • KP says:

          You are the one calling it fraud, that is, if you were consistent.
          There isn’t any reason why the market is fine with assets exceeding liabilities in one field but not another. Its just foolish to assume that people completely understand the risks on one side but not another. Further, the fact that fractional reserve banking generates interest and is free (as opposed to full reserve) looks like a good indicator as to whether people will choose it or not. And again, a bank note is not a deposit receipt so your attacking a straw-man.

          • Michael Suede says:

            You are the one creating straw-mans and transposing my arguments.

            Banknotes represent a promise by the bank to pay on demand.

            In a hard money system, banknotes represent a promise to pay specie on demand, ie. the real money you left with the bank for safe keeping.

            What is foolish or not is for the market to decide and the market is clear on this. When banks issue more receipts than they can make good on, people will run to withdraw their gold.

            So you can argue in favor of fractional reserve banking all day long, but in an unregulated market, the public will prevent it.

          • KP says:

            “Banknotes represent a promise by the bank to pay on demand.

            In a hard money system, banknotes represent a promise to pay specie on demand, ie. the real money you left with the bank for safe keeping.”

            And In a free market they represent a loan to the bank, with the bank promising to pay by the date stated in the option clause. I don’t know what this “hard money” system you keep mentioning is, if it simply means a system where fractional reserve banking is outlawed then you may be right, but that certainly isn’t a free market.

            “What is foolish or not is for the market to decide and the market is clear on this. When banks issue more receipts than they can make good on, people will run to withdraw their gold.”

            Good thing they aren’t issuing receipts! Problem solved.

            “So you can argue in favor of fractional reserve banking all day long, but in an unregulated market, the public will prevent it.”

            Perhaps, but to come to that conclusion you’d really have to completely ignore history .

  21. TGGP says:

    If they can’t actually create new money, how do they increase M in response to a drop in V?

  22. Current says:

    I don’t think there is really anything strange about what Bob Murphy describes.

    Let’s say we have free banking using gold. I start up a bank and I’ve got *no gold whatsover*. I then print some banknotes which are debts to me. I then offer to lend people money and take in deposits. This is all perfectly legal, but I don’t think I’d get many customers since anyone who examines my books would see the ridiculousness of my enterprise.

    Part of the problem with all this is the “money multiplier” theory. I think that theory is approximately correct, but not a full representation of what’s going on.

    I think what really happens is something like this, at least for a free bank. A bank has a big pool of liabilities from on-demand accounts, a constantly shifting one. It also has a big pool of assets and some reserves. What the bank must do is to ensure it remains solvent and has enough reserves to deal with redemptions. To deal with redemptions it must examine it’s how the customers of it’s on-demand accounts are using them. If it can tell how often they redeem and predict it then it can accurately size it’s reserves.

    Bob thinks that “wierd” situations occur if the bank knows the customer won’t withdraw. I don’t agree. Let’s say we have free banking with gold. Tim comes in with 10 ounces of gold. Does that cause the “money multiplier” to kick in and produce loads more money dependent on the reserve ratio. I don’t really think so. What’s happened here is that Tim has given the bank an asset that it can use as reserves and that allow it to serve more customers, an asset worth slightly more to the bank than to Tim. The issue here is that a free bank would have to find good credit risks in order to expand using this specie. All it’s gained here is some specie at a reasonable price, it could have bought some instead. Under free-banking the ratio of specie/other assets would be determined by the needs of redemption. What would determine the amount of liabilities a bank has would be the amount of gold and good assets it could obtain. The division of those liabilities between timed and on-demand would depend on customer demand and how much benefit the bank gets from redemptions through selling timed debt. There wouldn’t be a “money multiplier”.

    The “money multiplier” we are used to only comes about when the central bank and deposit insurers make finding good-enough creditors extremely easy. Once that happens the central bank must regulate the commercial banks using a required reserve.

  23. Current says:

    Just a little bit more about the money multiplier…

    In the normal explanation the money multiplier is supposedly tied up with loans. I don’t believe that it is directly.

    Consider the position of foobank, which operates within a central banking system. Foobank is running it’s minimum required reserve fractional. Then, Mary comes in wanting a mortgage. Mary’s credit is good so foobank want to give her a mortgage. But, since they’re reserves are tapped out what can they do? Well, they could borrow more reserves. But, they could also fund Mary’s mortgage through timed debt such as bonds. They could just borrow the reserves temporarily until they were withdrawn, then afterwards fund the loan through timed-debts such as bonds.

    So, the maximum amount of money-substitutes there could be is determined by the amount of bank assets. However that only defines the “ceiling”. Banks may fund some of their assets using timed-debt, it’s their decision how much. What injections of reserves do (in a central banking system) is allow banks the option of using more on-demand account liabilities and fewer timed-debts.

  24. Giedrius says:

    There is a fundamental difference between warehouse receipt and loan contract, which is erased in FRB with legal tender money.

    If you put money (let’s say gold) in a warehouse, you’d get a warehouse receipt, which can be exchanged into goods as if it is gold itself, i.e. at the face value (if warehouse is known as trustworthy), so warehouse receipt is the same as money. But if you lend money to someone, you get a loan contract, which can be traded for money of course, but not at the face value, so it’s not money.

    In FRB banks take your money as if they were warehouse (you, supposedly, can take your money back anytime), but in reality they act as if they took a loan from you and with the help of the government’s guns force people to treat those loan contracts equivalent to money, what is of course a fraud backed up by physical force.

    P.S. Sorry for my pour English, I hope you can understand what I mean.

    • Current says:

      That’s mostly right.

      Under most central banking system the central bank also runs and guarantees the inter-bank clearing system.

      Bank account money-substitutes are not legal tender, but through this action they are made equivalent to legal tender.

    • Michael Suede says:

      someone here finally gets it.

  25. Michael Suede says:

    @ Current
    “What you’ve said doesn’t relate to how the market perceives fractional reserve banking in a gold system.
    In all actually existing gold standards fractional reserves have been used. They have been driven out of existence as Rothbardians claim they would be.
    In the most free market situations that we know of fractional reserves were the system of banking used.”

    I beg to differ.

    What I’ve said directly relates to fractional reserve banking in a gold system.

    When the bank issues more receipts for gold than they can make good on, the public will run to withdraw their gold.

    Claiming otherwise is preposterous.

    People even do that in a purely fiat system if there was no tax payer backed insurance covering bank accounts.

    Fractional reserve banking is the most use because most bankers are a bunch of criminal scumbags. The fractional reserve system had its roots in safe deposit vaults. People would bring their gold to a vault owner for safekeeping and the vault owner would then issue a receipt for the gold.

    People started to use the receipts for this gold as money.

    The vault owners figured out that they could make even more money by lending instead of just charging to hold the gold for safe keeping. To do this, they started printing receipts for gold they didn’t have to cover the loans they were lending out.

    Hence, fractional reserve gold backed banking was born.

    When the customers eventually found out that the vault operator turned banker couldn’t cover all of his outstanding receipts for gold, they would engage in what we call bank runs. They wanted to be the first to get their gold out because they knew the last guy in line wasn’t going to get paid.

    Hence,we can say the market does not like fractional reserve banking and will shut it down if the fraud is discovered.

    • Doc Merlin says:

      People like fraction reserve, so long as there is no fear of a liquidity crisis. Once liquidity problems come into being, the system crashes.

      Anyway, I do suggest you read White’s book.

      And here is a podcast interview of his.
      http://www.econtalk.org/archives/2010/02/larry_white_on.html

    • Current says:

      > When the bank issues more receipts for gold than they can
      > make good on, the public will run to withdraw their gold.

      Not necessarily. What is important is if the bank can cover it’s obligations and continue providing services to the public. This is what Mises writes in “The Theory of Money and Credit”.

      A bank run occurs generally when a bank is *insolvent*, that is when it’s assets are worth less than it’s liabilities. It could also happen that a bank underestimates demands for redemption, but this hasn’t happened often historically speaking.

      When the bank is operating normally the customer has no reason to redeem because the banks money-substitutes are accepted in lieu of specie. A bank run begins if that situation comes under threat.

      > The vault owners figured out that they could make even
      > more money by lending instead of just charging to hold
      > the gold for safe keeping. To do this, they started printing
      > receipts for gold they didn’t have to cover the loans they
      > were lending out.

      This was sometimes done dishonestly. However, it was also commonly done *with the customers knowledge*.

      > When the customers eventually found out that the vault
      > operator turned banker couldn’t cover all of his
      > outstanding receipts for gold, they would engage in what
      > we call bank runs. They wanted to be the first to get their
      > gold out because they knew the last guy in line wasn’t
      > going to get paid.

      Certainly, if every customer of bank X went to withdraw at the same time then that bank couldn’t pay them specie (it could possibly pay them in assets). However, that doesn’t mean that fractional reserve banks would be run out of business in a free market. Because, what’s needed is a first cause for why a large number of customers would run.

      • Michael Suede says:

        I would argue that they would be driven out of the market rather quickly if customers felt they would not be able to get their money (the real money, gold) back from the bank.

        It is illogical to conclude otherwise.

        History shows us people will act rationally and remove their gold from the bank if they feel the bank is not able to cover all of its receipts with physical gold under a gold system.

        The only time this does not occur is when violence is used to implement a system of moral hazard, such as our modern day FDIC, that promises to cover the shortages of the banks holdings by assaulting innocent civilians and robbing them of their labor/resources.

        When banks are operated in a truly free market, people naturally reject fiat currency (which is why we have a system of violence that enforces legal tender laws at gun point today). Because fractional reserve banking inherently creates fiat receipts, the market will ultimately shut down those banks that can not deliver on the receipts issued.

        If you want to argue otherwise, I assume you must be against legal tender laws, since you consider fiat money to be just as good as gold right?

        Of course, we know its not as good as gold, its only as good as the bank’s investment manager.

        • Current says:

          > I would argue that they would be driven out of the market
          > rather quickly if customers felt they would not be able to
          > get their money (the real money, gold) back from the bank.
          >
          > It is illogical to conclude otherwise.

          Certainly, if customers don’t think they will get their money back then they won’t invest. But, that doesn’t mean that banks need 100% reserves in order for customers to be assured that they will get their money back.

          > History shows us people will act rationally and remove
          > their gold from the bank if they feel the bank is not able
          > to cover all of its receipts with physical gold under a
          > gold system.

          No it doesn’t. History tells quite a different story, it shows that customers were willing to accept fractional reserves.

          Read about the Scottish period of Free-banking,

          > The only time this does not occur is when violence is
          > used to implement a system of moral hazard, such
          > as our modern day FDIC, that promises to cover the
          > shortages of the banks holdings by assaulting innocent
          > civilians and robbing them of their labor/resources.

          Not true. There have been many historical instances where fractional reserves were accepted without such gaurantees.

          > When banks are operated in a truly free market, people
          > naturally reject fiat currency (which is why we have a
          > system of violence that enforces legal tender laws at
          > gun point today)

          I agree with you there.

          > Because fractional reserve banking inherently creates
          > fiat receipts, the market will ultimately shut down those
          > banks that can not deliver on the receipts issued.

          No. Fractional reserve notes are not fiat notes. Fiat notes cannot be converted fractional reserve notes can be.

          > Of course, we know its not as good as gold, its only as
          > good as the bank’s investment manager.

          If the bank’s investment manager screws up and the bank’s assets become worth less than it’s liabilities then one way or another the bank will go bankrupt.

          But, that doesn’t mean that a fractional-reserve money substitute is inferior to gold. If it were people wouldn’t accept them.

          Because FRB is based on investment a bank can use a portion of it’s investment profits to fund services for money-substitute holders. The small extra risk that the bank customer takes can be compensated for by the services the bank provides.

          I used to think all these things that you’ve written here, but I read about the subject more. You have to look at Rothbard’s stuff critically. But, once you understand the points the free-banking school make you’ll see they make sense.

  26. Gene Callahan says:

    “Before I tackle that issue directly, let me first say this: How can it be OK for the entire banking system to do it, if we don’t think it’s OK for an individual bank to do it?”

    Wow, Bob, you never got what Steve was saying at all, did you? He was specifically trying to illustrate why these things are very different.

  27. Gene Callahan says:

    “History shows us people will act rationally and remove their gold from the bank if they feel the bank is not able to cover all of its receipts with physical gold under a gold system.”

    Of course, there is not actual history that shows this — it is the made up history in Michael’s head that shows it!

  28. http://webdesign-boston.com/ says:

    “Affordable Webdesign Doesn’t Mean Compromise”…

    THE BEST SERVICE EVER AND MY SITE DIDN’T COST ME A FORTUNE….

  29. http://webdesign-boston.com/ says:

    #1 Webdesign Team in the U.S.A…

    No job is too small or big for this webdesign team!…

  30. REVIEW IT BEFORE YOU BUY IT!!! says:

    MOST INFORMATIVE SITE FOR ELECTRONICS….

    #1 SITE FOR THE LATEST REVIEWS ON THE HOTTEST TECHNOLOGY HITTING THE MAINSTREAM!…